Accounting Lecture 1

Introduction to investment
o Stock = Ownership certificate of the company
o There are returns and risks in investment
Function of accounting
o Accounting is a system:
Identifies
Records
Communicates information
Relevant
Reliable
o Useful information Not saying things only

favourable or not credible

Comparable
o Speaking the same language
o Accounting standard should be set the same

within the country

To help users make decisions
Financial accounting (external reports outside the
company)
Users: Minority owners, lenders, managers, suppliers,
customers, employees (For both insiders and

outsiders)
o Investment
o Monitoring and evaluation
o Planning and controlling
Managerial Accounting (internal reports)
Users: Managers
o Planning and controlling

Primary financial statements

o Balance Sheet (statement of financial conditions)
Net wealth, how much it owes and owns
Financial status at the end of the period
o Income statement (Statement of comprehensive income)
Earnings differences between revenue and expenses
Operating results for the period
o Statement of changes in equity
o Statement of cash flow
Sources and use of cash flow

Managerial Accounting: Internal reports

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o
o

E.g. McDonald: cost recorded and how prices changes

Competitors (business secret) run more efficiently and
competitively

Example 1: earning of certain company increases market price of share rises

Earning reflects: (different information)

o Market share
o Sales potential
o Managerial quality

Example 2: Accounting-based compensation (judging the earnings)

Remuneration for hard work

o Bonus and salary
o Stock of company
Financial statements
o For insider in this case (actually outsiders can use as well, but not
illustrated in this example)
Good side of such practice
o Incentives
Bad side of such practice
o May manipulate the accounting entries and records for better
compensation

Reliability: Is accounting information reliable?

o Earnings management and fraud
Fabricate sales members to inflate the sale results /

accounting records
Management may act opportunistically
Cause of the problem
Separation of ownership and control
Management effort (intensity) and talent not directly
observable
E.g. Go to the office sleep
Accounting records are important evidence towards

ones work
Ethics: beliefs that distinguish right from wrong
P.7

QUESTION TYPE:
Which of the followings is/are ethical decision making
e.g. Conflicting of interests

Company structure
o CEO and CFO prepare the financial statements

A case of accounting fraud: Moulin Global Eyecare

How to improve reliability

o Middle tier: Board of Directors
Oversea and discipline CEO
Invite professors from business faculty
POTENTIAL PROBLEM:
o BOD appointed by manager usually
o Cannot effectively execute the function
o Demand for independent audits
Certified Public Account (CPA), or auditor
Audit managers financial reports
Fail to detect fraud may face lawsuit from investors
POTENTIAL PROBLEM:
o Paying and hiring by the company

Comparability

Generally Accepted Accounting Principles (GAAP)

o External users need to understand the rules and assumptions used
o

by companies for constructing financial statements

International Financial Reporting Standard (IFRS)
Hong Kong (All development countries, except USA)

Principles and assumptions of Accounting

Business entity concept

o Proprietorship
Not separable from debts
o Partnership
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Not separable from debts

o Corporation
Monetary Unit Concept
o Implicit assumption: In real world we have inflation, but we wont
o
o

adjust for inflation in general.

Inflationary accounting standard: used unless going too high
unless assume no inflation
Going-concern Assumption
The business will continue operating
Liquidation accounting: If going to close ignore this
principle

Example: Cost of the land bought at $5M, revalued at $7M later

COST PRINCIPLE
Assets are recorded at the actual

FAIR VALUE PRINCIPLE

Assets are recorded at the amount

amount paid for their acquisition

for which an asset should be

exchanged between knowledgeable
willing parties in an arms length
transaction

The company can choose which system to use.

Tutorial notes:
(P.10) Accounting principle
a) Measurement / cost principle
b) Revenue recognition principle
c) Expense recognition principle
Understate revenue / overstate the expense without governing rules
lower in the income to pay less tax by manipulation
d) Full disclosure principle
(P.11) Accounting assumption
a) Going concern assumption
b) Monetary unit assumption
c) Time period assumption
d) Business entity assumption
parent company only, subsidiaries will not be recorded
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Transactions GAAP& management choices and estimates Financial

statements

Objective and subjective

Objective: GAAP
Subjective: Different choices of calculation
o Fair value / cost

Forms of business entities

Sole proprietorship
Partnership
Corporation

Translation of transection to financial statements

Transection

Events which will:

o Affect the financial condition of an entity (Relevance)
o Be reliably measured in monetary terms (Objectivity)
Limitation of accounting
o Not all relevant events enter accounting, especially forward looking
o

information
E.g. Appointment of new CEO difficult to express in monetary
terms / objectively measured NOT RECORDED

A=E+L
Assets: Bring future cash flow to the company (We dont know who is the owner
we look at EQUITY and LIABILITY (The other side of the equation)
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Liabilities: Obligations to pay

Equity: Net assets (owner
Transection Analysis
Account: an accounting equation item (A/E/L)

Accounts receivable: Results from CREDIT SALES

Notes receivable: Asset converted to cash flow results from LOAN
CONTRACT

Returned earnings:
Revenue - Expenses Dividend (Accumulate from time to time)
Revenue:

Amounts received from selling goods and services

Revenue recognition principle when they are delivered

Expenses:

Amounts incurred in the normal course of business to generate revenues

Matching principle

Dividends:
Proprietorship and partnership: a few peoples own, decide how to distribute
capital
Private companies: owners withdrawls
Matching Principle

e.g. Purchased inventory: situation 2

(when I bought the book, I did not know when it would be sold)

ILLUSTRATION:
Mr. Chan started a BMW dealership. Below are the transactions which occurred
during the first year.
1. Jan 1. Mr. Chan invested $50 cash in the Company.
2. Feb 2. The Company borrowed $50 cash from Citibank.
3. Feb 3. The Company bought two BMWs for cash, $40.
4. Feb 15. The Company acquired equipment for $30 on account/credit.
5. Mar 5. The Company sold a BMW for $60 cash.
6. Dec 6. The Company paid wages in cash, $5.
7. Dec 31. Depreciation of equipment was $10.
8. Dec 31. The Citibank debt was due and fully repaid with $2 interest.
9. Dec 31. A cash dividend of $3 was paid out to the owner, Mr. Chan.

(3) No expense = benefit has NOT YET been realized (Exchange cash for
inventory)

(5) Income Statement & Balance Sheet at the same time

Dr. Cash $60
Cr. Sales (COGS) $60

Dr. Cash $60

Cr. Sales (COGS)

Dr. Sales (COGS) $20

$40

Cr. Inventory $20

Cr. Inventory $20

(9) Dividend payment =/= expense

Income Statement for Year 1

$
Revenues:
Sales

60

Expenses:
Cost of goods sold

20

Dep. expenses

10

Salaries expense

Interest expense

Net Income

23

Return on Assets ratio (ROA)

Net income (Revenue expenses) Average total assets

Debt Ratio
Total liabilities Total assets
(Compare with similar companies in the same industry / past record)

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