Accounting Notes - Revision PDF

Preview

Summary

1. Introduction to Financial AccountingAccounting is the process of identifying, measuring and communicating economic information to assist users of that information to make informed decisions: - Financial accounting : periodic financial statements provided to external decision makers, - Management ...

Description

1.

Introduction to Financial Accounting

Accounting is the process of identifying, measuring and communicating economic information to assist users of that information to make informed decisions: - Financial accounting: periodic financial statements provided to external decision makers, - Management accounting: planning and performance reports to internal decision makers, accounting: a financial accounting system where revenues and expenses are recorded when they are incurred, regardless of whether cash has yet changed hands. Financial accounting presents information through financial statements: ¾ Balance Sheet A balance sheet measures and describes a company’s financial position, i.e. its set of financial resources and at a point in time. Its 3 main components are assets, liabilities and shareholder’s equity. The relationship between assets, liabilities and equity is given by: Assets Liabilities  Equity ¾ Income Statement An income statement measures a company’s financial performance, i.e. profitability over a period of time. It gives a based on the revenues and expenses incurred during the period. ¾ Statement of Cash Flow A statement of cash flows shows the change in cash of one balance sheet during a period of time. This is necessary because in an accrual system, revenues do not equal cash gained and expenses do not equal cash paid o Operating activities: provision of goods and services between customers, suppliers and etc. o Investing activities: or of noncurrent assets, e.g. o Financing activities: change in size and of the financial structure Financial Statement Assumptions: - Accrual basis: effects of transactions are recognised as they occur - Going concern: statements are prepared under the that the organisation will continue operating in the foreseeable future, otherwise it is necessary to report the values of an organisation’s assets - Accounting : the entity that prepares financial statements are separate from its owners - Accounting period: the life of a business needs to be divided into discrete periods of equal time to evaluate financial performance and position, e.g. quarterly, monthly, yearly - Monetary: transactions are all measured in a common denominator, e.g. $AUD - Historical cost: assets are recorded at their original cost at purchase - Materiality: everything on the statement is material, i.e. its could influence the economic decisions of users made on the basis of financial statements. Also, items that have a small dollar value are expensed rather than included as asset, e.g. a packet of lollies 2

2.

Measuring and Evaluating Financial Position and Performance

¾ Balance Sheet: For period up to/As at A balance sheet presents information on an entity’s financial position at a point in time, such as: - Assets, liabilities and shareholders’ equity - Solvency: the ability to pay debts in the long term - Liquidity: the ease with which assets can be converted to cash in normal course of business, short term Balance sheets are comparative, showing accounts at both beginning of the income statements period and at the end.  Assets Assets are resources controlled by the entity as a result of past events from which future economic benefits are expected to flow to the entity. An asset must have: - Future economic benefit to generate net cash flow for the entity - Ownership and control, i.e. able to benefit from the assets and to deny access to others - Obtained from past transactions or events through using cash, credit or barter transactions - A cost or value that can be measured with reliability Assets are classified into two types o Current assets: short term assets that are expected to be used or sold within the next year o Non-current assets: long term assets that will have benefit for more than a year into the future, such as long term investments and properties All assets are initially recorded at their historical cost, the cost at the time of purchase. During its useful life it has a depreciable present value and when its useful life expires it has a realisable value, the cost it could be sold at.  Liabilities Liabilities are present obligations of the entity arising from past events, the settlements of which are expected to result in an outflow from the entity of resources with economic benefits. The essential characteristics of liabilities are: - A present obligation (usually legally enforceable) exists and the obligation involves settlement in the future via the sacrifice of economic benefits - Adverse financial consequences for the entity - A cost or value that can be measured reliably Liabilities also have 2 types: - Current liability: obligations expected to be settled in the normal course of the entity’s operating cycle, or within a year of the end of the accounting period - Noncurrent liability: obligations due more than a year into the future, e.g. mortgages

3

 Equity Equity (owner for private, shareholders for public) is the residual interest in the assets after deducting all of its liabilities. Sources of equity include: - Direct contributions from owners or shareholders - Accumulation of profit not withdrawn by owners - Profit not distributed as dividends to shareholders Manipulating the accounting equation:

AL Net Assets

SE

SC



Share Capital

RP Re tained Pr ofits

 R  E  Re venue

Expenses

D Dividends

Definitions: - Share capital: equity obtained through trading stock to shareholder for cash - Retained profits: net income not distributed as dividends to shareholders - Revenue: income received from normal business activities - Expenses: outflow of cash to another company or person - Dividend: portion of profit paid out to shareholders. This is NOT an expense ¾ Income Statement: For period ending/As of An income statement presents information through accrual accounting on the profit or loss for a certain period of time. Profit or loss is calculated using: Net Profit Revenue  Exp enses  Revenue Revenue is defined as gross inflows of economic benefit (increase in wealth) during the period arising from ordinary activities of the company (provisions of services or sales of goods).  Expenses Expenses are decreases in economic benefits (wealth) during the period that are incurred when generating revenue. It is in the form of outflows or depletions of assets or incurrence of liabilities that results in a decrease in equity. Relationship between profit and retained profits: Retained profit at end of period Retained profit at beginning of period  Net profit – dividend Income statement and balance sheet cam be combined to gain useful information. This is called articulation of the two statements. E.g. income statement tells how much profit a company has made, on the balance sheet this contributes to total equity, but the balance sheet also explains where these profits come from. Capital Expenditure vs. Expenses Capital expenditures are costs that create future benefits through purchase of fixed assets or adding value to existing assets. When a firm spends money, if the resulting benefit is to be realised in the: - Current accounting period, then it is an expense - Next or future accounting period, then it is an asset 4

3.

Double Entry System

Transaction analysis is the analysis of how various transactions affect the accounting equation. The golden rule as always is that the accounting equation must balance: Assets Liabilities  Equity Double Entry Bookkeeping Under the double entry system, every transaction always affects at least two different accounts in order to maintain the balance in the accounting equation. The net effect of these amounts is called the account’s balance, and it is influenced by: - Debit (Dr) : increase to resources/assets, anything on the left hand side of a balance sheet - Credit (Cr) : increase to sources/liabilities or equity, anything on the right hand side of a balance sheet Ever transaction incurs a debit and a credit entry so at any point in time:

Total Debit Type of account Assets Liabilities Shareholder’s equity Revenue Expenses

Normal balance Debit Credit Credit Credit Credit

Total Credit Increase Debit Credit Credit Credit Debit

Decrease Credit Debit Debit Debit Credit

Journal entries are a method of recording transactions in terms of debit and credit. It can list as many accounts as needed to record the transaction, but for each journal entry, debit must equal credit. E.g. Company A bought $450 worth of supplies by paying $100 cash up front and the rest as credit to be paid in the next month. $ $ Inventory (asset) 100 Dr Cash (asset) 100 Cr Inventory (asset) 350 Dr Accounts Payable (liability) 350 Cr E.g. Company B made credit sales of $40 000 on goods that costed $16 000 $ $ Accounts receivable 40 000 Dr Sales Revenue 40 000 Cr Cost of goods sold 16 000 Dr Inventory 16 000 Cr

5

4.

Record-Keeping

The accounting cycle is the collective process of recording and processing accounting events of a company, starting from transactions to the preparation of financial statements. The stages are: ¾ Source Documents Source documents are documents that serve as evidence to show transactions have occurred. They permit auditing and verifying of errors and also reflect the various events in the operation of the business. Common source documents are: - Cheques for cash payment - Receipts for cash received - Invoices for credit sales ¾ Prepare Journal Entries Accounting transactions are recorded based on source documents using journal entries. A journal entry can list as many accounts as needed to record the transaction, but the sum of debits must always be equal to the sum of credits. Each journal entry has a posting reference to indicate which ledger account it affects. This number corresponds to the company’s chart of accounts, the list of all ledger accounts. ¾ Post to Ledgers Ledgers are used to determine the total change to an account, e.g. cash, after all the journal entries in a period. The general ledger is the complete set of all accounts: assets, liabilities, equity, revenues and expenses. A simplified version of ledgers is the T-account, which only lists debits and credits without calculating balance after every entry.

The journal entries are still necessary, because ledgers split up the transactions so we won't know what the debit and credit is in a particular transaction ¾ Prepare a Trial Balance A trial balance is an initial check for any mechanical errors while posting all journal entries to ledgers. Since the general ledger contains all accounts which come from balanced journal entries, it must also balance. In a trial balance, the credit and debit of every account is totalled and their sums should equal.

6

However, some errors are NOT can occur even if a trial balance balances: - If a journal entry was not posted - If a journal entry debited/credit the wrong account - If the amount debited and credit is equal but both wrong ¾ Adjusting Journal Entries At the end of each accounting period, it is necessary to adjust the revenue and expense accounts (and all related asset/liability accounts) to reflect: - Expenses incurred but not yet paid - Revenues earned but not yet received - Cash received from customer in advance for work - Using up of assets, which creates an expense such as depreciation ¾ Prepare an Adjusted Trial Balance Any adjusted entries are then posted to the relevant ledger accounts, which require another trial balance to be prepared to make sure no mechanical error has occurred. ¾ Prepare Closing Journal Entries Closing entries formally translates the balances of revenue and expense accounts to a profit-loss summary and then transfer the balances to retained profits. This is to prepare the company for the next accounting period. Two types of accounts when preparing closing entries are: o Temporary Accounts - Accounts closed at end of accounting period, i.e. revenue and expense accounts - DEBIT all revenue accounts and CREDIT profit-loss summary - CREDIT all expense accounts and DEBIT profit-loss summary - DEBIT profit-loss summary then CREDIT it to retained profits - Credit balance in profit-loss summary is a PROFIT - Debit balance in profit-loss summary is a LOSS o Permanent Accounts - Accounts NOT closed at end of accounting period, i.e. assets, liabilities and equity - Balances in these accounts are carried forward to the next accounting period ¾ Prepare a Post-Closing Trial Balance Again, another trial balance is prepared after closing entries are made to ensure total credit equal to total debit ¾ Prepare Financial statements The accounts in post-closing trial balance can then be used to prepare the balance sheet. The accounts in the profit-loss summary translate to the retained profits.

7

5.

Accrual Accounting Adjustments

Accrual accounting is the recognition of events, estimates and judgements that are important to the measurement of financial performance and position regardless of whether they are realised: - Revenues are recorded in the period when they are earned, not received. - Expenses are recorded in the period when they are incurred, not paid. - Collection of cash when revenue/expense has been previously recognised only affects assets/liabilities Revenue and Expense Recognition  Recognition at the SAME time as cash flow When the revenue/expense occurs at the same time as cash is exchanged, there is NO difference in entries between cash and accrual accounting:  Recognition BEFORE cash flow Revenue and expenses are recognised when they are made, not when the actual cash has exchanged hands. Cash accounting doesn’t account for this and therefore UNDERSTATES revenue/expenses E.g. manufacture estimates it will incur future warranty costs next year for goods sold in the current financial year. Warranty expense should therefore be recognised in the current year, since it is the year which the goods were sold Cash Accounting Accrual Accounting Dr Nothing Dr Warranty expenses (+E) Cr Nothing Cr Warranty liability (+L)  Cash collection/payment for PREVIOUSLY recognised revenue/expenses When cash is finally collected or paid, they are recorded as a change in assets or liabilities and do not affect the revenue/expense account E.g. manufacture makes payment under warranty Accrual Accounting Dr Warranty liability (-L) Cr cash (-A)  Cash Flow BEFORE Recognition Sometimes, cash is received or paid in advance before the sale is made. These revenue/expenses are yet to be realised. Cash accounting ignores this and thus OVERSTATES the sales or expenses. E.g. prepaid insurance for a 24 month period starting next month. This should be recognised as an asset because it provides benefit, the expense is deferred until next year. Dr Cr

Cash Accounting Insurance Expense (+E) Cash (-A)

Dr Cr

Accrual Accounting Prepaid Insurance (+A) Cash (-A) 8

 Recognition AFTER Cash Flow When deferred revenue/expenses need to be recognised, but the cash flow has already occurred. E.g. insurance policy purchased 24 month ago expires, recognised as an expense Accrual Accounting Dr Insurance Expense (+E) Cr Prepaid Insurance (-A) Accrual Adjustment Entries often need to be adjusted to incorporate accrual accounting in order to improve the measurement of financial position and position. These entries are internal transactions to make sure assets and liabilities are recognised in the correct amount. - Accrual: revenue/expenses recognised before cash flow - Deferral: revenue/expenses deferred after cash flow  Deferral: Expiration of Assets – Prepayment Prepayments are cash paid in advance that will incur expenses in the future. They are classified as assets because expenditure has been made but there are future economic benefits as a result of past transactions. Prepayments are current assets if the future value continues into only the next year. E.g. a company whose balance date is 30th June pays insurance on 1st January 2012 for the calendar year 2012 at a cost of $12 000. When the accounting statements are made, i.e. on balance date, only half the insurance have been used up. The other half is recorded as an asset, as it can still be used into the next accounting year: June

Dr Cr Dr Cr

Insurance expense Cash Prepaid Insurance Cash

6,000 6,000 6,000 6,000

 Deferral: Unearned Revenue Unearned revenue is future revenue where the cash has been received in advance of actually earning the revenue. Unearned revenue is classified as a liability, because it represents future sacrifices of economic benefits the entity is presently obliged to make. E.g. company receives subscription of $240 000 in January for a magazine to delivered monthly for 12 month in the next accounting period. Presently it is unearned revenue because no service is provided, but the company is obliged to provide them. When they do, they sacrifice economic benefit. $ Accrual Accounting $ Note payment received in advance Jan Dr Cash 240,000 Cr Unearned revenue 240,000 increase in liability, oblige to perform service Feb Dr Unearned revenue 20,000 service performed, less liability Cr Sales Revenue 20,000 revenue earned and now recognised Mar Dr Unearned revenue 20,000 repeat every month for 12 month Cr Sales Revenue 20,000 9

 Accrual: Accrued Revenues Accrued revenue is when a service is provided but cash will not be received until the following period, they are classified as assets. E.g. In January, a company deposits $50 000 into a bank at 10% interest rates payable at end of the period. Although the interest can't be collected yet, it is recorded as an asset: Jan Dr Accrued Interest 5,000 Cr Interest Revenue 5,000  Accrual: Accrued Expenses Accrued expenses are when an expense is incurred in a particular period but the cash will not be paid until the following period, they are classified as liabilities. E.g. A company pays weekly wages (5 day week) of $5000 each Friday. The balance is 30th June which falls on a Wednesday. So the 2 days’ wages after Wednesday for next period is: Jul Dr Wages Expenses 2,000 Cr Wages Accrued 2,000 Contra and Control Accounts Most accounts are control accounts, i.e. their value is supported by data and can be physically measured. Contra accounts are in opposite direction to their control account counterparts. They allow changes to control accounts without changing the underlying records and data.  Accumulated Depreciation: To account for property, plant and other physical assets being used up by incurring a depreciation expense. The asset account doesn’t change because their cost is the same, but their economic value is being used up. Accumulated depreciation is the amount of depreciation over the life of the asset to date, whereas depreciation charged this year is the depreciation expense E.g. A company buys a truck for $50000 with an annual depreciation of $8000. After 2 years, the truck is sold for $37000. Record the journal entries: Dr Depreciation Expense 8,000 Cr Accumulated Depreciation 8,000 After two years, deducting the accumulated depreciation gives a net book value. Cost Acc. Depreciation Net Book Value End of 1st Year 50,000 8,000 42,000 End of 2nd year 50,000 16,000 34,000 When sold, company makes a revenue “gain on sale” of $3000, while the asset and contra is removed Dr Cash 37,000 Cr Truck Asset 50,000 Dr Accumulated Depreciation 16,000 Cr Gain on sale of truck 3,000 10

6.

Special Journals, Subsidiary Ledgers and Control Accounts

Special Journals Special journals are journals that record common transactions of the same type to streamline the recording of transactions. Entries made in special journal are posted directly to their corresponding ledger account. Transactions not included in special journals, such as depreciation, are recorded in the general ledger instead. Common special journals are: o Sales Journal: records credit sales of inventory o Purchases Journal: records credit purchase of inven...