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ACCA - F3

FINANCIAL ACCOUNTING

Study Notes

TABLE OF CONTENTS Sr. #

TOPIC

Page #

1.

INTRODUCTION OF ACCOUNTING

2–9

2.

ACCOUNTING EQUATION

10 – 12

3.

DOUBLE ENTRY BOOK KEEPING RULES

13 – 17

4.

BOOKS OF PRIME ENTRY AND BUSINESS DOCUMENTATION

18 – 29

5.

SALES TAX

30 – 34

6.

ACCOUNTING FOR INVENTORY

35 – 41

7.

NON-CURRENT ASSETS

42 – 49

IRRECOVERABLE DEBTS AND ALLOWANCES FOR 8. 9.

50 – 53

RECEIVABLES ACCRUALS AND PREPAYMENTS

54 – 56

CONTROL ACCOUNTS, PERSONAL LEDGERS AND CONTROL 10.

57 – 63

ACCOUNTS RECONCILIATION

11.

BANKING RECONCILIATIONS

64 – 66

12.

CORRECTION OF ERRORS

67 – 70

13.

SOLE TRADERS FINAL ACCOUNTS

71 – 72

14.

INCOMPLETE RECORDS

73 – 75

15.

LIMITED COMPANIES

76 – 85

16.

STATEMENT OF CASH FLOWS

86 – 92

17.

INTERNATIONAL ACCOUNTING STANDARDS

93 – 104

18.

CONSOLIDATION

105 – 113

19.

ANALYSIS OF FINANCIAL STATEMENTS

113 – 123

20.

REGULATORY FRAMEWORK AND ACCOUNTING CONCEPTS

124 – 129

21.

GOVERNANCE AND FINANCIAL REPORTING

130 – 131

Financial Accounting (FFA/F3) Notes |

Page #1

INTRODUCTION TO ACCOUNTING Accounting isthe system of recording and summarizing business and financial transactions and analyzing, verifying, and reporting the results. Recording means that the transactions should be recorded as they occur to provide up to date information to the management. Summarizing means that the transactions for a period are summarized to provide information to the concerned parties. WHO NEEDS ACCOUNTING ?

Any organization/business/individual that needs to keep track of their income, expenses, assets and liabilities

BUSINESS Any activity undertaken with the intention to make profit, but result can be profit or loss. Thus, it is an organization which sells something or provides a service with the objective of earning profit.

ORGANIZATION It is a place where a group of people are working together to achieve a common goal.

TYPES/FORMS OF BUSINESS ORGANIZATION Sole-proprietorship/ Sole-trader

Partnership

Limited company

Sole Trader A sole trader is the simplest form of business where it is owned and managed (operated) by one person (although there might be any number of employees). The sole trader and their business are legally the same entity and therefore the sole trader is fully and personally liable for any losses of the business. E.g. small retailer, painter and decorator. Partnership A partnership is where a business is owned jointly by a number of partners (minimum 2). Some, or all, of them will be actively involved in the business. Partners share profits and losses in accordance with their agreement. The partners and their business are legally the same entity and therefore the partners are jointly and severally liable for the losses of their business. E.g. accounting firms, solicitors, estate agents. Companies Company is: a business owned by many people and operated by many (though not necessarily the same) people.

Financial Accounting (FFA/F3) Notes |

Page #2

Companies are more complex and have the following characteristics: ∑ Owned by shareholders (or members) Limited companies are of two types: 1. Public (shares issued to general public) 2. Private (share issue restricted to friends and family) A company is a legal entity in its own right, and therefore the shareholders have only limited liability for any losses a company makes. Non-business entities It is not just businesses that will need to have accounting information and prepare financial statements – also charities, clubs and government (or public sector) organisations need it.

BUSINESS TRANSACTIONS A transaction is an exchange of goods or services between two persons or parties. Every business buys and sells goods or services and gets paid for what it sells and has to pay for what it buys. Many businesses have employees and have to pay for their work. All businesses incur expenses for services they receive such as electricity, water, telephone services. They all are business transactions. Thus, it is an event (measurable in terms of money) that changes the financial position of a business entity e.g. sale / purchase of goods or services etc. Event (Anything that happens)

Monetary events (e.g. daily shopping, buying / selling of goods etc)

Non-monetary events (e.g. Winning a game, delivering a lecture in a meeting)

Only those events are considered in accounting which can be measured in monetary terms, as stated by the Money Measurement Concept .

Event (Anything that happens)

External (e.g. Purchase of furniture from Mr. A)

Financial Accounting (FFA/F3) Notes |

Internal (e.g. loss of furniture by fire, decrease in value of a car due to wear and tear etc).

Page #3

Recording of transactions: The primary objective is to know whether business has made a profit or suffered a loss after a certain period. Nature o f Transaction

Cash transaction

Credit transaction

∑

With a cash transaction, the buyer pays for the goods or services immediately as they are received or possibly in advance. Cash is directly involved in a cash transaction e.g., payment through bank or payment through cash in hand.

∑

With a credit transaction, the buyer doesn’t have to pay for the goods or services on receipt but is allowed some time. Cash is indirectly involved in a credit transaction. Payments and receipts are postponed for some future time (credit period) e.g. business buys goods for resale and payment is made after one month. Parties t o a Credit Transaction

Receivable (A person who owes money to business)

Payable (A person to whom business owes money).

TYPES OF ACCOUNTING ACCOUNTING

Financial Accounting ∑ Production of summary financial statements / accounting reports for external users ∑ Prepared annually (six-monthly or quarterly in some countries). ∑ Generally required by law. ∑ Reflects past performance and current position. ∑ Information is calculated and presented in accordance with International Financial Reporting Standards (IAS or IFRS)

Financial Accounting (FFA/F3) Notes |

Management Accounting ∑ Preparation of accounting reports for internal users e.g. Management, employees. ∑ Normally prepared on monthly basis. ∑ Not mandatory. ∑ Production of detail accounts, used by management to control the business and plan for the future. ∑ Includes budgets and forecast of future activities as well as reflecting past performance.

Page #4

KEEPING A RECORD Transactions are recorded in accounts. The system of recording transactions is therefore called the accounting system. It is also called the book keeping system and sometimes ledger accounts. Ledger Ledger is a book of Account in which all different accounts are maintained. Accounts (T-Accounts) An account is a summarized record in which financial transactions of similar nature are recorded. Accounting consists of three main steps. 1. Recording in books of prime entry. 2. Classifying the transactions according to their nature and posting them in their particular accounts e.g. Sales transactions are posted to the sales account and expenses are posted to the expense accounts. 3. Summarizing Accounting data is transformed into meaningful form and summarized commonlyin two financial statements named as STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME and STATEMENT OF FINANCIAL POSITION.

KEY TERMS OF ACCOUNTING ASSETS Assets are useful or valuable things owned by a business to earn income and profit. A business gets economic benefits out of these items. Definition as per IAS 1 An asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. Types of Assets

Non-Current Assets The assets that are bought with the intention of use rather than resale. They are expected to be used by a business for more than a year to help generate income. These may be tangible or intangible e.g. furniture, building, software, goodwill etc.

Current Assets The assets that are bought with the intention of resale. These may be cash or expected to generate cash or other economic benefits within 12 months. They change from day to day in the normal course of trading e.g. stock, debtors, prepayments, bank, cash

LIABILITIES Liability is the money owed by the business for resources supplied by people or organizations other than the owner. Definition as per IAS 1 A liability is a present obligation arising from past event, the settlement of which is expected to result in an outflow of economic benefits. Financial Accounting (FFA/F3) Notes |

Page #5

Types of Liabilities

Non-Current liabilities Which are payable in more than 12 months’ time from the reporting date e.g. loan etc.

Current liabilities Which are payable in less than 12 months’ time from the reporting datee.g. trade payable, overdraft

CAPITAL / EQUITY Capital is the amount invested in a business by its owner (the sole trader). It may include: ∑ Money initially injected by the sole trader to start the business up ∑ Money subsequently injected by the sole trader ∑ Profits made by the business, less ∑ Money taken out of the business by the sole trader as drawings. Note that profits made by a business are effectively a return for the sole trader on the moneythat they initially invested. Any profits not taken out of the business as drawings are therefore in effect extra capital. Capital is a type of liability to the business, as the business theoretically owes this amount backto the sole trader. DRAWINGS Drawings are reduction in the liability of business to the owner. Whatever the owner takes out of the business for personal use, whether goods or cash, reduces the liability of the business towards owner, and are thus called drawings. EXPENSES Expenses are decrease in economic benefits during the accounting period in the form of outflows or depletion (decrease in value) of assets or occurrence of liabilities. Expenses are cost of supply of goods or services i.e. cost of operating a business. Types of Expenses

Capital

Financial Accounting (FFA/F3) Notes |

Revenue

Page #6

Capital expenditure Capital expenditure is made when a business spends money either to: ∑ Buy non-current assets for use in business and not for resale. ∑ Add to the value of an existing non-current asset by improvement in its earning capacity (future inflow of economic benefits). ∑ They are mentioned as non-current assets in Statement of Financial Position. Revenue expenditure Revenue expenditures are expenses incurred either ∑ In the ordinary course of the business i.e. operational expenses ∑ To maintain the existing earning capacity of the business. ∑ They are mentioned as Expenses in Statement of Profit or Loss and Other Comprehensive Income. Error in recording If the capital expenditure or revenue expenditure is mistaken one for the other, then gross profit or net profit figure (or both) will be incorrectly stated, as will the statement of financial position figures. If capital expenditure is treated as revenue expenditure, then the assets and profits are understated and vice versa. INCOME Income means inflow of economic benefits (whether by sale for cash or on credit). The definition of income covers both revenue and gains. Revenue arises in the course of the ordinary activities of an entity and is referred to by a variety of different names including sales and turnover. Profit The excess of income over expenditures is recognised as profit. Loss The excess of expenditures over income is recognised as loss. Purchases Items which are purchased with the intention of resale are called purchases, whether these are on cash or credit basis. Inventory Goods (purchased for resale) that remain unsold at the end of an accounting year i.e. unsold “purchases” are called Stock or Inventory.

FINANCIAL STATEMENTS The objective of financial statements is to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making decisions. The two most commonly made financial statements for sole traders are: ∑ ∑

Statement of profit or loss and other comprehensive income Statement of financial position

Financial Accounting (FFA/F3) Notes |

Page #7

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME It is that component of financial statements that shows the financial performance of a business for an accounting period by comparing its income and expenses. Statement of Profit or Loss and Other Comprehensive Income For the year ended 30 June 20x7 $

$

Sales Cost of sales Opening inventory Add: purchases Add: carriage inwards Less: closing inventory Gross profit Expenses Rent and rates Wages and salaries Carriage outwards Postage and stationery Insurance Irrecoverable debts Sundry expenses Depreciation: Equipment Motors Operating profit Interest payable NET PROFIT

STATEMENT OF FINANCIAL POSITION It is that component of financial statements that shows the financial position of a business at a point in time, by stating the assets, liabilities & capital of business. Statement of Financial Position As at 30 June 20x7 $

DEPRECIATION $

NBV $

Non-current assets Land and Building Equipment Motor vehicles Current assets Inventory Trade receivables Prepayments Bank and cash TOTAL ASSETS

Financial Accounting (FFA/F3) Notes |

Page #8

Capital Opening capital Add: Capital Introduced Add: profit for the year Less: drawings Closing capital Non-current liabilities 10% Loan repayable 20x6 Current liabilities Trade Accruals TOTAL LIABILITIES AND CAPITAL The formula used to derive closing capital is as follows: Closing Capital = Opening Capital + Capital introduced + Profit/(Loss) – Drawings

Assets in the statement of financial position are shown in order of their increasing liquidity. ∑ Liquidity: Ease with which an asset can be converted into cash. ∑ Working capital/ Net Current Assets is the excess of current assets over current liabilities. ∑ Gross Profit is the difference between sales and cost of goods sold. ∑ Net Profit is the difference between gross profits and other expenses Debtor/ Receivable A person to whom the business has sold items and by whom the business is owed money. A receivable is an asset of business (the right to receive payment is owned by the business)e.g sale of any non-current asset (Transaction is of credit nature) Trade Receivable/ Trade debtor A person who owes the business money for debts incurred in the course of trading operations i.e. because the business has sold its goods or services. E.g. Business is involved in producing medicine and sale of those medicines on credit to its customer.All trade debtors are current assets of the business. Creditor/ Payable A person from whom a business has purchased items and to whom a business owes money. An account payable is a liability of the business. E.g purchase of a plant and machinery on credit. Trade payable / Trade creditor A person to whom a business owes money for debts incurred in the course of trading operations. The term might refer to debts still outstanding which arise from the purchase from suppliers of materials, components or goods for resale. E.g. purchase of stock of medicine for resale on credit. These are the current liabilities of business. All trade payables are current liability of the business.

Financial Accounting (FFA/F3) Notes |

Page #9

ACCOUNTING EQUATION THE BUSINESS ENTITY CONCEPT/ SEPERATE ENTITY CONCEPT It states that the business entity must be treated separate from its owner. Accounting is done only for business not for owner. Thus, the financial accounts should show only the activities of the business and not the personal activities of its owner.

THE ACCOUNTING EQUATION A consequence of the separate entity concept is that a business will buy assets using borrowed funds or capital. Therefore the accounting equation always holds true: Assets = Liabilities + Capital

An assetis something that the business OWNS A liabilityis something that the business OWES Capitalis how much the business OWES to the owner. (a liability towards owner) Assets – Liability = Capital / Net assets/ Equity

THE DUALITY CONCEPT/ DOUBLE ENTRY CONCEPT This concept states that every transaction has dual effects, which are equal and opposite. When the dual effect is taken into account, the accounting equation will remain true. Sales and profit When a sale is made at a profit, one asset (inventory) is replaced by another (cash or a receivable). The amounts however are not equal – the difference being profit. In order for the accounting equation to hold true after this transaction has been recorded, the profit must be reflected in capital. Effects of Some Important Transaction on Accounting Equation 1. Owner puts money into business ($1000) Cash $1,000 = Capital $1,000 2. Owner took loan from bank for business ($500) Cash ($1000 + $500)

= Capital $1000 + Loan $500

3. Purchase of building ($600) Cash ($1500 – $600) + Building $600

=

Financial Accounting (FFA/F3) Notes |

Capital $1000 + Loan $500

Page #10

4. Purchase of goods $100 for cash and $100 on credit Cash ($900 – $100) + Building $600 + Inventory $200

=

Capital $1000 + Loan $500 + Trade payable $100

5. Sale of all the stock goods for $300 ($200 on credit; $100 on cash) Cash ($800 +$100) + Building $600 + = Capital $1000 + Profit $100 + Inventory 0 + Trade receivable $200 Loan $500 + Trade payable $100 6. Payment to trade payable $100 Cash ($900-$100) + Building $600 + Inventory 0+ Trade receivables $200 7. Owner took $200 of cash for personal use Cash ($800 – $200) + Building $600 + Inventory 0 + debtors $200 ∑ ∑

=

=

Capital $1,00 + Loan $500 + Trade payable 0

Capital ($1,100 – drawings $200) + Loan $500

If a business makes a profit, its capital and net assets increase. If a business makes a loss, its capital and net assets decrease.

Equation will always remain balanced because of dual effect of transactions but after every transaction there is a change in financial position.

EXPANDED FORM OF ACCOUNTING EQUATION Assets = Liabilities + Capital + Profit /(Loss) – Drawings Net Assets Equation Assets – Liabilities = Capital + Profit –Loss – Drawings Net Assets = Capital + Profit –Loss– Drawings The Financial Statements The detailed accounting equation can be rearranged to produce a Statement of Financial Position. Users of Accounting Information/Stakeholders 1.

Owners of the business Owners of the business are interested in their current and future profits and security of their investment. Profits are shown by Statement of Profit or Loss and ...