FAF Financial Accounting Lecture Notes 2024/25 PDF

1 UNIVERSITY OF BRISTOL FAF 2024 / 25 Financial Accounting Lecture Material 1  2 STUDENT STUDY UNIT WEEK 1 F...

1 UNIVERSITY OF BRISTOL FAF 2024 / 25 Financial Accounting Lecture Material 1  2 STUDENT STUDY UNIT WEEK 1 FINANCIAL ACCOUNTING WHAT IS FINANCIAL ACCOUNTING? Financial Accounting Annual Accounts: Tends toward the past, or historic and reporting of ‘what happened’. Mainly for external users. Follows “rules” and accounting standards (set formats, concepts and conventions). “RULES” WHICH AFFECT THE ACCOUNTS (FINANCIAL STATEMENTS) Accounting Standards / Accountancy bodies: o UK GAAP: Generally Accepted Accounting Practice. o IAS : International Accounting Standards o IFRS : International Financial Reporting Standards Companies Acts / Company Law: o For example, in England and Wales, there are legal rules in The Companies Act 2006 which must be followed when presenting company financial statements. o Companies listed on the London Stock Exchange have extensive additional reporting rules to comply with. Stock Exchange Requirements. Taxation Requirements. QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION “If financial information is to be useful, it must be relevant and faithfully represent what it purports to represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely, and understandable.” Accounting is about the Financial Statements being “True and Fair”. It is impossible to guarantee that every single figure is correct. They just have to be “relevant” and a “faithful representation” of the business. ACCOUNTING CONCEPTS AND CONVENTIONS Other terms you may come across that are implied, and underpin the qualitative characteristics: a) Prudence b) Accruals or Matching c) Consistency d) Going concern e) Historic Cost f) Money Measurement g) Materiality h) Separate (Business) Entity i) Dual Aspect 2  3 BUSINESS STRUCTURES Different entities will report their Financial Statements in different ways (due to GAAP). In this course we focus on business entities only (entities seeking to make a profit for their owners). Other types of organisation exist, such as Charities, and the presentation of their financial statements will be slightly different, although many of the same basic accounting principles will apply. On this course, we will focus on producing Financial Statements for Sole Traders and Companies. ALL BUSINESS STRUCTURES PRODUCE FINANCIAL STATEMENTS We use the accounting concept of ‘Separate Entity’, by accounting for the assets, liabilities, equity and transactions of the entity, separately from the personal assets, liabilities and transactions of the entity owners. The business exists as an entity in its own right. Sole Traders (single owner) Partnerships (multiple owners) Limited Liability Partnerships (multiple owners) Companies (single or multiple owners) → PLC and LTD To become a company, the business must ‘incorporate’. DIFFERENCES DUE TO INCORPORATION Legal nature Liability (Debt) Taxation Financing opportunities (Debt v Equity) Costs of compliance and administration FINANCIAL STATEMENTS OR ACCOUNTS Financial reporting communicates accounting information to users, usually in a specified format. There are Three Major Financial Statements: The Statement of Financial Position (SOFP or Balance Sheet) (TB1) The Statement of Comprehensive Income (SOCI or I/S) (TB1) The Statement of Cash Flows (CFS) (TB2) PLUS The Statement of Changes in Equity (SOCE) only for Limited Companies or PLCs. (This links the SOCI to the SOFP by showing changes in profits, reserves and equity over a period of time.) 3  4 ELEMENTS OF THE FINANCIAL STATEMENTS: Some definitions and examples of accounts you might find under each heading: ASSETS (SOFP) “An Asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.” They can be split into: Non-current assets: These could include tangible and intangible assets that are used / held for a long period of time. Examples would include items like accounts like Property, Plant and Equipment. Current Assets: These could include assets that are held for a short period of time. Examples could include accounts like Inventories, Trade Receivables (amounts owed by trade customers to the business), Bank (positive account balance) and Cash (petty cash). [The “Bank” balance could be an asset (positive bank balance) or liability (overdraft).] LIABILITIES (SOFP) “A Liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in a future outflow from the entity of resources embodying economic benefits.” They can be split into: Non-current Liabilities These could include long term loans and borrowings which are not due to be repaid by the business within 1 year (so due > 1 year). Examples could include long term bank loans or mortgage accounts. Current Liabilities These could include short term loans and borrowings which are due to be repaid by the business within 1 year (so due < 1 year). Examples could include accounts like Trade Payables (amounts owed by the business to trade suppliers), and other short term liability accounts including the Bank Overdraft account. INCOME (SOCI or I/S) “Income is the increase in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.” Sales / Income / Revenue For example, all income raised from trading activities of the business. This includes all sales, regardless of whether cash was received from the sales (“cash sales”) or if cash is owed to the business from trade customers (“credit sales”) due to credit sales agreements. 4  5 EXPENSES (SOCI or I/S) “Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or increases of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.” Costs / Expenses For example, all costs arising from the day-to-day running of the business. This includes all costs incurred in the accounting year regardless of whether cash was paid for the expenses or still owed at the year-end. Examples could include expenditure during the financial period for manufacturing, administration, sales & distribution expenses, taxation and financing costs. EQUITY (SOFP) “Equity is the residual interest in the assets of the entity after deducting all its liabilities. So an annual profit increases equity (but not necessarily cash) and a loss decreases equity. This is sometimes called ‘Equity/ Capital’ or ‘Capital plus Reserves’.” Owners’ (Proprietor or Shareholders) Equity / Capital: For example amounts owed by the business to the owner(s) of the business. This would include: any amounts that the owner(s) put into the business and; all profits (retained earnings and reserves) built up over time by the business. (All profits made by the business ultimately belongs to the owner(s) THE YEAR-END Businesses prepare their accounts and produce Financial Statements every year to their year-end date. A businesses’ accounting year typically lasts 12 months and the year-end date is chosen by management. All accounting transactions that occur over the accounting year are recorded. This recorded information is used to produce a list of accounts at the year-end, and this list of accounts is called the Trial Balance. These accounts are then reflected in the financial statements (SOFP / Balance Sheet and SOCI or I/S) to show how the business has performed in the year (SOCI or I/S) and the position of the business (SOFP / Balance Sheet) at the year-end. (We will link the items in the Trial Balance to the Statements (the SOFP and SOCI) in Week 2.) THE TRIAL BALANCE (T/B) The Trial Balance includes a list of all general ledger accounts used by a business. Each account has either a Debit (Dr) or Credit (Cr) balance, depending on the account type and the nature of the account transactions. The Trial Balance totals the Debit and Credit accounts separately. A preliminary check of the accuracy of the accounting entries, is to ensure that the total for the debit column equals to the total of the credit column. Every Debit entry should have a corresponding Credit entry, and this would mean that the “Accounting Equation” holds. (We will cover the Accounting Equation in Week 2). 5  6 The list of all the account balances in the TB can be run at any date. The SOFP accounts would include all asset, liability and equity accounts at a point in time. The SOCI (I/S) accounts would include all income and expense accounts for the accounting year, to that same point in time. An example of an SOFP account could be “Inventories” (e.g. as at 31 December 2024). This asset balance could go up or down over time, when inventories are bought or sold. This balance is carried forward from one accounting period to the next. The starting / opening or brought forward figure (“b/fwd balance”) in a new accounting year, will be taken from the ending / closing or carried forward figure (“c/fwd balance”), from the accounting year just preceding it. An example of an I/S (SOCI) account could be “Sales” (e.g. for the accounting period to 31 December 2024). This account would only show the income generated from sales made during that accounting period. There are no balances brought forward or carried forward for Income Statement accounts as they are closed off at the end of an accounting period, and the relevant totals taken to the SOFP equity section. The I/S accounts start at zero at the start of every accounting period of the business. The table below shows which general ledger account types typically go into the Debit (Dr) or Credit (Cr) columns of the Trial Balance. THE TRIAL BALANCE (TB) SUMMARY OF ACCOUNTS EXAMPLE DEBIT (Dr) CREDIT (Cr) £ £ Assets (SOFP accounts) X (Non-Current Assets & Current Assets balances) Provisions against any Assets (SOFP accounts) X (Reduces the Asset figures above) Liabilities (SOFP accounts) X (Non-Current Liabilities & Current Liabilities balances) Equity (SOFP accounts) X (Capital & Retained Earnings / Reserves balances) Income (I/S or SOCI accounts) X (All income generated in the accounting period) Expenses (I/S or SOCI accounts) X (All costs incurred in the accounting period) TOTALS (should agree) TOTAL TOTAL The accounts, and their sub-accounts, in the Trial Balance can be listed out in any order. For every accounting transaction made, two entries (Dr and Cr) must be recorded. This is the dual aspect concept demonstrated in the double-entry accounting system. That is why the Trial Balance will always balance if there are two sides to each transaction. 6  7 TRIAL BALANCE EXAMPLE: Vegan Yum Cake is a bakery which started trading on the 1st January 2024 and has the following list of accounts as at 30th June 2024. Its accounting year-end date is 31st December 2024. £ Ovens and utensils (used to bake cakes) 26,000 Loan (due after 1 year) 25,000 Trade Payables (suppliers the bakery owes) 1,200 Inventories (flour, butter sugar, chocolate) 15,000 Trade Receivables (customers who owe the bakery) 1,500 Cash (petty cash in the safe) 150 Furniture and fittings (used in the bakery) 17,350 Bank Balance (money in the bank is a positive amount) 2,000 Sales (credit and cash sales for 6 months) 13,000 Cost of Sale of cakes (cost of baking / ingredients of cakes sold) 4,000 Rent and rates (cost for 6 months) 12,000 Staff Wages (cost for 6 months) 5,000 Cleaning and repairs (cost for 6 months) 200 Utilities (cost for 6 months) 6,000 Draw out a Trial Balance as at 30th June 2024 using the template below. [Hint : Think about what account might be missing from the table above that would be needed for the TB to balance.] VEGAN YUM CAKE TRIAL BALANCE AS AT 30 JUNE 2024: DR CR £ £ Ovens and kitchen utensils Loan Trade Payables Inventories Trade Receivables Cash Furniture and fittings Bank Balance Sales Cost of Sale of cakes Rent and rates Staff Wages Cleaning and repairs Utilities TOTALS Imagine during July 2024 there were movements in some of the accounts above. Every transaction that occurred in July must be recorded. In order for the Trial Balance to balance at the end of July too, each transaction recorded must have two sides to it. This is called the double entry system. Every transaction must have a Debit (Dr) and a Credit (Cr) side, and this will either increase or decrease the balances brought forward (B/fwd) at the start of the period to get to the balances carried forward (C/fwd) at the end of each period. 7  8 DOUBLE ENTRY SYSTEM Examples of the double-entry system (two sides to every transaction) in the transactions below: 1) If an asset is bought, the account with the asset will need to show a larger amount. Assets have a Debit balance so increasing an asset means Debiting the Asset’s account. One side: (i) Debit the Asset’s account (more assets are owned); There needs to be a corresponding Credit entry of the same value for the Trial Balance to balance. The Credit entry would depend on whether the Asset was bought with “cash” (as opposed to “on credit”) or if a payment for the asset was owed (bought “on credit”). If cash was paid for the Asset, that would mean money out of the bank, and we would end up with a lower Bank balance. If the Bank balance initially had a Debit balance, after a payment, this Debit balance would be lower. Crediting a Debit balance would lower it, so the other side of the transaction would be: (ii) Credit the Bank account (money has gone out of the bank account). 2) If an asset is bought on credit (instead of cash being paid), the account with the asset will still show a larger amount (same as before). One side would still be: (i) Debit the Asset’s account (same as before); The Credit entry would now have to reflect an increase in a liability (as cash is owed for the asset). A liability has a credit balance, and this credit balance would now need to be increased because more is owed. Now the other side would be: (ii) Credit the Liability (could be non-current or current) account. 3) If cash is paid for an expense like repairs. One side would be: (i) Debit the Expense account called “repairs” (expenses in a period are always debited); The Credit entry would now have to reflect that the expense was paid. This means the Bank balance would have to go down. The other side would be: (ii) Credit the Bank account (money has gone out to pay for the expense). [If cash was not paid (but owed) for the repairs, then you would Credit the liability account instead.] 4) If cash is received from a sale. One side would be: (i) Debit the Bank account (money has come into the bank account) The Credit entry would have to reflect that the sale was made. The other side would be: (ii) Credit the “Sales” account (income generated in the period is always credited). If however the sale was made on “credit”, (so no cash was received at the point of the sale but owed by credit customers), the double entry would be: (i) Debit the Trade Receivables account (customers owe the business for the sale); The Credit entry would still reflect that the sale was made. The other side would still be: (ii) Credit the “Sales” account (same as if the sale was for cash rather than credit). 8  9 Vegan Yum Cake Second Example: The transactions below occurred in July 2024. Adjust the Trial Balance figures brought forward (B/fwd) from 30th June 2024 to create a Trial Balance (C/fwd) for Vegan Yum Cake as at 31st July 2024. Transactions in July 2024: £ An Air Fryer was purchased with cash 3,000 Flour was purchased with cash (rather than credit) from a wholesaler 120 Cash was paid to repair an oven 500 Cash received from credit customers for previous credit sales 1,500 VEGAN YUM CAKE TRIAL BALANCE AS AT 31 JULY 2024: DR CR £ £ Ovens and kitchen utensils Loan Trade Payables Inventories Trade Receivables Cash Owner’s investment Bank Balance Sales Cost of Sale of cakes Rent and rates Staff Wages Cleaning and repairs Utilities Furniture and fittings Air Fryer TOTAL You may show any workings (in brackets), next to the account names in the left column. Always put any “cash” transactions through the “Bank” account rather than “Cash” account unless specifically told otherwise. Note: The bank figure can either be an asset (Dr balance) or an overdraft (Cr balance). Just picture your own bank account. It can go up (if you receive money) and go down (if you pay for items). If more money has gone into your account, than out of your bank account, then you will end up with a positive balance → Asset (Money in your account is a Debit Balance); If more money has gone out of your account, than into your account, you will end up with a negative balance → Liability (An overdraft is a Credit Balance). 9  10 Vegan Yum Cake Third Example: The transactions below occurred in July 2024 (instead of transactions in the Second Example). Adjust the Trial Balance figures brought forward (B/fwd) from 30th June 2024 to create a Trial Balance (C/fwd) for Vegan Yum Cake as at 31st July 2024. Transactions in July 2024: £ An Air fryer was purchased on credit (using a long term loan i.e. due> 1 year) 3,000 Flour was purchased on credit from a wholesaler 120 Oven repairs undertaken in July are to be paid in August 500 No cash received yet for previous credit sales made in June 0 VEGAN YUM CAKE TRIAL BALANCE AS AT 31 JULY 2024: DR CR £ £ Ovens and kitchen utensils Loan Trade Payables Inventories Trade Receivables Cash Owner’s investment Bank Balance Sales Cost of Sale of cakes Rent and rates Staff Wages Cleaning and repairs Utilities Furniture and fittings Air Fryer TOTAL Note: If all the transactions are done on credit, then there will be no cash movement in the period. You are now ready to attempt the Tutorial and Exercise Lecture questions for Week 2. In the next lecture we will link the Trial Balance to Statement of Financial Position (Balance Sheet) and the Statement of Comprehensive Income (I/S). 10