Fundamentals of Accounting

Introduction :
There are three basic reports that you should be familiar with:
a. The Cash flow statement
b. The Profit and Loss statement
c. The Balance sheet.

The Profit and Loss statement

The format of the Profit and Loss statement will be influenced by the nature of the firms
activities. It should also respond to the needs of those who use it.

The Profit and Loss statement for a trading firm falls in to two sections:
a. Calculation of gross profit ( Revenue Cost of Sales )
b. Calculation of net profit ( Gross profit Other expenses)

The Profit and Loss Statement Example

Revenue

Rs /-

Cash Sales

Rs /4,000
5,900
9,900
6,600

-Cost of Goods sold

Gross Profit
+ Rent

3,300
800
4,100

-Operating expenses
Selling expenses
Advertising
Depreciation of Motor

Rs /-

1700
100

vehicles
Salaries

1400
3200

Administrative expenses
Accounting fees
Supplies
Depreciation of Office
equipment
Finance expenses
Discount expense
Legal costs

450
150
200

100
300

Net Profit and Loss

(300)

In the example above the business make a loss and the loss has to be transferred to the balance
sheet. Explain why the business makes a loss yet the balance for bank has increased.

There are five basic elements of the Balance Sheet.

1.
2.
3.
4.
5.

Current assets
Noncurrent assets
Current liabilities
Noncurrent liabilities
Proprietorship

Classification of the terms for the Balance sheet.

Classification of items in to current and non current sections helps assess. There are three
criteria for separating current from non-current assets:

Time - How long before the asset is expected to be converted into cash?

Intention - Is it intended to convert the asset into cash in the near future?

Economic benefit - For how long will the asset continue to earn revenue for the
business?

Time is also a criterion for separating current and non-current liabilities. When classifying
liabilities it is important to check the date when a liability falls due. What may be a non-current

liability in this period may become a current liability in the next period. Liabilities such as loans
and mortgages may be in the form of instalment payments. This means that they have a current
and non-current component. For instance, if you borrowed 20,000 over five years then initially
you would have 4,000 of loan as a current liability and 16,000 as non-current liability. At the
end of the year with 4,000 repaid you would show in the balance sheet 4000 as a current
liability and 12,000 as noncurrent, both under the title of 'loan'.

Balance Sheet Tasks

Some of the tasks involving balance sheets you may be required to undertake include:

presenting fully classified balance sheets

determining current assets and current liabilities

using a previous balance sheet and additional information to prepare a current balance
sheet

considering the effect on the balance sheet of a series of transactions

identifying the different accounting concepts and principles and the manner in which they
relate to the balance sheet

analysis and interpretation of a series of balance sheets

Current Assets
Bank
Petty Cash
Prepaid Advertising
Accrued Rent
Stock of supplies
Debtors
Stock 31st May

Rs / -

Rs/-

Rs/2,600
100
500
600
200
6100
4200
14,300

Non Current assets

Equipment
-Accumulated

10,000
2,200

depreciation
equipment

of
7,800

Motor Vehicles
-Accumulated
depreciation of Motor
vehicles

8000

Total Assets
Equities
Current Liabilities
Creditors
Accrued Salaries
Prepaid Rent
Loan

1800

6,200
14000
28,300
3,400
300
200
4000
7900

Non-current liabilities
Loan
Owners equity
Capital
+ Net profit
-

Drawing
s

Total equities

16,000
10,000
300
10,300
4,900
5,400
29300

Understanding Accounting Terminology

Students in accounting should be familiar and competent in dealing with conceptual terms.
On the pages that follow examples are given of when students might use the different types of
activities.
Terms have different meanings. For instance, the word 'list' in any activity, test or exam, would
require only a simple statement. On the other hand the word 'explain' seeks a statement supported
by an elaboration saying why, an example or an illustration.

Accounting terminology, A - C
Analyse:
Accounting information in assessing the performance of a business operated
as a sole trader in such matters as profitability and liquidity;
Debtors using an ageing analysis;
The information presented in accounting reports and budgets for a business.
Balance:
Ledger accounts at the end of an accounting period;
The 'disposal of asset' account to determine the profit or loss on disposal of
assets.
Calculate:
Owners equity (capital) from a given list of assets and liabilities at a
particular date;
The amount of profit earned from a given set of information relating to a
specific period of time.
Check:
The accuracy of ledger recordings;
A bank statement against the cash records of a business.
Classify:
Items into categories of assets, liabilities and owners equity, with revenue
and expenses as elements of owners equity;
Items in Profit and Loss statements to provide information for assessing the
performance of different functions or responsibilities.

Compare:
a 'T' ledger with a three column ledger;
The cash method of recognising a transaction with the accrual method of
recognising a transaction.
Construct:
Acontrol account from data provided, e.g., a debtors control account, to
determine credit sales;
A table showing the impact of different methods of depreciation on the
Profit and Loss statement and balance sheet.
Criticise:
The preparation of annual accounting reports in terms of their value to the
management of a business.

Debate:

The view that a perpetual inventory system of recording for stock is a better system than
a physical inventory system for recording stock.

Define:

Accounting terms.

Demonstrate:

That 'equalling' totals at the foot of the trial balance does not ensure that accuracy has
been achieved in ledger recording;

That profit is an estimated measure.

Describe:

The accounting process in terms of its recording, reporting, interpreting and budgeting
functions;

What is involved in recording subsidiary ledger stock records using identified cost, and in
using assumed FIFO cost flows.

Design:

Columnar special journals to record transactions of a like nature;

Suitable headings for reports which specifically state the name of the firm, the type of
report, and the exact length and/or exact date of the report.

Discuss:

Alternative methods of revenue recognition and expense recognition;

Each accounting principle in terms of the effect on each of the recording and reporting
procedures.

Distinguish:

Between the asset approach to recording a payment in advance and the expense approach
to prepaid expenses;

Between a current asset, and a non-current asset and a current liability and a non-current
liability.

Enumerate:

With explanations, the reasons for a business adopting a perpetual system of recording
for stock.

Explain:

The consequences for both the Profit and Loss statement, and the balance sheet of
alternative values for stock;

Why the historical cost balance sheet does not show the current worth of the firm.

Evaluate:

Alternative methods of determining the cost of stock;

Alternative procedures in the recording and reporting of inventory.

Graph:

The effect of alternative methods of depreciation on the balance sheet value of a

particular non-current asset;

A firm's rate of return on investment over a number of equal-length accounting periods.

Group:

Ledger accounts in drawing up a chart of accounts;

Transactions according to their effect on the accounting equation.

Identify:

The accounting principles involved in accounting for non-current assets and depreciation;

The significance of a stocktake held at the end of the accounting period.

Illustrate:

How the entity principle effects the recording of transactions;

How a firm may experience an increase in cash but have operated at a loss.

Interpret:

Information provided on the profitability and liquidity of a firm.

Accounting data in assessing the performance (including profitability and liquidity) of a

business from an internal management point of view.

Justify:

The treatment of depreciation as an allocation of cost;

The application of the 'lower of cost and net realisable value' to individual items and
groups of items but not to aggregate stock valuations.

List:

Sources of finance available to a sole trader for normal trading and for expansion;

Advantages resulting from the use of a subsidiary ledger.

Outline:

Advantages and disadvantages resulting from the use of 'double entry' recording
compared with 'single entry' recording;

The differences between the recording and reporting for stock under a perpetual
inventory system, and the recording and reporting for stock under a physical recording
system.

Prepare:

Appropriately classified reports, such as a Profit and Loss statement and balance sheet for
a sole trader;

Budgeted reports, such as anticipated revenue, anticipated expenses, budgeted Profit and
Loss, budgeted balance sheet, and cash budget.

Prove:

That assets will always equal liabilities plus owners equity;

That 'single entry' and 'double entry' recording procedures are able to produce the same
accounting information.

Rank:

Documents in the order in which they are used for the sale of goods;

Current assets in the order of liquidity.

Recall:

The rules of posting involved in 'double entry' recording;

The accounting Equation.

Recognise:

A transaction involving credit;

Financial transactions amongst a set of business activities.

Reconcile:

The balances in subsidiary ledger accounts with the balance in the related control
account;

The bank balance shown in the firm's ledger account with that shown on the bank
statement.

Record:

Accounting transactions using both single and double entry recording procedures.

Transactions for firms selling services, firms selling goods, and firms selling goods and
services.

Report:

The performance of a sole trader-operated business in a fully classified Profit and Loss
statement;

The financial position of a business in reports showing such information as anticipated

revenue, anticipated expenses, budgeted profit, budgeted and historical cash flows, and
budgeted wealth.

Rule:

Appropriate journals or cash books to record information from original documents;

Ledger accounts to receive information being posted from journals.

State:

When each of the following methods of revenue recognition would be appropriate: point
of sale, point of delivery, collection of cash, and stages in completing a contract;

Why it is inappropriate to arbitrarily allocate expenses that do not bear a direct

relationship to a particular department or product.

Suggest:

Advantages in a recording system using control accounts;

Ways in which a cash budget is able to benefit a business.

Summarise:

The many reasons why a firm must continually review its policies on selling prices,
controlling costs, regulating terms of sale, limiting the level of stock on hand, controlling

cash, and close revenue and expense accounts necessary to calculate profit in the ledger
at the end of the accounting period and transfer that profit to the owner's capital account.
Tabulate:

Examples of adjusting and closing journal entries;

Examples of balance day adjustments under both 'single entry' and 'double entry'
recording procedures.

Use:

A set of cash books to record a series of transactions evidenced by original documents;

Ledger accounts based on 'double entry' to record a series of transactions evidenced by

original documents.

Write:

About the role of accounting in business;

About the problems of defining costs, and the effect of alternative values of stock in the
Profit and Loss statement and the balance sheet.

Accounting Principles
The impact of accounting principles (otherwise known as conventions, doctrines or assumptions)
on the preparation and presentation of financial information is an important aspect of all
Accounting units. These principles support the concepts listed above.
The principles are listed and described in the following pages. It is also important to recognise
how they may be breached.

Accounting concepts and principles

Accounting concepts are qualities that users expect to be present in financial reports. They form
a conceptual framework defining the nature, subject, purpose and broad content of financial
reporting.

General accounting concepts

Relevance
Accounting information must be based on information directly related to the business being
reported on.
Reliability
The accounting reports should represent an effective and faithful representation of financial
events relating to the business.
Materiality
This concept requires that all significant events be included in financial reports. An event is
regarded as material if it is likely to effect financial decisions.
Comparability
If accounting reports are to be compared from one reporting period to the next then the methods
of accounting used must be consistent from one period to the next.
Understandability
It is of no value to present accounting reports which users are simply unable to understand.
Constraint of timeliness
Lack of timeliness acts as a constraint to achieving the above qualities in reporting. Timeliness
indicates that reports are only of value if available within a reasonable time period.

Matching
Sets out the point of time at which revenue may be recognised.

Breach: A contract is signed for advertising in your magazine. Although you will not include any
advertising in this period's work you still include the revenue paid in advance.

Matching
Sets out the point of time at which revenue may be recognised.

Breach: A contract is signed for advertising in your magazine. Although you will not include any
advertising in this period's work you still include the revenue paid in advance.

Consistency
Accounting reports from one period to the next should be prepared on the same basis.

Breach: The owner uses one method of depreciation for a particular asset in one period and an
alternative method in the second period.

Diversity
Allows for the fact that no two firms are the same and therefore may use different accounting
methods.
Breach: The owner decides that because the business down the road uses the straight line method
of depreciation his or her business should do the same.

Dependability
Data used in accounting should be subject to stringent internal control.
Breach: Price calculations are based on outdated information.

Materiality
Is concerned with which data should be disclosed in financial reports. All transactions regardless
of size should be recorded.
Breach: The owner does not bother to record minor withdrawals of stock from the business.

Accounting Period
The life of the business is broken up into arbitrary periods for the purpose of measuring profit.

Breach: The owner decides to wait until the project is completed before preparing the financial
reports.

Monetary
Only events whose impact can be measured in money terms can be treated as a financial
transaction and thus entered in the books of the business.
All transactions should be recorded in money terms.
Breach: Stock is shown in financial reports in quantity amounts.

Verifiability
All transactions recorded in the books of the business are supported by documentary evidence.
Breach: Payments are made and recorded without supporting evidence, such as invoices or
cheque butts.

Going Concern
Assumes that the life of the business is ongoing, indefinite and continuous. Also known as the
continuity principle.
Breach: The owner does not wish to prepare a balance sheet but rather reports non-current assets
as costs in the period they were acquired.

Entity
Recognises that the business, from an accounting viewpoint, is separate from the owner.
Breach: The owner includes in the business balance sheet personal assets such as his or her golf
clubs.

Historical Cost
All items are recorded at the original cost, i.e. the cost at which they were acquired.
Breach: Property owned by the business is shown at the higher market value rather than for the
amount at which it was originally acquired.

Conservatism
May also be known as prudence. Losses should be recognised as soon as the business is aware of
their likely event, whilst profits should not be recognised until they actually occur.
Breach: The net realisable value of stock has fallen below cost yet the owner refuses to adjust
cost of goods sold calculations.

Accounting Introduction
The first step in designing an information system is to recognise information flows. These flows
are sorted into financial and non-financial data. The financial data is processed in journals and
ledgers and used to produce reports for users. These reports are the basis of business decision
making.
It is important that you realise that the system is coherent and interrelated. The design of the
system depends on what data is collected, and how that data is processed and reported. In turn,
what users seek from this data also impacts on system design.
It is very important that you are able to relate concepts and principles to each stage of the
accounting system.

Classification
Classification is the division of data into classes or categories to enable the more effective
provision of information from financial reports. Classification occurs in both records and reports.

Classification is designed to produce two outcomes-

Control planning
When discussing the reasons for classification ultimately you must come back to planning and
control.

Records

The special journals are exclusive in the data they contain, for instance, the cash receipts journal
only contains cash receipts. Within the journal the different sources of data may also be
classified. The cash receipts may be classified according to the source of those receipts, whether
they be from cash sales, debtors or other sources.

Functional classification

Functional classification refers to the manner in which expenses are grouped in the Profit and
Loss statement. The expenses are classified according to the function they perform and usually
correspond to the cost centres of the firm.

The advantages of functional classification include-

The opportunity to delegate responsibility, for instance, the sales manager is responsible for the
sales department expenses the capacity to compare one cost centre with another, with that of
similar firms, to benchmarks or with targets set by the firm to set limits on spending for
particular cost centres decisions may be made on the basis of information provided, such as
considering whether an increase in advertising leads to an increase in sales
When a group of motels gets a chance to have all their cleaning undertaken by a central linen
service an informed decision to do so cannot be made without a cost centre figure for their own
cleaning costs.

Classification of the balance sheet is discussed under that heading. Questions on classification of
the balance sheet are common and often include the need to recognise current assets and current
liabilities. The most common classification error is the treatment of a 'loan' as being exclusively
non-current.

Classification

Classification is the division of data into classes or categories to enable the more effective
provision of information from financial reports. Classification occurs in both records and reports.

Classification is designed to produce two outcomes-

control

planning
When discussing the reasons for classification ultimately you must come back to planning and
control.

Records

The special journals are exclusive in the data they contain, for instance, the cash receipts journal
only contains cash receipts. Within the journal the different sources of data may also be
classified. The cash receipts may be classified according to the source of those receipts, whether
they be from cash sales, debtors or other sources.

Functional classification

Functional classification refers to the manner in which expenses are grouped in the Profit and
Loss statement. The expenses are classified according to the function they perform and usually
correspond to the cost centres of the firm.

The advantages of functional classification include-

The opportunity to delegate responsibility, for instance, the sales manager is responsible for the
sales department expenses the capacity to compare one cost centre with another, with that of
similar firms, to benchmarks or with targets set by the firm to set limits on spending for
particular cost centres decisions may be made on the basis of information provided, such as
considering whether an increase in advertising leads to an increase in sales
When a group of motels gets a chance to have all their cleaning undertaken by a central linen
service an informed decision to do so can not be made without a cost centre figure for their own
cleaning costs.

Classification of the balance sheet is discussed under that heading. Questions on classification of
the balance sheet are common and often include the need to recognise current assets and current
liabilities. The most common classification error is the treatment of a 'loan' as being exclusively
non-current.

Balance sheets

The balance sheet taken from the 10 column worksheet (See topic titled 'Preparation of reports:
10 Column Worksheet') may be shown as follows:

Balance sheet as at 30 June

Current Assests

Prepaid rent

2,000

Debtors

12,500

Stock 30 June

22000

36500

Non Current Assets

Vehicles

18000
4700

13300
Equipment

32000
11100
20900
34200
70700

Total assets
Current liabilities
Bank overdraft

7600

Accrued wages
Creditors
Loan

1000
5800
4000
18400

Noncurrent liabilities
Loan
Owners equity
Capital
+ Net profit
-Drawings

16000
40,800
17500
58300
22000

Total equities
Likely errors include:
Failure to classify into current and non-current items
Inclusion of aliens, such as revenue or expenses
Incorrect titles, for example, depreciation instead of accumulated depreciation
The treatment of 'loan' as exclusively non-current
Failure to recognise 'bank' after preparing a cash statement
Failure to allow for the amount of the loan repaid
Non-inclusion of items, such as petty cash
Failure to add the current period's depreciation to accumulated depreciation

Profit and loss statement

36300
70700

Different aspects of the Profit and Loss statement are discussed earlier in this resource.

The Profit and Loss statement, drawn from the 10 column worksheet (See topic titled
'Preparation of reports: 10 Column Worksheet'), is presented below.

Profit and Loss statement for the six months ending 30 June

Revenue

Cash Sales

79000

Credit Sales

40000
119000
40200

Less cost of goods

sold
Gross Profit
+ Commission

78800
400
79200

Less Operating
expenses
Selling expenses
Advertising
Sales Wages
Depreciation of
motor vehicles

3000
22000
700
25
700

Administrative
expenses
Cleaning
Insurance
Office Salaries
Depreciation of
equipment
Rent

500
4500
19500
1,100
6000

31600
Finance expenses
Interest on loan
Net profit

4,400
61700
17500

The trial balance

At the end of the accounting period ledger accounts are closed off if they are revenue or expense
items, and balanced if assets, liabilities or owners equity items.
There are two presentations of the trial balance: the pre-trial balance and the post trial balance.
The distinction between the two is easily seen when preparing the '10 column worksheet', in the
next topic. The post trial balance occurs after balance day adjustments.
The purpose of the trial balance is to compile all the ledger account totals and balances in order
to confirm the accuracy of the recording process. Assets and expenses are listed in
then debit column while revenue, liabilities and owners equity items are shown in the credit
column. Negative items are also shown. Accumulated depreciation of non-current assets is
shown on the credit side and drawings are shown on the debit side of the trial balance.
It is possible for the trial balance to balance and yet be incorrect. Recording errors will not
necessarily be detected by carrying out a trial balance.
Examples of errors not detected by a trial balance:

a complete entry has been omitted from the ledger

an amount has been placed in the wrong account. For example, $300 paid wages should
have been included as cleaning expense

a compensating error has been made. For instance, both sales and purchases have been
overstated by $100

a money amount has been listed incorrectly

debit and credit entries have been reversed. A debtor has paid us money, yet debtors are
incorrectly debited and bank wrongly credited

The 10 column worksheet

The 10 column worksheet is a useful tool that shows the effect of balance day adjustments on the
Profit and Loss statement and the balance sheet. In the example provided amounts are given for
the ledger accounts at the end of the period but before balance day adjustments are made. This
trial balance totals and then the adjustments are provided. The impact can be followed through to
the financial reports.
The worksheet makes preparation of the Profit and Loss statement, and balance sheet easier.
Their respective columns are totalled, and the net profit or loss may be determined.

10 column worksheet
Account
s
Advertisin
g
Acc.depn/
equip.

Pre-trial balance

Adjustments

3
000

Post trial
balance

Profit and Loss

statement

3
000

3
000

10 000

1
100

11 100

Acc.depn/
motor
veh.

4
000

700

4
700

Bank

7
600

7
600

Capital

40 800

40 800

Cash sales
Cost of
sales
Credit
sales
Creditors

79 000

79 000

40 200

22 000

40 200
40 000

5
800

5
800

12 500

12 500

Cleaning

500

500

11
1
0
0

4
7
0
0

7
6
0
0
4
0
8
0
0
79 000
40 200

40 000

Debtors

Balanc
e sheet

40 000

5
8
0
0
12
500

500

Commissi
on
Drawings
Equipmen
t
Insurance
Interest on
loan
Loan (5 yr
inst.)

400

400

22 000

22 000

32 000

32 000

4
500
4
400

4
500
4
400
20 000

400
22
000
32
000
4
500
4
400

20 000

2
0
0
0
0

Motor
vehicles
Office
salaries
Prepaid
rent

18 000

18 000

19 500

19 500

19 500

2
000

Stock
control
Sales
wages

22 000

8
000

6
000

2
000
22
000

22 000

21 000
207 600

18
000

1
000

22 000

22 000

6
000
1
100

700

6
000
1
100

700

6 000

207 600

Rent
Depn of
equip.
Depn of
motor
veh.
Accrued
wages

1
000

1
100

700
1
000

17
500

Net Profit
and Loss

210 400

Preparation of reports

210 400

119 400

119 400

108
500

1
0
0
0
1
7
5
0
0
1
0
8
5
0
0

The cash report, the Profit and Loss statement, and the balance sheet are regarded as 'position
statements'.

Position statements reflect:

CASH
For ex : Statements of
receipts and Payments
Cash budget

PROFIT
Profit and loss

WEALTH
Balance sheet

Application
Prepaid Rent
31st May

Bank

6000 31st May

6000

Rent
expenses
Balance

4000
2000
6000

When preparing or reconstructing a record to determine dollar amounts it is important that the
relevant amount go to the correct position statement.

In the example above:

$6000 = cash position. It is the amount paid

$4000 = profit position. It is the amount incurred
$2000 = wealth position. It represents a future benefit