FINANCIAL ACCOUNTING

Accounting – The Language of Business

Prepared by:
Raza Saeed,
FCMA, MBA, ACIS, CIA, DAIBP
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Learning Objectives
After studying this chapter, you should be able to
1. Define accounting, financial reporting, and financial statements
2. Explain the phrase ― Generally accepted accounting principles.
3. Explain how accounting information assists in making decisions
4. Describe the components of the balance sheet
5. Analyze business transactions and relate them to changes in
the balance sheet
6. Compare the features of sole proprietorships, partnerships, and
corporations
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What is Accounting
• Accounting is the art of interpreting, measuring and
communicating the results of economic activities.

• Accounting is the process of identifying, recording,

summarizing, and reporting economic information for
decision makers.
• Often called the language of Business

• Accountants present this information in reports called

financial statements

Accountant’s
Analysis and Financial
Event Users
Recording Statements
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The Purpose of Accounting

• Accounting information is useful to anyone making
decisions that have economic consequences;
• Allocation and use of scarce economic resources
• These decision makers include
• Managers
• Owners
• Investors
• Government
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Financial Accounting
• General Purpose Information:
Describing the financial resources, obligations, and activities of an
economic entity
• Financial accounting serves decision makers:
• Internal:
• Management
• Board
• Investors
• Creditors
• External
• Stockholders
• Suppliers
• Banks
• Government agencies
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Management Accounting
• Management accounting involve the
development and interpretation accounting
information intended to aid management in
running the business.
• Management accounting serves internal
decision makers:
• Top executives
• Department heads
• College deans
• Hospital administrators
• Other managers within the organizations
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The Annual Report

• The annual report is prepared by management and
informs investors about the company’s past performance
and future prospects
• Cover page Overview
• Chairman' s report
• Information about the company
• Management' s discussion and analysis
• Market share, sales, and marketing
• Securities and equity
• Corporate governance structures, principles
• Financial statements, notes, comments
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Accounting Environment
• Generally Accepted Accounting Principles (GAAP)
• Financial Reporting/Accounting Standards — Trans-national
differences
• Locally Applicable Accounting Standards
• - International Financial Reporting Standards (IFRS) as
applicable in Pakistan
• Qualities of financial information
• - Relevance
• - Reliability
• - Materiality
• - Substance over form
• Accounting Assumptions
• Accrual basis
• Going concern basis
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GAAP
• The Business Entity Concept
• The business entity concept provides that the accounting for a business or
organization be kept separate from the personal affairs of its owner, or from any
other business or organization.

• The Continuing Concern Concept

• The continuing concern concept assumes that a business will continue to operate,
unless it is known that such is not the case. The values of the assets belonging to
a business that is alive and well are straightforward.
• The Principle of Conservatism
• The principle of conservatism provides that accounting for a business should be
fair and reasonable. Accountants are required in their work to make evaluations
and estimates, to deliver opinions, and to select procedures.

• The Objectivity Principle

• The objectivity principle states that accounting will be recorded on the basis of
objective evidence. Objective evidence means that different people looking at the
evidence will arrive at the same values for the transaction.
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GAAP
• The Time Period Concept
• The time period concept provides that accounting take place over specific time
periods known as fiscal periods. These fiscal periods are of equal length, and are
used when measuring the financial progress of a business.

• The Revenue Recognition Convention

• The revenue recognition convention provides that revenue be taken into the
accounts (recognized) at the time the transaction is completed. Usually, this just
means recording revenue when the bill for it is sent to the customer. If it is a cash
transaction, the revenue is recorded when the sale is completed and the cash
received.

• The Matching Principle

• The matching principle is an extension of the revenue recognition convention. The
matching principle states that each expense item related to revenue earned
must be recorded in the same accounting period as the revenue it helped to earn.

• The Cost Principle

• The value recorded in the accounts for an asset is not changed until later if the
market value of the asset changes
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GAAP
• The Consistency Principle
• The consistency principle requires accountants to apply the same
methods and procedures from period to period.

• The Materiality Principle

• The materiality principle requires accountants to use generally
accepted accounting principles except when to do so would be
expensive or difficult, and where it makes no real difference if the
rules are ignored.
• If a rule is temporarily ignored, the net income of the company must
not be significantly affected, nor should the reader's ability to judge
the financial statements be impaired.
• The Full Disclosure Principle
• The full disclosure principle states that any and all information that
affects the full understanding of a company's financial statements
must be include with the financial statements.
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Financial Statements
•A company’s financial statements consists of four
accounting related reports:
• Financial resources
• Obligations
• Profitability
• Cash Transactions of a business

• The four major financial statements includes:

• Balance sheet
• Income statement
• Statement of Owners Equity
• Statement of cash flows
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Accounting Assumption
• Accrual:
• The effects of transactions and other events are
recognized when they occur rather than when cash or its
equivalent is received or paid and they are reported in the
financial statements of the periods to which they relate.

• Going Concern:
• An entity is normally presumed to be a going concern if it
has neither the intention nor the necessity to liquidate or
to cease/curtail materially the scale of its operations for
the foreseeable future.
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What is a Financial Statement ?

• Financial statements are a structured representation of
financial Position (Balance Sheet) and financial
performance (Income Statement) of an entity.

• Provide information about financial position, financial

performance and cash flows of an entity that is useful to a
wide e range of users making economic decisions.

• Show results of management's stewardship of the

resources entrusted to it.
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Financial Statements -Components

Financial Position Statement of Financial Assets - liabilities =
Position (Balance Equity
sheet)
Financial Performance Statement of Profit & Income - expenses =
Loss and Other Net profit
Comprehensive Income

Sources & Outflow of Cash flow Statement Opening cash+ cash in -

cash cash out = Closing cash

•Movement
. in Owner’s Statement of Changes Change in net assets
Equity in Equity (SOCIE) over the period (all gains
and losses)
Explanatory Notes & Notes Watch the notes!!
Auditors Opinion Read carefully
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Financial Statements- Elements

• Assets — resources controlled by entity from which
future benefits are expected to flow to the company
• Liabilities — present obligations of the company, for
which when settled, future economic outflows are
expected
• Equity — shareowners' funds (assets — liabilities)
• Income — revenues and gains that enhance the
company's assets from ordinary activities
• Expenses — outflows/decreases in economic benefits
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Preparation of Financial Statements

• Financial statements must comply with:

• IFRS/IAS as applicable in Pakistan

• Directives of the Securities and Exchange
Commission of Pakistan (SECP)
• Listing Regulations of the Pakistan Stock
Exchange (PSX)
• Other Relevant law (s) (eg. according to
industry or sector)
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The Balance Sheet

• The balance sheet (also called the statement of financial
position) shows the financial status of a company at a
particular instant in time
• The left side lists the resources of the firm
• The right side lists the claims against those resources

Assets= Liabilities + Owners’ equity

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The Balance Sheet

• Assets are economic resources that the company expects
to help generate future cash inflows or reduce or prevent
future cash outflows
• Examples: Cash, inventories, equipment
• Liabilities are economic obligations of the organization to
outsiders (creditors)
• Example: A debt to a bank in the form of a note payable
• Owners’ equity is the owners’ claim on the organization’s
assets
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The Balance Sheet

• Open account – the practice of making most purchases
on a credit basis instead of cash basis
• Accounts receivable are assets that result from the sale
of goods or services on open account
• Accounts payable are liabilities that result from a
purchase of goods or services on open account
• Inventories are assets held by the company for the
purpose of sale to customers
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Balance Sheet Transactions

• Every transaction of a company or entity affects the
balance sheet equation
• An entity is an organization that stands apart from other
organizations and individuals as a separate economic unit
• A transaction is any event that affects the financial position of an
entity and that can reliably recorded in money terms

• An account is a summary record of the changes in a

particular asset, liability, or owners’ equity item
• The double-entry accounting system records each
transaction in at least two accounts
• A compound entry affects more than two balance sheet
accounts
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Balance Sheet Transactions

Transaction 1: Initial Investment of $400,000

Assets = Liabilities + Owners’ Equity

Cash Lopez, Capital

(1) + $400,000 = +$400,000

(Owner Investment)
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Balance Sheet Transactions

Transaction 2: Loan of $100,000 from Bank

Assets = Liabilities + Owners’ Equity

Cash Note payable Lopez, Capital

(1) + $400,000 = +$400,000

(2) + $100,000 = + $100,000
Bal. $500,000 = $100,000 $400,000
$500,000 $500,000
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Balance Sheet Transactions

Transaction 3: Acquire Store Equipment
for Cash, $15,000

Assets = Liabilities + Owners’ Equity

Cash Store Equipment Note payable Lopez, Capital

Bal. $500,000 = $100,000 $400,000

(3) -15,000 +15,000 =
Bal. 485,000 15,000 = 100,000 400,000

$500,000 $500,000
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Preparing the Balance Sheet

Biwheels Company
Balance Sheet January 3, 20X2

Assets Liabilities and Owners’ Equity

Cash $485,000 Liabilities (note payable) $100,000

Store equipment 15,000 Lopez, capital 400,000

Total assets $500,000 Total liabilities

and owners’ equity $500,000
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Effect of Business Transaction upon Balance Sheet

Transaction – 1
September 1, Roberts deposited $ 180,000 in a Bank Account in the
name of the business, Robert Real Estate Company

ROBERT REAL ESTATE COMPANY

Balance Sheet
As at September 1, 20____
Assets Liabilities & Owners Equity

Cash $180,000 James Roberts, Capital $180,000

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Effect of Business Transaction upon Balance Sheet

Transaction - 2
September 3, Roberts purchased Land for suitable office. The Land
price was $ 141,000 and payment was made in cash.

ROBERT REAL ESTATE COMPANY

Balance Sheet
As at September 3, 20____
Assets Liabilities & Owners Equity

Cash $ 39,000 James Roberts, Capital $180,000

Land 141,000

Total Assets $180,000 Total Owners Equity $180,000

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Effect of Business Transaction upon Balance Sheet

Transaction - 3
September 5, purchased a complete office Building at a price of
$ 36,000 ( included the cost of moving the building and installing at
site) The terms of payment was immediate cash payment $ 15, 000
and payment of balance $ 21,000 within 90 days.

ROBERT REAL ESTATE COMPANY

Balance Sheet
As at September 5, 20____
Assets Liabilities & Owners Equity

Cash $ 24,000 Liabilities :

Accounts Payable $ 21,000
Land 141,000

Building 36,000 Owner’s Equity: $180,000

James Roberts, Capital
Total Assets $201,000 Total Owners Equity & Liabilities $201,000
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Effect of Business Transaction upon Balance Sheet

Transaction - 4
September 10, Robert company sold a small, unused corner of the
lots to Carter’s Drugstore for a price of $11,000 to be paid within three
months.

ROBERT REAL ESTATE COMPANY

Balance Sheet
As at September 10, 20____
Assets Liabilities & Owners Equity

Cash $ 24,000 Liabilities :

Accounts Payable $ 21,000
Accounts Receivable 11,000

Land 130,000 Owner’s Equity: $180,000

James Roberts, Capital
Building 36,000

Total Assets $201,000 Total Owners Equity & Liabilities $201,000

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Effect of Business Transaction upon Balance Sheet

Transaction - 5
September 14, A complete set of office furniture and equipment was
purchased on credit from General Equipment, Inc for $ 5,400.

ROBERT REAL ESTATE COMPANY

Balance Sheet
As at September 10, 20____
Assets Liabilities & Owners Equity

Cash $ 24,000 Liabilities :

Accounts Payable $ 26,500
Accounts Receivable $ 11,000

Land 130,000 Owner’s Equity: $180,000

James Roberts, Capital
Building 36,000

Office Equipment 5,400

Total Assets $206,400 Total Owners Equity & Liabilities $206,400

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Effect of Business Transaction upon Balance Sheet

Transaction - 6
September 20, Cash was received from Carters Drugstore as partial
settlement of Accounts Receivable $ 1,500.

ROBERT REAL ESTATE COMPANY

Balance Sheet
As at September 10, 20____
Assets Liabilities & Owners Equity

Cash $ 25,500 Liabilities :

Accounts Payable $ 26,400
Accounts Receivable 9,500

Land 130,000 Owner’s Equity: $180,000

James Roberts, Capital
Building 36,000

Office Equipment 5,400

Total Assets $206,400 Total Owners Equity & Liabilities $206,400

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Effect of Business Transaction upon Balance Sheet

Transaction – 7
September 30, Robert Real Estate Company paid $ 3,000 in cash to
General Equipment Inc.

ROBERT REAL ESTATE COMPANY

Balance Sheet
As at September 30, 20____
Assets Liabilities & Owners Equity

Liabilities :
Cash $ 22,500 Accounts Payable $ 23,400
Accounts Receivable 9,500

Land 130,000 Owner’s Equity: $180,000

James Roberts, Capital
Building 36,000

Office Equipment 5,400

Total Assets $203,400 Total Owners Equity & Liabilities $203,400

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Types of Ownership
• Sole proprietorship – a business with a single owner
• Partnership – an organization that joins two or more
individuals who act as co-owners
• Corporation – a business organization created under
state laws in the Unites States
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Corporation
• Publicly owned corporation – A corporation owned by
the public through the sale of shares; it may have
thousands of owners
• Privately owned corporation – A corporation owned
by families or a small group of shareholders; shares are
not publicly sold
• Corporation stockholders have limited liability
• Creditors have claims against the corporation assets
only, not the personal assets of the owners
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Advantages and Disadvantages

of the Corporate Form
• Advantages • Disadvantages
• Limited liability • Unfavorable tax laws
• Easy transfer of • Regulation
ownership
• Ability to raise capital
from hundreds or
thousands of potential
stockholders
• Continuity of existence
• Prestige
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Accounting Differences
Among Legal Forms
• Proprietorships and partnerships
• Owners’ equities are labeled capital
• Owners’ equities are recorded in the capital account
• Corporations
• Owners’ equities are labeled stockholders’ equity or
shareholders’ equity. Total capital investment is called
paid-in capital
• Owners’ equity is recorded in two parts:
• Common stock at par value
• Paid-in capital in excess of par value
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The Meaning of Par Value

• Par value (or stated value) – the dollar amount printed on
the stock certificate
• Paid-in capital in excess of par value (or additional paid-in
capital) – the difference between the total amount the
company receives for the stock and the par value
• Common stock is recorded at the par value
• Common shareholders are owners who have a ―residual‖
ownership in the corporation through the purchase of
common stock
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Stockholders and the Board of Directors

• Shareholders elect a board of directors to look out for their
interests
• Members of a board often include CEOs and presidents of
other corporations;
• The chairman of the board is elected by the director.
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Stockholders and
the Board of Directors
• The board’s duty is to ensure that managers act in the
interest of shareholders
• When boards do their duty in monitoring management, the
corporate form of organization is effective

Stockholders Board of Directors Managers

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Credibility and the Role of Auditing

• The separation of owners and managers creates potential
problems in getting truthful information about the
performance of a company
• Shareholders must rely on managers to tell the truth
• The auditor examines the information that managers use
to prepare the financial statements and provides
assurances about the credibility of those statements
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The Accounting Profession

• Public accountants offer services to the general public for
a fee
• Private accountants work for businesses, government
agencies, and other nonprofit organizations
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Public Accounting Firms

• The four largest public accounting firms are
• Deloitte Touche Tohmatsu
• Ernst & Young
• KPMG International
• PricewaterhouseCoopers
• 97% of the firms listed on the NYSE are clients of these
four firms
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Standard-Setting Bodies
• The Financial Accounting Standards Board (FASB) is
responsible for establishing GAAP in the United States by
issuing FASB Statements
• The Securities and Exchange Commission (SEC) is
responsible for authorizing the GAAP for companies
whose stock is held by the general investing public
• The FASB and SEC work closely together and seldom
have public disagreements
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Thank you