MS 15D Financial Accounting

Purpose of Accounting
Financial accounting is a system that involves recording, analysis and communication of financial information. The purpose of accounting is to provide financial information about the current operations and financial condition of a business to individuals, agencies and organizations. In other words, accounting is a system that is used by businesses to monitor their activities and report their performance. The overall objective of accounting is to provide information that can be used in making economic decisions.

Users of Financial Information

Persons outside of the business who have interest in the business, but are not involved in its day-to-day operation (external users), as well as, persons inside the organization who are involved in its day-today operations (internal users), use financial information. Some of the main users of financial information are: 1. Investors Investors (both existing and potential) need information concerning the safety and profitability of their investment and to decide whether a change of ownership interest is warranted. Trade and Loan Creditors Both present and potential creditors of the business use financial information to help them in deciding whether or not it is safe to extend credit to the business. They need information about the profitability and stability of the enterprise. In other words, they are interested in the solvency of the business i.e. Can the business pay its debts when they fall due? Statutory Agencies They need this information to assist them in evaluating tax returns for assessment purposes and to see whether there is compliance with government rules and regulations e.g. Income Tax department and Registrar of Companies. Employees and Trade Unions They use financial information to assist in the making of employment decisions and in negotiating contracts and benefits. Financial Analysts Use financial information to evaluate the soundness of businesses for their clients who may wish to make investment decisions and for Stock Exchange purposes. Customers of Businesses Use financial information to help them in evaluating their relationship with businesses and to make decisions regarding possible future business relationships. Managers of Businesses To assist them in the decision making, controlling and directing the day-to-day running of the business, as well as, to aid in the formulation of policies and plan for the future of the 1

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enterprise. Managers have a special interest in the annual financial statements, as these are the statements popularly used by decision makers outside of the organization.

Branches of Accounting
Financial Accounting Provides information for external users e.g. Potential investors, creditors, tax authorities, trade unions and financial analysts. Management Accounting Provides information Management, board of directors and employees. for internal decision making e.g.

Accounting Associations
American Institute of Certified Public Accountants (AICPA) Institute of Chartered Accountants of Jamaica (ICAJ) Association of Chartered Certified Accountants (ACCA) Institute of Internal Auditors (IIA) Institute of Management Accountants (IMA)

Accounting Qualifications
Certified Internal Auditor (US) An internal auditor, who has achieved professional recognition by passing the uniform examination offered by the IIA. Certified Management Accountant (US) An accountant, who has passed an examination offered by the IMA Certified Public Accountant (US)/Chartered Accountant (UK; Jamaica) A public accountant, who has met certain educational and experience requirements and has passed an exam prepared by the AICPA or ACCA.

The Accounting Process

Accounting is a system of gathering financial information about a business and reporting this information to users. The six main steps of the accounting process are: Analyzing looking at events that have taken place and thinking about how they affect the business Recording entering financial information about the events in the accounting system. Classifying sorting and grouping similar items together. Summarizing bringing the various items of information together to determine a result. Reporting telling the results. Interpreting deciding the meaning and importance of the information in the various reports. This may include percentage analyses and use of ratios to help explain how pieces of information are related. 2

Types of Ownership Structures

Businesses are classified according to who owns them and the specific way in which they are organized. Sole Trader or Proprietorship A business with a single owner called a proprietor. Not required by law to make any of its financial information available to the public. No formal document required for formation. Low start-up cost. The owner is personally responsible for all the decisions made for the business i.e. the owner assumes all risk and makes all decision (owner manages business). Owner is responsible for all the debts of the business i.e. the owners liability is unlimited and therefore extends to his/her personal assets. Although the financial records of a business should be kept separately from the owners personal financial records, there is no separation of the sole proprietors books and its owners books for legal purposes. Any amount earned from the business is included on the personal tax return of the owner. Examples include small retail stores, doctor, attorney, accountant, and physician.

Partnerships Least common form of organization Owned by two or more persons e.g. physicians, attorneys and accountants. Like the proprietorship, the owners i.e. each of the partners, is responsible for the debts of the business i.e. the liability of a partner is unlimited and therefore extends to his/her personal belongings No formal document is required for formation. Details like how much work each will do and how they will share any earnings from the business are specified in a document called a partnership agreement. Like the sole proprietor, earnings by a partner from the partnership are included when filing their own personal tax returns. Corporation Legally and financially separate from its owners. As legal entities, corporations may enter into contracts just like individuals. Ownership in a corporation is divided into amounts called shares of capital stock, each representing ownership in a fraction of the corporation. An owner of shares in a corporation is called a stockholder or a shareholder. Stockholders are free to sell some or all of their shares to other investors at anytime (Transferable ownership rights). Owners risk is limited to their initial investment and they have very little influence on business decisions. Managed by a Board of Directors Unlike proprietorships and partnerships, corporation pays taxes on its earnings i.e. an owner in a corporation does not include the income of the corporation in his/her personal tax returns. Formal documents are required for formation 3

Articles of Incorporation This document states, among other things: The name of organization; where company office will be located; the objective of the company; that the liability of the owners is limited if it is not to be unlimited; how the business plans to acquire financing. The rules drawn up to govern the internal working of the company; regulate the holding of meetings; regulate the issue of capital; define powers and duties of directors, rights of shareholders etc. A corporation whose shares of stock are owned by a very small number of people is called a closely held corporation or a private company. For the first couple of weeks we will be focussing on the accounts of the sole proprietorship.

Types of Businesses
Service A business that provides a service e.g. travel agency, computer consultant, physician, hospital, law firm, accounting firm. Merchandising Buys products from another business and sells to customers e.g. department stores, pharmacies, jewellery stores, supermarkets. Manufacturing Makes product to sell e.g. automobile manufacturer, furniture maker, toy factory, and garment manufacturing company.

Financial Reporting
External financial reporting is governed by an established body of standards and principles that are designed to carefully define what information a firm must disclose to outsiders. The Financial Accounting Standards Board (FASB), in the US has developed a set of standards referred to as Generally Accepted Accounting Principles (GAAP). GAAP are standards that are adhered to in the preparation of accounting information for investors and creditors. The standards provide the general rules and guidelines to be followed in the accounting and reporting process i.e. they determine the amount of information to be included in the financial statements, as well as, the format of preparation and presentation of such information. The rules provide assurance that business entities are reporting business activities in a similar manner. GAAP are important in ensuring the integrity of financial accounting information, so that financial reports for different entities can be more easily compared. In the same manner than FASB establishes accounting standards for U.S. entities, other countries have their own standard setting bodies. In an attempt to harmonize conflicting standards, the International Accounting Standards Committee (IASC) was formed in 1973 to develop worldwide accounting standards. The International Accounting Standards Board (IASB) replaced the IASC in 2001. Since then the IASB has amended some IAS, has proposed to replace some IAS with new International Financial Reporting Standards (IFRS) and has proposed certain new IFRS on topics for which no IAS 4

previously existed. This body, the IASB, now represents more than 143 accountancy bodies from more than 103 countries, including the United States. The accounting standards produced by the IASC are referred to as International Accounting Standards (IASs). IASs are envisioned to be a set of standards that can be used by all companies, regardless of their physical location. IASC standards are gaining increasing acceptance worldwide. However the Securities and Exchange Commission (SEC), in the U.S. has so far not recognized the standards of the IASC, and has barred foreign companies from listing their shares on the U.S. stock exchanges unless those companies agree to provide financial statements in accordance with U.S GAAP. Jamaica adopted IAS on July 1, 2002. Note Investors and creditors need relevant and reliable information about an entity. To ensure that this is done, companies are required to have their financial statements audited by independent accountants. An audit is a financial examination of the financial statements of an entity to determine whether these statements give a true and fair view of the financial health of the business. Like any other profession, accounting is governed by ethical rules and standards. Recent scandals in the corporate world point to the importance of ethics. The preparers of financial statements should not only abide by GAAP, but also ethical standards and ensure that accurate and reliable information is provided by the financial statements of the entity. The IASB Framework The framework describes the basic concepts by which the financial statements are prepared. It serves as a guide to the Board in developing accounting standards and as a guide to resolving accounting issues that are not addressed directly in an IAS or IFRS. The IASB Framework i) defines the objective of financial statement ii) identifies the qualitative characteristics that make financial information useful iii) defines the basic elements of financial statements and the concepts for recognizing and measuring them in financial statements

Characteristics of Accounting Information

The objective of financial reporting is to provide useful information. The qualitative characteristics of useful accounting information are Understandability i.e. information should be presented in a way that is readily understandable by users who have a reasonable knowledge of business, economic activities and accounting. Relevance For information to be relevant it must have the following qualities i) Feedback value & Predictive value i.e. feedback on past events help confirm or correct earlier expectations. Such information can be used to help predict future outcomes. ii) Timeliness. This is important for information to make a difference. Information received after a decision is made is useless, hence for information to be relevant it must 5

be provided to users within the time period in which it is most likely to influence their decisions. Materiality is also a component of relevance. Is the item large enough to influence the decision of a user of the financial information? Information is said to be material if its omission or misstatement could influence the decision of a user. Managers usually exercise professional judgment in determining whether an item is material or immaterial. Reliability Information should be relatively free from error. Reliability does not mean absolute accuracy, as information that is based on judgment cannot be totally accurate. The information presented should therefore have: Verifiability i.e. the data should be free from material error and bias and can be verified by other trained accountants. Representational Faithfulness i.e. the economic events are properly measured Neutrality i.e. fairness. Comparability Users must be able to compare the financial statements to a standard or benchmark such as other firms within the industry or a prior period within the same firm. Comparability requires similar events to be accounted for in the same manner on the financial statements of different companies and for a particular company for different periods. Disclosure of accounting policies is essential for comparability. True and fair Adherence to the above ensures true and fair view. Benefits greater than cost Information like any other commodity must be worth more than the cost of producing it.

The Accounting Elements

Three basic accounting elements exist for every business entity: assets, liabilities and owners equity. i) Assets These are economic resources owned or controlled by an entity and will provide future benefit. Examples of assets include cash, merchandise, furniture and fixtures, machinery, building and land. Businesses may also have an asset called accounts receivable, which represents the amount of money owed to the business by its customers as a result of making sales on account or on credit. Assets can either be termed current assets or non-current assets. Current assets are assets that the business plans to convert into cash or use to generate earnings in the next 12 months or within the businesss accounting cycle, whichever is longer. Operating cycle is the period between the purchasing of goods from supplier to collecting from customers. Examples of current assets are cash, accounts receivable, short-term investments, unsold merchandise (inventory).

Non-current assets (also referred to as Long-term assets or Fixed assets) are assets that are not expected to be used up in a year. Examples of fixed assets are land, building, furniture and fixtures, machinery. Other categories of L-T assets include L-T investments. ii) Liabilities These are debts or obligations the business has incurred to obtain the assets it has i.e. liabilities are amounts the business owes that can be paid with cash, goods or services. Common liabilities are accounts payable, notes payable and short-term loans. An account payable is an unwritten promise to pay a supplier for assets purchased or services received. A formal written promise to pay suppliers or lenders specified sums at definite future dates is known as a note payable. Like assets, liabilities can be grouped as current liabilities or non-current liabilities. Current liabilities are amounts to be paid off within the next 12 months or within the operating cycle of the entity if it is longer. Examples of current liabilities are accounts payable, notes payable, interest payable and short-term loans. Non-current or long-term liabilities are amounts owing that will be paid off over a period longer than one year. E.g. Mortgages, long-term loans iii) Owners Equity Also referred to as Net Worth and Capital, owners equity represents the owners claim to the assets of the business. It is the amount by which the business assets exceed the business liabilities. There are two ways for the owners to increase their claims to the assets of the business - By making contribution - By earning contribution

The Accounting Equation

The relationship between the three basic accounting elements assets, liabilities and owners equity can be expressed in the form of a simple equation known as the accounting equation. Assets = Liabilities + Owners Equity All business transactions affect the accounting equation. Business transactions are economic events, which have a direct impact on the business. In financial accounting, all business transactions are quantified in monetary terms. Examples of business transactions are buying goods and services, selling goods and services, making loans and borrowing money. The accounting equation must remain in balance after the transaction is completed. Expanding the Accounting Equation Revenues These are amounts the business earns from providing goods or services to customers. E.g. sales from sale of merchandise, consulting fees, rent revenue- if the business rents space to others; interest revenue for interest earned on bank deposits. Revenues increase both assets and owners equity. Expenses Expenses are costs incurred to generate revenues. E.g. rent, salaries, supplies used. Expenses decrease assets or increase liabilities and reduce owners equity. 7

If revenues exceed expenses, the difference is referred to as Net Income. If expenses exceed revenues, the difference is referred to as a Net Loss. Withdrawals (Drawings) Drawings are cash or other assets taken by the owner from the business for his/her personal use. Drawings serve to reduce owners equity. Assets = Liabilities + [Owners Equity + (Revenues Expenses) Drawings]

Financial Statements
Information relating to a business is usually communicated by way of financial statements. These statements are usually analyzed to evaluate the performance of the business. As per IAS 1, a complete set of financial statements include: 1. 2. 3. 4. 5. Income Statement Statement of Changes in Owners Equity Balance Sheet (Statement of Position) Statement of Cash Flows Notes to the Financial Statements comprising a summary of accounting policies and other explanatory notes.

The financial statements commonly prepared are the income statement, statement of owners equity and balance sheet. All financial statements must carry a heading. This heading includes: The name of the business The title of the statement The time period covered or the date of the statement. The Income Statement and Statement of Owners Equity provide information concerning events covering a period of time, in this case the month ended. The balance sheet on the other hand, offers a picture of the business on a specific date. 1. The Income Statement Also called Statement of Earnings, Statement of Operations or Profit & Loss Statement is a summary of all the revenues (income from sale of goods or services) a company earns minus all the expenses incurred in earning the revenues, for a specific period a month, a quarter or a year. The Income statement is therefore regarded as an activity statement. The statement tells whether the business earned a net income i.e. total revenues > total expenses or a net loss i.e. total expenses > total revenues. There are two (2) types of income statement: Single step groups all revenues together and all expenses together. Multiple step reports gross profit, net income from operations and net income.

2. Statement of Owners Equity (Sole Proprietorship) This statement shows any change that took place in owners equity from net income or net loss, withdrawals and other investments during a specific time period. Net income increases owners equity, whereas net loss and withdrawals decrease owners equity. John Doe Statement of Owners Equity $ John Doe, Capital @ 1/1/Add additional investment by owner Total Investment Net Income For Period Less Withdrawals by owner Increase/(Decrease) in Capital John Doe, Capital 31/12/$ xxxxxx xxxxxx xxxxxx xxxxxx xxxxxx

xxxxxx xxxxxx

3. The Balance Sheet The balance sheet, also referred to as Statement of Financial Position/Condition, describes the financial position of the business at a specific point in time. It is a position statement, which gives a snap shot of the business at a point in time. The balance sheet reflects the accounting equation i.e. Assets = Liabilities + Owners Equity. IAS 1 requires that an entity must normally present a classified balance sheet, separating current and noncurrent assets and liabilities. The standard does not prescribe the format of the balance sheet. The balance sheet can be arranged in either of two formats Report format Assets at the top and liabilities and owners equity at the bottom Account format Assets on left and liabilities & owners equity on the right. Assets can be presented current then non-current or vice versa and liabilities can be presented current, non-current then equity or vice versa. A net asset presentation (assets liabilities) is allowed. The long-term financing approach used in the UK and elsewhere- Fixed Assets + Current Assets Current Liabilities = Long-term Debt + Equity, is also acceptable. Assets are listed in the balance sheet in order of liquidity. Liquidity is a measure of how easily an asset can be converted into cash. The more liquid an asset is, the more easily it can be converted into cash. 4. Statement of Cash Flows One of the purposes of financial statements is to assist users in making predictions about an entity's future cash inflows and outflows. Users can predict the future only if they have sufficient information. Unfortunately the IS and BS are not enough to furnish the requisite information. The statement of cash flows is very important in understanding an enterprise for purposes of investment and credit decisions. It depicts the ways cash has changed during a designated period the cash received from revenues and other transactions, as well as, the cash paid for certain expenses and other acquisition during the period. In short, the statement provides information about the nature and sources of an entitys cash inflows and outflows. The statement classifies the various cash flows into three categories: 1. Operating Activities 2. Investing activities 3. Financing Activities The information contained in the statement is useful in answering questions such as: 1. Did the business fund its operations from operations, loans or stockholders investments? 2. Were funds used for expansion; to reduce or repay outstanding debts, purchase fixed assets etc? 9

A clear understanding of a borrowers cash flow is one of the most important components of financial statements analysis in the banking sector. It provides the lender with a picture of the financial health of the business by focusing on receipts and disbursements. Operating Activities These are activities that are primarily related to the production and sales of goods and services, which enter into the determination of income i.e. items, which affect the income statement. Inflows Outflows Receipts from customers, loan interest received, dividends received. Payment for inventory, employees' wages & salaries, taxes, interest paid and other business expenses

Investing Activities These are activities, which involve investment of the resources of a business Inflows Receipts from sales of stock and bonds held in other businesses and from disposal of long-term resources such as land and buildings and receipt of loan principal from borrowers. Payments made to acquire long-term assets or securities in other businesses, loans made to other businesses etc.

Outflows

Financing Activities These are activities, which provide a business with resources from either owners or creditors, i.e. the owners or creditors investing money in the business and the repayments. A business is financed by either debt (from outsiders) or equity (from insiders) Inflows Receipts from issue of stocks and bonds, cash received from owner to finance operations, and loans Outflows Payment of loan principal to creditor and dividends paid. Parentheses are used to denote negative cash flows i.e. cash outflows. It is important to note that the financial statements are interlinked as balances derived from one statement are reflected in other statements. The statements are prepared in the following order: Income Statement Statement of Owners Equity Balance Sheet Statement of Cash Flows 5. Notes Accompanying Financial Statements

As a general rule, a company should disclose any facts that an intelligent person would consider necessary for the statements to be properly interpreted. The adequate disclosure principle means that the financials should be accompanied by any information necessary for the proper interpretation of the statements. These disclosures appear in what are called notes to the financials at the end of the accounting period. The items to be disclosed are based on a combination of official rules, tradition and the accountants professional judgement. Two main items that are always disclosed are the accounting methods used and the due dates of major liabilities. Other items to be disclosed include: lawsuits pending against the business; scheduled plant closings, Government investigations into the safety of the companys products or the legality of its pricing policies; significant events occurring after the balance sheet date but before the financials are actually issued; specific customers that account for a 10

large portion of the companys business; unusual transactions or conflict of interest between the company and its key officers. Companies are not required to disclose information that is immaterial or that does not have a direct financial impact on the business e.g. resignation, firing or death of key officers/executive.

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