What is Accounting?

Accounting is a language. The purpose of any language is to convey information. Thus, in simple terms,
Accounting is the language of business, which conveys financial information.
If we look at accounting from a different perspective, it is also an art of recording, classifying,
summarizing transactions and events that are of a financial nature in a meaningful way, and then
analyzing and interpreting the results.
The results of such analysis must be communicated to various groups that are, directly or indirectly,
concerned with the business.

Accounting Terminology Event

An event refers to an occurrence or happening, which may or may not have financial effects. An event
with financial effects triggers the accounting process.
Two examples of events are: The Olympic Games
A rock concert
The buying and selling of tickets for such events will have a financial effect (as cash is changing hands)
and will alter the financial position of the organization.

Transaction
Transaction refers to an economic activity or a financial event that affects the financial position
and/or earnings of a business.
For example, buying and selling tickets for a rock concert is a transaction. In this situation, cash changes
hands and will thus affect the financial position of the organization arranging the rock concert.
Accounting Period
Accounting period refers to the length of time covered by a financial statement. The length of time
can be a quarter covering three months, a calendar year, or a fiscal year. An income statement
reports the amount of net income over a period of time, which is called the accounting period. For
most entities, the official accounting period is one year. Accounting period could be a calendar year
(the year that ends on the last day of the calendar, which is December 31) or a fiscal year (starting
April 1 and ending on March 31 of the following year).
Revenue
Revenue refers to the increase in the Owner's Equity resulting from an organization's operating
activities over a period of time, usually from the sale of goods or rendering services.
Expense
An expense refers to the cost of the use of products or services for generating revenue. These costs are
incurred during the production and sale of the goods and services that produce the revenue. An
example is payment of salaries.
Capital Receipts
Capital receipts refer to the increase in the Owner's Equity resulting from an organization's operating
activities over a period of time, usually from the sale of goods or rendering services.
Revenue Receipts
Revenue receipts refer to all the recurring incomes that a business receives in the normal course of its
operations, mainly by the sale of goods and services. They do not create any interest income or liability
and comprise the sale proceeds of merchandise. All revenue receipts are treated as income.
Deferred Revenue Expenditure
Deferred revenue expenditure refers to the revenue expenditure that is spread over a number of
accounting years. Sometimes, the revenue expenditure may be unusually heavy and its benefit available
for more than a year. In this situation, it is better to spread the expenditure over a number of accounting
years. An example of such a situation is heavy advertising to introduce a new product or to explore a new
market. The advertising expenditure may not bring in immediate gains to the company. Hence, the entire
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expenditure is spread over a number of accounting years, so that it is not heavy in one particular year.
Assets
An item is considered as an asset, if the following conditions are met: It is owned or controlled by
the entity.
It must be valuable to the entity.
It must have been acquired at a measurable cost.
Thus, the term Asset refers to a resource legally owned or controlled by a firm and from which future
economic benefits are expected to flow to the enterprise.
Assets can be classified into Current Assets or Fixed Assets.

Current Assets
Current Assets are those assets of a business that are expected to be converted into cash, or used up in
the near future, usually within one year. An example is your bank balance.
Fixed Assets
Fixed Assets are those assets of a business that have been purchased for operating a business and are not
meant for resale or are expected to be useful for a longer period (usually more than one year). Examples
of Fixed Assets are equipment, machinery, and furniture.
Liabilities
The term Liability refers to a financial obligation or claims on the assets of an organization by an
outsider. Liability is debts owed, and can be classified into Long Term Liabilities and Current Liabilities.
Long Term Liabilities
Long Term Liabilities are those financial obligations that are payable after a long duration, generally
more than a year. An example of a Long Term Liability is a Bank Loan.
Current Liabilities
Current Liabilities are the obligations due within a short period of time, usually one year. An
example of a Current Liability is a bank overdraft.
Capital/Equity
The Equity section is often also termed as "Shareholders' Equity" or "Owners' Equity". Equity consists of
capital obtained from sources that are not classified as liabilities stated earlier.
There are two sources of Equity - Paid in Capital and Earnings.
Paid in Capital
Refers to an amount supplied by investors in the form of cash or assets. Capital is invested by the owner
and has money value. Capital is an owner's claim against the assets of an enterprise, since the owner is
assumed to be separate from the business. Examples of capital are as follows:
Share capital invested by the owner of an enterprise
Money rose from the public
Earnings
This is the income of the entity from operations that is retained by the organization for future use.
Expenditure
The term Expenditure refers to the payment of cash or incurrence of a liability from the purchase of
an asset or service whose benefit will be enjoyed over a number of accounting cycles. Expenditure
can be of two types: Capital Expenditure and Revenue Expenditure.
Capital Expenditure
Refers to the expenditure, the benefit of which is not fully consumed in one accounting period, but is
spread over several periods. This expenditure may or may not recur in the future. The amount spent in
erecting a cement plant is a Capital Expenditure since the benefit of such expenditure will be available
over a number of accounting cycles.
Revenue Expenditure
Refers to the expenditure incurred in one accounting period, the full benefit of which is consumed in the
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same period in which it has been incurred. Revenue Expenditure is normally of a recurring nature.
Revenue Expenditure neither increases the earning capacity of a business, nor does it bring into
existence an asset of an enduring nature.
Examples of Revenue Expenditure are as follows:
Expenses such as rent and salaries incurred in the day-to-day running of a business
Expenses incurred in the upkeep of Fixed Assets

Accounting Equation
The Accounting Equation forms the basis of all the calculations that are done in the accounting
process. Given below is the Accounting Equation:
CAPITAL + LIABILITIES = ASSETS

The Accounting Equation is based on the dual- aspect concept, which emphasizes that every business
transaction has a two-sided effect: one on the assets and the other on the claims on assets.
Accounting Concepts
Accounting principles are classified into two categories, Accounting Concepts and Accounting
Conventions.
Dual Aspect Concept Entity Concept

Cost Concept
Money Measurement Concept Matching Concept
Revenue Recognition Concept Going Concern Concept
Period Concept

Accounting Conventions
Convention of full disclosure
Convention of consistency
Convention of conservatism
Convention of materiality

Accounting Concepts
Accounting concepts are the necessary assumptions or conditions on which the principles of accounting
are based. They are the foundations of systematic and proper accounting. They form the necessary
condition or assumptions that should be followed while recording transactions. The eight Accounting
concepts generally followed are shown below.

Dual Aspect Concept

According to the Dual Aspect Concept, every transaction entered into by a firm or an institution will
have two aspects or a double effect. The Accounting Equation is based on this concept.
CAPITAL + LIABILITIES = ASSETS
Entity Concept

Cost Concept
The Cost Concept of Accounting focuses on the cost of Assets, rather than on the market value. It
emphasizes that the numbers report what the entity did pay for the Asset.
The reasons why accounting focuses on cost rather than on market values are:
Market values are estimates and hence subjective.
The Going Concern Concept makes it unnecessary to know the market value of many Assets. The
Assets will be used in future operations rather than sold immediately.
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Money Measurement Concept
According to this concept, only those transactions and events are recorded in the accounts of the
business that can be expressed in terms of money. In other words, an event will not be recorded unless
its monetary effect can be accurately measured.
The manager of Florida Furnishers delivers inventory in his personal car. His friends are also helping
him with the deliveries of the inventory. The manager sells inventory throughout March, and as a
result: Inventory worth $1,800 has been sold, that is, inventory worth $1,800 has been utilized
Cash worth $4,000 has been received by selling this inventory the basic measurement in
accounting is money. Money is the common denominator to express heterogeneous items of
business. The limitation of this concept is that it records only transactions, which are measured in
terms of money. Events and factors like working conditions, health, and quality are not recorded
due to any availability of their monetary value.
Matching Concept
Once revenues for an accounting period are recognized, expenses incurred in generating these revenues
are matched against them. This is called the Matching Concept of Accounting. This ensures that the sale
and cost of goods that appear in the Financial Statements refer to the same products. In other words:
Cost relates to goods and services that are delivered in the accounting period and whose revenues are
recognized in that period. Costs are associated with activities of the period.
Revenue Recognition Concept
The Revenue Recognition Concept stipulates that revenue is deemed to be earned only when it is
realized. This means that revenue is earned only when goods and services are delivered to the customer
and not when the contract is signed or goods are manufactured.
Revenue may be recognized before, during, or after the period in which the cash from the sale is
received. This concept is also known as Realization Concept as it describes when revenue is recognized.
Going Concern Concept
According to the Going Concern Concept, it is assumed that a business will continue its operations for an
indefinite period of time. There is no intention or willingness to liquidate the business immediately.
The Going Concern Concept also rests on the assumption that a business would continue its operations
over a long period of time. On this assumption, fixed assets are recorded at their original cost and
depreciated over a period of time in a systematic manner.
Period Concept
In order to ascertain the results of business operations and financial position of the firm periodically,
time is divided into segments referred to as Accounting Periods. Income is measured for these periods
and the financial position is assessed at the end of an Accounting Period. The Accounting Period can be a
calendar year (January to December) or a financial year (April to March).
Different businesses can follow different accounting periods depending on their convenience.
Convention of full disclosure
According to this convention, accounting statements should be complete and should disclose all
significant information relating to the economic affairs of the entity. The purpose is to communicate all
material and relevant facts concerning the financial position and the results of operations to users.
Moreover, various items or facts, which do not find place in accounting statements, are shown as
footnotes to the financial statements.
For example, if a business changes its method of depreciating assets, or method of valuation of finished
goods, this should be clearly reflected in the statements.
Convention of consistency
According to this convention, accounting practices, rules, and procedures should be continuously
observed and applied, year after year. This is necessary for the people in the business to compare its
financial results and make decisions in conformity to past trends. The principle of consistency does not
mean that it does not allow a firm to change the accounting methods according to the changed
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circumstances. Improved techniques of accounting can be introduced to replace old techniques,
wherever and whenever necessary.
Consistency eliminates personal bias and evens out personal judgment. However, this convention does
not rule out complete changes.
Convention of conservatism
This doctrine provides for caution or "playing it safe." The essence is "to anticipate no profits and
provide for all losses." Business should account for all the prospective losses but leave aside all the
prospective future profits.
To summarize, uncertainties inevitably surround many business transactions. This should be recognized
by exercising prudence of financial statements. Thus, financial statements are usually drawn up on a
conservative basis. Showing a position better than what exists is not permitted.
Convention of materiality
Materiality refers to the relative importance of an event or item. According to the American Accounting
Association, "an item should be regarded as material if there is reason to believe that knowledge of it
would influence the decision of an informed investor." Thus, deciding what material in accounting is is a
matter of exercising judgment, not of applying specific rules.
Materiality requires that accounting statements should not be made unwieldy or unintelligible due to a
strict adherence to accounting principles.

What is an Account?
An account (represented in short as a/c) is a summarized record of relevant transactions at one place,
relating to a person or business activities. These records enable individuals to ascertain a company's
(or a person's) financial position with reasonable accuracy at any point in time.
Every transaction either increases or decreases the Assets and/or Liabilities and/or the Capital.
When represented pictorially, an account looks like a big T as shown on the right side of the screen.
While recording transactions, increases in Assets are recorded on the left-hand side and decreases on the
right-hand side. However, increases in Liabilities are recorded on the right-hand side and decreases on
the left-hand side.

Types of Accounts
Personal accounts
Personal accounts relate to persons, individuals, firms, companies, etc. Personal accounts are of
natural persons (Kathy a/c, Michelle a/c, and Johnson a/c), artificial persons, or body of persons (Bank
a/c, Club a/c). This category also includes representative accounts such as outstanding salaries a/c
and prepaid insurance a/c.
NATURAL Personal Accounts
Proprietor's a/c, supplier's a/c, and receiver's a/c (such as Mohan's a/c, Shashi's a/c, and
Naresh's a/c)
Artificial Personal Accounts
Bank a/c, insurance company's a/c, any firm's a/c, any government's a/c, any institution's a/c, and any
club's a/c
Representative Personal accounts
Rent prepaid a/c, interest outstanding a/c, and interest received in advance a/c
Note: If an a/c represents a person, it is called a representative personal a/c.
Real accounts
Real accounts relate to the records of all the transactions of a business in tangible and intangible
assets. Examples of tangible assets are land, buildings, and investments. Examples of intangible assets
are patents and trademarks.

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Tangible Real accounts
This is an account recorded for materials like building a/c, furniture a/c, machinery a/c, stock a/c,
and cash a/c that can be touched, felt, measured and sold.
Intangible Real accounts
This is an account of things like trademarks a/c and patent rights a/c that are difficult to touch
physically, but can be measured in terms of money. Nominal accounts
Nominal accounts relate to expenses, losses, gains, and income of a business. Examples include
salary account and interest paid.
The net result of all nominal accounts is profit or loss, which is transferred to the Capital Account.
Examples of such accounts are salary account, interest paid, and commission.
Please note that when some prefix or suffix is added to a Nominal Account, it becomes a Personal
Account. For example, an Interest Account to which prefixes such as "Outstanding" and "Prepaid" are
added becomes a Personal Account. Thus, the accounts Outstanding Interest A/c and Prepaid Interest
Account are Personal Accounts.
Golden Rules of Accounting
1.Debit the Receiver and Credit the Giver
When a person receives some benefit or money, it is recorded on the debit side of the concerned account
and when money as benefit is given away, the concerned account is credited.
In other words, debit that person's account that receives something and credit that person's account that
gives something!
2.Debit what comes in and Credit what goes out
When a particular asset comes into the business, it is debited. When the asset goes out of the business, it
is credited.
3.Debit all expenses and losses and Credit all income and gains
According to this rule, expenses incurred (for example, Salaries) are debited and income received (like
Interest Income or Commission Income) is credited.
Rules of Debit and Credit
The term Debit has been derived from the Latin word debeo meaning 'owed to me, the proprietor.' It
may mean the left-hand side of a 'T account', or the actual charge to the customer's account.
The term Credit has been derived from the Latin word credo meaning 'trust or believe.' It may mean the
right-hand side of a 'T account', or may refer to the goods purchased and to be paid for at a later date.
Let's examine the rules of Debit and Credit in various types of accounts.

Account Name Credit Debit

Assets Account Decrease in the value Increase in the value
Capital Account Increase in the value Decrease in the value
Revenue Account Increase in the value Decrease in the value
Liability Account Increase in the value Decrease in the value
Expenses Account Decrease in the value Increase in the value

Double Entry System of Accounting

In order to enter into a valid contract, there must be two parties. In a contract, one party gives something
to another party, and receives something in return. The party who gives is called the seller, and the party
who receives is called the buyer.
For example, in a cash sale of goods, cash is received and goods are given in return. This transaction has
two aspects: cash comes in and goods go out. A complete record of both the aspects is necessary to give
the true picture of the business.
In the above example, the two accounts that are affected are the Cash a/c and the Goods a/c. Cash is
coming in, and thus the Cash a/c will be debited. Since Goods are going out, the Goods a/c will be
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credited.
This method of writing every transaction in two accounts is called the Double Entry system. One of
the accounts is debited, while the other is credited with an equal amount.
Accounting Process
The accounting process starts with a financial transaction and ends with the preparation of Financial
Statements, which are used for analysis and interpretation by various interested groups. A Financial
Statement comprises of an Income Statement, a Cash Flow Statement and a Balance Sheet.
Income Statement → Cash Flow → Balance Sheet → Financial Statements

Journal
The term journal comes from the French word jour, which means a diary or a daybook. A journal may,
therefore, be defined as a book containing a day-to-day record of transactions.
A journal is a primary book of entry, which is used to record all the business transactions systematically
and chronologically for the first time, according to the principles of the Double Entry system. This is also
known as the Book of Original Entry.
There are several advantages of maintaining journal entries for your business transactions. Regular and
correct journal entries:
Reduce the possibility of error while recording a transaction. As the amounts are debited or credited side
by side, they can be compared to check that they are equal.
Provide an explanation for a transaction. A complete explanation is written so that it is possible later
to understand the entry correctly. It
Helps In
Solving disputes in the business as it captures both the aspects of a transaction and ensures
observance of Double Entry System. Provide a chronological record of all transactions. Transactions
are entered in the journal, chronologically, in order of occurrence.
Journal Entries
Journalizing is an act of recording or entering transactions in a journal. On the basis of the rules discussed
earlier, the accounts to be debited or credited will be determined. Before recording transactions, the
following points must be considered:
Which two accounts are affected in that particular transaction? What type of accounts are
they?
On the basis of the golden rules, which are the accounts to be debited and credited?
Ledger Posting
Journal entries are used to make ledger postings. A ledger is a book that contains all accounts whether
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Real, Personal, or Nominal. The process of transferring information from a journal to a ledger is called
posting.
Depending on the convenience of the business, posting from a journal to a ledger is done periodically,
that is, weekly, fortnightly, or monthly.
There are a few rules that govern the posting of ledger entries. These rules are:
The debit side of the journal entry is posted on the debit side of the account.
The credit side of the journal entry is posted on the credit side of the account.
Trial Balance
The information from the ledgers flows into the Trial Balance. The Trial Balance is a statement showing
the debit and credit balance from the ledgers to test the arithmetical accuracy of the books of accounts
and to prepare the final accounts. The total of debits and credits should tally in a Trial Balance. An
agreement indicates a reasonable arithmetical accuracy of the accounting work.

Maintaining a Trial Balance:

Ascertains the arithmetical accuracy of ledger accounts
Helps in preparation of final accounts
Provides a summary of each account
Helps in locating errors

All About Revenue and Expenditure

Welcome to the Income Statement topic:
The purpose of preparing an Income Statement is to ascertain the net profit or loss for a particular
period. An Income Statement explains how income is earned. An Income Statement is used to compare
the profits between two or more years, ascertain deviations, which in turn helps in controlling expenses
that are incurred in running the business enterprise.

After completing this topic, you will be able to:

Identify the various components of an Income Statement.
Identify the methods of recording revenues on an Income Statement. Identify the methods of
expensing costs on an Income Statement. Describe the Realization Concept on an Income
Statement. Describe the Matching Concept on an Income Statement.

Financial Statements
The three major financial statements are Balance Sheet, Income Statement, and Cash Flow statement.
These financial statements summarize the financial status and the results of the operations of a business
entity.
Components of an Income Statement
Let's look at the Income Statement, one of the principle Financial Statements, which provides
information on the net income from the operating activities of a business. An Income Statement explains
how this income was earned. It is also called a Profit and Loss or Earnings Statement and is included in
the annual reports published by the business. Various parties, such as company leaders, financial
analysts, shareholders, industry analysts, and regulatory authorities are interested in Income
Statements.
Calculating Revenues
Revenues or net income (loss) can be calculated with a simple formula:
Revenue ---- Expenses = net income (loss)
A Revenues account shows an increase in retained earnings during the period. An Expenses
account shows a decrease in retained earnings.

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Revenues appear in two places on an Income Statement:
Direct Income (Net Sales Billed or Sales Revenue)
Indirect Income/Other Income
Revenues and Expenses Accounts
The difference between the revenues and expenses accounts is the net income of the period. At the end
of the accounting period, the revenue and the expenses accounts have zero balances. The net amount
ascertained is termed as " Income of the period" as a result of profitable operations during a period.
Retained earnings are an item of equity on the balance sheet. Any increase in retained earnings is an
increase in equity. Revenue and expense accounts are known as temporary accounts. They are started
afresh every year at the beginning of each period.

The Realization Concept

In order to recognize revenue, it has to be "realized". In other words, payment, or a promise of payment
has to be made. The Realization concept does not demand that the revenue be received in cash.
For example, the following transactions are carried out in the months listed below:
March: Customer orders a range
April: Customer is billed for the range
May: Customer pays the bill
June: Customer starts using the range
As per the Realization concept, revenue was recognized in April because all the conditions shown below
were fulfilled.
Matching Concept
The Matching Concept states that the expenses of a period are costs associated with the revenues or
activities of that period. The concept governing the recognition of expenses of the period is the matching
concept. As an example, consider an automobile that Bryan Company, a dealer in automobiles
1. Purchased for $15,000 in March
2. Sold for $18,000 in May

In May, Bryan Company recognizes revenue $18,000 from sale. It must match $15,000 cost with this
revenue in May (and not in March). Therefore, both the items of revenue and expenses will go to Income
Statement in the month of May and not in March. The Expenses match with the Revenue.

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More specifically, expenses of a period are:
Costs that are associated with the activities of the period.
Cost of goods and services that are delivered in the current period and whose revenues are recognized in
that period.

All About Assets, Liabilities, and Equity

Welcome to the Balance Sheet topic:
A Balance Sheet is prepared with a view to measuring the true financial position of a business
concern at a particular point of time.
A doctor determines the patient's health, after checking his or her pulse. Similarly, by looking at the
Balance Sheet of the organization, you can determine the financial health of a company. In a nutshell, a
Balance Sheet is a picture of the financial position of a business at a particular point of time.
Balance Sheet
A Balance Sheet is one of the principal Financial Statements. It is a statement, which sets out the assets,
liabilities and Owners' Equity of a firm or an institution on a certain date. A Balance Sheet lists the
investments of a business entity, and the financing of these investments by creditors and owners at a
specific point in time. The investments of a company are its assets and the financing pertains to the
Liabilities and Owners' Equity.

The main sections of a Balance Sheet are shown below:

Balance Sheet Analysis

In order to analyze a Balance Sheet, finance professionals first focus on the largest variances from the
prior year and the operating plan. After identifying significant variances and ratios, they examine
additional documentation such as the trial balance, journal entries, and various reports to understand
the root cause.
For example, in the Florida Furnishers case, the cash Variance from Operating Plan (VOP) of $3,000
(3x1000) is relatively small. If the business has enough cash to satisfy its short-term obligations, a small
cash balance is preferable to a large one. This means that the business' cash is not sitting idle, but is being
used for profit-making operations.
Important Adjustments
Adjustments are made for the continuous assessment of the final affairs of a firm. It is necessary that for
the year for which accounts are being prepared, all expenses and incomes for the year should be taken.
Thus, it is necessary that:
Expenditure whether paid or not, be included Income whether received
or not, be included
Expenditure relating to the succeeding years be excluded Incomes relating to the
succeeding years also to be excluded

Closing Stock
Often, all goods purchased or produced during an accounting year are not completely sold out at the end
of the year. The goods remaining unsold are called Closing Stock. Since the Closing Stock is known only at
the end of the year, it is not included in the Trial Balance. Therefore, the closing stock is treated in the
accounts as follows:
On the credit side of Profit and loss account as a separate item.
On the asset side of the Balance Sheet as a separate item under Current Assets.

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Entry for Adjustment is:
Closing Stock a/c Debit
To Profit and Loss account

Outstanding Expenses
Expenses incurred during a year, whose benefit has been derived during the year, but the payment for
which is yet to be made, are called outstanding or accrued expenses. At the end of the year, all such
expenses must be brought into books of accounts. Otherwise, profit will be overstated.

Entry for Adjustment is:

Salaries a/c Debit
To Salaries Outstanding a/c

Prepaid Expenses
In some cases, the benefit of the amount already spent will be available in the next accounting year too.
Such a portion of the expense concerned is called "Prepaid expenses". Prepaid expenses are treated in
the accounts as follows:
They will be subtracted from the insurance premium in the Income Statement.
This will be shown on the Assets side of the Balance Sheet as a separate item under Current Assets.

Accrued Incomes
The incomes that have been earned during the accounting period, but have not been received till the end
of the accounting period are called accrued incomes.

Entry for Adjustment is:

Accrued Income Debit
To Income a/c

Provision of Bad Debts

Bad debts often occur and they are a loss. When it is certain that a debt will not be recovered, the amount
is credited to the debtor's account to close it, and debited to the Bad Debts account. A provision may be
created to meet any possible loss that is likely to occur in the future.

Entry for Adjustment is:

Profit and Loss a/c Debit
To Provision for Bad & Doubtful Debts a/c

Interest on Capital
The funds provided by a proprietor to the business become a liability in terms of capital for the
business. Like other borrowings, the company can pay to the proprietor funds too.

Entry for Adjustment is:

Interest on Capital a/c Debit
To Capital a/c

Interest on Drawings
The proprietor may also realize that when he draws money for private use, the firm loses interest.
Therefore, the proprietor may be debited with the interest on the money drawn by him.

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Entry for Adjustment is:
Capital a/c Debit
To Interest on Capital a/c

Interest on Capital a/c Debit

To Profit and Loss a/c

Cash Flow Statement

A Cash Flow Statement contains receipts (inflows) and payments (outflows) of cash, either from business
operations or from non-business operations during the period covered by two consecutive Balance
Sheets. A Cash Flow Statement reports the major sources and uses of cash flowing through a business
during a period of time. It reports the flow of cash during the Accounting Period and is, therefore, called
the Statement of Cash Flows. Both the Income Statement and Cash Flow Statement reports flow during
the accounting period. The difference is that the Income Statement reports flow on an accrual basis, that
is, inflows are measured as revenues and outflows are measured as expenses. The Income Statement
focuses on profitability, while the Cash Flow Statement focuses on liquidity. The Income Statement
focuses on profitability, while Cash Flow Statement focuses on liquidity. Finance professionals prepare
Cash Flow Statements to explain changes in cash from one Balance Sheet period to another. A forecast of
Cash Flow helps the management and other users of financial information to estimate future needs for
cash.
Advantages Of Reporting Information On Cash Flow:

Helps in short-term planning:

The Cash Flow Statement shows the inflows and outflows of cash. This helps the management to form
various short-term plans about the internal as well as the external financial management. Also, it
provides information to the management to assess the capability of the business to meet its short-term
commitments towards creditors for goods and expenses.

Helps in preparing cash budget:

It helps in preparing cash budgets. It indicates the surplus or deficit of cash. In case of surplus, short-
term investments can be planned and in case of deficits, short-term loans can be planned.

Helps in ascertaining the changes in cash position:

It takes into consideration current as well as non-current accounts. The cash position can be analyzed by
comparing the figures on the two Balance Sheets and proper remedial action can be taken.
Helps in knowing the trend of cash flow
The Cash Flow Statement is helpful in determining the trend of cash flow. It indicates how cash is being
received from current assets, such as debtors and stock and how cash is being utilized for current
liabilities, such as creditors and bank overdrafts.

Helps to explain the relation between cash balances and earnings:

Cash Flow Statement also shows cash from operations. There may be less cash balance in spite of huge
profits or plenty of cash balances while the concern incurs heavy losses.

Sources Of Cash
The main sources of cash are:
Cash from Operations: This is an internal source of cash and the most important source of cash. Generally
net profit increases the cash and net loss decreases the cash. But it may be more or less than the profit
and loss of the year because there may be certain items which result neither in the increase in cash nor
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decrease in cash, such as depreciation and proposed dividend.

Sale of Fixed Assets: There are inflows of cash whenever fixed assets, such as furniture, land, building,
and machinery are sold. But, if these are sold on credit, there will be no inflow of cash.
Rising of Loans: Loans may be taken by mortgaging fixed assets. These increase cash. Therefore,
whenever a loan is raised, it results in the inflow of cash.

Issue of Share Capital: If shares are issued at a discount, then while calculating cash inflow, the
discount amount should be deducted from the value of the shares.

Non-trading Receipt: A trading concern gets cash many times from non-trading receipts, such as
income from investments and donations.

Uses Of Cash
Transactions that decrease the Cash Balance are called application of cash or cash outflows.

The main uses of cash are:

Cash lost from operations: As profits are taken as sources of cash, in the same way losses from
operations are outflows of cash. Loss means that some cash has gone out from the company as it
decreases the cash balance. So, it is treated as an application of cash.

Purchase of Fixed Assets: Whenever fixed assets, such as Land and Buildings, Plant and Machinery, and
Investments are purchased, these result in an outflow of cash. But, when these are purchased on credit,
there is no effect on cash.

Redemption of Shares and Debentures: When a company redeems its redeemable preference shares
and debentures, it results in outflow of cash. The premium paid on these is also an outflow of cash. But if
the debentures are redeemed by converting into shares, there will be no outflow of cash.

Payment of Loans: Whenever a company makes payment of its short -term and long-term loans, there
will be outflow of cash because cash goes out on payment of its liabilities.

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