UNIVERSITY OF THE WEST
MONA CAMPUS
Financial Accounting – ACCT 1005(MS15D)
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-to-day
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.
2.
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?
3.
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.
4.
Employees and Trade Unions
They use financial information to assist in the making of employment decisions and in
negotiating contracts and benefits.
5.
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.
1
6.
Customers of Businesses
Use financial information to help them in evaluating their relationship with businesses and to
make decisions regarding possible future business relationships.
7.
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
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.
2



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.
Types of Ownership Structures/Business Organizations
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 owner’s liability is unlimited and
therefore extends to his/her personal assets. Although the financial records of a business should
be kept separately from the owner’s personal financial records, there is no separation of the sole
proprietors books and its owner’s 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).
 Owner’s risk is limited to their initial investment and they have very little influence on business
decisions.
 Managed by a Board of Directors
3


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
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.
Types of Businesses
Service
A business that provides a service e.g. travel agency, catering business, 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
4
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 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 be provided to
5
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:
i)
Verifiability i.e. the data should be free from material error and bias and can be verified
by other trained accountants.
ii)
Representational Faithfulness i.e. the economic events are properly measured
iii)
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 owner’s equity.
1) 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 business’s 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.
6
2) 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
3) Owner’s Equity
Also referred to as Net Worth and Capital, owner’s equity represents the owner’s 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 owner’s equity.
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.
7
Withdrawals (Drawings)
Drawings are cash or other assets taken by the owner from the business for his/her personal use.
Drawings serve to reduce owner’s 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 Owner’s Equity
Balance Sheet
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 owner’s 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 Owner’s 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 Owner’s Equity (Sole Proprietorship)
This statement shows any change that took place in owner’s equity from net income or net loss,
withdrawals and other investments during a specific time period. Net income increases owner’s equity,
whereas net loss and withdrawals decrease owner’s equity.
8
John Doe Statement of Owner’s Equity
$
John Doe, Capital,1/1/Add: Additional investment by owner
Net Income For Period
Less: Withdrawals by owner
John Doe, Capital, 31/12/-
xxxxxx
xxxxxx
$
xxxxxx
xxxxxx
xxxxxx
(xxxxx)
xxxxxx
3.
The Balance Sheet
The balance sheet, also referred to as Statement of Financial Position or Report of Financial 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 + Owner’s 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 longterm 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 entity’s 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?
A clear understanding of a borrower’s 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.
9
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
Receipts from customers, loan interest received, dividends received.
Outflows
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
Outflows
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.
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
Outflows
Receipts from issue of stocks and bonds, cash received from owner to finance operations,
and loans
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 Owner’s 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 accountant’s 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
company’s 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 large
portion of the company’s 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.
10