Introduction to Accounting Lecture Notes PDF

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INTRODUCTION TO ACCOUNTINGLECTURE 1ASSETS= OWNER’S EQUITY + LIABILITIESAccounting summarises numerical data (accounting information usually in money terms) relating to past events and presents this data as information to managers (who have the authority to take action now to maintain or improve futu...

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INTRODUCTION TO ACCOUNTING

LECTURE 1 ASSETS= OWNER’S EQUITY + LIABILITIES Accounting summarises numerical data (accounting information usually in money terms) relating to past events and presents this data as information to managers (who have the authority to take action now to maintain or improve future outcomes) and other interested parties as a basis for both decision-making (accounting information is often used to determine what went well and which events didn’t go as planned) and control purposes.

Accounting is the process of  Identifying  Measuring  Communicating Financial information about an entity to permit informed judgments and decisions by users of the information. In other words, it is an information system to provide users with economic information in order to make decisions. Accounting information is useful for holding those entrusted by others with resources (stewardship) accountable for their actions, for instance information on how the government are spending taxes, or how directors are performing. It leads to CONTROL, ACCOUNT and ACCOUNTABILITY. Accounting is at the heart of every decision and every activity that a business undertakes. It underpins decisions made by the business, the accuracy of the accounting information must be good as it could lead to bad decisions.

LIMITATIONS OF ACCOUNTING INFORMATION: o Doesn’t provide you with measures of the quality of an organisation’s performance (measured by customers and customer satisfaction) o Doesn’t reveal the time, effort and thought gone into delivering the products and services to generate the profit o Doesn’t tell you about the pollution and environmental or social damage an entity has caused. o Doesn’t provide any valuation or measure of the skills base and knowledge of the organisation.

Two forms of accounting-



FINANCIAL ACCOUNTING: the reporting of past information to parties external to the organisation

Objective- financial statements provide information about the FINANCIAL POSITION, FINANCIAL PERFORMANCE and CASHFLOWS of an entity that is useful to a wide range of users in making economic decisions. Financial statements are issued annually and are directed at the needs of the users. FUNCTIONS Recording- TRANSACTIONS (e.g. expenses), REVENUES (sales) and BORROWING (from the bank)  Processing- the way the recorded data is turned into financial information  Presenting- three main financial statements: income statement (profit or loss), balance sheet (statement of financial position) and cashflow statement ACCRUEL CONCEPT- record transactions when they occur, not when cash is received or payed -> balance sheet won’t tell us how much cash actually comes in

FINANCIAL STATEMENTS: Issued annually. Directed at needs of users Part of process of financial reporting. Even if a business entity isn’t a company and there is no obligation to produce accounts, it will still produce financial statements to provide evidence of what it has achieved that year.

Main three: INCOME STATEMENT (Profit or Loss). BALANCE SHEET (Financial Position). STATEMENT OF CASH FLOWS. Primary users of Financial Statements:   

Investors (ownership interest, existing and potential) Lenders (provide funding) Other people you own money to/ creditors (suppliers, customers, employees)

Users of financial statements:  Internal stakeholders- employees (stability and profitability of employer), management  External stakeholders- government (shall we give them a loan, are they paying taxes, used for government planning, national statistics), community (support local economy, employment, philanthropic actions, environmental issues), suppliers, the bank, competitors, investors (risk of investment, ROI), customers  Shareholders

FUNDAMENTAL QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS (needs these to be useful): o Relevant- influence/ assists decisions, should have predictive and confirmatory value, must be capable of making a difference in decisionmaking o Faithful representation- complete, neutral (no bias), free from error

ENHANCING QUALITIVE CHARACTERISITICS (less important): o Comparability- should be comparable over time, comparable with similar information about other entities and their own o Verifiability- ensures users that information is faithfully represented, information should be proved to accurate, accuracy can be verified by observation and recalculation, auditors will verify it too o Timeliness- no longer useful or relevant if late, should be presented in time to make a difference in decision-making, the usefulness of information often declines with time, although information used in identifying trends continues to be timely in the future. o Understandability- to be useful to many, to cause this information should be CLASSIFIED, CHARACTERISED and PRESENTED CLEARLY.

MATERIALITY- information is ‘material’ if it could influence decisions that users make from the financial information of a SPECIFIC entity. Financial information should not be overloaded with unnecessary detail. COST vs BENEFIT: the benefit from obtaining information should always exceed the cost of obtaining the financial information (which is often relatively high).

 MANAGEMENT ACCOUNTING MANAGEMENT ACCOUNTING- cost and management accounting is concerned with reporting cost and accounting information to users within an organisation to assist those internal users in making decisions and managing the business. Application of accounting and financial management principles to CREATE, PROTECT, PRESERVE and INCREASE VALUES as to deliver that value to the stakeholders. It is an integral part of management requiring the IDENTIFICATION, GENERATION, PRESENTATION, INTERPRETATION and USE of information relevant to business strategy, decision making and performance improvement. INTERNAL USERS. Forecasts for future and to monitor current performance (to analyse and improve). Cost and management accountant’s primary concern is the costs that go into producing products and services to determine a selling price for them that will generate a profit for the business. Management accounting is then used to plan levels of production and activity in the future, as well as deciding what products to produce and sell to maximise profits. Management accounting also produces reports to evaluate the results of past plans to see whether they achieved their aim and the way in which improvements could be made. FUNCTIONS OF MANAGEMENT ACCOUNTING, mainly concerned with:   

PLANNING CONTROL DECISION MAKING

MAIN USERS

PRIMARY INFORMATION

FINANCIAL External. E.g. lenders, advisers, taxation authorities, customers, employees, the public. Reporting on past performance, current position

PRINCIPAL MEASUREMENTS

Financial

REPORTING AND FREQUENCY REGULATIONS

Annual

PRESENTATION OF INFORMATION CRITERIA

Set format required

IFRS comprising GAAP

Relevant and faithful representation

MANAGEMENT Internal

Forecast for future and monitor current performance. Short-term decision making and longerterm planning. Financial and non-financial, quantitative and qualitative Monthly or regularly Little regulation, management discretion What is required by organisation Relevance to management decisions and control of operations

Equity- how much the owners have invested in the company, as well as the profit they have made EQUITY = ASSETS - LIABILITIES

TYPES OF BUSINESSES

Ent i t y

Uni ncor porat ed (unl i mi t edl i abi l i t y)

Sol e propri et orshi p

Part nershi p

I ncorporat ed (l i mi t edl i abi l i t y)

Li mi t edl i abi l i t y Li mi t edl i abi l i t y part nershi p(LLP) company

Pri vat el i mi t ed company(Lt d)

Publ i cl i mi t ed company(Pl c)

SOLE TRADER- a person who is the exclusive owner of a business, entitled to keep all profits after tax has been paid but liable for all losses. If cash is not available, the sole trader may borrow from a bank to start the business, they may use personal possessions as collateral, meaning the business may be very much intertwined in their personal life. For accounting purposes, the business is regarded as separate economic entity, of which the sole trader is the owner who takes the risk of the bad times and benefit of the good times. THE ENTITY CONVENTION. Sole trader’s accounting information is needed by:   

Government: for tax and collection purposes The bank: for lending money to the business Potential buyer of the business: when the existing owner retires

PARTNERSHIP- a form of business where two or more people share ownership, as well as the responsibility for managing the company and the income or losses the business generates. This form of business permits the pooling of skills, for instance someone with good ideas can work with someone with money.

There can be real financial risks if the business is unsuccessful. There can be joint and several liability; one partner may be required to meet all the obligations of the partnership if the other partner does not have sufficient personal property, possessions and cash. For accounting purposes, the partnership is seen as a separate economic entity, owned by the partners. THE ENTITY CONVENTION. Partnerships accounting information is needed by:    

Partners checking they are receiving a fair share of the partnership profits HM Revenue and Customs Banks who may provide finance Other people who may be invited to join the partnership

The major risk attached to either a sole trader or partnership is that they could lose their personal property and possession if the business fails

LIMITED LIABILITY COMPANIES- a private company whose owners are legally responsible for its debts only to the extent of the amount of capital they invested. PLC or LTD. This encourages the development of larger business entities as it provides protection. Key features:     

Separate legal entity Share capital Limited liability Separation of ownership and control AGM (Annual General Meeting)

PLC vs LTD LTD- A private limited company is prohibited by law from offering its shares to the public. PLC- a public limited company is permitted to offer its shares to the public, but has to satisfy more burdensome regulations

PARTNERSHIP vs LIMITED LIABILITY COMPANIES

PARTNERSHIP

LIMITED LIABILITY COMPANY

FORMATION

By agreement, but not necessarily in writing

Registering the company under the Companies Act, Memorandum and Articles of Associations setting out the powers allowed to the company

RUNNING THE BUSINESS

All partners share in the running Shareholders must appoint of the business directors to run the business (although shareholders may appoint themselves as directors) Not obliged to make accounting Must make accounting information available to the information available to the public in the form of Annual public Financial Statements The personal liability of owners Partners are jointly and is limited to the amount they severally liable for the money pay for their shares owed by the firm

ACCOUNTING INFORMATION

FINANCIAL OBLIGATIONS

FINANCIAL ACCOUNTING THE REPORTING OF PAST INFORMATION TO USERS OUTSIDE THE ORGANISATION

FLOW OF STATEMENTS

STATEMENT OF PROFIT OR LOSS (performance) This provides the PROFIT for the period (net profit), this is included in the

STATEMENT OF CHANGES IN EQUITY This provides the EQUITY figure for the period, this is included in the

STATEMENT OF FINANICAL POSITION (position) These three statements are based on the accrual principle

STATEMENT OF CASH FLOWS Reconciles the opening and closing cash (bank) figures and provides insight into the liquidity of the business

Lecture 2 (financial statements)

THE ENTITY CONVENTION- the accounting principle that the entity should always be viewed separately from the owners of the business, regardless of whether the business is a SOLE PROPRIETOR, PARTNERSHIP or LIMITED COMPANY; (every transaction is viewed from the organisation’s perspective) THE GOING CONERN- the assumption that the business will still be functioning in 12 months (my definition, find a better one)

REAL ACCOUNTS Financial statements elements- income, expenditure, equity, assets, liabilities

ACCOUNTING EQUATION:

ASSETS = OWNER’S EQUITY + LIABILITIES

(A = O + L)

All accounting transactions are based on the accounting equation. The source of the funds must always equal the use of the funds. When something happens on one side, it also happens to the other (e.g. take out a £1000 loan, liabilities go up by £1000 but so does your assets) The equation can be rearranged to be O = A – L, this gives the Owner’s Equity (or Net Asset Value (NAV), it isn’t commonly used.

(TD= technical defintion) ASSET- something you own TD: a present economic resource (anything that will generate an economic benefit for the company) controlled by the entity (must be) as a result of a past event. Current (purchased for resale, cash or awaiting payment. Not intended to be held for over a year. Constantly changing).  Inventory  Trade and other receivables  Cash in hand/ at bank  Closing inventory  Receivables

 Prepayments by us  Income accrued- income we are owed  Stationary on hand Non-current (held for long-term use (over a year), not purchased for resale).  Shop  Property, plant and equipment  Patents  Trademarks  Motor vehicles Current and non-current are placed in order of liquidity (how easily they can be turned into cash), least liquid to most liquid -> non-current (land, vehicles, machinery, buildings) then current (inventory, receivables, cash) then total assets (non-current + current) -> balance sheet. To be recognised as an asset it: o o o o o o o

Must have a value that can be reliably measured Must have potential to produce economic benefits Must be a present resource of the entity Must be controlled by the entity Must have been bought as a result of past events Must have value that can be reliably measured Must be able to create economic benefit

Chairs in auditorium:    

Present resource Controlled by university Bought as result of past event (purchasing them) Value can be reliably measured by checking invoice for buying the chairs (look at historic cost, also consider depreciation causing lower value)… (people cannot be quantified in monetary terms, they are human capital)  Can create economic benefit as can be used throughout future

LIABILITY- something you owe. TD: present obligation of a business to transfer an economic resource, as a result of a past event.

Non-current liability- no requirement to pay these liabilities in the short term (i.e. the business will still owe the same amount in the next financial year)  Mortgage  Long-term loans.

Current liabilities- current portion of any long-term loan, creditors and tax liabilities, the business does not intend to hold the asset for the next financial year      

Short-term loans Short-term parts of long-term loans (e.g. instalments) Wages Payables (creditors e.g. suppliers) Accruals Interest on loans

Placed in order of liquidity, least liquid first, then most. To be recognised as a liability: o Must have a value that can be reliably measured o Must result in an outflow of economic resources o Must be an obligation to pay a particular amount at a particular moment in time

EQUITY (also known as Capital)- owner’s interest in the company.

O = A – L (Net Asset Value) TD: The residual interest (financial interest of owners) in the assets of the entity, after deducting all its liabilities. Owner’s equity = money put in + profit – money taken out.

In theory, equity represents the amount that owners of the entity should receive if the assets were all sold and the liabilities were all settled at the statement of financial position amounts. What the business owes the owners.

For limited companies (limited liability- plc, ltd) equity is made up of:   

SHARE CAPITAL (value of share x amount issued) SHARE PREMIUM (when each share is issued for an amount greater that its value) RETAINED EARNINGS (earnings not year distributed to shareholders as dividends)

SHARE CAPITAL + SHARE PREMIUM + RETAINED EARNINGS = EQUITY FOR LIMITED COMPANIES

For sole traders and unincorporated entities, they do not have share capital as they do not sell their shares. Nevertheless, they still have an equity section called the capital account. This is made up of: o + Capital at the start of the year (capital account balance at the end of the previous year) o + Capital introduced (owner’s own money) o + Retained profits for the year o - Capital withdrawn (money owner uses for personal expenses, these are drawings and are deducted from the capital amount) + capital account balance at start of year + capital introduced during the year + profit for the year - loss for the year - drawings during the year  components of equity for sole traders and unincorporated entities

To be recognised as equity:

  

Must have a value that can be reliably measured Must have a historical cost Must have a fair value (the amount at which an asset could be exchanged between knowledgeable and willing parties in an arm’s-length transaction)

HOW ASSETS ARE VALUED:

HISTORIC COST- what we paid for the item + any costs for preparation or installation and bringing the asset to the location and condition where it is ready for the purposes for which intended. Accounting has traditionally dictated that the value of assets and liabilities should be based on their original cost, this the historic cost convention e.g. inventory is valued at its cost to the business, not the selling price or current market value. Exceptions: o Land and building (valued by an evaluator, can be revalued) o Investments (valued at market valuation (fair value), share price, stocks and shares must be valued at market price) o Inventory-> lower of cost vs. Net Realisable value (i.e. original cost vs. selling price the costs to sell)

FAIR VALUE- the amount at which an asset could be exchanged (or a liability settled), between knowledgeable willing parties in an arm’s-length transaction (transactions at a distance). Fair value is market value. When the asset or liability trades regularly, its fair value is usually readily determined from its market price (as called fair market value). The fair value is equivalent to the market value, the amount at which an asset could be sold or a liability settled in an open market. The fair value option is rarely used by organisations, the only assets they’re likely to use it for is land and buildings as these assets tend to rise in value over time, for other assets and liabilities, the historic cost is preferred.

STATEMENT OF FINANICAL POSITION- Balance Sheet A summary of the assets, liabilities and equity of an entity at a particular point in time.

Reflects the financial position of the business on the last day of the financial year. It is a snapshot of the entity at a moment in time. It is a summary, in money terms, of the assets an organisation controls and the liabilities an organisation owes to outside parties. It does not reflect all assets and liabilities and so does not fully reflect the value of the business, but would be used to formulate that value.

THE STATEMENT OF FINANICAL POSITION IS A FINANICAL DEPICTION OF THE ACCOUNTING EQUATION ( A = O + L), on a day (as ...