FFA/FA Financial Accounting Lecture 1 - Introduction to Accounting PDF

FFA/FA Financial Accounting Introduction to Accounting  Sole Trader – this is the simplest form of business entity where a business is owned and operated by one individual. With this form of entity there is no distinction in law between and owner and the...

FFA/FA Financial Accounting Introduction to Accounting  Sole Trader – this is the simplest form of business entity where a business is owned and operated by one individual. With this form of entity there is no distinction in law between and owner and the business. Partnership – this is similar to a sole trader in that the owners of the partnership share all the profits and have unlimited liability for the losses and debts of the business. The key distinction is that there are at least two owners. Limited liability companies – this type of business entity differs from sole traders and partnerships. Limited liability companies are established as separate legal entities which make them distinct from their owners.  Advantages & Disadvantages Sole Trader: Disadvantages include: Advantages include: Owner is personally liable for all debts (unlimited liability). Limited paperwork and cost in establishing this type of Personal property may be vulnerable for debts and other structure. business liabilities. Owner has complete control over the business. Large sums of capital are less likely to be available to a sole Owner is entitled to profits and the ownership of assets. trader, leading to reliance on overdrafts and personal savings. Less stringent reporting obligations compared with other May lead to long working hours without the normal business structures – no requirement to make financial employee recreation leave and other benefits. accounts publicly available, no audit requirement. May be issues of continuity of business in the event of death Can be highly flexible. or illness of the owner.  Advantages & Disadvantages Partnership: Disadvantages include: Advantages include: Partners are jointly personally liable for all debts (unlimited Less stringent reporting obligations – no requirement to make liability). financial accounts publicly available, no audit requirement. There are costs associated with setting up partnership Additional capital can be raised because more people are agreements. investing in the business. There may be issues of continuity of business in the event of Division of roles and responsibilities and an increased skill death or illness of the partners. set. Slower decision making due to the need for consensus Sharing of risk and losses between more people. between partners. No company tax on the business (profits are distributed to Unless a clause is written into the original agreement, when partners and then subject to personal tax). one partner leaves, the partnership is automatically dissolved and another agreement is required between existing partners  Advantages & Disadvantages Limited Liability Companies: Disadvantages include: Advantages include: have to publish annual financial statements. This means that Investment is less risky than being a sole trader or investing anyone (including competitors) can see how well (or badly) in a partnership. However, lenders to a small company may they are doing. ask for a shareholder's personal guarantee to secure any loans. financial statements have to comply with legal and Raising finance easier (e.g. through the sale of shares) and accounting requirements. Sole traders and partnerships may there is no limit on the number of shareholders. comply with accounting standards for tax purposes. has a separate legal identity from its shareholders. The financial statements have to be audited. This means that relatively easy to transfer shares from one owner to another. the statements are subject to an independent review to ensure In contrast, it may be difficult to find someone to buy a sole that they comply with legal requirements and accounting trader's business or to buy a share in a partnership. standards. This can be inconvenient, time consuming and expensive.  Asset – present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits. Liabilities – present obligation of the entity to transfer economic resource as a result of past events. An obligation is a duty of responsibility that the entity has no practical ability to avoid. Equity – the residual interest in the assets of the entity after deducting all its liabilities. Income – increase in assets or decrease in liabilities that result in increases in equity, other than those relating to contribution from holders of equity claims. Expenses – decreases in assets or increases in liabilities that result in decrease in equity, other than those relating to distributions to holders of equity claims.  Fundamental qualitative characteristics Relevance Faithful representation Enhancing qualitative characteristics Comparability Verifiability Timeliness Understandability ✓ Materiality ✓ Substance over form ✓ Going concern ✓ Business entity ✓ Accruals basis ✓ Prudence ✓ Consistency  Accounting Principles 1. Going Concern Assumption the business will continue to operate for the foreseeable future, and that there is neither the intention nor the necessity to put the company into liquidation. The accountant will ignore the current liquidation values of the resources in the business because he assumes that these resources will not be sold but will be utilized by the business in its normal operations.  Examples Suppose that I buy an asset for $50,000. The asset is expected to last for 5 years. In this case, a depreciation cost of $10,000 per annum will be charged. Using going concern concept, the asset will carried at $50,000. After one year, the net book value will be $50,000 – $10,000 = $40,000 After two years it would be $30,000 and so on, until it has been written down to a value of zero after 5 years.  Examples (Cont.) Now suppose that this asset has no operational use and in a forced sale, the scrap value of the asset might be, say, $15,000 after one year. What would be the NBV of the asset next year?  Examples (Cont.) Now suppose that the business will be forced to close down next year, and the assets are expected to be sold for only $15,000. In this case, the going concern assumption became irrelevant. The assets will therefore be shown at the figure of $15,000 in balance sheet.  What situation where the going concern assumption should be rejected? if the business is going to close down in the near future; where shortage of cash makes it almost certain that the business will have to cease trading  Accounting Principles 2. Accruals Income is recognized in the financial statement as it is earned, not when the cash is received. Expenditure is recognized as it is incurred, not when it is paid for. Recognizes revenues when sales are made or services are performed, regardless of when cash is received. Recognizes expenses as incurred, whether or not cash has been paid out.  Accounting Principles 2. Accruals Revenue earned during an accounting period has to be matched with the expenses associated with earning that revenue. Sales made “Matched” during 1/1/16 – 31/12/16 Bills incurred during 1/1/16 – 31/12/16 Examples  Accounting Principles 3. Consistency A business should be consistent in: a) Similar items within a single set of accounts should be given similar accounting treatment b) The same treatment should be applied from one period to another in accounting for similar items. This allow valid comparisons to be made from one period to the next.  Accounting Principles 3. Consistency However, it does not mean that the business has to follow the method until the business closes down. A business can change the method used, but such a change is made with valid reasons.  Accounting Principles 3. Consistency When a company makes a change in accounting principles, it must make the following disclosures in the financial statements: (1) nature of the change; (2) reasons for the change; (3) effect of the change on current net income, if significant; and (4) cumulative effect of the change on past income.  Accounting Principles 4. Double Entry (Duality) Every financial transaction affects the entity in two ways and gives rise to two accounting entries, one a debit and the other a credit. The total value of debit entries is therefore always equal at any time to the total value of credit entries.  Accounting Principles 4. Double Entry (Duality) Debit Credit To own/have To owe An asset INCREASES An asset DECREASES e.g. new machine e.g. pay out cash Capital/liabilities DECREASES Capital/liabilities INCREASES e.g. pay creditor e.g. buy goods on credit Income DECREASES Income INCREASES e.g. cancel a sale e.g. make a sale An expense INCREASES An expense DECREASES e.g. incur advertising costs e.g. cancel a purchase Left hand side Right hand side  Accounting Principles 5. Business Entity Financial accounting information relates only to the activities of the business entity and not to the personal activities of its owners. Business is treated as a separate legal entity apart from its owners, creditors and others.  Accounting Principles 6. Materiality An item is material if its omission or misstatement could alter the economic decisions of user of the financial statements. An error which is too trivial to affect a user’s understanding of the accounting statements is referred to as immaterial. Determining whether or not an item is material is a very subjective exercise. In assessing whether or not an item is material, it is not only the amount of the item which needs to be considered. The context is also important.  Example Suppose that a sale of $100 has been recorded in error as a sale of $1000. If total sales are $10 mil, the error will not affect a user’s overall view of the business’s performance given by the income statement (and so the amount is said to be immaterial) If total sales are only $10,000, the error is material. If it is not corrected the income statement will be misleading.  Accounting Principles 7. Historical Cost All transactions of a business entity are recorded at the original cost i.e. the value of the item when the transaction occurred, not current market value. An important advantage of recording items at their historical cost is that there is usually objective, documentary evidence to prove the purchase price of an asset, or amounts paid as expenses. Any current market valuations would be based on opinions of the various valuers and thus would be subjective.  Accounting Principles 7. Historical Cost The problems to this concept is it ignores: Inflation Increase in market value of property Wearing out of asset over time  Qualitative Accounting Characteristics Those characteristics that make financial information more meaningful to anyone using them. The Conceptual Framework identifies two fundamental qualitative characteristics which is relevance and faithful representation, together with four enhancing qualitative characteristics which is comparability, verifiability, timeliness, and understandability.  Qualitative Accounting Characteristics 1. Relevance Information is relevant if it has the ability to influence the economic decisions of users and is provided in time to influence those decisions. Information is relevant if it can be used to predict future financial position and performance or if it used to confirm past predictions.  Qualitative Accounting Characteristics 2. Faithful Representation Information is faithfully presented if it is COMPLETE, NEUTRAL and FREE FROM ERROR. To be complete – all necessary information must be included To be neutral – objective and without bias, financial information not manipulated in any way in order to influence decisions of users. Free from error – no errors or omissions made in producing financial information  Qualitative Accounting Characteristics 3. Comparability Users must be able to compare the financial statements/information over time (current and prior year) to identify trends in its financial position and performance. Users must also be able to compare the financial statements/information of different entities to evaluate their relative financial position and performance. Comparability usually can be achieved through combination of consistency and disclosure  Qualitative Accounting Characteristics 4. Verifiability Means that a number of users would broadly agree that faithful representation of financial information has been achieved. Verifiability provides assurance to users regard its credibility and reliability.  Qualitative Accounting Characteristics 5. Timeliness Information may become less useful if there is delay in reporting it. There is trade-off between timeliness and fundamental characteristics of relevance and faithful representation. If information is reported on a timely basis but not all aspects of the transactions are known, it may not be complete or free from error. If every details of a transaction is known, it may be too late to publish the information. The overriding consideration is how best to satisfy the economic decision-making needs of the users.  Qualitative Accounting Characteristics 6. Understandability Financial information needs to be capable of being understood by users having a reasonable knowledge of business and economic activities and accounting. It must be presented in the way that users understand and able to make use of the financial information to base their decisions.