ACCT5930
Topic 1Introduction to
Financial
Accounting
& Balance Sheet
UNSW Quadrangle Building
ACCT5930- Financial Accounting course overview
Three key
statements
Balance Sheet
Income Statement
Statement of cash
flows
Foundationtopics
Introduction and overview of the three key financial statements (week1)
Assets, Liabilities and Equity
(week 1)
Introduce
Revenues and Expenses
(week 2)
Accrual accounting and transaction analysis (week 2)
The accounting cycle (week 3) including adjusting entries (week 4)
Expanded topics
Expanded record keeping (week 4)
Internal control (week 5)
Inventory / COGS (week 5)
Non-current assets (week 6)
Cash flows
(week 9 & 10)
Liabilities & Equity (week 7)
Financial statement analysis (week 8)
Learning Objectives - Introduction
•
Understand the distinction between financial and management
accounting.
•
Identify the three key financial statements.
•
Understand the accounting equation and how it relates to the Balance
Sheet and Income Statement.
•
Explain the limitations of cash accounting.
•
Explain the advantages of accrual accounting.
•
Appreciate the uncertainties inherent in financial accounting practice.
•
•
State and explain the financial statement assumptions.
State and explain the qualitative characteristics of accounting
information.
Identify users of financial accounting and how they use the information.
•
Learning Objectives – Balance Sheet
•
•
•
•
•
Describe the purpose and contents of a Balance Sheet.
Understand and be able to apply the definition of assets and
liabilities.
Understand and be able to apply the recognition criteria for assets
and liabilities.
Understand the distinction between current and non-current assets
and liabilities.
Be able to prepare a simple Balance Sheet.
Outline of Topic 1
Introduction to Financial Accounting
•
•
•
•
•
Key Financial Statements and relationships
Accrual Accounting vs. Cash Accounting
Financial Statement Assumptions
Qualitative Characteristics of accounting information
Users of accounting information
Balance Sheet
• Assets and Liabilities
• Recognition
• Current vs Non-current
• Shareholders’ Equity
What is Accounting?
Some definitions:
1. Accounting is the recording and reporting of an
enterprise’s performance and position in monetary
terms.
2. Accounting is the process of identifying, measuring,
recording, and communicating economic information
to assist users to make decisions.
The text book has a glossary starting on page 697 – it’s very useful!
What is Financial Accounting?
• Financial accounting will be the focus of this course.
• Financial accounting focuses on the provision of
information to users external to the enterprise.
• The focus is on reporting financial position and
financial performance.
What is Management Accounting?
• Management accounting will be the focus of later
courses.
• Management accounting focuses on the provision of
information to users within the enterprise (to aid in
operational and control decisions) - non-standardised
formats, not regulated by accounting standards.
Financial Accounting
The main participants in the art of financial accounting are:
• The information users (the decision makers);
• The information preparers, who put together the
information to facilitate the users’ decision making;
• The auditors, who assist the users by enhancing the
credibility of the information.
The Key Financial Statements
• Balance Sheet
• Financial position of an enterprise at a particular point in time
• What are the entity’s resources and how were they obtained?
• Income Statement
• Financial performance of an enterprise over a period of time.
• Has the entity used its resources efficiently and effectively?
• Statement of cash flows
• Cash inflows and outflows.
• Notes to the financial statements
Balance Sheet
• Shows resources (assets) and claims on those
resources (liabilities and equity) at a point in time.
(“snapshot” of the enterprise)
• Three main elements:
• Assets
• Liabilities
• Equity
Balance Sheet
• The balance sheet is structured around the accounting
equation:
Assets = Liabilities + Equity
Assets - Liabilities = Equity
Assets and liabilities
Examples of assets:
Cash, Accounts Receivable, Machinery, Motor Vehicles,
Buildings, Computers, Inventory, Goodwill.
Examples of liabilities:
Accounts Payable, Taxes Payable, Wages Payable,
Provision for Warranty Expense, Loans.
Further detailed definitions will be covered in the second
section of this topic.
What is Shareholders’ Equity?
• Recall the accounting equation:
Assets – Liabilities = Shareholders’ Equity
• Liabilities represent fixed claims on the entity (i.e. in fixed
dollar terms).
• Equity represents the residual (what is left) once all fixed
claims have been satisfied.
• Common accounts include Retained Profits and Share
Capital.
Balance Sheet
Assets
Cash
Accounts Receivable
Inventory
Property, Plant, and Equipment
Total Assets
2,000
16,000
12,000
90,000
$120,000
Liabilities & shareholders’ equity
Liabilities
Accounts payable
Wages payable
Provision for employee entitlements
Long-term loans
Total liabilities
Shareholders’ Equity
Share Capital
Retained Profits
Total Shareholders’ Equity
Total Liabilities and
Shareholders’ Equity
17 000
2 000
4 000
30 000
53 000
40,000
27,000
67,000
$120,000
Income Statement
• Reports the revenues earned during a period of time
with expenses incurred during that period.
– Revenue: inflows of economic benefits that increase
shareholders’ equity e.g., sales
– Expenses: use or loss of economic benefits that decrease
shareholders’ equity e.g., electricity, rent, salaries,
advertising
• The Income Statement provides information which is
linked to the Equity section of the Balance Sheet.
Income Statement
Sales revenue
less Cost of goods sold
Gross profit
less Operating expenses
Salaries
Depreciation
Electricity
Travel
Postage
Net profit before tax
less tax
Net profit after tax
21 000
8 000
13 000
2 500
500
300
300
400
4
9
3
6
000
000
000
000
Revision question:
Consider the list of accounts given and categorise them as an asset, liability
or shareholders’ equity item that would appear on the balance sheet or a
revenue or expense that would appear on the income statement by ticking
the appropriate column.
Asset
Share capital
Sales
Cost of goods sold
Loan to your business
Equipment
Wages expense
Wages payable
Retained profits
Accounts receivable
Accounts payable
Liability
Shareholders’
Equity
Revenue
Expense
Cash Flow Statement
• Provides details of movements in an business’s cash
balance.
• The cash flows are normally categorised into:
- Operating Activities
- Investing Activities
- Financing Activities
Cash Flow Statement
Cash flows from operating activities
Receipts from customers
17 000
Payments to suppliers
(7 700)
Payment to employees
(2 500)
(4 300) 2 500
Cash operating costs
Cash flows from investing activities
Purchase of machinery
(2 300)
Cash flows from financing activities
Issue of shares
4 000
(3 600)
400
Bank loan repayment
Total net cash flows
600
1 400
Cash: 1/7/2018 (o/bal.)
Cash: 30/6/2019 (c/bal.)
2 000
Relationship between financial statements
Balance Sheet
Cash
Other assets
Total assets
Liabilities
Share capital`
Retained profits
Total liabilities and
shareholders’ equity
Retained Profits Note
2018 balance
+ Net profit
- Dividends
2019 balance
2018
1,400
114,000
115,400
51,400
40,000
24,000
2019
2,000
118,000
120,000
53,000
40,000
27,000
115,400
120,000
24,000
6,000
30,000
3,000
27,000
Cash Flow Statement
From operating activities
From investing activities
From financing activities
Total net cash flows
Opening balance
Closing balance
2,500
(2,300)
400
600
1,400
2,000
Income Statement
Revenues
Expenses*
Net profit
21,000
15,000
6,000
Accrual accounting versus cash accounting
• Cash accounting involves recording revenues and
expenses at the time the cash is received or paid.
• This is reasonably precise given that the accountant
knows whether cash has been paid or received, and
the amount is easily determined.
HOWEVER …
Limitations of cash accounting
The complexity of business means that financial
position and financial performance are affected by many
transactions that involved a cash flow in the past or will
involve a cash flow in the future.
Examples of events where the timing of cash flows is
different from the substance of the transaction:
•
•
•
•
Selling merchandise on credit
Using machinery such that its usefulness has diminished
Using services that will be paid for in a later period
Receiving money in advance for services to be provided
in the future (e.g. magazine subscriptions)
Accrual accounting
To cope with these complexities, most businesses use
accrual accounting.
Accrual accounting involves recognising economic events
regardless of when cash transactions happen.
Therefore revenues and expenses (and related assets
and liabilities) are recorded at the time they occur, which
may not match up with cash receipt or payment.
Accrual versus Cash Accounting – Examples
In June, a company makes cash sales of $10,000 and
credit sales of $20,000 (all to be collected in July)
1. Revenue using accrual accounting in June?
2. Revenue using cash accounting in June?
3. Revenue using accrual accounting in July?
4. Revenue using cash accounting in July?
Revenue Example (Accrual accounting)
$2,000 of merchandise sold to a customer in June. The
customer will pay in July (a credit sale)
When is the:
(a) Cash recorded i.e., when is cash received?
(b) Revenue recorded? i.e., when is the revenue earned?
Expense Example (Accrual Accounting)
$5,000 of cleaning supplies were purchased with cash in
June. They will not be used until July.
When is the:
(a) Cash recorded i.e., when is payment made?
(b) expense recorded? i.e., when is the expense is incurred?
Accrual Accounting
Accrual profit – the result of revenues minus expenses
when both are calculated using accrual accounting.
When using accrual accounting, the accountant must
make many judgments and estimates relating to the
extent to which revenues and expenses have occurred.
Accounting is not as precise as many people
believe.
Revision question:
Comparing accrual profit with change in cash for a period.
1. Issued shares for $100 000.
2. Borrowed $50 000 from the bank.
3. Provided services to customers which generated sales revenue of
$80 000, of which $60 000 had been collected by year end.
4. Employees earned $30 000 of wages, of which $10 000 will be paid
next year.
5. Received an invoice for electricity used during the year for $8 000.
The bill will be paid next year.
Required:
What is accrual profit for the period?
What is the change in cash for the period?
What is the “cash profit” for the period?
Answer:
Annual Report
The three key financial statements are often found in the
company’s Annual Report, together with a wide range of
additional information about the company.
The Balance Sheet, in particular, is likely to show aggregated
figures with additional details provided in the notes.
Financial Statement Assumptions
• Accrual basis
• Accounting entity
• Accounting period
• Monetary
• Historical cost
• Going concern
It is important that you understand the impact that
each of these assumptions has on the preparation
and interpretation of financial statements.
Qualitative characteristics
(not discussed in class please read section 1.7 of textbook)
• Fundamental qualitative characteristics:
• Relevance: Materiality
• Faithful representation
• Enhancing qualitative characteristics:
•
•
•
•
Comparability
Verifiability
Timeliness
Understandability
Who Prepares Financial Information?
• It is management’s responsibility for the preparation and
presentation of financial statements.
• The role of the auditor is to add credibility to this
information (not to prepare it!).
Accounting Standards
• Set out a framework of concepts that underlie the
preparation and presentation of financial statements.
• Australian standards follow those prescribed by the
International Accounting Standards Board.
• However, a lot of what the financial accountant does is
not regulated by accounting standards.
• Therefore, Generally Accepted Accounting Principles
(GAAP) guide much of the work that the accountant
does.
Users of Financial Statements
• Investors
• Employees
• Lenders
• Suppliers and other Trade Creditors
• Customers
• Governments and their Agencies
• Public
General Purpose Financial Statements
• Clearly these users have differing needs! Financial
statements are designed to meet the needs of the widest
range of users.
• May not necessarily provide all the information that users
might desire - focus on past transactions (not the future)
and little non-financial information.
Outline of Topic 1
Introduction to Financial Accounting
•
•
•
•
•
Key Financial Statements and relationships
Accrual Accounting vs. Cash Accounting
Financial Statement Assumptions
Qualitative Characteristics of accounting information
Users of accounting information
Balance Sheet
• Assets and Liabilities
• Recognition
• Current vs Non-current
• Shareholders’ Equity
Balance Sheet
• Concerned with financial position as at a particular date
• Resources (Assets)
• Sources of financing (Liabilities and Equity)
• Financial structure (mix of Liabilities & Equity)
• Liquidity and solvency (can company pay its debts and
continue operations?)
THE Accounting Equation
Assets
=
Liabilities
+
Equity
•
Remember: the accounting equation always balances!
•
Relies on the accounting entity assumption
– The entity is the enterprise/business for which the accounting
is being done - the financial statements are for the entity only
– Activities of the entity are separate from those of the owners
Balance Sheet Identifying Information
•
•
•
•
Name of the reporting entity
Type of statement: Balance Sheet
Date – what point in time it refers to
Currency used – e.g., $
Balance Sheet
Assets
Current assets
Cash
Accounts receivable
Inventory
Noncurrent assets
Land
Equipment (net)
Total assets
JIL Ltd
Balance Sheet
As at June 30, 20XX
$
60
80
120
100
150
Liabilities
$ Current liabilities
Accounts payable
Wages payable
260 Noncurrent liabilities
Loan
Total Liabilities
Shareholders’ equity
Share capital
250 Retained profits
510 Total Liabilities & SE
$
90
20
$
110
90
200
130
180
310
510
Assets
• Definition: “An asset is a resource
– controlled by the entity
– as a result of past events
– and from which future economic benefits are expected to flow to
the entity”
• Examples include:
Cash, Accounts Receivable, Machinery, Motor Vehicles,
Buildings, Computers, Inventory, Goodwill.
Liabilities
• Definition: “A liability is
– a present obligation of the entity arising from past events,
– the settlement of which is expected to result in an outflow from the entity
of resources embodying economic benefits”
• Examples include:
Accounts Payable, Taxes Payable, Wages Payable,
Provision for Warranty Expense, Loans.
How are Assets and Liabilities Reported?
• Not all assets & liabilities are on the balance sheet
• Assets and liabilities have to:
(1) Meet essential definition criteria (from previous two slides)
And THEN
(2) Meet recognition criteria (defined on the next slide)
To be recognised (reported) on the Balance Sheet.
If they meet (1) but not (2), they are disclosed in the notes
Recognition of Assets and Liabilities
Recognition is the process of incorporating assets and
liabilities that meet the definitions into the Balance Sheet.
An item that meets the definition of an element
should be recognised if:
a)
b)
It is probable that any future economic benefit
associated with the item will flow to or from the entity;
and
The item has a cost or value that can be measured with
reliability.
Decision path for asset recognition
Does the item have all three essential
characteristics of an asset?
Yes
Does the asset meet both
the recognition criteria?
Yes
Asset recognised in the
entity’s balance sheet
No
Details might appear in
the annual report
No
Separately disclosed in
the notes
Illustration 1 (assets)
i A storage warehouse purchased with cash.
Essential characteristics
Recognition criteria
i
Future economic benefit
ii
Control by the entity
iii
Past transactions/events
a
Probable future economic benefits
b
Measure reliably
Illustration 2 (assets)
ii A highly specialised machine that has resale value.
Essential characteristics
Recognition criteria
i
Future economic benefit
ii
Control by the entity
iii
Past transactions/events
a
Probable future economic benefits
b
Measure reliably
Illustration 3 (assets)
iii A new artificial sweetener that the company has
developed, but requires government approval before
being sold to the public.
Essential characteristics
Recognition criteria
i
Future economic benefit
ii
Control by the entity
iii
Past transactions/events
a
Probable future economic benefits
b
Measure reliably
Decision path for liability recognition
Does the item have all two essential
characteristics of a liability?
Yes
Does the liability meet
both the recognition
criteria?
Yes
Liability recognised in
the entity’s balance
sheet
No
Does not appear in
the balance sheet but
may appear in a note
No
Separately disclosed
in the notes
Illustration 1 (liability)
i A loan obtained from a bank to be repaid in 5 years.
Essential characteristics i
Existence of a present obligation
ii
Involves settlement in the future
a
Probable future sacrifice
b
Amount measured reliably
Recognition criteria
Current vs Non-Current
• Current assets and liabilities
will be converted to cash, paid off, or used up within one year
of the balance sheet date.
• Non-current assets and liabilities
will remain assets or liabilities for at least the next year.
Reason for distinction:To help the financial statement user
assess short-term financial position.
Examples of Assets
Current or non-current?
•
•
•
•
Cash
Term deposits (< 12 months)
Intangible Assets - patents, brand names, mastheads, goodwill
Accounts Receivable (a) < 12 months
(b) > 12 months
• Inventory
• Fixed assets/Equipment - held for use, not for resale
• Prepayments (< 12 months)
Things to Watch Out For!
• Sometimes ‘assets’ can be negative. In which case, the
account is renamed and reclassified in the Balance Sheet
• E.g., overdrafts (see p.103 of textbook)
• Contra Accounts
• Taken away from an asset to yield net book value (can
be done in a footnote).
• E.g., Allowance for Doubtful Debts and Accumulated
Depreciation
Examples of Liabilities
Current or non-current?
•
•
•
•
•
•
•
•
Overdrafts
Accounts Payable (a) < 12 months
(b) > 12 months
Income Tax Payable
Dividends Payable
Provision for employee entitlements (Portion that is < 12 months)
Provision for employee entitlements (Portion that is > 12 months)
Mortgages/Loans (Portion that is < 12 months)
Mortgages/Loans (Portion that is > 12 months)
Working Capital
• WC ($) = Current Assets - Current Liabilities
Low or negative working capital can be an indication of
short-term financial difficulties.
• Current ratio = Current Assets/Current Liabilities
This gives an indication of the magnitude of working
capital (rather than a $ value).
Equity
• “Equity is the residual interest in the assets of the entity
after deducting all its liabilities”
• Recall the balance sheet equation
• Assets - Liabilities = Equity or
• Assets = Liabilities + Equity
• Examples: Share capital, Retained Profits and Reserves
Recap of Topic 1
Introduction to Financial Accounting
•
•
•
•
•
Key Financial Statements and relationships
Accrual Accounting vs. Cash Accounting
Financial Statement Assumptions
Qualitative Characteristics of accounting information
Users of accounting information
Balance Sheet
• Assets and Liabilities
• Recognition
• Current vs Non-current
• Shareholders’ Equity
Preparation for Week 2
• See you next week! Don’t forget to refer to the Course
Schedule to see what readings and questions you need to do
for this class and before the next class e.g., Discussion
Question 1.15, and Problems 1.3, 1.5 etc. before class
• Raise any questions on the weekly discussion boards
• Check the Topic 2 materials for any pre-class content