Mechanics of Financial Accounting

Prof. M S Narasimhan
Fundamental Accounting Terms

Our Accounting equation has five terms. They are fundamental accounting terms. We need to
understand these terms bit more than what they normally convey.

Our first accounting term is asset. Assets are economic resources that are capable of generating a
stream of future revenues. Examples of assets include plant and machinery, furniture, raw material,
investments (in bonds and equity shares), cash, and many other things. Assets are normally tangible,
but there are exceptions. Technical know-how, patent, trademark are also assets. They are
intangible assets. They also play a role in generating future revenue. Assets that appear in the
financial statements are normally owned by the company. Here, also, there are exceptions. Suppose
you acquire an asset through a long-term lease; you are not the owner of the asset legally during this
lease period. Today, accounting regulations require you to treat these assets are also as asset. Some
large expenditure, whose benefit is likely to be realised in future is also treated as asset. Examples of
such assets are major expenditure on information technology to develop a new software or business
restructuring expenses. These are few exceptions. Most items shown on the asset side are tangible
and owned by the company.

The next accounting term is liabilities. Liabilities are financial obligations of the firm to outsiders.
There is no need for company to have liabilities. Many organizations, like Infosys, are debt free. They
are also many others who borrow heavily. Many companies acquire resources through loans or on
credit. Bank loan is something very common in most companies. Similarly, materials are acquired
through credit purchases. There are several reasons for the companies to acquire resources on
credit terms. It may not be possible to raise equity always. Equity finance is also costlier than other
source of finance. You may disagree and argue equity has no cost. We will discuss this part
later. When you borrow money or buy a material on credit, you know how much to pay. In few
cases, we need to estimate the liabilities. Take an example like retirement benefit. It is paid at the
time of retirement, but the liability accrues every year when an employee completes the service of
that year. Accounting requires you to estimate future retirement payment and show this as a
liability. Liabilities are of several types. Some of them are long term and others are short term. Those
that are to be discharged beyond one-year period are classified as long term. Liabilities which are to
be paid within one year are classified as a short-term liability.

Our third accounting term is equity. Equity represents owners' wealth. In the company form of
organisations, owners are called shareholders. Shareholders bring equity share capital when they
start the business and periodically when required. Every year, they contribute fresh capital in the
form of allowing the management to retain a part of the profit available to them. Such retained
profit is called retained earnings or reserves and surplus. Equity or shareholders' wealth or
shareholders' fund can be defined as owners' claim against or interest in the company. Naturally,
they can claim the assets only after discharging all liabilities, including estimated liabilities. We can
rearrange our accounting equation to show shareholders equity is equal to assets less liabilities.

Our fourth accounting term is revenue. Revenues are income generated when a firm sells goods or
services. Revenue increases the shareholders' wealth. Revenue need not be realised in the form of
cash immediately. Accounting transactions are recorded or recognised on accrual basis. Recognising
revenue is one of the challenging task for accounting managers in certain cases. For instance, a

All Rights Reserved. This document has been authored by Prof. M S Narasimhan and is permitted for use only within the course
Accounting for Decision Making delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means electronic,
mechanical, photocopying, recording or otherwise without the prior permission of the author.
 Mechanics of Financial Accounting
Prof. M S Narasimhan
Fundamental Accounting Terms

software company undertaking a large project running for three years or a construction company
building an irrigation dam or a power project. These are special cases. Accounting standards helps
the accountant to recognise some reasonable value as a revenue based on the amount of work
completed.

Our last accounting term is expenses. Expenses are incurred in the process of generating
revenue. Expenses are incurred for manufacturing, selling, general administrative purpose.
Manufacturing expenses are incurred to produce the goods. Assets when used become expense.
One good example is depreciation. As and when assets are used, the company charges depreciation
based on the usage of asset. It reduces owners' wealth.

All Rights Reserved. This document has been authored by Prof. M S Narasimhan and is permitted for use only within the course
Accounting for Decision Making delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data,
illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means electronic,
mechanical, photocopying, recording or otherwise without the prior permission of the author.