Unit 1 Study Guide

BASIC ACCOUNTING

CONCEPTS AND REPORTS

U1

A C C O U N T I N G

CHARACTERISTICS USERS

FINANCIAL

STATEMENTS

ACCOUNTING

INFORMATION

1. INTERNAL

2. EXTERNAL 1. COMPARABILITY

2. UNDERSTANDABILITY

3. RELEVANCE

4. RELIABILITY

1. STATEMENT OF FINANCIAL

PERFORMANCE

2. STATEMENT OF FINANCIAL POSITION

3. STATEMENT OF CHANGES IN EQUITY

4. CASH FLOW STATEMENTS

Unit 1 Concept Map This map represents the core concepts that we will be

covering in this unit, and the relationships between them.

U1: Basic Accounting Concepts and Reports 1.3

Study organiser

Topic Learning Outcomes Activities

1.1 The Nature and

Purpose of

Accounting

Explain the nature of accounting and its main

function

1.2 Users of Accounting

information

Identify the potential users of accounting information

Activity1.1

1.3 Accounting

Assumptions,

characteristics of

information and

the Accounting

Equation

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

Activity 1.2

1.4 Financial Reports Identify the basic financial statements used in business

to report to users for

decision-making purposes

Activity1.3

Activity1.4

Activity1.5

1.5 Double Entry

Record Keeping

Explain how the double entry system works

Activity1.6

1.6 Ethics and

Accounting

Understand the importance of ethics in business and

accounting and how to

recognize and handle

ethical dilemmas as part of

the decision making

process.

Activity 1.7

You should spend approximately 10 hours in this unit.


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.


Figure 1.1: The Complete Accounting Cycle

STEPS IN THE

ACCOUNTING

CYCLE

ACCOUNTING

RECORDS

1 Recognise and record

transactions

Source documents

2 Journalise

transactions

General journal

3 Post to general ledger

accounts

General ledger

4 Prepare unadjusted trial

balance of general ledger

Trial balance

(unadjusted)

5 Determine adjusting

entries

and journalise

General journal

6 Post to general ledger

accounts

General ledger

7 Prepare adjusted trial

balance

of general ledger

Trial balance (adjusted)

8 Journalise closing entries

General journal

9 Post closing entries

to general ledger

and balance accounts

General ledger

(revenue/expense

accounts closed)

10 Prepare post-closing trial

balance of general ledger

Trial balance

(post closing)

11 Prepare

financial statements

Worksheet

(optional)

Financial statements

(reports)

12 Journalise reversing

entries

General journal

13 Post reversing entries

to general ledger

General ledger


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.


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


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

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.

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.

Read Chapter 1, pp. 5 19 of your textbook.

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.


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 general-

purpose 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

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.

Activity 1.1

Read: Chapter 1, pp. 9 - 10 of your textbook,


User Types of Decisions Information Requirements

Small

shareholders

Potential

shareholders

Creditors and

lending

institutions

Customers/

competitors

Employees/

trade unions

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.


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

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:

Read Chapter 2, pp. 36 - 40 of your textbook.


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

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

Activity 1.2

Read Chapter 2, pp. 41 - 45 of your textbook.


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.

Liabilities: Debts or obligations (expressed as future sacrifices of

economic benefits) owed to outside parties (excluding

owners).

Owners equity: 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).

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


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.

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.

Keep these points in mind as you progress through the unit. We will keep

coming back to this abstract future economic benefits concept.


Figure 1.2: Sample Balance Sheet

DONS AUTO REPAIRS

STATEMENT OF FINANCIAL POSITION

AS AT 30 JUNE 2012

Current Assets

Cash at bank $50 340

Accounts receivable 77 790

Repair supplies 14 610

Total Current Assets 142 740

Non-Current Assets

Land 60 000

Building 455 000

Repair equipment 110 700

Total Non-Current Assets 825 700

Total Assets

$968 440

Current Liabilities

Accounts payable 80 760

Total Current Liabilities 80 760

Non-Current Liabilities

Mortgage payable 401 000

Total Non-Current Liabilities 401 000

Total Liabilities 481 760

Net Assets 486 680

Owners Equity

Don Brady, Capital 486 680

Total Owners Equity 486 680

Total Liabilities

& Owners Equity

$968 440

The values on this

statement are true

for this date only

The heading expresses the accounting entity

assumption by identifying the business entity

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.

LIABILITIES are the

obligations the business

presently has to creditors

and lenders. The liability

amounts represent future

sacrifices of economic

benefits

OWNERS EQUITY

represents the firms

obligation to the owner

(his residual interest).

It enables the equality

between the two sides

of the accounting

equation. Both segments (lists) show equal totals as

required by the accounting equation. The

statement thus balances or is in balance.


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


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 Non-current

Assets

For use and/or resale

within one year of the

position statement date.

For use over several

accounting periods. Items

not held for resale.

Liabilities

To be paid or settled

within one year of the

position statement date.

To be paid or settled over

several accounting periods.

Reading 1.5

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.

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:

Activity 1.3

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


1 Super SLR camera, valued at 900

Darkroom equipment which had cost 1 600

Second hand van bought for 2 400

Films, chemicals, photographic paper that had cost 200

Personal cash savings (deposited in a current banking

account in the name of the business) 1 400

Amount owing by customer for photographs taken

in 2007 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.

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 non-

current (n). If you are correct the column totals should balance using the

accounting equation.

Activity 1.4


Assets = Liabilities + Owners Equity

$ $ $ $

Cash in bank 2 930 2 930

Money owed to suppliers

(accounts payable)

2 300

Equipment 9 450

Mick Daniels capital 56 270

Land 18 000

Building 56 500

Bank loan 34 000

Supplies of plumbing fittings 1 720

Money owed from customers

(accounts receivable)

3 970

= +

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


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

REVENUES

The inflows or savings

in outflows of

economic benefits

LIABILITIES

The future sacrifices of

economic benefits

EXPENSES

The consumption or

losses of economic

benefits

FUTURE

ECONOMIC BENEFITS

CENTRAL

CONCEPT

OF VALUE


Take the time now to attempt Activity 1.5


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 Expenses

$ $ $

Wages 15 000

Petrol for work vehicle 2 750

Telephone 1 300

Interest received on business account 1 500

Maintenance of equipment 490

Gas cylinder rental 160

Receipts from plumbing 48 000

Advertising 1 800

Rent received 2 500

Interest paid on bank loan 2 250

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;

Revenue Expenses = Net Profit

AAActiviActy 1.5


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.


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:


Transaction Effect on Position Statement

The firm paid $1, 000 in part

settlement of debts owed to its

creditors.

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.

An amount of $500 owed by

debtors was received and banked.

This transaction will increase the

asset cash at bank by $500 and

decrease the asset accounts

receivable by $500.

Repair supplies to the value of

$100 were found to be damaged

and hence worthless.

This transaction will have the

effect of decreasing the asset

repair supplies by $100 and

decreasing owners equity by the same amount.

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

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 sub-

totals after each transaction).

Read: pp. 41 45 of your textbook, Chapter 2


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);


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.



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 $2 000

Telephone 1 000

Stationery 1 000

Repairs and licences 8 200

Wages 181 000

Interest on loan 13 200

$206 400

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

Activity 1.6


6) Joe Chan withdrew $48, 000 cash during the year for his personal living

expenses.

7) Paid $30, 000 on the last day of the year for the instalment owing on the

loan.

8) At the end of the year Joe worked out the following:

Spare parts used 800

Diesel fuel still in bulk storage 12 000

Depreciation of trucks 30 000

Depreciation of office computer 1 000

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) Statement of financial position

b) Statement of financial performance

c) Statement of owners equity d) Statement of cash flows


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

Now take the time to attempt Activity 1.7


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.

Activity 1.7

Read: pp. 20 21 of your textbook, Chapter 1


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 [I]

(b) Operating [O]

(c) Financing [O]

(d) Financing [O]

(e) Investing [O]

(f) Operating [O]

(g) Financing [I]

(h) Operating [I]


Problem 2.10

A. and B. Assets = Liabilities + Equity

Cash at

Bank

+

Accounts

Receivable

+

Office

Supplies

+

Office

Equipment

=

Accounts

Payable

+

Loan

Payable

+

Xiu

Miao,

Capital

. $16 000 + $26 500 + 2 000 + $39 750 = $4 850 + $17 500 + $61 900

(1) -4 720 - 4 720

11 280 + 26 500 + 2 000 + 39 750 = 130 + 17 500 + 61 900

(2) +14 800 -14 800

26 080 + 11 700 + 2 000 + 39 750 = 130 + 17 500 + 61 900

(3) -3 000 + 12 400 + 9 400

23 080 + 11 700 + 2 000 + 52 150 = 130 + 26 900 + 61 900

(4) + 11 640 + 11 640

23 080 + 23 340 + 2 000 + 52 150 = 130 + 26 900 + 73 540

(5) + 680 + 680

23 080 + 23 340 + 2 680 + 52 150 = 810 + 26 900 + 73 540

(6) -9 300 - 9 300

13 780 + 23 340 + 2 680 + 52 150 = 810 + 26 900 + 64 240

(7) - 1 440 - 1 440

13 780 + 23 340 + 1 240 + 52 150 = 810 + 26 900 + 62 800

(8) + 13 500 - 13 500

27 280 + 9 840 + 1 240 + 52 150 = 810 + 26 900 + 62 800

(9) -1 200 - 1 200

26 080 + 9 840 + 1 240 + 52 150 = 810 + 26 900 + 61 600


C.

XIU MIAO- SOLICITOR

Income Statement

for the month ended 31 July 2013

INCOME

Legal services earned $11 640

EXPENSES

Wages expense $4 100

Rent expense 4 000

Advertising expense 1 200

Supplies expense 1 440

10 740

PROFIT $900

XIU MIAO SOLICITOR

Statement of Changes in Equity

for the month ended 31 July 2013

Xiu Miao, Capital 1 July 2013 $61 900

Add: Profit for the month 900

62 800

Less: Drawings during the month 1 200

Xiu Miao, Capital 31 July 2013 $61 600


XIU MIAO SOLICITOR Balance Sheet

as at 31 July 2013

ASSETS LIABILITIES

Cash at bank $26

080

Accounts payable $810

Accounts

receivable

9 840 Loan payable 26 900

Office supplies 1 240 EQUITY

Office equipment 52 150 Xiu Miao, Capital 61 600

$89

310

$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

Water expense

560

350

Advertising expense 500

3 010

PROFIT $6 790


B.

FIT PRO

Balance Sheet

as at 28 February 2014

ASSETS LIABILITIES

Cash at bank $16

500

Accounts payable $460

Accounts

receivable

800 EQUITY

Fitness equipment 4 000 Ryan Stallard,

Capital

$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 $15 000

Add: Profit for the six months 6 790

21 790

Less: Drawings during the six months 950

Ryan Stallard, Capital 28 February 2014 $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.


Solutions to Activity

Activity 1.1

User Types of

Decisions

Information

Requirements

Small shareholders Buy, sell or hold shares Future earnings/profit

Potential shareholders Buy shares Future earnings/profit

Creditors and lending

institutions (e.g. banks)

To offer credit or lend

money

Debtors or borrowers ability to pay the debt;

also type of security

offered

Customers/competitors Customers to continue to shop there

Competitors to try and outperform the

business

Customers services offered; profit levels

Competitors all available information

Employees/trade unions Security of

employment

Ability of the business

to pay higher wages

Profits

Future plans (expansion

or down sizing)

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

Case

Total

Assets

Total

liabilities

Total

equity

Total

income

Total

expenses

Profit

(loss)

A $120 000 $69 000 $51 000 $123 000 $66 000 $57 000

B $135 000 $49 500 $85 500 $124 500 $96 000 $28 500

C $151 500 $66 000 $85 500 $135 000 $150 000 ($15 000)

D $75 000 $43 500 $31 500 $22 500 $34 500 ($12 000)

E $144 000 $60 000 $84 000 $84 000 $48 000 $36 000


Activity 1.3

Jacksons Photographic Studio

Statement of Financial Position

As at 1 January 2008

$

Current Assets

Cash at bank 3 400

Accounts receivable 540

Photographic supplies 200


Non-Current Assets

Motor vehicle 2 400

Photographic equipment 2 500

Total Non-Current Assets 4 900

Total Assets

$9 040

Current Liabilities



Non-Current Liabilities

Loan 2 000

Total Non-Current Liabilities 2 000


Owners Equity Capital, P Jackson 4 000


Total Liabilities and Owners Equity

$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.


Activity 1.4

Micks Plumbing Services


As at 30 June 2008

$

Current Assets

Cash at bank 2 930


Plumbing supplies 1 720


Non-current Assets

Land 18 000

Building 56 500

Equipment 9 450

Total Non-current Assets 83 950

Total Assets

$92

570

Current Liabilities



Non-current Liabilities

Bank loan 34 000

Total Non-current Liabilities 34 000


Owners Equity Capital, Mick Daniels 56 270


Total Liabilities and Owners Equity

$92

570

Assets = Liabilities + Owners Equity

92

570

= 36 300 + 56 270


Activity 1.5

Micks Plumbing Services

Statement of Financial Performance

For the year ended 30 June 2003

$

Revenues

Plumbing 48 000

Interest 1 500

Rent 2 500

52 000

Less Expenses

Advertising 1 800

Gas cylinder rental 160

Interest 2 250

Maintenance of equipment 490

Petrol 2 750

Telephone 1 300

Wages 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!).


Activity 1.6

JC Transporters


As at 31 December 2003

JC Transporters

Statement of Financial

Performance

For the year ended

31 December 2003

$ $

Current Assets Revenues

Cash at bank 57 600 Transport fees 450 000


Fuel and spares 13 200 Expenses

Total Current Assets 190 800 Rates 2 000

Telephone 1 000

Non-Current Assets Stationery 1 000

Land & building 40 000 Repairs & licenses 8 200

Office equipment 9 000 Wages 181 000

Motor vehicles 120 000 Interest on loan 13 200

Total Non-Current

Assets

169 000 Spares & fuel 6 800

Total Assets

$359 800

Depreciation 31 000

244 200

Current Liabilities

Current portion of

bank loan

30 000 Net profit $205 800

Total Current

Liabilities

30 000

Non-Current

Liabilities

Bank loan 60 000

Total Non-Current

Liabilities

60 000

Total Liabilities

90 000

Owners Equity

Capital, J Chan 269 800


Total Liabilities

and Owners Equity

$359 800

Teaching points

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.


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 112 000

Add: Net profit 205 800

317 800

Less: Drawings 48 000

Balance at 31 December

$269 800

JC Transporters

Statement of Cash Flows

for the year ended 31 December 2003

$

Cash flows from operating activities

Receipts from customers 330 000

Payments to suppliers and employees (213 200)

Interest paid (13 200)

Net cash provided by operating activities 103 600

Cash flows from investing activities

Payment for land and building (40 000)

Payment for new equipment (10 000)

Payment for new vehicles (30 000)

Net cash used in investing activities (80 000)

Cash flows from financing activities

Investment by owner, J Chan 112 000

Drawings, J Chan (48 000)

Repayment of debt (30 000)

Net cash flows provided by financing

activities

34 000

Net increase in cash held 57 600

Cash at beginning of year NIL

Cash at end of year 57 600


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.

Documents

Unit 1 Study Guide