FINANCIAL ACCOUNTING

Financial accounting is confined to the preparation of the financial statements for the use
of outsiders (external decision makers).
The chief purpose of the financial accounting is to calculate profit and loss made by the
business and to exhibit (show) the financial position of the business as on a particular
date.

CONVENTIONS/PRINCIPLES OF
ACCOUNTING
Accounting convention refers to the common practices which are universally followed in
recording and presenting accounting information of the business institute.
It helps in comparing accounting data of different business units or of the same unit for
different periods.
There are four conventions of accounting.
1. Convention of consistency 2. Convention of disclosure
3. Convention of materiality 4. Convention of conservatism

Convention of consistency
It means that accounting practices should remain unchanged for one period to another. A
meaningful conclusion can be drawn from the financial statement of the same enterprise
when there is a comparison between them over a period of time but this can be possible
only when accounting policy and practices followed by the enterprise are uniform and
constitute over a period of time. If different procedures and practices are used for
preparing financial statements of different years, then the result will not be compared.
However, consistency doesn’t mean inflexibility if a change becomes necessary, then the
change and its effect should be stated clearly.

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Convention of disclosure
Convention of disclosure requires that all the material and relevant facts about the
financial statement should e fully disclosed. Full disclosure means that there should be
full fair and adequate disclosure of the accounting information to the reader.
• Adequate means sufficient set of information to be disclosed.
• Fair indicates an eligible treatment of the users.
• Full refers to the complete and detailed presentation of the information.

Convention of materiality
It means that. To make financial statements meaning full, important and relevant
information should be supplied to the user of the accounting information. Materiality of
the effect depends on its nature and the amount involved.
• Material facts mean the information which will influence the decisions of its
users.

Convention of conservatism
This convention is based on the principal that “anticipate no profit but provide for all the
possible losses”. It is based on the policy of playing safe in regards to showing profit.
Main objective of this convention is to show minimum profit. Profit shouldn’t be
overstated. If profit shows more than actual it may cause distribution of dividend out of
the capital. Profit should not be recorded until it is realized/received. But if the business
anticipates any loss in the near future provision should be made in the book of accounts.

LIABILITIES
1. Current/short term liabilities 2. Fixed/Long term liabilities

Current liabilities
Those liabilities which are to be paid by the business within one accounting period are
called current liabilities.

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Current liabilities include.
NOTES PAYABLE:
Notes payable is the promise made in writing by the firm to make payment of a specified
sum to creditors at some specified date.
Notes payable is written by creditors over the firm and become payable once they are
accepted by the firm.
ACCOUNTS PAYABLE:
An oral agreement between the firm and the creditor, in which the firm promises to pay a
specific amount at specific future date. For example, purchase of goods or services on
credit.
ACCRUED EXPENSES:
An expense which is incurred but not yet paid by the firm is called an accrued expense.
For example: utility bills, wages etc.
UNEARNED REVENUE:
Payment received before a product is sold or service is provided is called unearned
revenue. Unearned revenue is recognized as current liability in the balance sheet until it is
recognized as revenue earned by the business.
PAYROLL LIABILITIES:
Amount paid to the employee for a service provided during a certain period of time is
called liability. Payroll liability tracks taxes that are deduced from the employee. Pay
cheques hold temporary until handed over to the government. For example wages,
salaries, medical and travel allowances etc.
DIVIDEND PAYABLE:
That portion of the profit which is distributed among the share holders is called dividend
payable. Declaration of dividend reduces retained earning creates current liabilities.

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 AMORTIZATION
The gradual repayment of the loan through a fixed number or fixed amount by monthly
installments, while the amount of installment is same every month; however it is
apportioned unequally between interest and principal amount. The amount payment must
be sufficient to cover both interest and principal amount.
• Amortization is gradual repayment of loan in monthly installment of interest and
principal amount.

BOND
A debt instrument yielding a fixed rate of interest, returned in a certain period of time and
repayment of principle amount at maturity.

• Bonds are issued by the company.

• Bond holder is the creditor to the company.
• Bonds can be resold.

Types of bonds

1. Secured bond
2. Unsecured bond
3. Callable bond
4. Convertible bond
5. Junk bond

Secured bond/mortgage bond

Bond secured by the pledge of a specific asset is called a secured bond.
It is also called a collateral bond. Collateral means “a guarantee of repayment of principle
and interest”.

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Unsecured bond/debencher
This type of bond has no guarantee for repayment and is issued solely on trust. It is issued
against the general credit of the borrower. It also has a higher rate of interest than the
secured bond.

Callable bond
In callable bond the corporation has the right to redeem the bond in advance of the
maturity date at a call price which is higher than the face value. These bonds can be
repurchased before the maturity date at a call price (higher than the face value).

Convertible bond
Bond that can be exchanged for a fixed number of shares in the company’s common
stock, at the option of the bond holder is called a convertible bond. After the conversion
of the bond the bond holder becomes a share holder of the company.

• The bond can only be converted in a fixed time period after being issued.
• Bond to share ratio is decided by the company according to the face value of the
bond.

Junk bond
Bond with a higher risk of default and a higher expected return is called junk bond.

Here,
Risk α return
These types of bonds are issued by fresh companies.

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 SHARES AND STOCK
Share
The capital of the company is divided into a number of transferable units. Each unit is
called share. The profit on the share is called dividend. Shares certificate of ownership.
OR
A certificate of ownership in the company is called share. A person who owns a share is
called a share holder.

Stock
A collection of share is called stock. A person who owns many shares or stock is called a
stock holder.

Types of stocks
Common Stock
• Type of security that serves as an evidence of proportionate ownership, imparts
proportionate voting rights and gives its holder unlimited claim on the assets and
income of business is called a common stock.
• Common stock constitutes the equity capital of the firm which is never paid back
and is lost if the firm fails.
• Common stock has par value but has no value afterwards.
• In bed years (years of financial crisis) common stock holders may receive little or
no income but in good years there is no limit to the amount they receive except
the limit imposed by the government or the financial position of the firm.
• Common stock holders elect directors of the firm and thus participate in
determining its policies and direction but their claim on the firm assets are
subordinate (secondary) to the bond holders, creditors, debencher holders and
preferred stock holders.

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 • On the winding up of the firm the surplus assets over liabilities is divided among
common stock holders in proportion to their stock holding.

Common Stock (Summary)

• Real owners.
• Right to receive dividends.
• Voting rights.
• Pay interest to creditors (1).
• Pay dividend to preferred stock holders (2).
• Pay dividend to common stock holders (3).
• In case of winding up of the company the same order as above is followed.

Characteristics of Common Stock

1. Voting Rights 2. Right to receive dividend
3. Merger Condition 4. Liquidation or Dissolution

VOTING RIGHTS:
Common stock holders have the right to vote on issues affecting the corporation.
Normally each share represents one vote. Typical voting issues include the election of
board of directors, approval of merger with other corporations and the corporate
takeovers. Voting is done at the corporation’s annual meeting but can also occur at the
special meeting determined by the corporation’s directors through mail or through proxy.

RIGHT TO RECEIVE DIVIDEND:

Common stock holders have the right to receive dividend. When announced by the
corporation’s board of directors. There is no fixed schedule for the payment of the
dividend. Dividend may be periodically increased, decreased or discontinued depending

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 upon the financial success. Normally dividends are paid in cash but can also be paid in
the form of additional shares of stock.

MERGER CONSIDRATION:
When the corporate merger is approved by the share holders. They have the right to
receive financial consideration for their shares. Normally they will receive a cash
payment for the shares or in an acquisition of the corporation by another company. They
may purchase share in the acquiring company in exchange for the shares they currently
own.

LIQUIDATION OR DISSOLUTION:
In the event that a corporation is liquidated, its common share holders will have the final
claim on its assets that is the claim is secondary to the claim of the creditors, bond
holders and preferred stock holders. Once these stakes holder have been paid any amount
remaining from the liquidation of the company. Any corporate assets will e distributed
among the common stock holders.

Preferred Stock
It has some special preferences.
• Preferred in distribution of dividend.
• Preferred in distribution of assets in case of winding up the company.

Types of preferred Stock

1. Cumulative preferred stock 2. Non-cumulative preferred stock
3. Callable preferred stock 4. Convertible preferred stock

1. CUMMULATIVE PREFERRED STOCK:

This type of stock holders are paid dividend of current year as well the arrears of previous
years in which the dividend was not paid.

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2. NON-CUMMULATIVE PREFERRED STOCK:
In this type of preferred stock the stock holder are the only paid the dividend of the
current year.
3. CALLABLE PREFERRED STOCK:
Those shares which can be repurchased by the issuing corporation at a call price and the
call price is higher then the par value.
4. COVERTIBLE PREFERRED STOCK:
Those shares which can be converted into a specific number of common shares at the
option of the share holders.

CAPITAL
Amount of money invested by the owner in the business.

Authorized share capital or Registered capital

It is the amount of money with which the company is registered.
OR
The total amount of shares, which the company is authorized to issue to the public.

Issued capital
Issued capital is that portion of the registered capital which has been issued to the public
for subscription.

Paid-in capital
It is the amount contributed by the investors in exchange of capital stock at par value.
OR
The amount which we get by the sale of issued capital or issued shares.

Additional Paid-in capital

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It is the amount contributed by the investor in exchange of capital stock in exchange of
par.

VARIOUS DEFINATIONS

Average price / share

When we add the total par value of the issued shares with the additional paid in and
divide it by the number of issued shares.
Average price / share =
Total par value + additional paid in
No of issued share

Net Income
Total income of the company excluding taxes, dividend, wages etc is called net income.

Call option in a share

It is the option in which the company wants to take back the shares from you. Company
purchases them from you at a price higher then the par value.

Retained Earning
Profit which is not distributed as dividend among the share holders is called retained
earning. But is either reinvested in the business or kept as a reserve for the specific
objective.
(If the board of directors do not announce the dividend in a specific year then all the
income of that year becomes retained earning.)

Outstanding shares
The total numbers of shares which are in the hands of the share holders or which are
actually purchased by the share holders are called outstanding shares. These are floated in
the market.

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Donated Capital
Funds or property given as a gift to a corporation is called donated capital. The donation
may be from an individual or organization which is not affiliated with the corporation.

Stock Split
An increase in the number of outstanding shares with a decrease in its par value / market
value is called stock split. Its purpose is to decrease the market price to make it affordable
to the investors.

Treasury Stock
Shares of a corporation's stock that have been issued and the reacquired but not cancelled
are called treasury stock.
Its purpose is to:
• Reissue for better price.
• Reduce the number of outstanding share and increase par share earning.

Cash flow statement

A financial statement which shows sources of cash flow, in and out of the business. It has
3 parts.
• Cash flow of operating activities. (day to day activates of business)
• Cash flow of investing activities. (spending money to make more money)
• Cash flow of financing activities. (arrangement of money)

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