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Accounting Chapter 1: Accounting in action
Three activities:
As a starting point to the accounting process, a company identifies the economic events relevant to its business. Once a company identifies economic events, it records those events in order to provide a history of its financial activities. Recording consists of keeping a systematic, chronological diary of events, measured in monetary units. In recording, a company also classifies and summarizes economic events. Finally, the company communicates the collected information to interested users by means of accounting reports. The most common of these reports are called financial statements. Bookkeeping usually involves only the recording of economic events. In total, accounting involves the entire process of:
- Identifying
- Recording
- Communicating economic events.
Who uses accounting data?
There are two broad groups of users of financial information: internal users and external users.
- Internal users of accounting information are managers who plan, organize, and run the business. These include marketing managers, production supervisors, finance directors, and company officers.
- External users are individuals outside a company who want financial information about the company. The 2 most common types of external users are investors and creditors. Investors (owners) use accounting information to make decisions to buy, hold, or sell ownership shares of a company. Creditors (such as suppliers and bankers) use accounting information to evaluate the risks of granting credit or lending money. The building blocks of accounting
Ethics in financial reporting
A sound, well-functioning economy depends on accurate and dependable financial reporting. The standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest, fair or not fair, are ethics.
Accounting standards
In order to ensure high-quality financial reporting, accountants present financial statements in conformity with accounting standards that are issued by standard- setting bodies. Two primary accounting standard-setting bodies are: the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB). Most companies in the US follow standards issued by the FASB, referred to as Generally Accepted Accounting Principles (GAAP).
Measurement principles
IFRS generally uses one of two measurement principles, the historical cost principle, or the fair value principle. Selection of which principle to follow generally relates to trade- offs between relevance and faithful representation.
- The historical cost principle dictates that companies record assets at their cost. This is true not only at the time the asset is purchased, but also over the time the asset is held.
- The fair value principle states that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market value information is readily available for these types of assets.
Assumptions
Assumptions provide a foundation for the accounting process. Two main assumptions are the monetary unit assumption and the economic entity assumption.
- The monetary unit assumption requires that companies include in the accounting records only transactions data that can be expressed in money terms. This assumption enables accounting to quantify (measure) economic events. The monetary unit assumption is vital to applying the historical cost principle.
- An economic entity can be any organization or unit in society. The economic entity assumption requires that the activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities. Forms of business ownerships:
- Proprietorship – a business owned by one person is generally a proprietorship. The owner is often the manager/operator of the business. The owner receives any profits, suffers any losses, and is personally liable for all debts of the business.
- Partnership – a business owned by two or more persons associated as partners is a partnership. Each partner generally has unlimited personal liability for the debts of the partnership.
- Corporation – a business organized as a separate legal entity under corporation law and having ownership divided into transferable shares is a corporation. The holders of the shares enjoy limited liability. Shareholders may transfer all or part of their ownership shares to other investors at any time.
The basic accounting equation
The 2 basic elements of a business are what it owns and what it owes. Assets are the resources a business owns. Liabilities and equity are the rights or claims against these resources.
ASSETS = LIABILITIES + EQUITY
Assets are resources a business owns. The common characteristic possessed by all assets is the capacity to provide future services or benefits. Some assets are Cash, Inventory, Equipment etc. Liabilities are claims against assets – that is, existing debts and obligations. These debts and obligations are usually owed to creditors. Some liabilities are Accounts
Steps in the recording process
- Analyse each transaction for its effects on the accounts.
- Enter the transaction information in a journal.
- Transfer the journal information to the appropriate accounts in the ledger.
The journal
- It discloses in one place the complete effects of a transaction.
- It provides a chronological record of transactions.
- It helps to prevent or locate errors because the debit and credit amounts for each entry can be easily compared.
Simple and compound entries
Some entries involve only 2 accounts, one debit and one credit and it is considered a simple entry. Some transactions, however, require more than two accounts in journalizing and it is called a compound entry.
The ledger
A general ledger contains all the asset, liability, and equity accounts. The ledger keeps in one place all the information about changes in specific account balances. For example, the Cash account shows the amount of cash available to meet current obligations.
Posting
Transferring journal entries to the ledger account is called posting. This phase of the recording process accumulates the effects of journalized transactions into the individual accounts.
Trial balance
A trial balance is a list of accounts and their balances at a given time. Customarily, companies prepare a trial balance at the end of an accounting period. In addition, a trial balance is useful in the preparation of financial statements. The steps for preparing a trial balance are:
- List the account titles and their balances.
- Total the debit and credit columns.
- Prove the equality of the two columns. A trial balance does not guarantee freedom from recording errors, however. Numerous errors may exist even though the totals of the trial balance columns agree.
Currency signs and underlining
- Currency signs do not appear in journals or ledgers. They are typically used only in the trial balance and the financial statements.
- A currency sign is only shown for the first item in the column and for the total of that column.
- A single line is placed under the column of figures to be added or subtracted.
- Total amounts are double underlined to indicate they are final sums.
- Negative signs or parentheses do not appear in journals or ledgers. Chapter 3: Adjusting the Accounts
Timing issues
Accountants divide the economic life of a business into artificial time periods which is called time-period assumption.
Fiscal and calendar years
Accounting time periods are generally a month, a quarter, or a year. Monthly and quarterly time periods are called interim periods. An accounting time-period that is one year in length is called a fiscal year. A fiscal year usually begins with the first day of a month and ends 12 months later on the last day of a month.
Accrual- versus Cash-Basis Accounting
Under the accrual basis, companies record transactions that change a company’s financial statements in the periods in which the events occur. Or example, using the accrual basis to determine net income means companies recognize revenues when the perform a service (rather than when they receive cash). It also means recognizing expenses when incurred (rather than when paid). Under cash-basis accounting, companies record revenue when they receive cash. They record an expense when they pay out cash. Accrual basis accounting is in accordance with IRFS while cash-basis is not.
Recognizing revenues and expenses
When a company agrees to perform or sell a product to a customer, it has a performance obligation. When the company meets this obligation, it recognizes revenue. The revenue recognition principle therefore requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied.
the asset. Depreciation allocates an asset’s cost to the periods in which it is used. Depreciation does not attempt to report the actual change in the value of the asset. There are two methods to allocate depreciation: straight line method and reducing balance method. The straight-line method: The straight-line method of providing for depreciation charges an equal annual amount as an expense so that the asset falls in value evenly throughout its useful life.
- EXAMPLE: Buy a fridge costing €630 to be used for 3 years, at the end of which it will have a residual value of €30. Total depreciation: €630-€30 = €
- Annual depreciation charge = €600/ 3 = €200 per annum.
- The depreciation charge will reduce the profits by €200 each year.
- Statement of financial position entries: New=€630 End yr1=€430 End yr2=€230 End yr3=€ Accumulated Depreciation is a contra asset account (credit). Appears just after the account it offsets (Equipment) on the balance sheet. Book value is the difference between the cost of any depreciable asset and its accumulated depreciation. An adjusting entry for a prepaid expense result in an increase (a debit) in expenses and a decrease (a credit) in the assets account. When companies receive cash before services are performed, they record a liability by increasing (crediting) a liability account called unearned revenue. In other words, a company now has a performance obligation. Airlines, for instance, treat receipts from the sale of tickets as unearned revenue until the flight service is provided. The adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account. Estimated Statement of profit and loss Net book value (NBV) Stat. fin. pos. - HELPFUL HINT All contra accounts have increases, decreases, and normal balances opposite to the account to which they relate.
Adjusting entries for accruals
Revenues for services performed but not yet recorded at the statement date are accrued revenues. Accrued revenues may accumulate with the passing of time as in the case of interest revenue. Companies do not record interest revenue daily because it is often impractical to do so. Accrued revenues also may result from services that have been performed but not yet billed or collected because only a portion of the total service has been performed and the clients will not be billed until the service has been completed. An adjusting entry for accrued revenues results in an increase (a debit) to an asset account and an increase (a credit) to revenue account. Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses. Interest, taxes, and salaries are common examples of accrued expenses. Companies make adjustments for accrued expenses to record the obligations that at exist at the statement of financial position date and to recognize the expenses that apply to the current accounting period. An adjusting entry for accrued expenses results in an increase (a debit) to an expense account and an increase (a credit) to a liability account.
The Adjusted Trial Balance and Financial Statements
After a company has journalized and posted all adjusting entries, it prepares another trial balance from the ledger accounts. This trial balance is called an adjusted trial balance. It shows the balances of all accounts, including those adjusted, at the end of the accounting period. The purpose of an adjusted trial balance is t prove the equality of the total debit and credit balances in the ledger after all adjustments. Because the accounts contain all data needed for financial statements, the adjusted trial balance is the primary basis for the preparation of financial statements.
- Fair value principle indicates that assets and liabilities should be reported at a fair value (the price received to sell an asset or settle a liability). Revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. Expense recognition principle dictates that efforts (expenses) be matched with results (revenues). The full disclosure principle requires that companies disclose all circumstances and events that would make a difference to financial statement users. Cost constraint weighs the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available. Chapter 4: Completing the accounting cycle.
Closing the books
At the end of the accounting period, the company makes the accounts ready for the next period. This is called closing the books. In closing the books, the company distinguishes between temporary and permanent accounts. Temporary accounts relate only to a given accounting period. They include all income statement accounts and the Dividends account. The company closes all temporary accounts at the end of the period. Permanent accounts relate to one or more future accounting periods. They consist of all statement of financial position accounts, including equity accounts. Permanent accounts are not closed from period to period.
Preparing closing entries
Closing entries formally recognize in the ledger the transfer of net income and Dividends to Retained Earnings. The retained earnings statement shows the result of these entries. Closing entries also produce a zero balance in each temporary account.
Preparing a Post-Closing Trial Balance
The post-closing trial balance lists permanent accounts and their balances after journalizing and posing of closing entries. The purpose of the post-closing trial balance is to prove the equality of the permanent account balances carried forward into the
next accounting period. Since all temporary accounts will have zero balances, the post-closing trial balance will contain only permanent – statement of financial position
The classified statement of financial position
The statement of financial position presents a snapshot of a company’s financial position at a point in time. To improve users’ understanding of a company’s financial position, companies often use a classified statement of financial position, which groups together similar assets and similar liabilities, using a number of standard classifications and sections. Intangible assets – assets that do not have physical substance, such as patents, copyright, and trademarks. Property, plant, and equipment – assets with relatively long useful lives that a company is currently using in operating the business. This category includes land, buildings, machinery, and equipment. Depreciation allocates the cost of assets to a number of years. Accumulated depreciation is the total amount of depreciation expensed so far in the asset’s life. Long-term investments – can be either (1) investments in ordinary shares and bonds of other companies that are normally held for many years, or (2) non- current assets such as land or buildings that a company is not using in its operating activities. Current assets – assets that a company expects to convert to cash or use up within a year or its operating cycle, whichever is longer. The operating cycle of a company is the average time it takes to purchase inventory, sell it on account, and then collect cash from customers. Equity – the content of the equity section varies with the form of the business organization. In a proprietorship, there is one capital account. In a partnership, there is a capital account for each partner. Corporations divide equity into Share Capital-Ordinary and Retained Earnings. Non-current liabilities – obligations that a company expects to pay after one year.
Freights costs
Freight terms are expressed as either FOB shipping point or FOB destination. The letters FOB, mean free on board. Thus, FOB shipping point means that the seller places the goods free on board the carrier, and the buyer pays the freight. Conversely, FOB destination means that the seller places the goods free on board to the buyer’s place of business, and the seller pays the freight.
Purchase returns and allowances
A purchaser may be dissatisfied with the merchandise received because the goods are damaged or defective, of inferior quality, or do not meet the purchaser’s specifications. Purchase return - in such cases, the purchaser may return the goods to the seller for credit if the sale was made on credit, or for a cash refund if the purchase was for cash. Purchase allowance – alternatively, the purchaser may choose to keep the merchandise if the seller is willing to grant an allowance from the purchase price.
Purchase discounts
The credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment. The buyer calls this cash discount a purchase discount. This incentive offers advantages to both parties: the purchaser saves money, and the seller is able to shorten the operating cycle by converting the accounts receivable into cash.
Recording sales of merchandise
In accordance with the revenue’s recognition principle, companies record sales revenues when the performance obligation is satisfied. The performance obligation is satisfied when the goods transfer from the seller to the buyer. At this point, the sales transaction is complete, and the sales price established. Sales may be made on credit or for cash. A business document should support every sales transaction, to provide written evidence of the sale.
The seller makes 2 entries for each sale:
Sales returns and allowances
There is a “flip side” to sales returns and allowances, which the seller records as sales returns and allowances. This is a contra-revenue account to the Sales Revenue account (debited). In this case, sales are not reduced (debited), because: (1) it would obscure the importance of sales returns and allowances as a percentage of sales and (2) could distort comparisons.
Sales discount
The seller may offer the customer a cash discount – called by the seller a sales discount – for the prompt payment of the balance due. Like a purchase discount, a sales discount is based on the invoice price less returns and allowances, if any. This is a contra-revenue account to Sales Revenue. The seller increases (debits) the Sales Discounts account for discounts that are taken.
Adjusting entries
A merchandising company generally has the same types of adjusting entries as a service company. However, a merchandiser using a perpetual system will require one additional adjustment to make the records agree with the actual inventory on hand, because at the end of each period, for control purposes, a merchandising company that uses the perpetual system will take a physical count of its goods on hand. The company’s unadjusted balance in Inventory usually does not agree with the actual amount of inventory on hand. The perpetual inventory records may be incorrect due to recording errors, theft, or waste. This involves adjusting Inventory and Cost of Goods Sold. (1) (2) Forms of financial statements The income statement is a primary source of information for evaluating a company’s performance. The format is designed to differentiate between the various sources of income and expense.
- Determining ownership of goods. One challenge in computing inventory quantities is determining what inventory a company owns. a) GOODS IN TRANSIT. A complication in determining ownership is goods in transit (on board a truck, train, ship, or plane) at the end of the period. The company may have purchased goods that have not yet been received, or it may have sold goods that have not yet been delivered. To arrive at an accurate count, the company must determine ownership of these goods. Goods in transit should be included in the inventory of the company that has legal title to the goods. b) CONSIGNED GOODS. In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. These are called consigned goods. Many car, boat, and antique dealers sell goods on consignment to keep their inventory costs down and to avoid the risk of purchasing an item that they will not be able to sell. Inventory costing Inventory is accounted for at cost. Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale. After a company has determined the quantity of units of inventory, it applies unit costs to the quantities to compute the total cost of the inventory and the cost of goods sold.
- Specific identification Identifying which particular units have been sold and which are still in ending inventory. This practice is relatively rare. Instead, rather than keep track of the cost of each particular item sold, most companies make assumptions, called cost flow assumptions, about which units were sold. Ethics note: a major disadvantage of the specific identification method is that management may be able to manipulate net income. For example, it can boost net income by selling units purchased at a low cost or reduce net income by selling units purchased at a high cost.
- Cost flow assumptions a) First-in, first-out (FIFO). The FIFO method assumes that the earliest goods purchased are the first to be sold. FIFO often parallels the actual physical flow merchandise. That is, it generally is good business practice to sell the oldest units first. Under FIFO, companies obtain the cost of the ending inventory by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed.
b) Average-cost. The average-cost method allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred. The company the applies the weighted- average unit cost to the units on hand to determine the cost of the ending inventory. There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods.
Financial statement and tax effects of cost flow methods
Either of the 2 cost flow assumptions is acceptable for use. For example, adidas (DEU) and Lenovo (CHN) use the average-cost method, whereas Syngenta Group (CHE) and Nokia (FIN) use FIFO. A recent survey of IFRS companies indicated that approximately 60% of these companies use the average-cost method, with 40% using FIFO. In fact, approximately 23% use both average-cost and FIFO for different parts of their inventory.
Statement of financial position effects
- On the one hand, management wants to have a great variety and quantity on hand so that customers have a wide selection and so that items are always in stock. But such a policy would incur high carrying costs (e.g., investment, storage, insurance, obsolescence, and damage)
- On the other hand, low inventory levels lead to stock-outs and lost sales.
