Accounting and Financial Management

Importance of Preparing a Balance Sheet

1. Reveals financial position — It shows the exact assets, liabilities and capital of the business on a particular date, so the true financial strength (solvency) of the firm is known.
2. Helps in decision making — Management can judge liquidity, debt-paying capacity and capital structure, and can plan investment, borrowing and expansion accordingly.
3. Shows the result of past operations — By comparing the balance sheet of two years, the increase or decrease in assets, liabilities and capital (net worth) is clearly seen.
4. Basis for loans and credit — Banks and financial institutions study the balance sheet before granting loans, and creditors judge the security of their dues.
5. Statutory requirement and evidence — It is required by law (Companies Act) and is a permanent record/evidence of the financial position for owners, investors, tax authorities and the government.

Main Components (Constituents) of a Balance Sheet

A. Assets (what the business owns)

• Fixed/Non-current assets — land, building, machinery, furniture, vehicles, long-term investment.
• Current assets — cash in hand, cash at bank, bills receivable, debtors, stock/inventory, prepaid expenses.

B. Liabilities (what the business owes)

• Long-term/Non-current liabilities — loan, debenture, mortgage.
• Current liabilities — creditors, bills payable, bank overdraft, outstanding expenses, short-term loan.

C. Capital / Owner's Equity

• Capital, reserves and surplus, net profit (or less drawings and net loss).

Note: Total assets must always equal total liabilities plus capital — $A = L + C$ (the balance sheet equation).

The three golden rules of the double entry accounting system are:

1. Rule of Debit and Credit (Personal Accounts) "Debit the receiver, credit the giver."

Example: Goods worth Rs 10,000 sold to Ram on credit. Ram is the receiver of goods, so Ram's account is debited; the giver is the business (sales), so Sales account is credited.

2. Rule of Debit and Credit (Real Accounts) "Debit what comes in, credit what goes out."

Example: Furniture purchased for cash Rs 50,000. Furniture (asset) comes into the business, so Furniture account is debited; cash goes out, so Cash account is credited.

3. Rule of Debit and Credit (Nominal Accounts) "Debit all expenses and losses, credit all incomes and gains."

Example: Rent paid Rs 8,000 in cash. Rent is an expense, so Rent account is debited; cash goes out, so Cash account is credited.

Conclusion: These three rules ensure that every transaction is recorded with equal debit and credit, keeping the accounting equation (Assets = Liabilities + Capital) always balanced.

Fixed cost (TFC)

Cost that does not change with the level of output in the short run is fixed cost. It is incurred even when output is zero. Examples: house rent, salary of permanent staff, insurance premium, depreciation of machinery.

Variable cost (TVC)

Cost that changes with the level of output is variable cost. It is zero when output is zero. Examples: raw materials, wages of daily workers, packing and transport charges.

Total cost (TC)

Total cost is the sum of fixed and variable costs of producing a given output.

$TC = TFC + TVC$

Relationship among them

1. $TC = TFC + TVC$, so $TFC = TC - TVC$ and $TVC = TC - TFC$.
2. TFC is constant at every level of output and is never zero; its curve is a horizontal line.
3. TVC is zero at zero output and rises as output rises.
4. At zero output, $TC = TFC$, so the TC curve starts from the TFC level on the vertical axis.
5. As output rises, TC increases by exactly the same amount as TVC, because TFC does not change ($\Delta TC = \Delta TVC$).
6. The vertical gap between the TC and TVC curves is always equal to TFC, so it stays constant at all outputs.
7. Per unit, average fixed cost ($AFC = TFC/Q$) falls continuously as output rises, while average variable cost ($AVC = TVC/Q$) first falls and then rises (U-shaped).

A balance sheet is a financial statement that shows the assets, liabilities and capital (equity) of a business at a particular date. It is considered one of the most important financial statements for the following reasons:

1. Shows financial position: It presents what the business owns (assets) and what it owes (liabilities) on a specific date, thus revealing its true financial position and net worth.

2. Helps assess liquidity and solvency: By comparing current assets with current liabilities and total debt with total capital, it helps judge whether the firm can pay its short-term and long-term obligations.

3. Basis for decision-making: Management, investors, lenders and creditors use it to take decisions on investment, lending, expansion, dividend and credit sales. It also helps determine the creditworthiness of the business.

4. Aids planning, control and comparison: It provides data for future planning, budgetary control and performance evaluation. It also allows comparison of results over different years and with other similar firms.

5. Legal and regulatory requirement: Companies and banks must prepare a balance sheet as required by laws and regulatory authorities such as the Companies Act and Nepal Rastra Bank for audit, disclosure and tax purposes.

In the double entry accounting system, every transaction affects two accounts — one is debited and the other is credited — and the two sides must always be equal. The methods (rules) of debit and credit are applied according to the type of account. There are two widely used approaches:

1. Traditional (English) Approach — Golden Rules

2. Modern (American) Approach — Accounting Equation

Based on the equation: Assets = Liabilities + Capital

Conclusion: Under either method, the total of debits must equal the total of credits in every transaction. The traditional approach uses the golden rules of personal, real and nominal accounts, while the modern approach applies the rules of increase and decrease on the basis of the accounting equation.