Chapter 1 Introduction to Accounting in Business PDF

CHAPTER ONE Introduction to Accounting in Business OBJECTIVES Knowledge Explain why a business needs an accounting system. Identify the three classes of users of accounting information. Explain the various...

CHAPTER ONE Introduction to Accounting in Business OBJECTIVES Knowledge Explain why a business needs an accounting system. Identify the three classes of users of accounting information. Explain the various forms of ownership and the different types of business. Explain the initial definition of Accounting. Explain the qualitative features of accounting and the underlying assumptions in the recording of transactions and the preparation of financial statements. Explain the difference between the viability of a business and the need for a proper cash flow in order to meet the immediate cash needs of the business. Have an initial understanding of the role of the three major financial statements. Explain the concept and understand the logic of the accounting equation. Problem solving skills ▪ Analyse and explain why different users require different information ▪ To analyse and interpret the effects of transactions on the accounting equation Analytical skills ▪ To analyse the transactions using the accounting equation and to draw up a simple statement of comprehensive income and Statement of Financial Position Communication skills ▪ Present logical ,structured discussion on the need for financial information ▪ Explain why a business would choose a certain form of ownership Accounting Page 1 of 22 Chapter 1 Course Notes Glossary of terms used Company A particular type of business organisation that is owned by shareholders (see below). Other types of business organisation are: sole proprietor, partnership, close corporation. Financial period A specific period of time for which financial reporting is done. , usually a period of 12 months but could be a month, three months, six months etc.. Financial statements Financial reports for a specific period prepared from the accounting records of the business. Profit The excess of revenues over expenses for a period. Shareholders Collective name for the share owners of a company. Stock Goods bought and held for resale or for manufacture into goods for resale. Sometimes known as inventory. Transaction For accounting purposes, any business deal of a financial nature; e.g. buying or selling goods, providing a service for a fee, incurring expenses. Members Collective name for the owners of a close corporation. Accounting Page 2 of 22 Chapter 1 Course Notes  Forms of business ownership. In South Africa there are different types of mechanisms for conducting a business. The most usual forms of entity are the company and close corporation - these are incorporated entities and the unincorporated entity, being the sole trader and partnership. There are advantages and disadvantages to the each of these different forms of ownership.. Comparison between the different forms of ownership Sole trader Partnership Close Companies corporation Legal None None Juristic Juristic personality no separation No separation personality, personality, between owner between separate legal separate legal and business owners and entity entity entity business entity Life Limited Limited Unlimited Unlimited Liability Owner liable for Partners jointly Members have Shareholders debts of the and severally limited liability have limited business liable for debts for the debts of liability. of the business the business – loss of their limited liability in some cases Management Owner Partners Members Board of directors Introduction In order to survive, every business needs to ensure that the business is viable and that it has sufficient cash resources to continue in business. To be viable a business must ensure that the price of the goods or services it provides to its customers is sufficient to cover the cost of those goods or services and provide an acceptable return to the providers of capital. In other words the business must make a profit. Making a profit however, is not sufficient to ensure the continued existence of the business. It must also have cash resources to cover its immediate needs, e.g. for the payment of salaries and wages and payment to suppliers of goods and services. Many a business has gone under in spite of making a profit and holding valuable assets, simply because it was unable to pay its immediate debts. Accounting Page 3 of 22 Chapter 1 Course Notes The Role of Accounting The owners and managers of a business will never know if the business is making a profit or if it has sufficient cash resources unless there is an orderly system of accounting capable of producing timely and accurate reports. In fact, accounting has no other function but to produce reports on which economic decisions can be made. Users of Accounting Information Financial statements are prepared and presented at least once a year. The information presented in these financial statements is directed at meeting the needs of a wide range of users. Financial statements include a Statement of Financial Position, a statement of comprehensive income, a statement of changes in equity, a cash flow statement and other explanatory notes and statements. These financial statements are a major source of information about the entity. The users of financial statements include present and future/potential investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agencies (eg. SARS) and the public. The information presented in the financial statements will satisfy their different needs. Accounting Page 4 of 22 Chapter 1 Course Notes These users could be broadly categorised into three classes: 1. Primary users. Investors These are the providers of risk capital and they would be concerned with the risk and return of their investment. These are persons or institutions with an ownership interest in the business. They may or may not have a management role in the business but as owners they are interested in their investment in the business and the accounting reports will be part of the information they need to make decisions on whether to hold, invest or sell their investment. Potential primary users would have similar information needs and this would aid their decision to invest or not invest in the business. 2. Secondary users. Those with a financial but not an ownership interest. This would include management, lenders, employees, suppliers and customers. Although these groups are classed together, their needs and the level of information would differ greatly. For example, management would receive detailed information on a daily, weekly or monthly basis. Customers on the other hand, may not be interested in any information at all unless they are large customers buying a critical product from the business. In this case, their continued existence may be bound to the continued existence of their supplier and a regular examination of financial reports may alert them to potential problems in the future. 3. Tertiary users. Those with no ownership or financial interest in the business. This group would include financial analysts, the public, government institutions/agencies such as the SA Revenue Services, and regulatory bodies such as the Stock Exchange, etc Accounting Page 5 of 22 Chapter 1 Course Notes The objectives of financial statements: The accounting framework states the objective of producing financial statements as being “ to provide information about the financial position(Statement of Financial Position), performance (statement of comprehensive income) and changes in financial position(cash flow statement) of an enterprise that is useful to a wide range of users in making economic decisions “ The financial statements interrelate because they reflect different aspects of the same transaction or event. Financial statements prepared for this purpose meet the common needs of most users. However they do not provide all the information since they portray past events and do not necessarily provide non-financial information. The objectives of the accounting framework, amongst others is: ▪ To provide a basis for reducing the number of alternative accounting treatments ▪ To assist auditors in forming an opinion as to whether the financial statements comply with IFRS ▪ To assist users of financial statements to interpret the information contained in them So what is accounting? Accounting has been described as “the process of classifying and recording transactions of an individual or organisation in terms of money or some other unit of measurement, in the books of account/accounting records and of summarising, reporting and interpreting the results thereof.”1 Kolitz and Quinn describe accounting as “an information system (that) selects data, processes that data and produces information about an economic entity.”2 1Canadian Institute of Chartered Accountants. Terminology for Accountants Toronto. 2Kolitz, D.L. and Quinn, A.B. A Concepts-Based Introduction to Financial Accounting. Cape Town, Juta & Co. Accounting Page 6 of 22 Chapter 1 Course Notes Bookkeeping would cover the first part of these definitions, i.e. “the process of classifying and recording transactions” and “…that selects data, processes that data…” Accounting is involved in “summarising, reporting and interpreting the results” (of the bookkeeping process). For the purpose of these notes we will use the term accounting to cover both processes. International Financial Reporting Standards (IFRS) Accounting may seem to outsiders to be an exact science akin to mathematics where one plus one equals two. In fact the preparation of financial statements generally involves subjective valuation that may open a gate to deliberate manipulation. Thus losses can be hidden or profits increased or diminished depending on the objectives of the owners or managers of a business. In an attempt to counter such practices and to provide for a degree of standardisation and comparability, international and national accounting bodies have produced a set of accounting standards. International Financial Reporting Standards (IFRSs) are standards and interpretations adopted by the International Accounting Standards Board (IASB). They comprise International Reporting Standards (IFRS) and International Accounting Standards (IAS). ▪ IFRS and IAS are a set of rules and regulations that have been developed over the years between industry and the profession. ▪ IFRS and IAS are a standard or benchmark – these standards can be defined as authoritative and generally accepted guidelines for the recording and measuring of financial information in the annual financial statements. These standards are documents issued by standard setting bodies.(IASB) ▪ IFRS and IAS aids comparisons and fair presentation. ▪ IFRS and IAS are a common set of rules which make comparisons and conclusions acceptable. The profession in South Africa has moved towards total harmonization with International Finance Reporting Standards (IFRS). During the course we will be referring to the following statements IAS Title Framework Framework IASCF IAS 1 Presentation of Financial Statements IAS 2 Inventories IAS 7 Cash Flow Statements IAS 16 Property Plant and Equipment IAS 36 Impairment of assets Accounting Page 7 of 22 Chapter 1 Course Notes Underlying assumptions All financial statements are produced using two basic underlying assumptions: 1. Accrual basis. Transactions are reported in the financial period in which they occurred, which may not correspond with the receipt or payment for such transactions. Thus if a company’s financial year ends on 31 December a sale on that date is recorded in that financial year even if payment is made in the following financial period. Another example: if stock is bought in one financial period but is unsold at the end of that period, it is not treated as an expense until it is actually sold. The accrual basis thus matches income and expenditure in the same financial period. 2. Going concern. A business (entity) is assumed to continue in the future and not to close down in the near future. The valuation of assets in a going concern could be considerably different from a business about to be closed down. The entity convention as used for accounting purposes separates the business and owner, even though legally they may be treated as one. For example, a sole proprietor of a business may own a house in which he lives or a car that is for his personal use. Under the entity principle such assets will not be recorded as business assets. But from a legal perspective, these assets may be attached to pay business creditors if the business is unable to pay them. Another aspect of the entity convention is that drawings by the owner are not considered to be business expenses, but cash or other assets taken by the owner for his personal use. We will learn later how other business forms viz. the close corporation and limited liability company overcome the legal problems of the entity convention. Accounting Page 8 of 22 Chapter 1 Course Notes The qualitative characteristics of financial statements. Qualitative characteristics are the attributes that make the information provided useful to the users. These notes will not go into such statements in detail but below is a summary of what these statements are attempting to achieve: Understandability. Financial statements should be prepared in such a manner that users with a reasonable understanding of business and accounting would be able to understand such statements. Relevance. Financial reports should be relevant to the needs of users. Thus the needs of shareholders, operational managers, lenders, etc. will differ and the financial reports will be tailored accordingly. The relevance of information is affected by its nature and materiality. Materiality. Many companies publish financial statements with amounts to the nearest thousand, or in some cases, million rand. The omission of an item below such threshold amounts would thus not impair the relevance or reliability of such financial statements. Materiality The relevance of information is affected by its nature and materiality. Reliability. Financial statements should be free from error or bias. This would depend largely on the reliability of the bookkeeping system. The reliability of this information is influenced by the following considerations: ▪ Faithful representation ▪ Substance over form ▪ Neutrality ▪ Prudence ▪ Completeness Comparability. The methods of subjective judgement used to value and measure various assets should be consistent from year to year. If there have been changes to methods of valuation, this should be stated and a comparison with the old method given. Accounting Page 9 of 22 Chapter 1 Course Notes Fair presentation. Financial statements shall present fairly the financial position, financial performance and cash flows of an entity. Fair presentation requires the faithful representation of the effects of transactions, other events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework. (IASCF 13) Even if there is no malicious intent, the preparation of financial statements always requires some subjective judgement. The financial statements therefore can never be absolutely correct but should be “fairly presented” within a range of constraints. The following are constraints on relevance and reliability of information Timeliness. Financial statements should be prepared within a reasonable time after the end of the financial period. The maximum time generally allowed is six months but most companies would prepare their financial statements within two or three months. Cost/benefit. The benefits of producing the information should not exceed the benefit of producing such information. This becomes questionable when one sees expensive annual reports prepared by listed companies, but the cost would be justified on the grounds of good public relations with the company’s shareholders, financial analysts, and the community it serves. The importance of time in accounting Business transactions are a seamless operation taking place day after day in the life of a business. Accounting however has to introduce the concept of time periods mainly to compare the results of one period with another. All businesses are required to have a “year end”, to comply with tax regulations, or the requirements of the Companies Act , or the Stock Exchange in the case of listed companies. Popular year-ends are 28 February, 31 March, 30 June, 31 August, 30 September or 31 December, but a business could chose any date in the year. This date is the date on which the financial transactions for that year will cease. Transactions on the next business day will be accounted for in the next financial year. Thus the longest financial reporting period for a business is a year; within that year it may also prepare financial statements for each month, each quarter or for the half year. Accounting Page 10 of 22 Chapter 1 Course Notes The role of accounting in business All businesses whether large or small, need to keep records of their financial transactions. Not all will keep their records in the precise way we shall explain in the next chapter, but most will have some sort of record, especially of their cash transactions, sales to customers and details of amounts owing to them by customers. For goods or services purchased they will keep the invoice or till slip. Even from such records, it is possible to draw up financial statements that will measure the profit or loss made in a particular financial period and show the net worth of the business at the end of that period. It will also be possible to show where the cash has come from and how it has been spent during that period. To illustrate these concepts we will take a very simple business and follow it through from its start-up through to its first month of trading. Accounting Page 11 of 22 Chapter 1 Course Notes Example Jack was a young man in his early twenties who had worked for a large pharmaceutical company. He was retrenched during the global economic crisis and had received a payment of R30 000 and some guidance on running a small business before leaving the pharmaceutical company. He decided to set up a reflexology business in the precincts of the stock exchange building in Sandton. Because of his optimistic and out-going nature, Jack soon built up a regular clientele and his small business thrived. Informal traders were allowed to operate in the precincts of the stock exchange but had to register with the property administrators and pay a rental of R300 per month. In return they were provided with a space within a covered area and the number of informal traders was restricted. A few days before he started trading, Jack registered with the property administrators and paid R300 for the first month’s rental. He gave R6 000 of his package (from the pharmaceutical company) to his sister to help pay for her wedding gown and her wedding cake. Soon he would be a wealthy businessman and would be able to throw her an exquisite wedding! He bought some chairs and a specially constructed reflexology bed with a built-in cupboard for his equipment. This all cost R1 440. He also paid R195 for some bottles of aromatherapy oils. These were fully used in the first few days of trading, so more oils would be needed In a rash moment after seeing an advert, he bought a second-hand cell- phone for R900 and a Vodago two-month airtime voucher for R300. He rationalised that this would enable his clients to phone him for appointments. The balance he put into a savings account at the nearby Capitec Bank. At the course he attended he was advised to keep a notebook of all his receipts and payments. He charged R20.00 for a foot massage. At the end of the first month, Jack was dismayed to find that he had less money in his savings account than he started with and he asks Solly (as a valued customer) to tell him where he has gone wrong. Solly gets Jack’s notebook and discovers the following (in addition to the information above): - Money received for massages R2520 - Bought more essential oils (oils fully used for the month) R960 - Taken for personal use R1800 Activity From the information above, draw up a "cash book" showing all the receipts and payments to date, and the balance in Jack's savings account. Think of reasons why he should or should not be dismayed at what he sees. Solution Accounting Page 12 of 22 Chapter 1 Course Notes  Cash received Cash payments Balance The first thing Solly does is draw up a statement showing where the cash has come from and where it has gone. Later in the course we will learn about the cash flow statement and how this should be drawn up. Accounting Page 13 of 22 Chapter 1 Course Notes This is how Solly drew this statement for Jack. This indicates that of the initial R………… Jack invested in the operation, he has …………… left. He made ………….. cash from the reflexology operation and together with the initial …………… he started with, would have given him ………….. However, he paid ………….. for assets that will last for some time, and drew out R1 800 for his personal use. He won’t have to buy any beds or cellphones next month, but if he draws more money for his personal use than he is making from the operation, he will soon have no money left. One of the underlying assumptions in the preparation of financial statements is that such statements are drawn up using the accrual basis. Obviously the cash statement shown above shows only the cash movements for the month, but if we are to draw up a statement showing how much profit Jack has made, we must use the accrual basis. This means that we must show all the transactions for the month that affect the income and expenditure regardless of when the cash was paid. Accounting Page 14 of 22 Chapter 1 Course Notes Statement of comprehensive income R Revenue/Income Less Expenses Accounting Page 15 of 22 Chapter 1 Course Notes Solly draws up such a statement: *Jack reckons that the furniture will last about five years and will not be worth anything after that. The cellphone will last about three years after which he can probably sell it for R144. So the use of the furniture for the first month is R1440 / 60, and the use of the cellphone is R900-144/36. Later in the course we will look in more detail at the concept of writing off long-term (or fixed) assets. From this statement we can see that Jack earned ………… using the accrual basis of accounting. This is the measure that he should use to gauge how much he can draw out for his personal use. If he draws out more he will in time exhaust all his capital; if he draws less he will build up his capital and personal wealth. Accounting Page 16 of 22 Chapter 1 Course Notes Solly also draws up a statement showing the net worth of Jack’s business at the end of the first month: R Assets Furniture (1440 – 24) 1 416 Cellphone (900 – 21) 879 Airtime voucher (300 – 150) 150 Savings account Liabilities - Net worth of business Original capital Profit Drawings (1 800) If Jack had drawn out only R870, the net worth of his business at the end of the first month would be R……………, i.e. the original capital put into the business. However, he drew out R……………. more than the profit made and this reduced the net worth of the business to R…………. IAS 1 Presentation of Financial Statements Financial statements should provide information about the financial position, performance and cash flows of the business that is useful for economic decision making by the users of these statements. Components of financial statements. ▪ Statement of comprehensive income shows the net income or profit earned for a particular period of time i.e. financial performance for a period of time. ▪ Statement of Financial Position shows the financial position of the business at a particular date. ▪ Statement of changes in equity reflects the changes in equity between two Statement of Financial Position dates. This change reflects the increase or decrease in its net assets or wealth. ▪ Cash flow statement reflects the ability of the entity to generate cash and cash equivalents and the needs of the entity to utilise those cash flows ▪ Accounting policies and explanatory notes Accounting Page 17 of 22 Chapter 1 Course Notes Assets, liabilities and the owner’s equity Assets are described as ▪ resources controlled by the business. ▪ They must arise from a past event; assets a business may buy in the future are not resources available to the business now. ▪ An asset must provide some future benefit; for example, a machine may be capable of producing goods that the business is able to sell. If this machine was not capable of producing anything, it is not a resource that will produce future benefits and is therefore not an asset. Note also that a business does not have to own an asset but must control the asset and receive the benefits therefrom. For example, a vehicle leased by a business is legally owned by the bank or finance house, but is controlled and used exclusively by the business, and is therefore considered to be an asset of the business. In summary, an asset is a resource: · Controlled by the business; · That arose from a past event; · That will provide a future benefit to the business. Liabilities are obligations of the business. ▪ Like assets they must arise from a past event. ▪ Liabilities will result in the outflow of resources; i.e. the business will have to repay the obligation at some time either in cash or by means of some other resource. Owner’s equity is simply the difference between assets and liabilities. If the liabilities exceed the assets, the business is technically insolvent; i.e. the owner’s equity is negative. Accounting Page 18 of 22 Chapter 1 Course Notes Recognition criteria: For an item to be incorporated into the financial statements it must meet the definition of an element of the financial statements and must satisfy the following that it is probable that any future economic benefit associated with the item will flow to or from the business the item has a cost or value that can be measure reliably. Note that for any business, the only sources of finance are owner’s equity and/or borrowings from third parties (i.e. liabilities). Accounting Page 19 of 22 Chapter 1 Course Notes  Activity Determine whether the following transactions fit the definitions of assets or liabilities: Transaction Resource or Past event? Future benefit or Asset or liability obligation? outflow of or neither? resources? Amount owing by customer for goods sold to him Amount owing to municipality for electricity used R1000 paid by client for services to be rendered next month R7000 paid to landlord for next year’s rent Piece of land bought for R800 000. To be used for expansion of factory. Accounting Page 20 of 22 Chapter 1 Course Notes The Accounting Equation If the owner’s equity is the difference between assets and liabilities, then we can state the above three elements in an equation: Assets – liabilities = owner’s equity or Assets = Liabilities + Owner’s Equity Assets are represented by a number of different items from non current assets such as property, plant and equipment (land and buildings, plant and machinery and motor vehicles), to current assets such as inventory, accounts receivable and cash. Liabilities consist of amounts owing to third parties such as banks and finance houses, and suppliers of goods and services. Owner’s equity has four major areas: ▪ capital introduced by the owner, ▪ drawings by the owner, ▪ income and expenses. The difference between income and expenses represents the profit or loss made by the business, and this belongs to, or must be borne by, the owner. Income is defined as ▪ increases in economic benefits during the accounting period in the form of: inflows or enhancements of assets, that result in increases in equity, other than those relating to contributions from owners. Expenses are defined as decreases in economic benefits during the accounting period in the form of: outflows or depletions of assets, that result in decreases in equity other than those relating to distributions to owners. Every financial transaction must be entered in the books of account in such a way that the accounting equation stays in balance at all times. Accounting Page 21 of 22 Chapter 1 Course Notes Examples: ▪ Owner introduces cash to start the business; increase an asset (cash) and increase the owner’s capital. ▪ Business buys a motor vehicle for cash; increase one asset (motor vehicles and decrease another asset (cash). ▪ Business buys a motor vehicle by using bank finance; increase assets (motor vehicles) and increase liabilities (bank loan) ▪ Owner brings his motor vehicle into the business; Increase assets (motor vehicles) and increase owner’s equity (capital). ▪ Business sells goods for cash; increase asset cash, and increase income (under owner’s equity) ▪ Business buys stock on credit; increase asset stock, and increase liability accounts payable. There are obviously many more examples that could be given, in fact as many examples as there are business transactions. In the next chapter we will deal with the accounting procedures that deal with such transactions in a way that keeps the accounting equation in balance at all times. Accounting Page 22 of 22 Chapter 1 Course Notes