Introduction to Financial Accounting

Accountancy is the process of communicating financial information about a business entity to users such as shareholders and managers (Elliot, Barry & Elliot, Jamie: Financial accounting and reporting).

Accounting has been defined as:

the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof.(AICPA)

Accountancy therefore encompasses the recording, classification, and summarizing of transactions and events in a manner that helps its users to assess the financial performance and position of the entity. The process starts by first identifying transactions and events that affect the financial position and performance of the company. Once transactions and events are identified, they are recorded, classified and summarized in a manner that helps the user of accounting information in determining the nature and effect of such transactions and events.

Users of Accounting Information - Internal & External

Accounting information helps users to make better financial decisions. Users of financial information may be both internal and external to the organization.

Internal users of accounting information include the following:

Management: for analyzing the organization's performance and position and taking appropriate measures to improve the company results.

Employees: for assessing company's profitability and its consequence on their future remuneration and job security.

Owners: for analyzing the viability and profitability of their investment and determining any future course of action.

Accounting information is presented to internal users usually in the form of management accounts, budgets, forecasts and financial statements.

External users of accounting information include the following:

Creditor: for determining the credit worthiness of the organization. Terms of credit are set according to the assessment of their customers' financial health. Creditors include suppliers as well as lenders of finance such as banks.

Tax Authourities: for determining the credibility of the tax returns filed on behalf of the company.

Investors: for analyzing the feasibility of investing in the company. Investors want to make sure they can earn a reasonable return on their investment before they commit any financial resources to the company.

Customers: for assessing the financial position of its supplier which is necessary for a stable source of supply in the long term.

Regulatory Authorities: for ensuring that the company's disclosure of accounting information is in accordance with the rules and regulations set in order to protect the interests of the stakeholders who rely on such information in forming their decisions.

External users are communicated accounting information usually in the form of financial statements.

Accounting is a vast and dynamic profession and is constantly adapting itself to the specific and varying needs of its users. Over the past few decades, accountancy has branched out into specialized areas to cater for the different needs of the users.

Types of Accounting

Accounting is a vast and dynamic profession and is constantly adapting itself to the specific and varying needs of its users. Over the past few decades, accountancy has branched out into specialized areas to cater for the different needs of the users.

Main types of accounting are as follows:

Financial Accounting, or financial reporting, is the process of producing information for external use usually in the form of financial statements. Financial Statements reflect an entity's past performance and current position based on a set of standards and guidelines known as GAAP (Generally Accepted Accounting Principles). GAAP refers to the standard framework of guideline for financial accounting used in any given jurisdiction. This generally includes accounting standards (e.g. International Financial Reporting Standards), accounting conventions, and rules and regulations that accountants must follow in the preparation of the financial statements.

Management Accounting produces information primarily for internal use by the company's management. The information produced is generally more detailed than that produced for external use to enable effective organization control and the fulfillment of the strategic aims and objectives of the entity. Information may be in the form budgets and forecasts, enabling an enterprise to plan effectively for its future or may include an assessment based on its past performance and results. The form and content of any report produced in the process is purely upon management's discretion.

Cost accounting is a branch of management accounting and involves the application of various techniques to monitor and control costs. Its application is more suited to manufacturing concerns.

Governmental Accounting, also known as public accounting or federal accounting, refers to the type of accounting information system used in the public sector. This is a slight deviation from the financial accounting system used in the private sector. The need to have a separate accounting system for the public sector arises because of the different aims and objectives of the state owned and privately owned institutions. Governmental accounting ensures the financial position and performance of the public sector institutions are set in budgetary context since financial constraints are often a major concern of many governments. Separate rules are followed in many jurisdictions to account for the transactions and events of public entities.

What are Financial Statements

Financial Statements represent a formal record of the financial activities of an entity. These are written reports that quantify the financial strength and performance of a company.

Financial Statements reflect the financial effects of business transactions and events on the entity.

Types of Financial Statements

The four main types of financial statements are:

Statement of Financial Position (Balance Sheet) Income Statement (Profit and Loss Account) Cash Flow Statement Statement of Changes in Equity

Statement of Financial Position

Statement of Financial Position, or Balance Sheet, presents the financial position of an entity at any given date. A Statement of Financial Position has three main components:

Assets: Something a business owns or controls.

Liabilities: Something a business owes to someone

Equity: What the business owes to its owners. This represents the amount of capital that is left in the business after its assets are used to pay off its outstanding liabilities.

Following is an Example of Statement of Financial Position (Balance Sheet):

Statement of Financial Position as at 31st December 2011 $

Assets

Property, Plant & Equipment 100,000

Cash 10,000

Inventory 10,000

Receivable5,000

Total Assets 120,000

Equity

Share Capital 80,000

Retained Reserves 20,000

Total Equity 100,000

Liabilities

Payables 5,000

Bank Loan15,000

Total Liability 20,000

Assets of an entity may be financed from internal sources (i.e. share capital and profits) or from external credit (e.g. bank loan, trade creditors, etc.). Since the total assets of a business must be equal to the amount of capital invested by the owners (i.e. in the form of share capital and profits not withdrawn) and any borrowings, its no surprise that in the above example total Assets worth $120,000 equal to the sum of Equity ($100,000) and Liabilities ($20,000).

This leads us to the Accounting Equation:

Assets = Liabilities + Equity

The Equation may be re-arranged as follows:

Equity = Assets - Liabilities

Liabilities = Assets - Equity

Purpose of Financial Statements

The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions (IASB Framework).

Financial Statements provide useful information to a wide range of users:

Managers require Financial Statements to manage the affairs of the company by assessing its financial performance and position and taking important business decisions.

Shareholders use Financial Statements to assess the risk and return of their investment in the company and take investment decisions based on their analysis.

Prospective Investors need Financial Statements to assess the viability of investing in a company. Investors may predict future dividends based on the profits disclosed in the Financial Statements. Furthermore, risks associated with the investment may be gauged from the Financial Statements. For instance, fluctuating profits indicate higher risk. Therefore, Financial Statements provide a basis for the investment decisions of potential investors.

Financial Institutions (e.g. banks) use Financial Statements to decide whether to grant a loan or credit to a business. Financial institutions assess the financial health of a business to determine the probability of a bad loan. Any decision to lend must be supported by a sufficient asset base and liquidity.

Suppliers need Financial Statements to assess the credit worthiness of a business and ascertain whether to supply goods on credit. Suppliers need to know if they will be repaid. Terms of credit are set according to the assessment of their customers' financial health.

Customers use Financial Statements to assess whether a supplier has the resources to ensure the steady supply of goods in the future. This is especially vital where a customer is dependant on a supplier for a specialized component.

Employees use Financial Statements for assessing the company's profitability and its consequence on their future remuneration and job security.

Competitors compare their performance with rival companies to learn and develop strategies to improve their competitiveness.

General Public may be interested in the effects of a company on the economy, environment and the local community.

Governments require Financial Statements to determine the correctness of tax declared in the tax returns. Government also keeps track of economic progress through analysis of Financial Statements of businesses from different sectors of the economy.

Accounting Concept and Principles

Accounting Concepts and Principles are a set of broad conventions that have been devised to provide a basic framework for financial reporting. As financial reporting involves significant professional judgments by accountants, these concepts and principles ensure that the users of financial information are not mislead by the adoption of accounting policies and practices that go against the spirit of the accountancy profession. Accountants must therefore actively consider whether the accounting treatments adopted are consistent with the accounting concepts and principles.

In order to ensure application of the accounting concepts and principles, major accounting standard-setting bodies have incorporated them into their reporting frameworks such as the IASB Framework.

Following is a list of the major accounting concepts and principles:

Relevance

Reliability

Neutrality

Faithful Representation

Substance over Form

Prudence

Completeness

Comparability/Consistency

Understandability

Materiality

Going Concern

Accruals

Business Entity

In case where application of one accounting concept or principle leads to a conflict with another accounting concept or principle, accountants must consider what is best for the users of the financial information. An example of such a case would be the trade off between relevance and reliability. Information is more relevant if it is disclosed timely. However, it may take more time to gather reliable information. Whether reliability of information may be compromised to ensure relevance of information is a matter of judgment that ought to be considered in the interest of the users of the financial information.

Relevance:

Information should be relevant to the decision making needs of the user. Information is relevant if it helps users of the financial statements in predicting future trends of the business (Predictive Value) or confirming or correcting any past predictions they have made (Confirmatory Value). Same piece of information which assists users in confirming their past predictions may also be helpful in forming future forecasts.

Example:

A company discloses an increase in Earnings Per Share (EPS) from $5 to $6 since the last reporting period. The information is relevant to investors as it may assist them in confirming their past predictions regarding the profitability of the company and will also help them in forecasting future trend in the earnings of the company.

Relevance is affected by the materiality of information contained in the financial statements because only material information influences the economic decisions of its users.

Example:

A default by a customer who owes $1000 to a company having net assets of worth $10 million is not relevant to the decision making needs of users of the financial statements.

However, if the amount of default is, say, $2 million, the information becomes relevant to the users as it may affect their view regarding the financial performance and position of the company.

Reliability

Information is reliable if a user can depend upon it to be materially accurate and if it faithfully represents the information that it purports to present. Significant misstatements or omissions in financial statements reduce the reliability of information contained in them.

Example:

A company is being sued for damages by a rival firm, settlement of which could threaten the financial stability of the company. Non-disclosure of this information would render the financial statements unreliable for its users.

Reliability of financial information is enhanced by the use of following accounting concepts and principles:

Substance Over Legal Form

Meaning

Substance over form is an accounting concept which means that the economic substance of transactions and events must be recorded in the financial statements rather than just their legal form in order to present a true and fair view of the affairs of the entity.

Substance over form concept entails the use of judgment on the part of the preparers of the financial statements in order for them to derive the business sense from the transactions and events and to present them in a manner that best reflects their true essence. Whereas legal aspects of transactions and events are of great importance, they may have to be disregarded at times in order to provide more useful and relevant information to the users of financial statements.

Example:

There is widespread use of substance over form concept in accounting. Following are examples of the application of the concept in the International Financial Reporting Standards (IFRS).

IAS 17 Leases requires the preparers of financial statements to consider the substance of lease arrangements when determining the type of lease for accounting purposes.For example, an asset may be leased to a lessee without the transfer of legal title at the end of the lease term. Such a lease may, in substance, be considered as a finance lease if for instance the lease term is substantially for entire useful life of the asset or the lease agreement entitles the lessee to purchase the asset at the end of the lease term at a very nominal price and it is very likely that such option will be exercised by the lessee in the given circumstances.

IAS 18 Revenue requires accountants to consider the economic substance of the sale agreements while determining whether a sale has occurred or not.For example, an entity may agree to sell inventory to someone and buy back the same inventory after a specified time at an inflated price that is planned to compensate the seller for the time value of money. On paper, the sale and buy back may be deemed as two different transactions which should be dealt with as such for accounting purposes i.e. recording the sale and (subsequently) purchase. However, the economic reality of the transactions is that no sale has in fact occurred. The sale and buy back, when considered in the context of both transactions, is actually a financing arrangement in which the seller has obtained a loan which is to be repaid with interest (via inflated price). Inventory acts as the security for the loan which will be returned to the 'seller' upon repayment. So instead of recognizing sale, the entity should recognize a liability for loan obtained which shall be reversed when the loan is repaid. The excess of loan received and the amount that is to be paid (i.e. inflated price) is recognized as finance cost in the income statement.

Importance

The principle of Substance over legal form is central to the faithful representation and reliability of information contained in the financial statements. By placing the responsibility on the preparers of the financial statements to actively consider the economic reality of transactions and events to be reflected in the financial statements, it will be more difficult for the preparers to justify the accounting of transactions in a manner that does fairly reflect the substance of the situation. However, the principle of substance over form has so far not been recognized by IASB or FASB as a distinct principle in their respective frameworks due to the difficulty of defining it separately from other accounting principles particularly reliability and faithful representation.

Comparability/Consistency

Financial statements of one accounting period must be comparable to another in order for the users to derive meaningful conclusions about the trends in an entity's financial performance and position over time. Comparability of financial statements over different accounting periods can be ensured by the application of similar accountancy policies over a period of time.

A change in the accounting policies of an entity may be required in order to improve the reliability and relevance of financial statements. A change in the accounting policy may also be imposed by changes in accountancy standards. In these circumstances, the nature and circumstances leading to the change must be disclosed in the financial statements.

Financial statements of one entity must also be consistent with other entities within the same line of business. This should aid users in analyzing the performance and position of one company relative to the industry standards. It is therefore necessary for entities to adopt accounting policies that best reflect the existing industry practice.

Example:

If a company that retails leather jackets valued its inventory on the basis of FIFO method in the past, it must continue to do so in the future to preserve consistency in the reported inventory balance. A switch from FIFO to LIFO basis of inventory valuation may cause a shift in the value of inventory between the accounting periods largely due to seasonal fluctuations in price.

Understandability

Transactions and events must be accounted for and presented in the financial statements in a manner that is easily understandable by a user who possesses a reasonable level of knowledge of the business, economic activities and accounting in general provided that such a user is willing to study the information with reasonable diligence.

Understandability of the information contained in financial statements is essential for its relevance to the users. If the accounting treatments involved and the associated disclosures and presentational aspects are too complex for a user to understand despite having adequate knowledge of the entity and accountancy in general, then this would undermine the reliability of the whole financial statements because users will be forced to base their economic decisions on undependable information.

Example:

One of the main problems with the financial statements of ENRON was that it contained a very complicated structure of special purpose entities that were presented in a manner that concealed the financial risk exposure of the company. The accounting treatments of ENRON were not comprehensible by the capital market participants who consistently overvalued its worth until the inevitable collapse of its share price in 2001 upon the news of its bankruptcy.

Materiality

Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements (IASB Framework).

Materiality therefore relates to the significance of transactions, balances and errors contained in the financial statements. Materiality defines the threshold or cutoff point after which financial information becomes relevant to the decision making needs of the users. Information contained in the financial statements must therefore be complete in all material respects in order for them to present a true and fair view of the affairs of the entity.

Materiality is relative to the size and particular circumstances of individual companies.

Example - Size

A default by a customer who owes only $1000 to a company having net assets of worth $10 million is immaterial to the financial statements of the company.

However, if the amount of default was, say, $2 million, the information would have been material to the financial statements omission of which could cause users to make incorrect business decisions.

Example - Nature

If a company is planning to curtail its operations in a geographic segment which has traditionally been a major source of revenue for the company in the past, then this information should be disclosed in the financial statements as it is by its nature material to understanding the entity's scope of operations in the future.

Materiality is also linked closely to other accounting concepts and principles:

Relevance: Material information influences the economic decisions of the users and is therefore relevant to their needs.

Reliability: Omission or mistatement of an important piece of information impairs users' ability to make correct decisions taken on the basis of financial statements thereby affecting the reliability of information.

Completeness: Information contained in the financial statements must be complete in all material respects in order to present a true and fair view of the affairs of the company.

What is a Going Concern?

Going concern is one the fundamental assumptions in accounting on the basis of which financial statements are prepared. Financial statements are prepared assuming that a business entity will continue to operate in the foreseeable future without the need or intention on the part of management to liquidate the entity or to significantly curtail its operational activities. Therefore, it is assumed that the entity will realize its assets and settle its obligations in the normal course of the business.

It is the responsibility of the management of a company to determine whether the going concern assumption is appropriate in the preparation of financial statements. If the going concern assumption is considered by the management to be invalid, the financial statements of the entity would need to be prepared on break up basis. This means that assets will be recognized at amount which is expected to be realized from its sale (net of selling costs) rather than from its continuing use in the ordinary course of the business. Assets are valued for their individual worth rather than their value as a combined unit. Liabilities shall be recognized at amounts that are likely to be settled.

What are possible indications of going concern problems?

Deteriorating liquidity position of a company not backed by sufficient financing arrangements.

High financial risk arising from increased gearing level rendering the company vulnerable to delays in payment of interest and loan principle.

Significant trading losses bieng incurred for several years. Profitability of a company is essential for its survival in the long term.

Aggressive growth strategy not backed by sufficient finance which ultimately leads to over trading.

Increasing level of short term borrowing and overdraft not supported by increase in business.

Inability of the company to maintain liquidity ratios as defined in the loan covenants.

Serious litigations faced by a company which does not have the financial strength to pay the possible settlement.

Inability of a company to develop a new range of commercially successful products. Innovation is often said to be the key to the long-term stability of any company.

Bankruptcy of a major customer of the company.

Accruals Concept

Financial statements are prepared under the Accruals Concept of accounting which requires that income and expense must be recognized in the accounting periods to which they relate rather than on cash basis. An exception to this general rule is the cash flow statement whose main purpose is to present the cash flow effects of transaction during an accounting period.

Under Accruals basis of accounting, income must be recorded in the accounting period in which it is earned. Therefore, accrued income must be recognized in the accounting period in which it arises rather than in the subsequent period in which it will be received. Conversely, prepaid income must be not be shown as income in the accounting period in which it is received but instead it must be presented as such in the subsequent accounting periods in which the services or obligations in respect of the prepaid income have been performed.

Expenses, on the other hand, must be recorded in the accounting period in which they are incurred. Therefore, accrued expense must be recognized in the accounting period in which it occurs rather than in the following period in which it will be paid. Conversely, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it must be presented as such in the subsequent accounting periods in which the services in respect of the prepaid expense have been performed.

Accruals basis of accounting ensures that expenses are "matched" with the revenue earned in an accounting period. Accruals concept is therefore very similar to the matching principle.

Business Entity Concept

Financial accounting is based on the premise that the transactions and balances of a business entity are to be accounted for separately from its owners. The business entity is therefore considered to be distinct from its owners for the purpose of accounting.

Therefore, any personal expenses incurred by owners of a business will not appear in the income statement of the entity. Similarly, if any personal expenses of owners are paid out of assets of the entity, it would be considered to be drawings for the purpose of accounting much in the same way as cash drawings.

The business entity concept also explains why owners' equity appears on the liability side of a balance sheet (i.e. credit side). Share capital contributed by a sole trader to his business, for instance, represents a form of liability (known as equity) of the 'business' that is owed to its owner which is why it is presented on the credit side of the balance sheet.

Elements of the financial Statements

There are five main elements of the financial statements:

Assets

Liabilities

Equity

Income

Expense

The first three elements relate to the statement of financial position while the latter two relate to income statements.

Assets

Asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity (IASB Framework).

In simple words, asset is something which a business owns or controls to benefit from its use in some way. It may be something which directly generates revenue for the entity (e.g. a machine, inventory) or it may be something which supports the primary operations of the organization (e.g. office building).

Assets may be classified into Current and Non-Current . The distinction is made on the basis of time period in which the economic benefits from the asset will flow to the entity.

Current Assets are ones that an entity expects to use within one-year time from the reporting date.

Non Current Assets are those whose benefits are expected to last more than one year from the reporting date.

Following are the most common types of Assets and their Classification along with the economic benefits derived from those assets.

Asset Classification Economic Benefit

Machine Non-currentUsed for the production of goods for sale to customer.

Office Building Non-current

Provides space to employees for administering company affairs.

Vehicle Non-current

Used in the transportation of company products and also for commuting.

Inventory CurrentCash is generated from the sale of inventory.

Cash Current Cash!

Receivables CurrentWill eventually result in inflow of cash.

It may be appropriate to break up a single liability into their current and non current portions. For instance, a bank loan spanning two years and carrying 2 equal

installments payable at the end of each year would be classified half as current and half as non-current liability at the inception of loan.

Liabilities

According to IASB Frmework liability is defined as follows:

A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits (IASB Framework).

In simple words, liability is an obligation of the entity to transfer cash or other resources to another party.

Liability could for instance be a bank loan, which obligates the entity to pay loan installments over the duration of the loan to the bank along with the associated interest cost. Alternatively, an entity's liability could be a trade payable arising from the purchase of goods from a supplier on credit.

Liabilities may be classified into Current and Non-Current. The distinction is made on the basis of time period within which the liability is expected to be settled by the entity.

Current Liability is one which the entity expects to pay off within one year from the reporting date.

Non-Current Liability is one which the entity expects to settle after one year from the reporting date.

Following are examples of some of the common types of liabilities along with their usual classification:

Liability Classification

Long Term Bank Loan Non-current

Bank Overdraft Current

Short Term Bank Loan Current

Trade Payble Current

Debenture Non-current

Tax Payble Current

It may be appropriate to break up a single liability into their current and non current portions. For instance, a bank loan spanning two years and carrying 2 equal installments payable at the end of each year would be classified half as current and half as non-current liability at the inception of loan.

Liability Classification

Long Term Bank Loan Non-current

Bank Overdraft current

Short Term Bank Loan current

Trade Payble current

Debenture Non-current

Tax Payble Current

It may be appropriate to break up a single liability into their current and non current portions. For instance, a bank loan spanning two years and carrying 2 equal installments payable at the end of each year would be classified half as current and half as non-current liability at the inception of loan.

Equity

Equity is the residual interest in the assets of the entity after deducting all the liabilities (IASB Framework).

Equity is what the owners of an entity have invested in an enterprise. It represents what the business owes to its owners. It is also a reflection of the capital left in the business after assets of the entity are used to pay off any outstanding liabilities.

Equity therefore includes share capital contributed by the shareholders along with any profits or surpluses retained in the entity. This is what the owners take home in the event of liquidation of the entity.

The Accounting Equation may further explain the meaning of equity:

Assets - Liabilities = Equity

This illustrates that equity is the owner's interest in the Net Assets of an entity.

Rearranging the above equation, we have

Assets = Equity + Liabilities

Assets of an entity have to be financed in some way. Either by debt (Liability) or by share capital and retained profits (Equity). Hence, equity may be viewed

as a type of liability an entity has towards its owners in respect of the assets they financed.

Examples of Equity recognized in the financial statements include the following:

Ordinary Share Capital

Preference Share Capital (irredeemable)

Retained Earnings

Revaluation Surpluses

Income

Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants (IASB Framework).

Income is therefore an increase in the net assets of the entity during an accounting period except for such increases caused by the contributions from owners. The first part of the definition is quite easy to understand as income must logically result in an increase in the net assets (equity) of the entity such as by the inflow of cash or other assets. However, net assets of an entity may increase simply by further capital investment by its owners even though such increase in net assets cannot be regarded as income. This is the significance of the latter part of the definition of income.

There are two types of income:

Sale Revenue: Income earned in the ordinary course of business activities of the entity;

Gains: Income that does not arise from the core operations of the entity.

For instance, sale revenue of a business whose main aim is to sell biscuits is income generated from selling biscuits. If the business sells one of its factory machines, income from the transaction would be classified as a gain rather than sale revenue.

Following are common sources of incomes recognized in the financial statements:

Sale revenue generated from the sale of a commodity.

Interest received on a bank deposit.

Dividend earned on entity's investments.

Rentals received on property leased by the entity.

Gain on re-valuation of company assets.

Income is accounted for under the accruals principal whereby it is recognized for the whole accounting period in full, irrespective of whether payments have been received or not.

As income is an element of the income statement, it is calculated over the entire accounting period (usually one year) unlike balance sheet items which are calculated specifically for the year end date.

Expense

Expenses are the decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants (IASB Framework).

Expense is simply a decrease in the net assets of the entity over an accounting period except for such decreases caused by the distributions to the owners. The first aspect of the definition is quite easy to grasp as the incurring of an expense must reduce the net assets of the company. For instance, payment of a

company's utility bills reduces cash. However, net assets of an entity may also decrease as a result of payment of dividends to shareholders or drawings by owners of a business, both of which are distributions of profits rather than expense. This is the significance of the latter part of the definition of expense.

Following is a list of common types of expenses recognized in the financial statements:

Salaries and wages

Utility expenses

Cost of goods sold

Administration expenses

Finance costs

Depreciation

Impairment losses

Expense is accounted for under the accruals principal whereby it is recognized for the whole accounting period in full, irrespective of whether payments have been made or not.

As expense is an element of the income statement, it is calculated over the entire accounting period (usually one year) unlike balance sheet items which are calculated specifically for the year end date.

Concept of Double Entry

Every transaction has two effects. For example, if someone transacts a purchase of a drink from a local store, he pays cash to the shopkeeper and in return, he gets a bottle of dink. This simple transaction has two effects from the

perspective of both, the buyer as well as the seller. The buyer's cash balance would decrease by the amount of the cost of purchase while on the other hand he will acquire a bottle of drink. Conversely, the seller will be one drink short though his cash balance would increase by the price of the drink.

Accounting attempts to record both effects of a transaction or event on the entity's financial statements. This is the application of double entry concept. Without applying double entry concept, accounting records would only reflect a partial view of the company's affairs. Imagine if an entity purchased a machine during a year, but the accounting records do not show whether the machine was purchased for cash or on credit. Perhaps the machine was bought in exchange of another machine. Such information can only be gained from accounting records if both effects of a transaction are accounted for.

Traditionally, the two effects of an accounting entry are known as Debit (Dr) and Credit (Cr). Accounting system is based on the principal that for every Debit entry, there will always be an equal Credit entry. This is known as the Duality Principal.

Debit entries are ones that account for the following effects:

Increase in assets Increase in expense Decrease in liability Decrease in equity Decrease in income

Credit entries are ones that account for the following effects:

Decrease in assets Decrease in expense Increase in liability Increase in equity Increase in income

Double Entry is recorded in a manner that the Accounting Equation is always in balance.

Assets - Liabilities = Capital

Any increase in expense (Dr) will be offset by a decrease in assets (Cr) or increase in liability or equity (Cr) and vice-versa. Hence, the accounting equation will still be in equilibrium.

Examples of Double Entry

1. Purchase of machine by cash

Debit Machine (Increase in Asset)Credit Cash (Decrease in Asset)

2. Payment of utility bills

Debit Utility Expense (Increase in Expense)Credit Cash (Decrease in Asset)

3. Interest received on bank deposit account

Debit Cash (Increase in Asset)Credit Finance Income (Increase in Income)

4. Receipt of bank loan principal

Debit Cash (Increase in Asset)Credit Bank Loan (Increase in Liability)

5. Issue of ordinary shares for cash

Debit Cash (Increase in Asset)Credit Share Capital (Increase in Equity)

Ledger Accounts

Accounting Entries are recorded in ledger accounts. Debit entries are made on the left side of the ledger account whereas Credit entries are made to the right side. Ledger accounts are maintained in respect of every component of the

financial statements. Ledger accounts may be divided into two main types: balance sheet ledger accounts and income statement ledger accounts.

Balance Sheet Ledger Accounts

Balance Sheet ledger accounts are maintained in respect of each asset, liability and equity component of the statement of financial position.

Following is an example of a receivable ledger account:

Receivable Account

Debit $ Credit $

Balance b/d 1 500 Cash 3 500

Sales 2 1000 Balance c/d 4 1000

1500 1500

Balance brought down is the opening balance is in respect of the receivable at the start of the accounting period.

These are credit sales made during the period. Receivables account is debited because it has the effect of increasing the receivable asset. The corresponding credit entry is made to the Sales ledger account. The account in which the corresponding entry is made is always shown next to the amount, which in this case is the Sales ledger.

This is the amount of cash received from the debtor. Receiving cash has the effect of reducing the receivable asset and is therefore shown on the credit side. As it can seen, the corresponding debit entry is made in the cash ledger.

This represents the balance due from the debtor at the end of the accounting period. The figure has been arrived by subtracting the amount shown on the credit side from the sum of amounts shown on the debit side.

This accounting period's closing balance is being carried forward as the opening balance of the next period.

Similar ledger accounts can be made for other balance sheet components such as payables, inventory, equity capital, non current assets and so on.

Income Statement Ledger Accounts

Income statement ledger accounts are maintained in respect of incomes and expenditures.

Following is an example of electricity expense ledger:

Electricity Expense Account

Debit $ Credit $

Cash 1 1,000 Income Statement 2 1,000

1,000 1,000

This is the amount of cash paid against electricity bill. The expense ledger is being debited to account for the increase in expense. The corresponding credit entry has been made in the cash ledger.

This represents the amount of expense charged to the income statement. The balance in the ledger has been recycled to the income statement which is being debited by the same amount. Unlike balance sheet ledger accounts, there is no balance brought down or carried forward. Instead, the income statement ledger is closed each accounting period end with the balancing figure representing the charge to income statement.

Similar ledger accounts can be made for other income statement components.

Accounting Equation

Double entry is recorded in a manner that the accounting equation is always in balance:

Assets = Liabilities + Equity

Assets of an entity may be financed either by external borrowing (i.e. Liabilities) or from internal sources of finance such as share capital and retained profits (i.e. Equity). Therefore, assets of an entity will always equal to the sum of its liabilities and equity.

The accounting equation may be re-arranged as follows:

Assets - Liabilities = Equity

We may test the Accounting Equation by incorporating the effects of several transactions to see whether it still balances as theorized in the accountancy literature. For the purpose of this test, we may classify accounting transaction into the following generic types:

Transactions that only affect Assets of the entity

Transactions that affect Assets and Liabilities of the entity

Transactions that affect Assets and Equity of the entity

Transactions that affect Liabilities and Equity of the entity

Note:

For all the examples on the next pages, it will be assumed that before any transaction, Assets of ABC LTD are $10,000 while its Liabilities and Equity are $5,000 each.

Depreciation

Depreciation is systematic allocation the cost of a fixed asset over its useful life. It is a way of matching the cost of a fixed asset with the revenue (or other economic benefits) it generates over its useful life. Without depreciation accounting, the entire cost of a fixed asset will be recognized in the year of

purchase. This will give a misleading view of the profitability of the entity. The observation may be explained by way of an example.

Example

ABC LTD purchased a machine costing $1000 on 1st January 2001. It had a useful life of three years over which it generated annual sales of $800. ABC LTD's annual costs during the three years were $300.

If ABC LTD expensed the entire cost of the fixed asset in the year of purchase, its income statement would present the following picture the end of the three years:

Income Statement 2001 2002 2003

$ $ $

Sales 800 800 800

Cost of Sales (300) (300) (300)

Fixed Asset Cost 1000 - -

Net Profit (Loss) (500) 500 500

As you can see, income statement of ABC LTD shows net loss in the first year even though it earned the same revenue as in the subsequent years. Conversely, no fixed asset will appear in ABC LTD's balance sheet although it had earned revenue from the machine's use through out its useful life of 3 years.

If ABC LTD, instead of charging the entire cost of fixed asset at once, depreciates the capital expenditure over its useful life, its income statement and balance sheet would present the following picture at the end of the three years:

Income Statement 2001 2002 2003

$ $ $

Sales 800 800 800

Cost of Sales (300) (300) (300)

Fixed Asset Cost 333.3 333.3 333.3

Net Profit (Loss) (166.7) (166.7) (166.7)

Balance Sheet (Extract) 2001 2002 2003

$ $ $

Fixed Assets 1,000 1,000 1,000

Accumulated Depreciation (333.3) (666.7) (1,000)

Net Book Value 666.7 333.3 Nill

As you can see, the process of relating cost of a fixed asset to the years in which the economic benefits from its use are realized creates a more balanced view of the profitability of the company. Hence, depreciation is an application of the matching principle whereby costs are matched to the accounting periods to which they relate rather than on the basis of payment.

Accounting Entry

Double entry involved in recoding depreciation may be summarized as follows:

Debit Depreciation Expense (Income Statement)

Credit Accumulated Depreciation (Balance Sheet)

Every accounting period, depreciation of asset charged during the year is credited to the Accumulated Depreciation account until the asset is disposed. Accumulated depreciation is subtracted from the asset's cost to arrive at the net book value that appears on the face of the balance sheet. Using the last example, following double entries will be recorded in respect of depreciation:

Depreciation Expense Account

Debit $ Credit $

2001 Accumulated Depreciation 333.3 2001 Income Statement 333.3

2002 Accumulated Depreciation 333.3 2002 Income Statement 333.3

2003 Accumulated Depreciation 333.4 2003 Income Statement 333.4

Accumulated Depreciation Account

Debit $ Credit $

2001 Balance c/d 333.3 2001 Depreciation Expense 333.3

333.3 333.3

2002 Balance c/d 666.6 2002 Balance b/d 333.3

2002 Depreciation Expense 333.3

666.6 666.6

2003 Balance c/d 1000 2003 Balance b/d 666.6

2003 Depreciation Expense 333.4

1000 1000

Reducing Balance Depreciation Method

Reducing Balance Method charges depreciation at a higher rate in the earlier years of an asset. The amount of depreciation reduces as the life of the asset progresses. Depreciation under reducing balance method may be calculated as follows:

Depreciation per annum = (Net Book Value - Residual Value) x Rate%

Where:

Net Book Value is the asset's net value at the start of an accounting period. It is calculated by deducting the accumulated (total) depreciation from the cost of the fixed asset.

Residual Value is the estimated scrap value at the end of the useful life of the asset. As the residual value is expected to be recovered at the end of an asset's useful life, there is no need to charge the portion of cost equaling the residual value.

Rate of depreciation is defined according to the estimated pattern of an asset's use over its life term.

Example:

An asset has a useful life of 3 years.

Cost of the asset is $2,000.

Residual Value is $500.

Rate of depreciation is 50%.

Depreciation expense for the three years will be as follows:

NBV R.V Rate Depreciation Accumalated Depreciation

Year1: (2000 - 500) x 50% = 750 750

Year2: (1250 - 500) x 50% = 375 1125

Year3: (875 - 500) x 50% = 375* 1500

*Under reducing balance method, depreciation for the last year of the asset's useful life is the difference between net book value at the start of the period and the estimated residual value. This is to ensure that depreciation is charged in full.

As you can see from the above example, depreciation expense under reducing balance method progressively declines over the asset's useful life.

Reducing Balance Method is appropriate where an asset has a higher utility in the earlier years of its life. Computer equipment for instance has better functionality in its early years. Computer equipment also becomes obsolete in a span of few years due to technological developments. Using reducing balance method to depreciate computer equipment would ensure that higher depreciation is charged in the earlier years of its operation.

Methods of Depreciation

Cost of fixed asset must be charged to the income statement in a manner that best reflects the pattern of economic use of the asset. Most common methods of depreciation include Straight Line Method and Reducing Cost Method.

Straight Line Depreciation Method

Straight line method depreciates cost evenly through out the useful life of the fixed asset. Straight line depreciation is calculated as follows:

Depreciation per annum = (Cost - Residual Value) / Useful Life

Where:

Cost includes the initial and any subsequent capital expenditure.

Residual Value is the estimated scrap value at the end of the useful life of the asset. As the residual value is expected to be recovered at the end of an asset's useful life, there is no need to charge the portion of cost equaling the residual value.

Useful Life is the estimated time period an asset is expected to be used from the time it is available for use to the time of its disposal or termination of use. Useful life is normally calculated in units of years but it may be calculated based on an alternative basis. Useful life of an oil extraction company may for example be the estimated oil reserves.

Accruals and Prepayments

Accruals Basis of Accounting

Financial statements are prepared under the Accruals Basis of accounting which requires that income and expense must be recognized in the accounting periods to which they relate rather than on cash basis. An exception to this general rule is the cash flow statement whose main purpose is to present the cash flow effects of transaction during an accounting period.

Under accruals basis of accounting, an entity must account for the following types of transactions:

Accrued Income

Accrued Expense

Prepaid Income

Prepaid Expense

Accrued Income

Accrued income is income which has been earned but not yet received.

Income must be recorded in the accounting period in which it is earned. Therefore, accrued income must be recognized in the accounting period in which it arises rather than in the subsequent period in which it will be received.

As income will be credited to record the accrued income, a corresponding receivable must be created to account for the debit side of the transaction. The accounting entry to record accrued income will therefore be as follows:

Debit Income Receivable (Balance Sheet)

Credit Income (Income Statement)

Example

ABC LTD receives interest of $10,000 on bank deposit for the month of December 2010 on 3rd January 2011. ABC LTD has an accounting year end of 31st December 2010.

ABC LTD will recognize interest income of $10,000 in the financial statements of year 2010 even though it was received in the next accounting period as it relates to the current period. Following accounting entry will need to be recorded to account for the interest income accrued:

$ $

Debit Interest Income Receivable 10,000

Credit Interest on Bank Deposit (Income) 10,000

On the date of receipt of interest (i.e. 3rd January of the next year) following accounting entry will need to be recorded in the subsequent year:

$ $

Debit Bank 10,000

Credit Interest Income Receivable 10,000

Accrued Expense

Accrued expense is expense which has been incurred but not yet paid.

Expense must be recorded in the accounting period in which it is incurred. Therefore, accrued expense must be recognized in the accounting period in which it occurs rather than in the following period in which it will be paid.

As expense will be debited to record the accrued expense, a corresponding payable must be created to account for the credit side of the transaction. The accounting entry to record accrued expense will therefore be as follows:

Debit Expense (Income Statement)

Credit Expense Payable (Balance Sheet)

Example

ABC LTD pays loan interest for the month of December 2010 of $10,000 on 3rd January 2011. ABC LTD has an accounting year end of 31st December 2010.

ABC LTD will recognize interest expense of $10,000 in the financial statements of year 2010 even though it was paid in the next accounting period as it relates to the current period. Following accounting entry will need to be recorded to account for the interest expense accrued:

$ $

Debit Interest Expense 10,000

Credit Interest Payable 10,000

On the date of payment of interest (i.e. 3rd January of the next year) following accounting entry will need to be recorded in the subsequent year:

$ $

Debit Interest Payable 10,000

Credit Cash 10,000

Prepaid Income

Prepaid income is revenue received in advance but which is not yet earned.

Income must be recorded in the accounting period in which it is earned. Therefore, prepaid income must be not be shown as income in the accounting period in which it is received but instead it must be presented as such in the subsequent accounting periods in which the services or obligations in respect of the prepaid income have been performed.

Entity should therefore recognize a liability in respect of income it has received in advance until such time as the obligations or services that are due on its part in relation to the prepaid income have been performed. Following accounting entry is required to account for the prepaid income:

Debit Cash/Bank

Credit Prepaid Income (Liability)

Example

ABC LTD receives advance rent from its tenant of $10,000 on 31st December 2010 in respect of office rent for the following year. ABC LTD has an accounting year end of 31st December 2010.

ABC LTD will recognize a liability of $10,000 in the financial statements of year 2010 in respect of the prepaid income to acknowledge its obligation to make the office space available to the tenant in the following year. Following accounting entry will be recorded in the books of ABC LTD in the year 2010:

$ $

Debit Cash 10,000

Credit Prepaid Rent Income (Liability) 10,000

The prepaid income will be recognized as income in the next accounting period to which the rental income relates. Following accounting entry will be recorded in the year 2011:

$ $

Debit Prepaid Rent Income (Liability) 10,000

Credit Rent Income (Income Statement) 10,000

Prepaid Expense

Prepaid expense is expense paid in advance but which has not yet been incurred.

Expense must be recorded in the accounting period in which it is incurred. Therefore, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it must be presented as such in the subsequent accounting periods in which the services in respect of the prepaid expense have been performed.

Entity should therefore recognize an asset in respect of expense it has paid in advance until such time as the services that are due in relation to the prepaid expense have been performed by the suppliers/contractors. Following accounting entry is required to account for the prepaid expense:

Debit Prepaid Expense (Asset)

Credit Cash

Example

ABC LTD pays advance rent to its landowner of $10,000 on 31st December 2010 in respect of office rent for the following year. ABC LTD has an accounting year end of 31st December 2010.

ABC LTD will recognize an asset of $10,000 in the financial statements of year 2010 in respect of the prepaid expense to recognize its right to use office space in the following year. Following accounting entry will be recorded in the books of ABC LTD in the year 2010:

$ $

Debit Prepaid Rent 10,000

Credit Cash 10,000

The prepaid expense will be recognized as expense in the next accounting period to which the rental expense relates. Following accounting entry will be recorded in the year 2011:

$ $

Debit Rent Expense (Income Statement) 10,000

Credit Cash/Bank 10,000

What is a Trial Balance?

Trial Balance is a list of closing balances of ledger accounts on a certain date and is the first step towards the preparation of financial statements. It is usually prepared at the end of an accounting period to assist in the drafting of financial statements. Ledger balances are segregated into debit balances and credit balances. Asset and expense accounts appear on the debit side of the trial balance whereas liabilities, capital and income accounts appear on the credit side. If all accounting entries are recorded correctly and all the ledger balances are accurately extracted, the total of all debit balances appearing in the trial balance must equal to the sum of all credit balances.

Purpose of a Trial Balance

Trial Balance acts as the first step in the preparation of financial statements. It is a working paper that accountants use as a basis while preparing financial statements.

Trial balance ensures that for every debit entry recorded, a corresponding credit entry has been recorded in the books in accordance with the double entry concept of accounting. If the totals of the trial balance do not agree, the differences may be investigated and resolved before financial statements are prepared. Rectifying basic accounting errors can be a much lengthy task after the financial statements have been prepared because of the changes that would be required to correct the financial statements.

Trial balance ensures that the account balances are accurately extracted from accounting ledgers.

Trail balance assists in the identification and rectification of errors.

Example

Following is an example of what a simple Trial Balance looks like:

ABC LTDTrial Balance as at 31 December 2011

Account TitleDebit Credit

$ $

Share Capital 15,000

Furniture & Fixture 5,000

Building 10,000

Creditor 5,000

Debtors 3,000

Cash 2,000

Sales 10,000

Cost of sales 8,000

General and Administration Expense 2,000

Total 30,000 30,000

Title provided at the top shows the name of the entity and accounting period end for which the trial balance has been prepared.

Account Title shows the name of the accounting ledgers from which the balances have been extracted.

Balances relating to assets and expenses are presented in the left column (debit side) whereas those relating to liabilities, income and equity are shown on the right column (credit side).

The sum of all debit and credit balances are shown at the bottom of their respective columns.

Limitations of a trial balance

Trial Balance only confirms that the total of all debit balances match the total of all credit balances. Trial balance totals may agree in spite of errors. An example would be an incorrect debit entry being offset by an equal credit entry. Likewise, a trial balance gives no proof that certain transactions have not been recorded at all because in such case, both debit and credit sides of a transaction would be omitted causing the trial balance totals to still agree. Types of accounting errors and their effect on trial balance are more fully discussed in the section on Suspense Accounts.

How to prepare a Trial Balance

Following Steps are involved in the preparation of a Trial Balance:

All Ledger Accounts are closed at the end of an accounting period.

Ledger balances are posted into the trial balance.

Trial Balance is cast and errors are identified.

Suspense account is created to agree the trial balance totals temporarily until corrections are accounted for.

Errors identified earlier are rectified by posting corrective entries.

Any adjustments required at the period end not previously accounted for are incorporated into the trial balance.

Closing Ledger Accounts

Ledger accounts are closed at the end of each accounting period by calculating the totals of debit and credit sides of a ledger. The difference between the sum of debits and credits is known as the closing balance. This is the amount which is posted in the trial balance.

How closing balances are presented in the ledger depends on whether the account is related to income statement (income and expenses) or balance sheet (assets, liabilities and equity). Balance sheet ledger accounts are closed by writing 'Balance c/d' next to the balancing figure since these are to be rolled forward in the next accounting period. Income statement ledger accounts on the other hand are closed by writing 'Income Statement' next to the residual amount because it is being transferred to the income statement as revenue or expense incurred for the period.

The steps involved in closing a ledger account may be summarized as below:

Add the totals of both sides of a ledger

The higher of the totals among the debit side and credit side must be inserted at the end of BOTH sides.Closing balance is the balancing figure on the side with the lower balance.

In case of ledger accounts of assets, liabilities and equity, 'balance c/d' is written next to the closing balance whereas in case of income and

expenses ledger accounts, 'Income Statement' is written next to the closing balance.

The closing balances of all ledger accounts are posted into the trial balance.

Next sections contain examples illustrating how the various types of ledger accounts are closed at the period end 31 December 2011.

Posting Closing ledger balances into Trial Balance:

Closing Balance of all ledger accounts are posted into the trial balance. It is important to remember that a debit closing balance in the ledger account appears on the credit side but in the trial balance it is presented in the debit column and vice versa.

Posting of closing balances should be done carefully as many errors may occur during the posting process such as Posting Error, Transposition Errors and Slide error.

Following is an example of a trial balance prepared from the closing balances of the ledgers detailed above.

ABC LTDTrial Balance as at 31 December 2011

Account TitleDebit Credit

$ $

Share Capital 10,000

Bank Loan 10,000

Cash 30,000

Salaries Expense 5,000

Sales Revenue 15,000

Total 35,000 35,000

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