ACF 403: Introduction to
Accounting
Pre-course notes 1
The first set of notes introduces you to accounting terminology, the financial statements,
accounting entities and the accounting equation. ACF 403 will assume that you are familiar
with the contents of these course notes.
Please treat these notes as revision if you have studied accounting recently. You should
engage with the material to the extent that you need to, given your background in accounting.
The Moodle page for ACF 403 contains some self-test questions and answers and a multiplechoice quiz (MCQ) for you to test your understanding of the content of these notes.
Learning objectives:
By reading these notes and doing the exercises you should be able to:
-
Explain the meaning of the key accounting terms and concepts
Explain the relevance of the accounting entity concept in financial accounting.
Distinguish between sole traders, partnerships and companies.
Identify the key financial statements
Describe the accounting equation, including how it is reflected in the statement of
financial position
Explain the nature of assets, liabilities and equity.
Sources of definitions
The main definitions in the notes below are derived from the Conceptual Framework for
Financial Statements (2010) and from other pronouncements from by the International
Accounting Standards Board (IASB). Information about the IASB will be covered in more
detail in your course lectures for ACF 403.
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Further reading
These notes are designed to be a very brief outline of these basic areas. However, if you have
not studied accounting recently and you find the content of these notes unfamiliar, you may
also want to read further about the subjects covered in these notes. You are not expected to
do any further pre-course work other than reading these notes and trying the exercises and
questions.
We do not recommend purchasing any textbook until you arrive at Lancaster as we have
prepared a specific textbook for the accounting courses ACF 403 and ACF 503 which is only
available at Lancaster.
If you have access to any accounting textbooks, please read the relevant chapters which cover
the contents of these notes. Examples of textbooks which provide basic financial accounting
information include:
Andrew Thomas and Anne Marie Ward, Introduction to Financial Accounting, 7th edition,
McGraw Hill, 2012
Pauline Weetman, Financial accounting: an introduction, 6th edition, Pearson 2013
Michael Jones, Accounting, 3rd edition, Wiley 2013 (Section A only)
You may have access to different textbooks, and you should feel free to use any suitable
basic financial accounting textbook. If you use a US book, bear in mind there are differences
between US standards and International Accounting Standards, although many good US
textbooks outline these differences. At the basic level of these notes, these differences will
not be important.
Other sources:
I have provided two dictionaries of accounting terminology for you to use throughout the
course. They are included in the “Extra resources for self-study” section on the ACF 403
Moodle page.
There are lots of Youtube videos dealing with various parts of the contents of these notes. A
couple are suggested below but again, you should feel free to search for ones that you find
easy to understand.
http://www.youtube.com/watch?v=vLv6CqCK1Sc
http://www.youtube.com/watch?v=yoN_feo9uHo
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1.
What is accounting?
1.1
Accounting information
Accounting involves recording, classifying and interpreting business transactions to allow the
communication of business information. Accounting reports aim to facilitate economic
transactions by providing people with the information they need to make decisions about
businesses. Accounting information should allow resources to be allocated efficiently.
Accounting developed to allow wealthy individuals to identify what they owned and what
they owed. The difference between what they owned (their assets) and what they owed (their
liabilities) was their wealth (capital). As economies grew, the ownership and management of
a business often become separate and accounting reports allowed owners, who were no
longer able to access internal information as managers can, to gain information about the
company.
Accounting information allows business owners and/or managers to answer questions such
as:
-
1.2
How much profit has the company made?
Can the company afford to pay dividends to owners/shareholders?
Is there sufficient cash to pay staff wages?
Can the company meet bank loan repayments?
Can the company afford the investment required to introduce a new product?
Financial and management accounting
Financial accounting information is used by external users to the organisation for decisionmaking. Financial accounting is backward-looking information and meets an entity’s legal
requirements. Financial statements are prepared using rules/standards and generally cover all
the entity’s operations.
In contrast, management accounting is information primarily prepared for internal users at an
organisation to assist with managing costs and for decision-making. It is current and futurelooking, and is not covered by accounting standards and rules. It often focuses on specific
departments or activities in the business rather than on the business as a whole.
A summary table of the differences between financial and management accounting is given
on the next page. The focus of ACF 403 is on financial accounting.
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Financial Accounting
Management Accounting
Users
Mainly external
Internal
Regulations
Regulated
Unregulated
Detail
of
Information
Focus on financial information,
and report highly aggregated
information
Often very detailed, encompassing
financial, non-financial and qualitative
information
Reporting
Interval
Annually. In some cases quarter
or semi-annual reports are
produced
Any frequency – on an hourly, daily, weekly,
yearly etc. basis
Time
Period
Mostly historical
Historical and current information as well as
expected future performance and activities
2.
Accounting terminology – the language of accounting
2.1
The financial statements
The objective of general purpose financial statements is to provide information about the
financial position, financial performance, and cash flows of an entity that is useful to a wide
range of users in making economic decisions. To meet that objective, financial statements
provide information about an entity’s assets, liabilities, equity, income and expenses,
including gains and losses, contributions by and distributions to owners and cash flows.
(IAS 1, Presentation of Financial Statements, 2007)
All entities have to produce documents periodically (usually at least annually) with details of
the performance (profit or loss) during the period and the financial position of the firm at the
end of the period.
The performance statement can be presented as one statement, called the Statement of
Comprehensive Income. This includes profits for the period plus any gains and losses (often
unrealised) on other assets. Companies more commonly split the performance statement into
two parts, the first showing performance in the period, called the Statement of Profit and/or
Loss (SOPL) or the Income Statement and the second, which shows the gains and losses,
called the Statement of Other Comprehensive Income.
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The statement showing the financial position of the firm is called either the Statement of
Financial Position (SOFP) or the Balance Sheet.
Larger firms also have to provide a third statement, called the Statement of Cash Flows
(SOCF) which shows how cash has been generated and used in the period.
These statements are called collectively the Financial Statements or the Accounts. In
addition, Notes to the Accounts are provided which give more detail on the figures in the
financial statements. The accounts also usually contain business reviews and other reports
which are required under accounting standards or law, such as information on corporate
governance. Combining the financial statements with, all these different reports may cause
large firms’ accounts to be very large documents, for example, Tesco plc’s 2013 accounts are
142 pages long. As well as being called the Accounts, this document may also be called the
Annual Report.
2.2
The elements of financial statements
The financial statements portray the financial effects of transactions and other events by
grouping them into broad classes (elements) according to their economic characteristics. The
main elements relating to the statement of financial position are assets, liabilities and equity.
The main elements relating to performance (the statement of profit or loss/the statement of
comprehensive income/the income statement) are income (revenues) and expenses.
(IASB, 2010)
Each of the main elements are briefly outlined below.
(a)
Assets
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
(IASB, 2010).
Assets are items held by entities to generate income. Assets may be grouped into the
categories, such as:
-
Tangible assets (property, plant and equipment/inventory) are assets which can be
seen and touched, such as a factory or car.
Intangible assets – assets which cannot be seen or touched but which have value, for
example, a brand or patent.
Available for sale assets – these are investments which the entity expects to sell in
the future
Investments – in associate companies, for example.
Assets must be grouped by how long a company intends to keep them:
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-
(b)
Current assets – assets which are expected to turn into cash by sale or use within a
year
Non-current assets – assets which will be used for more than one year from the date
of the financial statements.
Liabilities
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.
(IASB, 2010).
Liabilities are amounts owed by the company. These could be payments to suppliers (trade
payables), accruals, which are expenses owed at the date of the SOFP, repayments of bank
loans (often classified as financial liabilities) or provisions, which are amounts provided for
liabilities likely to occur in the future.
As for assets, liabilities are grouped into current liabilities or non-current liabilities by
whether the entity is required to pay the liability within a year or beyond.
(c)
Equity
Equity is the residual interest in the assets of the entity after deducting all its liabilities
(IASB, 2010).
Equity (capital) refers to the ownership interest in the company. It is a type of liability
because it is what the business owes to the owner. Equity includes the capital invested by the
owners plus their share of profits and reserves of the firm.
(d)
Income
Income is increases in economic benefits during the accounting period in the form of inflows
or enhancements of assets or decreases of liabilities that result in increases in equity other
than those relating to contributions from equity participants.
(IASB, 2010).
Income is defined to include both revenues (sales) and gains. Revenues arise from the firm’s
activities, usually selling goods or services. Gains are increases in the value of other
economic benefits of the firm. We will focus mainly on revenues in ACF 403.
(e)
Expenses
Expenses are decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in decreases in equity
other than those relating to distributions to equity participants.
(IASB, 2010).
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Expenses are generally the yearly costs of running the business, such as utility bills and staff
wages. The wider definition given by the IASB includes reductions in value of other
economic benefits. As with income, we will focus mainly on the yearly running expenses of
the company for ACF 403.
The terminology here will be frequently used in ACF 403 and a more detailed discussion of
these elements will be part of the lecture course.
3.
Accounting entities
3.1
The entity concept
An accounting entity is the organisational unit for which the accounting records are prepared.
It can be a legal entity, such as a club, or part of a legal entity.
The term “entity” is used to show that the business is separate from its owners. This means
that, for example, when a shop owner pays his business rates, that is an expense of the
business but when he buys a washing-machine for his house, that is a personal expense. The
accounting entity concept determines which transactions will be recorded in the financial
statements as revenue and expenses of the business.
An accounting entity can also be part of another accounting entity. Examples include where
one company is a subsidiary of another, and where a branch of a larger store produces its own
accounts as well as being included in the accounts of the whole store.
The accounting entity concept is also called the business entity or the entity concept.
3.2
Types of entity
The accounting information an entity needs to provide will depend on the type of entity
providing the information. In ACF 403 we will focus on companies’ accounting
requirements, which are covered by accounting standards. However, there are different types
of entity which have more simple requirements than companies.
(a)
Sole traders
Sole traders are individuals who start their own business, of which they are the owner and
manager. Sole traders are responsible for the debts of the business (unlimited liability), and
businesses are not separate legal entities (unincorporated). Profits are regarded as their own
and income tax (not corporation tax) is charged on them. Sole trader’s accounts tend to be
less complicated than those of companies and partnerships.
Typical examples of sole traders would be a small shop or a sole practitioner accountant.
(b)
Partnerships
Partnerships result from two or more people deciding to go into business together.
Partnerships are usually unincorporated businesses and similar rules to sole traders apply to
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them. Partners face unlimited liability and are jointly liable for the business debts. Profits are
shared between partners according to a partnership agreement. Partnerships usually have
financial statements for the tax authorities and pay income tax on their share of partnership
profits. In recent years, some partnerships have chosen to become limited liability
partnerships which allow them to limit their liability. Limited liability partnerships face
similar rules to companies, as discussed below.
Typical examples of partnerships are architects, lawyers and accountants. Many of the large
accounting firms have become limited liability partnerships in recent years.
(c)
Companies
Companies are incorporated as separate legal entities. The company exists independently of
owners and managers, and owners’ liability is limited to the amount of capital they have
invested. This means that creditors cannot pursue them for the company’s debts beyond the
amount of the owners’ original investment. Companies can own assets and act in their own
right.
Two main types of companies exist: public limited companies (which have PLC at the end of
their title) and private limited companies (which have Limited at the end of their title). In
both cases, the equity of the business is divided into shares, which investors purchase. PLC’s
offer shares to investors on public stock exchanges, such as the London Stock Exchange.
Limited companies are privately owned, often by families or small groups of investors.
Shareholders benefit from their investments in two possible ways; first by receiving
dividends, which are a share of profits for the year, and second, by the value of their shares
increasing over time, which means they can sell them for more than the shares cost.
Companies are usually owned and managed by separate people, with the directors running the
company, and the owners having the ability to vote on who the directors are. This is known
as the separation or divorce of ownership and control.
We focus on companies in ACF 403 and will come back to issues relating to companies
during the course.
Typical examples of PLC’s are Google Inc (the US equivalent of PLC) or Marks and Spencer
plc. Large limited companies include Virgin Atlantic Airways Limited.
4.
The accounting equation.
To start a business, owners will need resources to buy assets to generate cash. The total assets
acquired will be equal to the total funds introduced by the owners.
The basic accounting equation represents this:
Assets = Sources of funds
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Funds to purchase assets can come from an owner or from an external source such as a bank
loan.
Funds from an owner are called equity (or capital), and funds from other sources are
liabilities.
The basic accounting equation thus becomes:
Assets = Equity + Liabilities
A
=
E + L
The statement of financial position/balance sheet is formed from this equation. It shows the
list of assets owned by an entity and the sources of funds for those assets.
The statement of financial position always balances because the assets of an entity always
equal the equity and liabilities (this is where the name “balance sheet” comes from).
The accounting equation can also be reformulated as follows:
Assets - Liabilities
A -
L
= Equity
=
E
This is the conventional format of the statement of financial position (SOFP) in the UK. An
example of Tesco plc’s Balance Sheet (SOFP) is provided at the end of these notes. You
should note the format, which shows assets less liabilities is equal to equity.
The accounting equation is premised on the concept of duality, which is that every
transaction has two aspects which will affect the accounting equation. These two aspects may
be one effect on an asset and one on a liability, or two changes to assets or liabilities.
For example, if a business buys a motor vehicle for cash, it will increase the vehicle asset and
reduce the cash asset. If it buys a motor vehicle using a loan, it will increase the vehicle asset
and increase the loan liability.
This duality and two aspects of each accounting transaction is discussed further in Pre-course
notes 2 as part of a discussion of double-entry book-keeping.
Equity/capital shows the ownership interest in the business. This changes from year to year as
the company makes a profit. Profit is part of equity because it is owed to the owners of the
firm.
Profit is the difference between the revenues earned by the entity less the expenses incurred
to generate the revenues. When an entity earns a profit, both its assets and equity increase. In
a simple example, at the end of the first year of operation (time = t), equity is composed of
two elements, the capital contributed by the owners plus the increase in the business value
from the generation of profit since the company began at the start of the year (time = t-1).
Equityt = Equityt-1 + profit for the year t
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which can be expanded to
Equityt = Equityt-1 + (Revenues – Expenses)
And the accounting equation can be expressed as:
Assets = Equityt-1 + (Revenues – Expenses) + Liabilities 1
Example
A company starts with a motor vehicle worth £15,000 which was acquired through £10,000
paid by the owner and a £5,000 bank loan. In the first year of the business, the company
makes £6,000 in profit, comprised of revenues of £9,000 and expenses of £3,000.
Illustrate how the accounting equation works for this company.
1. At the start:
A
=
E + L
£15,000 = £10,000 + £5,000
2. At the end of the year
A
=
E + L
£21,000 = £16,000 + £5,000
Using the expanded definition of the accounting equation:
Assets = Owners’ capital + (revenues – expenses) + Liabilities
£21,000 = £10,000 + (£9,000 - £3,000) + £5,000
Assets have increased to £21,000. If these haven’t been used to buy other assets, these will be
in the form of cash or receivables (amounts owing from customers).
(Revenues – Expenses) equals profit and profit increases owner’s capital/equity.
The accounting equation underlies double-entry book-keeping and the structure of financial
statements. This is a very brief introduction and it will be covered further later in the precourse notes and over the course of ACF 403.
This is the end of the first set of notes. Please look at the balance sheet/SOFP for Tesco
to start familiarising yourself with the formats used in the UK and under international
accounting standards.
Try the self-test questions and the multiple choice quiz to test your understanding of
these notes.
1
This simple formulation assumes that there are no introductions of capital and that profit is before any
dividends are paid out.
10
Tesco plc – 2013 Balance Sheet/SOFP
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