Session 1 Introduction to accounting 1.

1 Introduction
In this session you will discover the principles on which accounts are constructed. You will meet the balance sheet, profit and loss account and cash flow statement and encounter some of the issues that must be considered when these financial statements are prepared. You will also be encouraged to assemble some simple accounts for yourself, and also to begin to interpret the accounts published by real companies.

Topics covered in this session

The uses of accountancy Accounting statements Financial record keeping Basic accounting rules reparing financial statements !aluation

Resources you will need

"yson #$%&%' (hapter &, $ and )

1.2 The uses of accountancy

*obody really knows how old accounting actually is. The earliest accounts ever discovered date back to )+%% B( and were in the form of ta, returns. In their simplest form, accounts are the keeping of financial records, in other words, they are a response to economic activity. *owadays accounting is done for three reasons Administration . to help organise a business. /tock records and debtors0 ledgers would fall into this category. 1egulation . the things that must be done. This would cover !.A.T. records and company accounts. "ecision.making . (ash flow forecasts and budgets would each assist senior managers to make the correct decision.

There are various groups of people who need the information contained in accounts. 1ead "yson 23.24

1.3 The accounting statements

There are three ma5or accounting statements that you must understand.

&

The profit and loss account (income statement) This tells you how you have performed in the previous accounting period, by showing how much wealth has been created6 it is the financial history book. The 7 890 matches up the incomes you have earned by running your business with the actual running costs incurred in earning those incomes. There are a number of accounting conventions which dictate how costs are allocated to the profit and loss account and we will e,amine some of these later in this session. The alance sheet (statement of financial position) This is purely a position statement that shows how the business finances look at a point in time . a financial snapshot. It will firstly add the value of all the business possessions or assets and then e:uate this to the total finance invested in the business from various sources. These two amounts must always balance each other. The cash flow statement This is a statement of flow of cash and cash e:uivalents, unencumbered by accounting concepts and conventions. It will reveal with much more clarity whether an organisation can meet its commitments. 1ead "yson page 4).4; for an overview of these statements. The following e,ample shows how it all fits together. "on0t worry if you do not understand all the details of the statements. <e will be looking at them in more depth later in the session. At this point, the important thing is to see the different kinds of information recorded in the various statements. You want to start a business and you put in =$%,%%% of your own money. This is not enough, so you obtain a bank loan of =&%,%%%. <ith this you purchase a lease, costing =&+,%%%. You decorate and e:uip the premises at a cost of =&%,%%% You buy stocks of chocolate costing =)%%% with the intention of selling them at a profit. You now have =&%%% remaining.

This information can be presented in the form of a balance sheet. *otice that the net assets are e,actly balanced by the claims on the business. *otice too the split of assets between fi,ed #or long term', and net current assets #or short term'. !""" #i$ed assets remises >:uipment &+ &%

%et current assets /tock (ash &ong term lia ility 9oan %et assets #inanced y ?wner0s capital #>:uity' A cash flow statement will reveal a similar position'ash flow statement Inflows #Finance' ?utflows #Assets' (ash remaining

) & 2% #&%' $% $%

!""" 2% $@ &

*ow see what happens when the business starts selling stock and making a profit. A first sale of stock is made, =2,%%% of stock is sold for =+,+%% The customer does not pay you and so is a debtor A further =&,%%% is spent in order to achieve the sale #advertising, staff costs and transport'. As there is no more cash available, it is necessary to buy stock on credit to continue trading. =$,%%% of stocks are bought on credit from a supplier.

This information can be recorded in the following way'ash flow statement (accumulative) Inflows #Finance' ?utflows #Assets' (ash remaining $@ A & Income Statement !""" Income /ales ($penses Baterials /undries 2 & ) +.+ !""" 2% 2% .

*et profit

&.+

*ote that only the costs used in earning the income have been matched with the income from sales. Anything left over in our possession is a balance sheet asset. By the same token, the sales income is included even though the cash has not yet been received. Any other procedure would provide a mismatch of costs and incomes, and so would not represent the economic reality of the transactions. )alance sheet !""" #i$ed assets remises >:uipment %et current assets /tock "ebtors (ash (reditors 2 +.+ . #$' 3.+ 2&.+ &ong term lia ility 9oan %et assets #inanced y ?wner0s capital 1etained profit #1eserves' $% &.+ $&.+ This is a very simple e,ample and does not address the more comple, issues of valuation. Cowever, in accounting terms value can be processed easily. If you 5udge that an asset has fallen in value #depreciated', you will recognise that as a cost in your profit and loss account, thereby deflating your profit and hence the owners0 capital. You would also deflate the value of the asset in the balance sheet, to show a true worth of that asset. In practice, valuation is one of accounting0s greatest challenges. <e will e,amine valuation in more detail later in this session. #&%' $&.+ &+ &% $+

1.* #inancial record +eeping

Financial record keeping really only re:uires an orderly mind and tidy approach. Accountants tend to see things in terms of double entry . debits and credits, but this really isnDt necessary where there are a small number of transactions in a straightforward situation.

1ecord keeping systems comprise original documents #invoices, receipts etc.' generation of prime entry E this could be simple filing of invoices etc in a bo, file and recording on control sheet. summarisation as an accounting debit and credit.

It is important that original documents are 7classified0. Cuman beings en5oy labelling and classifying things in their environment as it increases the illusion of controlF It also assists in decision making and planning. The basic accounting classifications areBalance sheet categories rofit and loss account categories Assets Incomes 9iabilities >,penses

These classifications are important as the difference between incomes and e,penses is profit, or surplus, and the assets and liabilities show the financial position on the balance sheet. There are of course many sub divisions of these which are specific to the organisation. Your e,penses for e,ample may be classified into travelling, stationery, entertainment, salaries etc.

1., )asic accounting rules

The regulatory framework of accounting has evolved to ensure that comparability is possible between statements. These rules reflect the tension between the need for confidentiality and disclosure. /ome countries have a less evolutionary and more statutory system, but the outcomes in terms of statement appearance are remarkably similar. )oundary rules >ntity eriodicity Going concern Huantitative -easurement rules Boney measurement Cistoric cost 1ealisation Batching "ual Aspect Bateriality the organisation itself, not the owner#s' a defined and regular accounting period assume that the organisation will e,ist into the foreseeable future only :uantifiable data is recorded data must be translated into monetary terms data recorded at original cost entries at the point of legal transfer of title cash received and paid ad5usted to reflect the economic reality all transactions recorded to reflect the giving and receiving rules not applied rigidly to insignificant items

(thical rules rudence (onsistency ?b5ectivity 1elevance if there is doubt over a transaction, then the entry to understate profit should be chosen accounting rulesIpolicies should not be amended unless there is a fundamental change in circumstance personal views should be avoided statements should give the user a true and fair view

1.. /ro lems of valuation

Just as individuals have problems with assessing value, so do businesses. In accounting, there are various conventions which dictate how different items are recorded in the balance sheet. Fi,ed assets . normally valued at cost less depreciation. "epreciation itself can only be an estimate, as absolute value is known only on disposal. /ome fi,ed assets are revalued. /tocks . "ifferent conventions e,ist such as first in first out. In the case of manufactured stocks, fi,ed overheads are usually apportioned to stock values. This process is arbitrary. "ebtors . "ebtors tend to generate a proportion of non payers and so conservative accountants usually depress debtor values to allow for this. Investments . It is :uite normal for one firm to buy shares in another and accounting convention re:uires these to be shown at cost. It is clear however that these shares will fluctuate in value along with market conditions. Goodwill . <hen one firm takes over another, the value of the taken over firm, above the sum of its parts is called goodwill, and is shown on the 5oint or consolidated balance sheet. Bany firms argue that goodwill must therefore e,ist in firms which have not been taken over, and should therefore be shown on balance sheets. Brand names . In modern business, firms spend enormous amounts to establish product credibility with the consumer, such that brand names have a worth of their own. These are not always shown on balance sheets, thus allowing firms worth to be under reported. *atural resources . ?wnership of :uarries, wells, mines forests etc. can be valued in any number of ways, representing as they do, many years worth of income. Cuman assets . Bany organisations have very few material assets but enormous human assets e.g. management consultancies. !ery few firms show human assets 3

on balance sheets. Interestingly some football clubs have 5ust started to show players as assets rather than putting transfer fees on the profit and loss account. For all these reasons a balance sheet may not represent the value of a company that its owners feel is appropriate. A balance sheet is often described as a list of une,pired assets and liabilities although it is often cited as evidence for a businessDs value. In particular, no recognition is made of a companyDs profit earning potential. Summary <e have covered a great deal of ground in this first session. You have considered what various user groups re:uire from accounts. You have been introduced to the three main financial statements, the balance sheet, the profit and loss account and the cash flow statement. You have considered how items are classified and how assets are valued. You have also e,amined the principles and conventions that underpin accounting. Finally, you have been shown some of the :uestions you should ask when e,amining a company0s published accounts. Before you attempt the self.assessment :uestion at the end of this session, consolidate your knowledge of basic accounting principles and the preparation of the financial statements by reading all of chapters &, $ and ) in "yson. Try the following additional activities in "yson. The solutions for all these activities are provided at the back of the te,t book(hapter &, page $&- >,ercise &.) (hapter ), page @)- >,ercises ).4 and ).;