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Accounting
Economic entities: Human activity often takes place within and through economic entities. Economic entities use resources to get outcome, and they are: Firms and companies: generally aimed at generating wealth (profit) through the production and sale of goods and services (Profit = Revenues – Costs). The revenues emerge from the market, from the intersection between the willingness of the firm to sell and that of the consumer to buy. In private entities profit it’s validated by the existence of markets and competition. Hospitals, governments, public sector entities or non-profit entities: generally aimed at generating public value or public goods (through the collection of revenues such as taxes, donations or public debt, that future generation will have to repay). Generally, they will aim at ensuring that revenues are at least sufficient to cover expenditures. “Balancing budgets” as a means for the generation of public value (profit seen as a mean not an end, it is something seen as wrong, if there exists, they have to reinvest them). States have a social contract with citizens, they got right to vote and elect representatives in exchange for taxes; actually, the parliament was born to tackle public expenditure. So there will be no losses as long as governments can ask people to pay more taxes. But now there is a trend of using in the public sector systems of the private one. Families and individuals: also, generally perform economic activities to ensure their continuity, though they do not usually have generation of wealth or profit as their main goals (wealth seen as a means rather than an end). Economic entities to perform their activities and generate output, or revenues for the private sector, will generally need to obtain resources from the external environment: inputs for starting the production cycle, and legitimation and reputation (ex. working in a way that is deemed acceptable, for example not exploiting workers and the environment, respecting laws, having a reputation for good customer care). Each input carries with it a related expense, for example: labour (salaries), money (interests), property, plants, equipment (depreciation), goods, utilities, public services (taxes). Operating in an economic environment thus requires them to be able to secure those resources from relevant stakeholders. To do this they need to: build a relationship of trust with suppliers, workers, customers, financial institutions and markets, be “accountable” to them for the use of the resources given (how they spend the inputs received) and offer them the information needed to continue their relationship, or for example to plan their future investments. Financial statements are central in “managing” the relationship with the external environment. These documents work as accountability and decision-making tools. To understand financial statements and navigate the economic environment people need to speak and understand the “accounting language”. What is accounting? Accounting is traditionally concerned with collecting, analysing and communicating financial information; such as the financial position, performance and changes in financial position of an enterprise. Though, increasingly, non-financial information is becoming very relevant. Accounting provides financial information for a range of users to: help them make informed choices about issues and decisions concerning economic and financial activities; provide accountability reports of transactions for a given period.
Accounting, very much like language, relies on conventions and requires interpretations, created by human beings, so we can change it as we are constantly progressing. Indeed, subjectivity is present in financial accounting numbers, even though the perception is that all accounting numbers are ‘objective’. Accounting has to do with quantification, but also needs non-financial information, such as the PESTO (Personnel, Equipment, Supply, Training, and Ordnance) or knowing the credibility or the governance of a company, or indicators of happiness of consumers. The users of this information are, for example: investors, like the owners, that need information for buying, holding and selling shares of their company; creditors, such as lenders and suppliers, that need information to determine whether their loans and interests will be paid when due; other users, such as employees, to assess the ability of the enterprise to provide remuneration, customers, to evaluate the ability of the company to continue to operate in the future, government, to regulate the activities of enterprises and determine taxation policies, public. We can divide them in external (investors, creditors, customers, and government) and internal (employees, managers, owners) users. Accounting as we know it today developed as a fundamental tool first for merchants and bankers during the period of the explorations, and then for companies, to keep capital, debts and credits under control, to inform stakeholders and to support managers’ decisions. The accounting framework is based on a crucial assumption, known as the entity concept namely that: “each individual business is an isolated entity, divorced from its owners, employees, managers and other business entities”. Accounting will only record transactions concerning the “entity” (firm, company, organization), not for example the personal transaction of the members of the family of the entrepreneur, or of the employees, shareholders, customers, etc. Accounting standards: Accounting is based on human conventions, so numerous standards at different level exist to make things easier and to ensure high-quality financial reporting. Primary accounting standard-setting bodies are: the International Accounting Standards Board (IASB), that determines International Financial Reporting Standards (IFRS), which are used in 130 countries; the Financial Accounting Standards Board (FASB), that determines generally accepted accounting principles (GAAP), used by most companies in the U.S.; the National accounting standard-setting bodies ITA GAAP (OIC), which determines the accounting standards for unlisted companies; and separate standards may exist for Non-profits and the public sector (ex. IPSASB; ITAS). IFRS Revised Conceptual Framework sets out: the objective of general purpose financial reporting; the qualitative characteristics of useful financial information; a description of the reporting entity and its boundary; definitions of an asset, a liability, equity, income and expenses and guidance supporting these definitions; criteria for including assets and liabilities in financial statements (recognition) and guidance on when to remove them (derecognition); measurement bases and guidance on when to use them; concepts and guidance on presentation and disclosure; and concepts relating to capital and capital maintenance. Accounting Equation: At first individuals or shareholder invest an amount of resources on a firm/business/company. This investment is called capital for the shareholders or equity for owners and can be in the form of cash or in kind (land, equipment, shares etc.). It is often referred to as residual equity, that is, the equity “left over” after creditors’ claims are satisfied. Examples of equity are reserves, which are profits that have been stored for a particular purpose, and net income, also called net earnings or retained earnings, which is sales minus cost of goods sold, general expenses, taxes, and interest, so revenues minus expenses and dividends, or assets minus equity.
profit or loss for that time period. This information helps you make timely decisions to make sure that your business is on a good financial footing. The classification of expenses is often a matter of judgment, although there are some statutory rules for businesses that trade as limited companies. The cash flow statement (or the Statement of Changes in Financial Position, or Financial adaptability) shows the cash movements over a particular period. It provides information about the activities of the company and the effects of those activities on the financial position of the company and its ability to generate cash flows. The cash flow statement should report cash flows during the period classified by: operating activities: the company’s everyday activities, such as buying and selling, they can also be divided in types, such as administrative or distribution, these divisions are useful to know if the company is profitable and where; investing activities: the actions of buying and selling non-current assets for long-term purposes; financing activities: are the actions of raising and repaying the long-term finance of business. By summing all of these we create the net increase in cash and cash equivalents over the period. Underlying Assumptions and Qualitative Characteristics of Financial Statements: Going Concern: The financial statements are normally prepared on the assumption that an enterprise is a going concern and will continue in operation for the foreseeable future. Accrual basis: The effects of transactions and other events are recognized when they occur (and not as cash or its equivalents are received or paid) and events are recorded in the accounting records and reported in the financial statements of the periods to which they relate. There are essentially two main methods to record accounting transactions. The core difference between the two systems is a matter of timing: in the cash basis the elements are recognized/unrecognised at the time of payment or at the time of receipt; on the accrual basis the elements are recognized when they occur, independently from the time of payment or the time of receipt. All Financial statements (except the Cash Flows Statement) are prepared on the accrual basis of accounting. Recognition of the Elements of Financial Statements Recognition is the process of incorporating in the balance sheet or income statement an item that meets the following criteria: it is probable that any future economic benefit associated with the item will flow to or from the enterprise and; the item has a cost or value that can be measured with reliability. Probability in accounting is more likely to, possibility less likely to. A number of different measurement bases are employed to different degrees and in varying combinations in financial statements. IFRS generally uses one of two measurement principles, the historical cost principle or the fair value principle. Historical cost principle: dictates that companies record assets at their acquisition cost. Most commonly enterprises in preparing their financial statements use it. The use of historic cost means that problems of measurement reliability are minimised, as the amount paid for a particular asset is often a matter of demonstrable fact (objectivity, money measurement). But historic cost may not be relevant to user needs. Historic costs may become outdated compared to current market values. This can be misleading when assessing current financial position. Fair value principle: states that assets and liabilities should be reported at fair value (the selling price that can be obtained under current market conditions). It provides a more realistic view of financial position and would be relevant for a wide range of decisions. But it may vary significantly over time, not being
sufficiently prudent. In addition, not always a market exist for certain assets. Moreover, may cause confusion/excessive discretion as several definitions of fair value exist. We don’t use often, but it was becoming fashionable before the crisis of 2008. Qualitative characteristics Qualitative characteristics are the attributes that make the information provided in financial statements useful to users: Understandability: readily understandable by users. Relevance: information must be relevant to the decision-making needs of users. The relevance of information is affected by its nature and materiality. Relevance means that financial information is capable of making a difference in a decision. Comparability: Users must be able to compare the financial statements of different companies through time to identify trends in its financial position and performance. Reliability: information needs to be free from material errors or bias and it assures that the information captures the conditions or events it purports to represent. o Faithful Representation: the numbers and descriptions match what really existed or happened, they are factual. o Substance Over Form: information must reflect the substance of transactions, irrespective of their forms. o Neutrality: information must not prioritize the interests of certain stakeholders to the disadvantage of others. o Prudence: an entity must not overestimate its revenues, assets and profits; it must not underestimate its liabilities, losses and expenses. o Completeness. Reading financial reporting: Reading is an important pre-requisite before analysing and interpreting financial statements. First check to which entity the statements are referring: a single company or a consolidated group of companies. In financial reporting context attains relevancy to understand the results. For example, regulations and accounting policies are relevant as they influence contents of statements. Indeed, is fundamental to check which accounting standards are being used in the Accounting Policy pages. Further important are the Auditors’ Statements, the tell us if the data is reliable and the qualitative characteristics are being respected. Auditors are accountant. They change every tot year, but big four dominate their market. They are private figures but work in public interest. They have deontological rules and specific laws. It is not only a matter of reading the three main statements as it’s important to consider them all. A complete set of financial statements normally includes: Management report; Financial statements: o Balance sheet, o Income statement, o Cash flow statement, o Statement of shareholders’ equity, o Notes to the financial statements, a set of explanatory notes that discuss the items included in the financial statements, it may contain additional information and provide qualitative information; Auditor’s report.
A debit is an increase in an asset, a decrease in liability or a decrease in a shareholders’ equity item, including expenses. While a credit is a decrease in an asset, an increase in a liability or an increase in a shareholders’ equity item, including revenues. For every transaction, the total amount of debits must equal the total amount of credits. Otherwise, a transaction is “unbalanc1ed”. The recording process begins with the analysis of the transaction that are entered firstly in the journal, than transferred in the ledger. The journal allows to record all transactions in the chronological order. While the ledger records all transactions from the journal and it keeps in one place all information about changes in specific accounts balances. A general ledger contains all assets, liabilities and equity accounts. Journalizing is the action of “entering transaction data in the journal”. The elements of the general journal are:
- Column titled Ref. or N° (Reference), with the number of rows;
- Preposition “a” (@) that goes before the accounts that should be credited;
- Date of transaction. Names of the accounts that have to be debited and credited and brief explanation of the transaction. The debit account’s title is entered first, the credit account’s title is entered on the next line;
- Amount to be debited (in the debit column);
- Amount to be credited (in the credit column). The “Account Balance” is determined by netting the two sides (subctracting one amount from the other). From the comparison between Debits and Credits, we can have: Debit > Credit: Debit balance, Debit = Credit: Account balance is zero; Debit < Credit: Credit balance. After recording changes in the various accounts in a given period, it is possible to prepare a trial balance that is a “list of accounts and their balances at a given time”. Companies prepare the trial balance at the end of an accounting period. The list of accounts is shown in the order in which they appear in the ledger (debit balances appear in the left column, credit balances in the right column). The trial balance proves the mathematical equality of debits and credits after “posting”. Under the double-entry system, this equality occurs when the sum of the debit account balances equals the sum of the credit account balances. It is useful to check records, detect errors and prepare the financial statements. In the past, it was used to create the financial statements, but it was too complicated and long. Accounting for merchandise operations: The operating cycle of an entity is the time that a company takes in realizing its assets in cash or cash equivalents. The entities that we are analysing are essentially merchandising companies whose main activity is the purchase and sale of goods (and the main expenses are cost of goods sold and operating expenses). The operating cycle of a merchandising company covers the period that elapses between the acquisition of goods from suppliers and the receipt of sales from customers. The operations of a merchandising company involve the purchase of merchandise for sale (purchasing), the sale of the products of customers (sales), and the receipt of cash from customers (collection). The operating cycle of a merchandising company ordinarily is longer than that of a service company. Merchandising companies sell and buy merchandise rather than perform services as their primary source of revenue. Merchandising companies that purchase and sell directly to consumers are called retailers (wholesalers). Company purchases inventory using cash or credit (on account). Normally purchases are recorded when goods are received from the seller. Purchase invoice should support each credit purchase. A purchaser may be dissatisfied because the goods received are damaged or defective, or inferior quality, or do not meet the purchaser’s specifications. There are two options: purchase return or purchase
allowance. The support document for return registration is a credit note issued by the seller. Alternatively, the purchaser may choose to keep the merchandise if the seller is willing to grant an allowance (deduction) from the purchase price, purchase allowances. The costs of acquiring goods include: the purchase price; import taxes and other taxes not recoverable; and freight costs (transportation costs); while purchase discounts, rebates and other similar items, may decrease the costs. Freight Costs (transport expenses) incurred by the buyer are considered expenses and part of cost of purchasing inventory. In contrast, freight costs incurred by the seller on outgoing merchandise are operating expenses for the seller. A particular type of cost is that of labour. The employee earns gross wages, but they are not being paid that, due to the income tax and social securities, which both employees and employers pay. Purchase discounts and rebates reduce the cost of purchased goods. Cash discounts are not reflected in “Purchases” account and should be recorded in “Other Income” or “Prompt payment discounts obtained”. In accordance with the revenue recognition principle, companies record sales revenues when the performance obligation is satisfied. A company transfers to the buyer the significant risks and advantages inherent to the property, which, in general, happens with the delivery of the goods to the buyer. A sales invoice provides support for the transaction. The sale can be made on cash (immediate payment) or on credit. The registration is generally based on the invoice or invoice-receipt issued by the seller. The seller has to make two entries for each sale: the first entry records the sale, the goods are sold (output) and cash or receivables increase; the second entry records the cost of the merchandise sold, the merchandise is no longer in stock, but becomes cost of goods sold (input). The selling price minus the cost of goods divided by the selling price gives the margin or profit made over the selling price. While if we use the same formula we substitute the selling price with the cost of goods we have the margin over the cost of goods. When the seller incurs transport expenses with the goods sold, these expenses are not recorded as a reduction in income from the sale but are recognized as expenses in the External supplies and services (ESS) -Transport of goods. If commercial discounts or rebates are granted, they are recognized as a reduction to the sale price of the goods (so they decrease the amount recorded in the Sales account). While prompt payment discounts (or cash discounts) are not reflected in the Sales account but must be recorded in Other Expenses – Prompt payment discounts granted, because they have a financial nature. In order to carry out the business activity (and in addition to the purchase of goods), companies acquire other goods (ex. land, buildings, transport equipment, etc.) that are not intended to be sold in the normal course of the entity's operations, so they are not registered in Purchases (class 3 - Inventories) but are recognized in other accounts (classes) of the asset, depending on their nature and function that they have in the company. We can divide them in: specialized services, such as publicity and advertising, surveillance and security, maintenance and repair, and others; utilities expense or separate expense accounts for each type of utility such as gas, electricity and water, telephone, and others; supplies such as tools and utensils of rapid wear, office materials, and others. For example, in the case of fast-wearing goods (ex, paper, pens, etc.) they are not recorded as “assets” but are immediately recognized as expenses. Same, for the services consumed in the period (ex. electricity, water, telephone, etc.). Inventories: Manufacturers usually classify inventory into three categories: finished goods inventories are manufactured items that are completed and ready for sale; work in progress, that are that portion of manufactured inventories that have been placed into the production process but are not yet complete; or raw materials are the basic goods that will be used in production but have not yet been placed into production.
weighted average cost of inventories held. This method allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred. The following formula describes how to calculate it: Weighted-Average Unit Cost= ∑i (Quantity i x Unit cost i) / ∑i Quantity i When preparing financial statements nowadays for external reporting, the cost of inventories are normally determined using either FIFO or AVCO. Under inflation periods, like in the 80s, LIFO was the most used. With rising prices (inflation) FIFO will give the highest gross profit. This is because sales revenue is matched with the earlier (and cheaper) purchases. Conversely, inventories will be the highest as they will consist of the most recent (more expensive) purchases. LIFO will give the lowest gross profit because sales revenue is matched against the more recent (and dearer) purchases. LIFO will give the lowest closing inventories figure, as the goods held will be based on the earlier (and cheaper) purchases. But it’s a more prudent choice under rising prices. The AVCO method will normally give a figure that is between these two extremes. While if prices are falling (deflation) FIFO will give the lowest gross profit as sales revenue is matched against the earlier (and dearer) goods bought. The closing inventories figure in the statement of financial position will be lowest under FIFO, as the cost of inventories will be based on the more recent (and cheaper) purchases. This choice is more prudent under falling prices. LIFO will give the highest gross profit as sales revenue is matched against the more recent (and cheaper) goods bought. LIFO will provide the highest closing inventories figure. AVCO will give a cost of sales figure between these two extremes. Companies can use one of the two following systems to record the movements of inventories: Perpetual Inventory system, which keeps detailed records of the cost of each inventory purchased and sold, records the flow of inventories also in term of quantity and value, shows continuously the inventories that should be on hand for every item. Under this system, a company determines cost of goods sold each time a sale occurs. Periodic Inventory system (our focus in general) does not keep detailed records of the goods on hand throughout the period, and determines the value of inventories in warehouse and cost of goods sold only at the end of the accounting period (periodically). The relation between stocks (Beginning Inventory and Final/Ending Inventory) and economic flow of goods (Purchases and Cost of Goods Sold) is summarized by the following cost formula: Beginning inventory + purchases = cost of goods sold + ending inventory.
