ACCOUNTING

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BASIC ACCOUNTING CONCEPTS AND REPORTS

FINANCIAL STATEMENTS

1. STATEMENT OF FINANCIAL PERFORMANCE 2. STATEMENT OF FINANCIAL POSITION 3. STATEMENT OF CHANGES IN EQUITY 4. CASH FLOW STATEMENTS

ACCOUNTING INFORMATION

USERS

CHARACTERISTICS

1. INTERNAL 2. EXTERNAL

1. COMPARABILITY 2. UNDERSTANDABILITY 3. RELEVANCE 4. RELIABILITY

Unit 1 Concept Map

This map represents the core concepts that we will be covering in this unit, and the relationships between them.

Study organiser
Topic 1.1 The Nature and Purpose of Accounting 1.2 Users of Accounting information 1.3 Accounting Assumptions, characteristics of information and the Accounting Equation Learning Outcomes Explain the nature of accounting and its main function Identify the potential users of accounting information Explain the main assumptions made and the characteristics of information to be used in the preparation of financial statements Analyse the effects of the business transactions on the accounting equation and on the financial statements Identify the basic financial statements used in business to report to users for decision-making purposes Explain how the double entry system works Understand the importance of ethics in business and accounting and how to recognize and handle ethical dilemmas as part of the decision making process. Activity1.1 Activity 1.2 Activities

1.4 Financial Reports

Activity1.3 Activity1.4 Activity1.5 Activity1.6 Activity 1.7

1.5 Double Entry Record Keeping 1.6 Ethics and Accounting

You should spend approximately 10 hours in this unit.

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Introduction
In this unit, we introduce you to the area of accounting known as financial accounting, and to some important assumptions and definitions that accountants use to produce reports on the outcome of business activities. These reports explain how well off a business is at a particular point in time and how successfully it has performed over a given period. We also explain briefly why accounting is an important social and business activity and how accounting numbers are useful to people. We end by showing you a simple arithmetical model (called the accounting equation) which is useful to record transactions (of buying and selling) and from which the rules of double entry record keeping are derived. This is the first of three units in this Study Guide that deal with the accounting cycle. The accounting cycle is the logical sequence of accounting procedures that take place during each accounting period. It begins with the recording of business transactions using the rules of double entry, and ends with the preparation of a set of financial statements (reports). Some of these procedures are repeated a number of times during the accounting period and others are carried out only at the end of the period. These procedures are illustrated in your textbook (Figure 3.2, p. 69, Figure 3.8, p. 79, Figure 4.1, p. 126 and Figure 5.1, p. 178). To give you an overview of the steps in the accounting cycle and of what is covered in this and the next two units we reproduce Figure 5.1 from the textbook, in a slightly different format, as Figure 1.1 on the following page. Keep referring to it as you work through this and the next two units.

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Figure 1.1: The Complete Accounting Cycle STEPS IN THE ACCOUNTING CYCLE 1 2 3 4 5 Recognise and record transactions Journalise transactions Post to general ledger accounts Prepare unadjusted trial balance of general ledger Determine adjusting entries and journalise Post to general ledger accounts Prepare adjusted trial balance of general ledger Journalise closing entries Post closing entries to general ledger and balance accounts Prepare post-closing trial balance of general ledger Prepare Worksheet financial statements (optional) Journalise reversing entries Post reversing entries to general ledger ACCOUNTING RECORDS Source documents General journal General ledger Trial balance (unadjusted) General journal General ledger Trial balance (adjusted) General journal General ledger (revenue/expense accounts closed) Trial balance (post closing) Financial statements (reports) General journal General ledger

6 7

8 9

10 11 12

13

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Steps 1 to 4 are repeated monthly, while steps 5 to 13 are only carried out at the end of the financial year. You will learn all of these procedures and the accounting records involved in the first three units of this Study Guide (which is the first five chapters of the textbook). We present them to you progressively during the first five weeks of study. Together with the new concepts and terminology they make up the foundation on which all subsequent accounting units are developed. We have spaced activities throughout the units so that you can see how well you are keeping up to date and whether you have mastered this foundation.

References
Textbook 1. Chapter 1 & 2 Accounting, Hoggett, J., Edwards, L., Medlin, J., & Tilling, M. 8th ed., John Wiley & Sons Australia Ltd Additional Reading 1. Chapter 17 Accounting, Hoggett, J., Edwards, L., Medlin, J., & Tilling, M. 8th ed., John Wiley & Sons Australia Ltd

1.1 The Purpose and Nature of Accounting

A commonsense starting point for learning a new discipline is to reflect on what it is really about and why it is worth learning. Accounting is important because it is concerned with the way in which individuals, managers of businesses and other types of organisations use and control their economic resources (look up economic resources in the textbook!). Thus, accounting is to do with a widespread social activity involving the use and exchange of money and of other resources that can be measured in money terms. At its simplest and least technical level it is a way of record keeping which allows individuals, families and small social groups to keep track of how they spend their wages or other income, and how they can plan to save for a new car or house, for retirement, or for some type of social activity. At its most complex it is a means used by managers in large business organisations to: plan and budget for future activities; record how their business resources are affected by activities of buying and selling goods and services; and report the outcomes of these business activities to individuals and other businesses that have contributed or lent money or have granted credit.
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Business managers are also obliged by law to report on their financial activities to a range of government agencies, such as the Australian Tax Office (and the Tax Office in your own country), and sometimes to other organisations like the Australian Stock Exchange. To people untrained in accounting, these reports are complicated, are expressed in a highly technical language and are difficult to understand. Get hold of a set of financial statements for any business and see if this is true for you! The numbers or monetary amounts in accounting reports are important for other reasons too. People find them useful and base their business dealings and private investment decisions on these numbers. For example, research into how accounting numbers are used shows that: the general body of investors in the stock market use reported profit amounts as one factor in deciding whether to buy or sell shares; individual investors use accounting numbers, such as interest rates, as signs or signals which help them decide how to invest their own resources efficiently; and business managers, shareholders and lenders use accounting numbers about profit and business resources as a basis for making contracts for managerial salary packages, and borrowing and lending money.

You will learn a lot more about the importance of accounting numbers if you go on to study Accounting Theory. This particular subject will focus on accounting from a business point of view. Its primary purpose is to identify, measure and record transactions for a business and communicate this information to people and other organisations. These people and organisations need it to make informed judgements and decisions about how best to use their own financial resources. This implies that the information should be in some way useful for its users. It also implies that accountants will keep to high ethical standards when they process the information and prepare reports (otherwise the information may be misleading and not useful). So from this point of view, accounting is a process in which accountants: identify and record the effects of transactions (the exchanges of money for goods and services) that have actually taken place, and measure these in terms of money (dollars); analyse and classify the monetary transactions into categories (headings) that are meaningful for users; and summarise the transactions to get rid of unnecessary or unhelpful detail, and present them in the form of financial reports.

In this way, accountants and business managers communicate to users. In classifying, summarising and reporting financial information, accountants have
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developed a special terminology, comprising words and symbols (the textbook glossaries and our own Key Terms and Concepts!), which is used so extensively that it is often called the language of business. Reading 1.1 Read Chapter 1, pp. 5 19 of your textbook.

1.2 Users of Accounting Information

We can sort accounting information by considering who uses it. Internal information is prepared for managers and employers and owners of small businesses to assist in the daily operations and control of business activities. It may be produced as often as it is needed, in as much detail as is needed, and in whatever format best suits the users. Some of these special managerial reports can be confidential to managers at various levels. Providing internal information to managers is known as management accounting. External information is prepared for people who are not employees or managers. They are outsiders who have, or are likely to have, dealings with the business. Reports for these external users are produced less frequently, usually once a year (annually), and contain highly summarised information in very formal formats. They are general-purpose documents and are usually widely available to a range of users. This is the field of financial accounting.

Look at Figure 1.3 on page 9 of the textbook. It is a good illustration showing the various users of accounting information. Note especially who gets special-purpose reports and who gets general-purpose reports.

Internal users of information, as mentioned above, are clearly managers and owners of small business who can get special purpose reports and information for their special needs, and managers of large businesses who need it to plan, control and monitor financial activities. These users have access to detailed records and transactions. External users are persons who have no rights to demand special information and who dont have access to business records. These users must rely on general-purpose reports usually in the form of annual financial statements.
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A list of external users will include: shareholders of large companies and potential shareholders, creditors and lending institutions, employees through their trade unions, customers and competitors, and the general public concerned with the environment and consumer affairs.

Governments (and their agencies), strictly speaking, are external users but can demand special purpose reports for taxation, statistical and other regulatory purposes. Financial accounting, which is what this subject is about, tries to meet the diverse needs of the many external users and can do this only by providing generalpurpose financial reports. Apart from the government, external users only get some of the information they want or need. From their viewpoint this is clearly unsatisfactory, but it is a practical and cost effective compromise that is feasible for businesses. Can you imagine the cost and unproductive effort for a business trying to give detailed (and commercially confidential) information to hundreds of customers, creditors and shareholders? Reading 1.2 Read: Chapter 1, pp. 9 - 10 of your textbook,

Activity 1.1
Now do a quick exercise to reinforce your understanding (do not spend more than a couple of minutes on it). Complete the following table by listing beside each of the external users: a) Several types of decisions each user might want to make, and b) The type of information they may require in order to make such decisions.

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User Small shareholders Potential shareholders Creditors and lending institutions Customers/ competitors Employees/ trade unions

Types of Decisions

Information Requirements

1.3 Accounting Assumptions, Characteristics of Information and the Accounting Equation

Accounting, like other disciplines, is based on a number of simplifying concepts, conventions, principles and assumptions (these terms are often treated as being the same (synonymous) that evolved over a long period of time. Some of these are described, in this section and again in more detail in Chapter 17. To avoid confusing you at this early stage we introduce these concepts gradually. We begin by considering the accounting entity assumption because it is the basis of a primary financial report, the statement of financial position (sometimes called a balance sheet). We also look at the accounting equation, which expresses the relationships and links between the various components of a position statement in a way that permits a special system of record keeping.

Accounting Entity Assumption

For the purpose of recording and reporting transactions accountants always treat the business as an entity separate from its owner(s). (If you think about it, a business or entity is just an idea or something we imagine to exist! Three types business entities are described on pp. 17 -18 in your textbook) . From this accounting viewpoint, if we pretend that it is the business entity (not the owner or owners) that owns the money and other resources (assets), incurs debts (liabilities) and carries out transactions with third parties (which can include the owner/s). This viewpoint or idea is formally known as the accounting entity assumption.

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The accounting entity assumption leads to the derivation of accounting equations, which is discussed shortly.

The Accrual Basis Assumption

According to the framework under accrual basis the effects of all transactions and events are recognised in accounting records when they occur, and not the cash is received or paid.

The Going Concern Assumption

This assumption pretends that the entity will not wound up in the future, but will continue its activities and so the liquidation values of the entitys assets are not generally reported.

The Period Assumptions

This assumption divides the life of a business into equal time intervals for the purpose of preparing financial statements.

The Characteristics of Accounting Information

1. Relevance means that the information can influence the economic decisions made by users. 2. Reliability- means that the user is assured that the information presented represents faithfully, without bias or undue error, the underlying transactions and events being reported in the financial statements. 3. Comparability allows users to identify similarities and differences between two sets of data. 4. Understandability - users are able to comprehend the meaning of accounting information. Reading 1.3 Read Chapter 2, pp. 36 - 40 of your textbook.

Accounting Equation
Since all business assets must be provided by the owner or financed by creditors or lenders, the total value of all assets (economic resources)owned by the business must be exactly equal to the total claims of the owner (owners equity or capital) plus those of creditors (liabilities). This basic relationship between assets, liabilities and owners equity that follows from the accounting entity assumption can be expressed in the form known as the accounting equation:

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ECONOMIC RESOURCES

SOURCES OF FINANCE

or
ASSETS = LIABILITIES + OWNERS EQUITY (ENTITY VIEWPOINT)

or
ASSETS LIABILITIES = OWNERS EQUITY (PROPRIETARY VIEWPOINT)

This equation is a descriptive model of the firm because it describes what assets the firm has and who has provided or financed them. It is used for preparing the position statement (balance sheet), which is a listing of assets, liabilities and owners equity. The concept of owners equity (another accounting idea) as a special type of creditor is very important because it ensures that all position statements must balance arithmetically (without the owners equity the equation would not exist). We will learn more about position statements in section 1.4 of this unit, and how to make use of the accounting equation in section 1.5. The accounting entity assumption holds for any business regardless of its legal form. The fact that a business may be organised as a sole trader or partnership that has no separate legal existence from its owner(s) does not affect the accounting viewpoint. The assumption also enables the business to record transactions with the owner. As examples, the owner can contribute (invest) assets in the business and withdraw (disinvest) assets from the business. Withdrawals of assets by the owners of sole proprietorships or partnerships are also called drawings. So, to this extent the owner is able to transact with the business (the position is somewhat different for the shareholders of a company). Reading 1.4 Read Chapter 2, pp. 41 - 45 of your textbook.

Activity 1.2
You can now attempt Problem 2.3 on page 52 of your textbook.

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1.4 Financial Reports

In this section we look at the three primary general-purpose accounting reports that are derived from the relationships between the items in the accounting equation, and at a fourth one that gives special information about the asset cash: The statement of financial position The statement of financial performance The statement of owners equity The cash flow statement

The relationship between the first three of these statements is shown in Figure 2.6 on page 40 of your textbook. Study this carefully and note how the statement of owners equity links the other two.

Statement of Financial Position

This statement provides reports on the wealth or financial position (hence its title) of a firm at one particular point in time. It comprises the three major components, or elements, of the accounting equation: Assets: Resources of economic value (expressed as future economic benefits) to the business. Debts or obligations (expressed as future sacrifices of economic benefits) owed to outside parties (excluding owners). This represents the obligation of the business to the owner (or the owners residual interest in the net assets, being the value of total assets less the value of all liabilities).

Liabilities:

Owners equity:

These components are set out to reflect the equality, in money terms, of the relationship expressed in the accounting equation as shown in Figure 2.2 on p. 32 of your textbook.

Assets: Future Economic Benefits

At this stage it is worth concentrating again on what accountants mean when they refer to the value of assets. Assets are economic resources of various types that an organisation uses to conduct its business. They are acquired for their future usefulness, which is defined as future economic benefits. These future economic benefits are usually measured by the amounts of cash or other resources
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exchanged for them, so acquisition costs are the amounts recorded. This idea that assets should, in the first instance, be recorded and valued at their historical acquisition cost is known formally as the cost assumption or cost principle. This concept of value in use is highly abstract and is not always understood or shared by users who do not have special knowledge of accounting. These users often mistakenly (but perhaps understandably) interpret the values of assets as being value in exchange or market-selling prices. Do you? For example, if you own a motorcar is its value to you what you paid for it, what you can sell it for or its usefulness in transporting you from place to place? Accountants choose the latter! The value in use concept is also a problem because a resource or asset will not always have the same usefulness for different individuals or businesses. This in turn presents other problems, for example when calculating depreciation or the amount of fuel or supplies used (the decrease in usefulness). Also, not all future economic benefits have a physical form and some may not even be owned by the business, for example when a business leases an asset under a financial lease or wishes to record an asset called goodwill. Keep these points in mind as you progress through the unit. We will keep coming back to this abstract future economic benefits concept.

Now let us put the three components of financial position together. A very simple position statement is illustrated in your textbook on page 32. The second one is page 33.

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Figure 1.2: Sample Balance Sheet

The values on this statement are true for this date only The heading expresses the accounting entity assumption by identifying the business entity

DONS AUTO REPAIRS STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE 2012 Current Assets Cash at bank Accounts receivable Repair supplies Total Current Assets Non-Current Assets Land Building Repair equipment Total Non-Current Assets

$50 340 77 790 14 610 142 740

ASSETS (except cash and accounts receivable) are recorded at the amounts paid to acquire them, thus conforming with the cost assumption. The asset amounts represent the future usefulness or economic benefits to the business.

60 000 455 000 110 700 825 700

Total Assets Current Liabilities Accounts payable Total Current Liabilities Non-Current Liabilities Mortgage payable Total Non-Current Liabilities Total Liabilities Net Assets Owners Equity Don Brady, Capital Total Owners Equity Total Liabilities & Owners Equity

$968 440

80 760 80 760

LIABILITIES are the obligations the business presently has to creditors

401 000 401 000 481 760 486 680

and lenders. The liability amounts represent future sacrifices of economic benefits

486 680 486 680

OWNERS EQUITY represents the firms obligation to the owner (his residual interest). It enables the equality between the two sides of the accounting equation.

$968 440

Both segments (lists) show equal totals as required by the accounting equation. The statement thus balances or is in balance.

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This format, and the one in Figure 2.2 in your textbook reflect the entity viewpoint (A=L+OE), which regards liabilities and owners equity as joint contributors of finance, both with claims against the assets owned by the business. Figure 2.2 in the textbook shows the proprietary viewpoint, which emphasises the claim of the owner (the proprietor) to the net assets of the business. This proprietary theory of accounting considers that the focus of accounting records and reports should be on the interests of the owner(s) or proprietor(s), that is, on the proprietors net worth (AL=OE). NB: The format in Figure 1.2 (the entity viewpoint) is the format that you are expected to use for all position statements that you prepare in Units One to Three because it shows the equality between the two sides of the accounting equation. Please disregard any other formats you may have learned. There is another point regarding format. The numbers (dollar values) on the position statement are shown in single columns with sub-totals and totals shown in bold type. This conforms to modern practice, does not take up the space that the insetting of numbers requires, and makes it easier to compare several columns of numbers (statements with lots of money columns can be confusing). You must set out your numbers in the same way. Classifying Assets & Liabilities as Current & Non-current You will note that on the position statement in Figure 1.2 that the assets and liabilities and owners equity have been separated into two categories described as current and non-current. This distinction follows from the going concern and accounting period assumptions. The going concern assumption expresses the observation that normally a business will keep operating for an unknown period of time covering several accounting periods. The accounting period assumption holds that twelve months is the normal time period for recording, measuring and reporting transactions. Based on these assumptions, the business is seen to be an ongoing concern with a normal operating and reporting cycle of twelve months, or one year. These assumptions are both important because accountants can record transactions that overlap more than one accounting period and it allows asset and liability values to be carried over from one accounting period to another. Current assets are cash and other types of assets that have a short life. This is because accountants reasonably expect them to be used up, converted to cash, sold or consumed (economic benefits used up) within one year after the position statement date. Similarly current liabilities are debts that are to be paid or settled in the next twelve months (or within the firms operating cycle). On the other hand, accountants expect non-current assets to be used (render economic benefits) over several accounting periods and consider that they are not held for resale. In the same way accountants view non-current liabilities as those debts that do not have to be paid within the next year. These distinctions are
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summarised below in Table 1.3 and are described in more detail in your textbook on pages 146-147. Figure 1.3: A time basis for classifying assets and liabilities Current Assets For use and/or resale within one year of the position statement date. To be paid or settled within one year of the position statement date. Non-current For use over several accounting periods. Items not held for resale. To be paid or settled over several accounting periods.

Liabilities

Reading 1.5 Read Chapter 2, pp. 30 34, of your textbook.

Can you see the usefulness of this current and non-current distinction? If we compare the totals for current assets and the totals for current liabilities we will get one indication that a business can or cannot meet its short-term debts from assets that can be converted into cash in the short term. We call this a measure of short-term liquidity. Compare the two totals in Figure 1.2. Do you think that Dons Auto Repairs is liquid? Now take time to attempt Activity 1.3 to demonstrate your understanding of the subject matter we have covered above.

Activity 1.3
You should spend 15 minutes on this activity. J. Jackson has worked for some years as a technical manager for a film processing company. In his spare time he has often undertaken private photographic work, such as weddings and portraits, and over a period has acquired his own equipment and materials. At the end of 2007 Jackson resigned from the company to establish his own full-time business, Jacksons Photographic Studio. He started business on 1 January 2008 and contributed the following personal possessions for use in the business:

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1 Super SLR camera, valued at Darkroom equipment which had cost Second hand van bought for Films, chemicals, photographic paper that had cost Personal cash savings (deposited in a current banking account in the name of the business) Amount owing by customer for photographs taken in 2007

900 1 600 2 400 200 1 400 540 $7 040

As he needed to buy more sophisticated equipment, Jackson persuaded his uncle, P Wilks, to lend him $2,000 for business use. This sum, which is interest free, and is repayable at the end of 2009, was banked in the business banking account on 1 January. The business is also to be responsible for the $2, 200 that Jackson still owes on the van and $840 that he owes to the supplier of the photographic equipment. Both amounts must be paid before the end of April 2008. Required Prepare the statement of financial position for Jacksons business at 1 January 2008, using the format shown in Figure 1.2. To make the position statement balance, you will have to calculate the amount of J. Jacksons owners equity (capital). Now attempt Activity 1.4.

Activity 1.4
Spend 15 minutes on this activity. Below is a list of position statement items for Micks Plumbing Services as at 30 June 2008. For each item listed you should identify whether it is an asset, liability, or owners equity item and place the amount in the corresponding column. State beside each asset or liability, whether it is current (c) or noncurrent (n). If you are correct the column totals should balance using the accounting equation.

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Assets $ Cash in bank Money owed to suppliers (accounts payable) Equipment Mick Daniels capital Land Building Bank loan Supplies of plumbing fittings Money owed from customers (accounts receivable) 3 970 2 300 9 450 56 270 18 000 56 500 34 000 1 720 2 930 $

Liabilities $

Owners Equity $

2 930

Required Prepare a statement of financial position using the above information.

Statement of financial performance

For an example of the set out of a statement of financial performance, see Figure 2.3 on page 34 of your textbook. Remember that you should show all the figures in a single column. The report shows the results of the trading and service activities of the business over a given period of time. As we saw in the previous section, this period is known as the accounting period, which normally is one year. The statement of financial performance introduces two more elements you must understand and remember: Revenue refers to earnings by the business from trading activities (sales), for performing specific services (commissions), or from investment activities (rents, interest and dividends). Revenues cause assets to increase, or stop them from decreasing, and are therefore inflows, or savings in outflows of future economic benefits.

Expenses are costs incurred by the business in the process of earning revenue and which have been consumed or used up during the
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year. They include wages, advertising, insurance, rent paid, telephone, stationery and power charges. These are all losses or consumptions of future economic benefits that decrease the values of assets. The notion of earning revenue and incurring expenses will be discussed in more detail in Unit 3 of this Study Guide. There is also a relationship between revenues and expenses:
REVENUES EXPENSES = NET PROFIT (OR LOSS)

Net profit represents the net earnings of the firm during the reporting period and represents an increase in the owners equity (the proprietary viewpoint!). If expenses exceed revenue a net loss will result in a decrease in owners equity. These revenue and expense effects on the owners equity are illustrated in Figure 1.4 later in this unit. Revenues, expenses and net profit are all abstract concepts that accountants use to explain how resources are received and used, and ultimately increased or decreased, through business operations. Figure 1.3: Central concept of value
OWNERS EQUITY The residual interest in the assets of the entity after deducting its liabilities ASSETS The future economic benefits LIABILITIES The future sacrifices of economic benefits

FUTURE ECONOMIC BENEFITS

CENTRAL CONCEPT OF VALUE

REVENUES The inflows or savings in outflows of economic benefits

EXPENSES The consumption or losses of economic benefits

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Take the time now to attempt Activity 1.5

AAActiviAc ty 1.5
Spend 15 minutes on this activity. Now try the same thing with the following list of revenues and expenses. When you have completed the table work out the net profit and then prepare a statement of financial performance using this information.
Revenue $ Wages Petrol for work vehicle Telephone Interest received on business account Maintenance of equipment Gas cylinder rental Receipts from plumbing Advertising Rent received Interest paid on bank loan 15 000 2 750 1 300 1 500 490 160 48 000 1 800 2 500 2 250 $ Expenses $

Revenue

Expenses

Net Profit

Statement of changes in equity

This statement reveals the changes in the owners equity for the period over which the financial performance statement has been prepared. (See Figure 2.4 on page 35 of your textbook.) Specifically it shows: the owners equity at the beginning of the period; any further investment by the owner during the period;

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the amount of net profit or net loss made; withdrawals (drawings) made by the owner; and the owners equity at the end of the period.

This statement provides the link between two successive position statements and the statement of financial performance. (This link is illustrated in Figure 2.5 on page 35 of your textbook. The net profit, determined by the statement of financial performance, is included in the statement of changes in equity and therefore is also represented in the position statement as part of the increase in the owners equity. NB: The changes to the owners equity are not shown on the position statement itself. Only the total amount is shown. If you are in the habit of showing the detail in the position statement you should drop it immediately.

Statement of cash flows

The previous three statements are all products of the accounting equation and how it is affected by transactions. Only cash at bank in Figure 1.2 represents cash and cash equivalents. (See Figure 2.6 on page 36 of your textbook.) The existence of accounts receivable and accounts payable also implies that Dons Auto Repairs buys and sells services on credit as well as for cash. This means that not all revenues for a period are necessarily received in cash or expenses for a period paid in cash, and that net profit will not necessarily result in an increase in cash of an equal amount. However, the changes in cash are considered to be so important for an entitys liquidity that accountants produce a special statement to show them. NB: Cash flows are shown under the headings of operating activities, investing activities and financing activities. Operating activities are those concerned with profit making. Net cash from operating activities is not the same as the net profit shown in the performance statement. The statement gives information not available from the other three statements.

Reading 1.6 Read Chapter 2, pp. 30 36 of your textbook.

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1.5 Double Entry Record Keeping

In section 1.3 we briefly discussed the accounting equation, saying that it is a descriptive model of a business that shows the relationship between assets, liabilities and the owners equity. In this section we will show you how we can use the accounting equation to record transactions and apply double entry accounting! In accounting, transactions are defined as events that make up the economic activities of a business. Examples are the payment or collection of cash, a purchase or sale made on credit, or the contribution or withdrawal of assets by the owner. Transactions between the business and outside parties, such as other businesses and customers, are called external transactions and involve the exchange of economic resources. However, some events such as using up existing assets within a business do not involve outside parties and are thus called internal transactions. It is the internal transactions that cause measurement problems, as you will learn in later chapters. The task facing the accountant is to devise a way of recording, analysing, classifying and summarising this transaction data for an accounting period that will produce the information needed for the statement of financial position, the statement of financial performance and the statement of the owners equity. If you look back to the position statement for Dons Auto Repairs (Figure 1.2) you will see that: it distinguishes assets from liabilities and the owners equity; it balances because the value of assets must always be exactly equal to the value of liabilities plus the owners equity; and the set of values reported on the position statement are true for that particular date only.

It follows logically that any transaction that occurs after that date must alter at least two position statement values if the next position statement is to balance, which it must. Consider these examples for Jacksons business, which took place on, say, 1 July:

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Transaction The firm paid $1, 000 in part settlement of debts owed to its creditors.

Effect on Position Statement The effect of this transaction is to decrease the asset cash at bank by $1, 000 and to decrease the liability accounts payable by $1, 000. This transaction will increase the asset cash at bank by $500 and decrease the asset accounts receivable by $500. This transaction will have the effect of decreasing the asset repair supplies by $100 and decreasing owners equity by the same amount.

An amount of $500 owed by debtors was received and banked.

Repair supplies to the value of $100 were found to be damaged and hence worthless.

Make sure you can understand the logic behind these effects. Note that the first two transactions are external and the third one internal. It is conceivable that the business could record the arithmetical effects of these transactions by preparing a new position statement after each transaction, or at the end of each day, but the reality is that there are too many transactions for this to be feasible. In any case position statements are not needed that frequently. An alternative approach is to list the asset, liability and owners equity items on a table or worksheet set out in the form of the accounting equation. Reading 1.6 Read: pp. 41 45 of your textbook, Chapter 2

This example for Darrens Lawn and Gardening Services sets up the basis for the dual recording process known as double entry record keeping (accounting) and the reasoning for each of the ten transactions is spelt out in your textbook. However, it is important enough to spend more time on. Consider Figure 1.4, which shows the completed worksheet at the end of January (without the subtotals after each transaction).

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Figure 1.4: Worksheet showing double entry record keeping

Once again, be sure that you follow the logic for the revenue and expense transactions. As shown in Figure 1.4, the worksheet itself has all the attributes of an accounting system in that it is used to: Record the economic effects of transactions (the + and - effects);
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Analyse transactions into various types of assets, liabilities and owners equity (by adding extra columns and column headings); Summarise transactions for a period (deriving column totals); and Produce accounting reports (by rewriting the column totals in financial position format and analysing the transactions in the cash at bank and capital columns for cash flow and performance information).

The worksheet also provides checks on the arithmetical accuracy of what is recorded because the equality of the equation can be checked line by line for each transaction and in total at the end of the period (the sum of the assets column totals must equal the sum of the liability plus owners equity column totals). Furthermore all column totals should be positive or normal. A negative asset or liability total would be abnormal and would usually indicate that a recording error has been made (what would a negative Cleaning equipment column mean? There is no definition for a negative asset). The financial reports for Darrens Lawn and Gardening Services in your textbook (Figure 2.7, p. 45) were all produced from the information on the worksheet. As Figure 1.2 shows, the position statement is prepared from the column headings and column totals. The statement of financial performance is prepared by analysing the revenue and expense effects in the owners equity or capital column. These revenue and expense effects reinforce the concept of net profit as an increase in capital (and the converse for a net loss). The cash flow statement is prepared from information in the cash at bank column and the statement of owners equity is also derived from the owners equity column. The latter shows all changes arising from Darren Jones investment transaction with the business, the increase from profit earning activities and the decrease from his drawings. The worksheet on the previous page gives a perfectly adequate accounting system for a small business with relatively few asset and liability items and very few transactions. However, most businesses have a large number of transactions and need more analysis columns than a worksheet can accommodate, so the accounting system must be expanded to cope with these. One-way of doing this is to set aside a page or account for each asset, liability and owners equity item. This use of accounts is developed in the next unit. Now attempt Activity 1.6.

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Activity 1.6
Spend 15 minutes on this activity. After 10 years experience as an officer in military transport, Joe Chan decided to start up his own transport business, to be called JC Transporters, operating out of Suva. The purpose of the business is to sell transport services to customers throughout the island. Customers will be given credit and they will be billed at the end of each month and allowed 10 days to pay their debts. Joe started up the business on 1 January 2003 by paying $112, 000 of his personal cash savings into a business banking account. He immediately employed four of his former army colleagues as drivers. The firms transactions for the 2003 financial year were: 1) On the first day of the financial year Joe, as the firms proprietor and manager: a) Bought a property consisting of an area of land and a small warehouse. The firm paid $40, 000 in cash to the seller. b) Bought a Macintosh desktop computer to keep the business records and paid $10, 000 in cash. c) Bought 3 new trucks for $50, 000 each. The firm paid $30, 000 in cash and raised a bank loan for the remaining $120, 000. The loan is for 4 years and is secured by a mortgage over Joes home. Interest at 11% per year plus one quarter of the debt must be paid on the last day of each year. Joe estimates that the trucks will run efficiently for 5 years. 2) Customers are billed $450, 000 for trucking fees, for services provided on credit during the year. 3) Bought spare parts $2, 000 and a bulk supply of diesel fuel $18, 000, and paid cash. 4) Paid normal operating expenses for the year in cash $206, 400. The operating expenses paid were for: Property rates Telephone Stationery Repairs and licences Wages Interest on loan 5) $2 000 1 000 1 000 8 200 181 000 13 200 $206 400

Received $330, 000 cash from credit customers and banked this amount.
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6)

Joe Chan withdrew $48, 000 cash during the year for his personal living expenses. Paid $30, 000 on the last day of the year for the instalment owing on the loan. At the end of the year Joe worked out the following: Spare parts used Diesel fuel still in bulk storage Depreciation of trucks Depreciation of office computer 800 12 000 30 000 1 000

7)

8)

Required 1) Record the above eight transactions on the worksheet on the next page, total all columns and check that totals of assets columns equal the totals of liability plus capital columns. (Record transaction (4) as $206 ,400 and ignore the detail for expenses.) 2) Using the column totals, and details in the capital and cash at bank columns prepare the following accounting reports for 2003: a) b) c) d) Statement of financial position Statement of financial performance Statement of owners equity Statement of cash flows

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1.6 Ethics and Accounting

An ethical behaviour is very important for all types of businesses to function effectively. That is all the people working in the entity have to be honest, abide by the rules and do the right thing. In early 2000s there were a number of large business and financial institution collapses which had lead to monetary losses and hardships to shareholders and policy holders. Thus there was an increased pressure from the community to improve the ethics of all people working in business. All entities have some forms of code of ethics which establishes the main principles of professional ethics and provides a conceptual framework for applying those principles. Some of the ethical principles that members are expected to adhere to are integrity, objectivity, independence and confidentiality of client information. Reading 1.7 Read: pp. 20 21 of your textbook, Chapter 1

Now take the time to attempt Activity 1.7

Activity 1.7
Spend 15 minutes on this activity. Attempt the ethical case given on pp.27 in chapter 1 of your text book

Important Notes
It is also important for you to go over Chapter 17 of your text book to see what a Conceptual Framework is and everything you will find in the framework. After looking at this chapter you will notice that the components of the framework have been discussed in the above sections.

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Summary
This unit has led you very rapidly through some important and complex ideas. Assets, liabilities, owners equity, revenues and expenses are the five essential elements of three accounting reports, namely the statement of financial position, statement of financial performance and the statement of changes in equity. You have also been shown how the elements are linked through the value in use concept of future economic benefits. You have also been introduced to the cash flow statement. The unit has also put forward four important assumptions which underpin accounting record keeping and reporting and it has introduced an arithmetical model which can be used to record the effects that transactions have on the three key elements making up the position statement. This model would be an effective and complete accounting system if a business had only a few transactions each accounting period. But, in real life, there are too many transactions and too many types of assets, liabilities, expenses and revenues. The next unit shows how this simple accounting system is developed and expanded, using ledger accounts, to deal with the large number of transactions which businesses really have to record, analyse, summarise and report.

End of Unit Exercise

Attempt the following exercises and problems from your textbook by Hoggett, Edwards & Medlin: Exercise 2.5, p. 47 Problem 2.10, p.55 Problem 2.15, p. 58

Solutions to End of Unit Exercise

Exercise 2.5 (a) Investing (b) Operating (c) Financing (d) Financing (e) Investing (f) Operating (g) Financing (h) Operating [I] [O] [O] [O] [O] [O] [I] [I]

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Problem 2.10 A. and B.

Assets Cash at Bank . (1) $16 000 -4 720 11 280 (2) +14 800 26 080 (3) -3 000 23 080 (4) 23 080 (5) 23 080 (6) -9 300 13 780 (7) 13 780 (8) + 13 500 27 280 (9) -1 200 26 080 + 9 840 + 1 240 + 52 150 = 810 + 26 900 + + 23 340 13 500 9 840 + 1 240 + 52 150 = 810 + 26 900 + + 62 800 1 200 61 600 + 23 340 + + 2 680 1 440 1 240 + 52 150 = 810 + 26 900 + 52 150 = 810 + 26 900 + 23 340 + + + 11 700 11 640 23 340 + + + 2 000 680 2 680 + 52 150 = + 52 150 = 130 + 680 810 + 26 900 + + + 73 540 9 300 64 240 1 440 62 800 + 26 900 + 2 000 + + 26 500 -14 800 11 700 + 2 000 + + + 39 750 12 400 52 150 = 130 = 130 + + + 17 500 9 400 26 900 + + + 61 900 11 640 73 540 + 61 900 + 2 000 + 39 750 = Accounts + Receivable + $26 500 Office + Supplies + 2 000 Office + Equipment + $39 750 = Liabilities Loan + Payable + $17 500 Accounts = Payable = $4 850 - 4 720 130 + 17 500 + 61 900 + Equity Xiu Miao, + Capital + $61 900

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C.

XIU MIAO- SOLICITOR Income Statement for the month ended 31 July 2013 INCOME Legal services earned EXPENSES Wages expense Rent expense Advertising expense Supplies expense PROFIT $11 640 $4 100 4 000 1 200 1 440 10 740 $900

XIU MIAO SOLICITOR Statement of Changes in Equity for the month ended 31 July 2013 Xiu Miao, Capital 1 July 2013 Add: Profit for the month Less: Drawings during the month Xiu Miao, Capital 31 July 2013

$61 900 900 62 800 1 200 $61 600

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XIU MIAO SOLICITOR Balance Sheet as at 31 July 2013 ASSETS Cash at bank Accounts receivable Office supplies Office equipment $26 080 9 840 LIABILITIES Accounts payable Loan payable $810 26 900

1 240 EQUITY 52 150 $89 310 Xiu Miao, Capital 61 600 $89 310

Problem 2.15 A. FIT PRO Income Statement for the six months ended 28 February 2014 INCOME Fitness income earned $9 800 EXPENSES Rent expense $750 Electricity expense 850 Telephone expense 560 Water expense 350 Advertising expense 500 3 010 PROFIT $6 790

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B. FIT PRO Balance Sheet as at 28 February 2014 LIABILITIES $16 500 Accounts payable $460

ASSETS Cash at bank Accounts receivable Fitness equipment

800 EQUITY 4 000 Ryan Capital Stallard, $20 840 $21 300

$21 300

FIT PRO Statement of Changes in Equity for the six months ended 28 February 2014 Ryan Stallard, Capital 1 September 2013 Add: Profit for the six months Less: Drawings during the six months Ryan Stallard, Capital 28 February 2014

$15 000 6 790 21 790 950 $20 840

C. The income statement shows that Ryan made a profit for the six months of $6,790. Although he has only drawn out $950 in this period, he does still have $16,500 in the business bank account at the end of the first 6 months. Whether he continues with his business venture or not depends on whether he believes he will be able to improve the profits in the future, and also on what alternatives he has available. It is common for businesses starting out to make losses initially, or to start with very modest profits until they build up a client base and a reputation. At this stage there is no reason why Ryan shouldnt persevere for a while longer and try to build his business. On the other hand, Ryan may have determined that, given the maximum number of hours he can work each day, it is not possible for him to generate sufficient profits to give him the income he was hoping to get from his business, and he may decide to close it down and seek alternative employment or business opportunities.
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Solutions to Activity
Activity 1.1 User Small shareholders Potential shareholders Creditors and lending institutions (e.g. banks) Types of Decisions Buy, sell or hold shares Buy shares To offer credit or lend money Information Requirements Future earnings/profit Future earnings/profit Debtors or borrowers ability to pay the debt; also type of security offered Customers services offered; profit levels Competitors all available information Profits Future plans (expansion or down sizing)

Customers/competitors

Customers to continue to shop there Competitors to try and outperform the business

Employees/trade unions

Security of employment Ability of the business to pay higher wages

The above are only some of the possible decisions that external users could make, and the information they may need. You may have come up with different examples that are just as acceptable. Activity 1.2 Total Assets $120 000 $135 000 $151 500 $75 000 $144 000 Total liabilities $69 000 $49 500 $66 000 $43 500 $60 000 Total equity $51 000 $85 500 $85 500 $31 500 $84 000 Total income $123 000 $124 500 $135 000 $22 500 $84 000 Total expenses $66 000 $96 000 $150 000 $34 500 $48 000 Profit (loss) $57 000 $28 500 ($15 000) ($12 000) $36 000

Case A B C D E

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Activity 1.3 Jacksons Photographic Studio Statement of Financial Position As at 1 January 2008 $ Current Assets Cash at bank Accounts receivable Photographic supplies Total Current Assets Non-Current Assets Motor vehicle Photographic equipment Total Non-Current Assets Total Assets Current Liabilities Accounts payable Total Current Liabilities Non-Current Liabilities Loan Total Non-Current Liabilities Total Liabilities Owners Equity Capital, P Jackson Total Owners Equity Total Liabilities and Owners Equity 3 400 540 200 4 140 2 400 2 500 4 900 $9 040

3 040 3 040 2 000 2 000 5 040 4 000 4 000 $9 040

This form of position statement shows the entity viewpoint of the firms resources and obligations. It illustrates clearly the relationship Assets = Liabilities + Owners Equity. Later in the subject we will switch to the more usual proprietorship form of presentation. Make sure that you understand the criterion for distinguishing between current and non-current assets and liabilities. Also note the order (sequence) in which the current assets are listed.

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Activity 1.4 Assets = Liabilities + 92 570 = 36 300 + Owners Equity 56 270

Micks Plumbing Services Statement of Financial Position As at 30 June 2008 $ Current Assets Cash at bank Accounts receivable Plumbing supplies Total Current Assets Non-current Assets Land Building Equipment Total Non-current Assets 2 930 3 970 1 720 8 620

18 000 56 500 9 450 83 950

Total Assets

$92 570

Current Liabilities Accounts payable Total Current Liabilities Non-current Liabilities Bank loan Total Non-current Liabilities Total Liabilities Owners Equity Capital, Mick Daniels Total Owners Equity Total Liabilities and Owners Equity

2 300 2 300

34 000 34 000 36 300

56 270 56 270

$92 570

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Activity 1.5 Micks Plumbing Services Statement of Financial Performance For the year ended 30 June 2003 $ Revenues Plumbing Interest Rent 48 000 1 500 2 500 52 000 Less Expenses Advertising Gas cylinder rental Interest Maintenance of equipment Petrol Telephone Wages 1 800 160 2 250 490 2 750 1 300 15 000 23 750 Net Profit $28 250

Note: When there are the sub-headings revenues and expenses you need not write revenue and expense for each line item. The repetition is not necessary (this is different from the textbook illustrations!).

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Activity 1.6 JC Transporters Statement of Financial Position As at 31 December 2003 JC Transporters Statement of Financial Performance For the year ended 31 December 2003 $ Revenues Transport fees 450 000 Expenses Rates Telephone Stationery Repairs & licenses Wages Interest on loan Spares & fuel Depreciation Total Assets Current Liabilities Current portion of bank loan Total Current Liabilities Non-Current Liabilities Bank loan Total Non-Current Liabilities Total Liabilities Owners Equity Capital, J Chan Total Owners Equity Total Liabilities and Owners Equity Teaching points $359 800 244 200 30 000 30 000 Net profit $205 800

$ Current Assets Cash at bank Accounts receivable Fuel and spares Total Current Assets Non-Current Assets Land & building Office equipment Motor vehicles Total Non-Current Assets 57 600 120 000 13 200 190 800

40 000 9 000 120 000 169 000

2 000 1 000 1 000 8 200 181 000 13 200 6 800 31 000

60 000 60 000

90 000

269 800 269 800

$359 800

1) If your schedule does not give the same numbers as in the position statement check it for mistakes. 2) Expenses are shown in detail.
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3) Remember that these two separate reports are still linked together (articulated) by the statement of owners equity. JC Transporters Statement of Owners Equity For the year ended 31 December 2003 Capital, J Chan Invested 1 January Add: Net profit Less: Drawings Balance at 31 December

$ 112 000 205 800 317 800 48 000 $269 800

JC Transporters Statement of Cash Flows for the year ended 31 December 2003 $ Cash flows from operating activities Receipts from customers Payments to suppliers and employees Interest paid Net cash provided by operating activities Cash flows from investing activities Payment for land and building Payment for new equipment Payment for new vehicles Net cash used in investing activities Cash flows from financing activities Investment by owner, J Chan Drawings, J Chan Repayment of debt Net cash flows provided by financing activities Net increase in cash held Cash at beginning of year Cash at end of year 112 000 (48 000) (30 000) 34 000 (40 000) (10 000) (30 000) (80 000) 330 000 (213 200) (13 200) 103 600

57 600 NIL 57 600

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Teaching point The above report is a cash basis report. Compare the net cash provided by operating activities $103 600 with the accrual basis net profit $205 800. Can you see at least two reasons why the numbers do not agree? (Revenue is $120, 000 more than receipts from customers and depreciation and fuel & spares used are not in the cash flow statement).

Activity 1.7 Ethical practice among friends A. The stakeholders or the involved parties in this situation are Mickey and Minnie. B. Mickey has gained $15 by acquiring the text at a price lower than the bookshop text price of $80. He has misled his friend Minnie by failing to disclose the cost price of $65 which represents what he paid for the textbook. His friend has lost the benefit of the reduced price cost saving of $15. He has not acted honestly by retaining the $15 cash saving. He has not acted ethically nor has he acted as a friend. Mickey has not told Minnie the economic value of the book. He has breached his duty to his friend by not buying the new book at $65 and offering $15 balance in return. C. Mickeys alternatives are: tell Minnie what happened and give her the correct change; or buy a brand-new textbook for $80 as listed by the bookshop.

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