Katikati College Accounting – Year 13 Booklet Number: Definitions Booklet Name: 2/12/2008 Common Accounting Terms and Definitions This booklet contains: Definitions and applications used in Level Two Accounting Achievement Standard 2.1. Features and/or legal requirements of business entities used Achievement Standard 2.1 Characteristics of Accounting used in Achievement Standard 2.1. Purposes and objectives of Financial Statements used in Achievement Standards 2.1 and 2.5. Term Definition Purpose/Application Function of Accounting To provide information (both financial and non financial) to users for decision making. To provide information for users when making financial decisions. To be useful, information must be relevant to the decision-making needs of users. Information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future events (predictive role) or helping the users to confirm or correct their past evaluations (confirmatory role). Predictive value - assists in forming, revising or confirming expectations about the future Carrying amount has predictive value because it provides an indication of the future economic benefit to flow into the business from the use of the “delivery van” Feedback value confirms or corrects prior expectations about the past. QUALITATIVE CHARACTERISTICS Relevance Materiality The relevance of information is affected by its size and nature and materiality Information is material if its inclusion or non inclusion could influence the economic decisions of users taken. Materiality depends on the size of the item or error judged in the particular circumstances of its omissions or misstatement. Year 12 Accounting – Definition Booklet Actual expenses incurred has feedback value because it can be compared to budgeted figures and changes made. Example of relevant information affected by its nature – director fees The shareholders employ the directors to earn profit so that they can receive a dividend. Therefore, directors’ fees are shown separately from other expenses so this amount can be reviewed and a decision made on whether or not it is worth paying directors that amount based on how much profit the company makes. (Confirmatory role) Example of relevant information affected by materiality – a reporting entity purchases $500 worth of furniture. The amount of $500 for furniture is insignificant in size compared with total assets of over $20 million and is not going to influence users’ decision and therefore is immaterial. It is not relevant to record this purchase as an asset and the amount of $500 will be recorded as an expense. 2 Reliability Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent. Reliability consists of the following components Faithful Representation Information must represent faithfully the transactions it claims to represent. For example: A source document provides faithful representation as it is evidence that a transaction has occurred. Substance Over Form If information is to represent faithfully the transactions and other events that it claims to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. Neutrality The information contained in financial statements must be free from bias. Prudence A degree of caution is needed in making judgements about estimates under uncertain conditions, such that assets or income are not overstated and liabilities or expenses are not understated. Some uncertainties entities deal with are doubtful debts, useful life of plant and equipment. Completeness The information in financial statements must be complete within the bounds of materiality and cost. If information is not included this can be false or misleading, therefore unreliable and lacking in terms of its relevance. Understandability The financial statements must The users are assumed to have a be readily understandable by reasonable knowledge of business and users. economic activities and a willingness to study the information with reasonable diligence. Comparability Users must be able to compare financial statements through time in order identify trends in the entity’s financial position and performance. They must be able to compare the financial statements of different entities. Year 12 Accounting – Definition Booklet Therefore o the measurement and display of the financial information and elements must be consistent. users be informed of accounting policies and changes 3 Term Definition Purpose/Application An example of the qualitative characteristic trade off between reliability and timeliness • Constraints on Relevance and Reliability: Timeliness Benefit and Cost Balance between Qualitative characteristics (trade-off) Fair presentation (true and fair view) Fair Presentation The financial position, performance and cash flows of an entity must be fairly presented in the financial statements. This means that the information presented must be relevant, reliable, comparable and understandable. Accounting Entity Notion Monetary Measurement Notion Accrual Basis Assumption • to provide timely information, it may be necessary to estimate amounts (because all aspects of a transaction are not known) therefore impairing reliability. To provide reliable information the delaying of reporting information may result in the information being of little value to users because it is not timely The financial affairs of the business are separate and distinct from the affairs of the owner. All transactions, i.e. assets, liabilities, expenses, incomes and equity in financial statements are recorded in NZ dollars/dollar terms. The effects of transactions and other events are recognized when they occur and are reported in the financial statements of the period to which they relate. When the financial statements of XYZ are prepared only the assets, liabilities, income and expenses of XYZ are included The equipment has been recorded in NZ dollars. If we export or import, all our transactions will be recorded in equivalent New Zealand dollars. The wages owing is added to the wages expense account in the Income Statement to report the total wages that relate to the period because the wages have been incurred (earned by the employees) in the period The wages owing is a liability at the end of the period and has been reported as accrued expenses because it represents an obligation to pay the employees that will result in a future out flow of cash when the wages are paid The financial statements are prepared on the assumption that the business will continue its present operations for the foreseeable future and there is no intention or need to liquidate or cut back on the business operations. Year 12 Accounting – Definition Booklet The Going Concern Assumption When a business purchases fixed assets they are assuming that the business will continue into the foreseeable future as some of the economic benefit from the asset will not be utilised until some time in the future. 4 Term Definition Purpose/Application Period Reporting Assumption Entities present financial statements on an annual basis (the reporting period) so as to report profit, assets , liabilities, revenue and expenses and enables comparisons from one year to the next. Assets are recorded at the amount of cash paid or consideration given at the time of purchase/acquisition. Income Statement for year ended … Balance Sheet as at…….. Historical Cost Concept Financial Statements are comparable because assets of businesses are recorded at historical cost FINANCIAL ELEMENTS Assets Asset Recognition Criteria Liabilities 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 into the entity. a) it is probable that any future economic benefit associated with the asset will flow to the entity. AND b) The asset has a cost or value that can be measured reliably. NB. The materiality concept needs to be taken into account when deciding if it is an asset or an expense. 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 Liability a) It is probable that any Recognition Criteria future economic benefit associated with the liability will flow from the entity. AND b) The settlement has a cost of value that can be measured reliably. Year 12 Accounting – Definition Booklet The van was purchased/bought in the past by the business. The business has exclusive/sole use of the van for delivery. The van will be used to carry out deliveries of goods which brings revenue and so a cash flow to the business. The delivery van is recognised in the Balance sheet because (1)its cost can be reliably measured by the source document/ invoice recording its purchase (2) the van will be used to make deliveries of goods so it is most probable that the future economic benefit of revenue and so cash will be received/flow to the business Accounts payable are a liability because in the past the business purchased goods on credit. The business has a legal responsibility/ obligation to pay for the goods. When the business pays the account payable is will result in an outflow of cash (resources) A mortgage on the building for Joe's Shoes is a liability (because it has the three characteristics of a liability – state these as above). It is probable that there will be an outflow of money as there is a contract to ensure the loan is repaid. The settlement has a cost value that can be reliably measured as the dollar amount will be shown in the loan contract. 5 Term Definition Purpose/Application Owner’s Equity Assets – liabilities The residual interest in assets after deducting all liabilities The assets in Paris’s Landscape Design total $237,000 less total liabilities of $68,000, giving Owner’s Equity of $169,000 Income Income is increases in economic benefits during the accounting period in the forms of increases in assets (or decreases in liabilities), that result in an increase in equity, other than those relating to contributions from the owner. Income Recognition Criteria An item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability. Expenses Expenses are decreases in Advertising is an expense for Paris’s economic benefits during the Landscape Design as: accounting period in the form of decreases in assets (or Advertising decreased profit which increases in liabilities) that decreases equity result in a decrease in equity Advertising paid decreases the asset by decreasing profit, and is not bank when money is paid but is not owner’s drawings. Is not owners drawings. Year 12 Accounting – Definition Booklet Sales are an increase equity by increasing profit and Sales of goods result in an inflow that increases the asset bank when money is received for the sale (or increases the asset accounts receivable) and Is not owners contribution Fees, commission received and interest received are all forms of income for Paris’s Landscape Design because (increase, increase, increase, Not – as above) This income can be reliably measured because there are receipts to indicate their dollar value. 6 Recognition Criteria Expense An item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and Advertising is an expense for Paris’s Landscape Design as (decrease, decrease, decrease, NOT.. as above) This expense can be measured reliably as there will be an invoice to show the price. (b) the item has a cost or value that can be measured with reliability. Profit Income Statement Balance Sheet Statement of Cash Flows Profit is an increase in the net Profit is recorded in the Income assets of a business which is Statement (as a debit) and the Balance not attributable to contributions Sheet (as a credit). by the owners. Provides information about: Limitations Income Amounts for depreciation and doubtful debts are based on Expenses estimates and so the net profit may and shows the not be accurate. Net Profit Errors may have occurred in for the period arising from the inventory valuation resulting in entities activities incorrect Gross Profit. Non financial information (eg quality of sales staff is not included) Provides information about: Limitations Assets Non financial information is not disclosed. Liabilities Accumulated Depreciation and Equity Allowance Doubtful debts are based and the relationship of these on estimates elements at a point in time. Enables owner to measure Assets (except land) are reported at his/her return on investment. carrying amount which may not reflect market value Provides information that allows users to assess the ability of the entity to generate cash and how the entity to utilise those cash flows. Show where cash has been generated from and how it has been spent in the period and it impact on the bank account provides information about an entity’s activities in generating cash to repay debt, or expand operating capacity. Year 12 Accounting – Definition Booklet Limitations Does not show credit transactions eg credit purchases or include non cash items eg depreciation. The statement does not reflect the operating performance (profit) of the business. The cash flow statement is based on past cash receipts and payments and does not show future planned cash receipts / payments you would need a budget for that. 7 Statement of Accounting Policies To show the rules and valuation methods and assumptions followed measuring the financial elements when preparing the financial statements. Cost of Goods Sold To show who the statements have been prepared for and what policies have been used and makes the reports comparable. This shows how much the business has spent on purchasing the goods that they sell for a profit. Distribution Costs The expenses involved in achieving the sales of a business and distributing goods to customers. Administrative These expenses are the Expenses general expenses involved in running a business e.g. office wages, rent, stationery, electricity etc. Finance Costs These are expenses incurred in managing finance including the raising of capital and the repayment of debt, Is limited to interest expense Current Assets Any of: (a) it is expected to be realised in, or is intended for sale or consumption in, the entity’s normal operating cycle; (b) it is held primarily for the purpose of being traded; (a) (c)it is expected to be realised within twelve months after the balance sheet date; or (b) (d)it is cash or a cash equivalent This item appears in the trading section of the Income Statement. Current Liabilities These liabilities are recorded in the Balance Sheet. They are subtracted from Current Assets to gain the calculation of Working Capital. Any of: (a) it is expected to be settled in the entity’s normal operating cycle; (b) it is held primarily for the purpose of being traded; (c) it is due to be settled within twelve months after the balance sheet date; or (d) the entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the balance sheet date. Year 12 Accounting – Definition Booklet These expenses are recorded in the Income Statement. Usually the first classification. These expenses are recorded in the Income Statement. Usually the second classification. These expenses are recorded in the Income Statement. Usually the third classification. These assets are recorded in the Balance Sheet. They are part of the equation for calculating Working Capital and are used in the Current Ratio. 8 Term Definition Purpose/Application Non Current Assets Assets which are expected to be retained in the business beyond the end of the next accounting period. Assets with long term use in the business which will provide future economic benefit or service potential to the business for more than one year. These assets are recorded in the Balance Sheet. They are added onto the Working Capital figure. Property Plant and Equipment Investment Assets Intangible Assets Non Current Liabilities Income (Revenue) Expenditure Assets such as term deposits or shares in companies which are expected to be kept in the firm for more than one accounting period. These are normally more easily converted into cash than fixed assets. They produce revenue for the business such as interest or dividends, but are not normally the main revenueproducing assets of the firm. Assets which do not have a physical existence. An example of an intangible asset is goodwill. Goodwill represents an amount paid when purchasing a business that is over and above the value of the net assets of the business. People may pay goodwill for a business because the business has a good name and reputation. Liabilities which will be paid over a period of time beyond the next accounting period. These liabilities include mortgages, hire purchase payments and long term loans. Expenditure whose benefits are consumed (used up) in the current period. They are costs incurred to earn revenue and affect the years profit and so owners equity. EG paid rates, insurance, car registration. Year 12 Accounting – Definition Booklet These assets are recorded in the Balance Sheet under the heading of Non-current Assets and recorded at their carrying amount.. Depreciation and Accumulated Depreciation is calculated in the Property Plant and Equipment Note to the Balance Sheet. These assets are recorded in the Balance Sheet under the heading of Non-current Assets and are usually kept for more than one accounting period. These assets are recorded in the Balance Sheet under the heading of Non-current assets. These liabilities are recorded in the Balance Sheet. Revenue expenditure are recorded in the Income Statement as either Distribution, Administrative or Financial Expenses 9 Term Definition Purpose/Application Capital Expenditure Expenditure on items that will benefit the business beyond the current financial period. It creates an asset and does not affect Equity. Eg - purchase of building, costs incurred in installing new equipment or improvements made to an existing asset that extend its useful life Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. Capital expenditure on assets is recorded in the Balance Sheet. Consider materiality. Straight Line Depreciation Assumes the use (consumption) of economic benefits the asset can provide occurs evenly over its useful life eg A Building’s pattern of use is consistent each accounting period. The same amount of the cost is the asset is allocated each year. Can be calculated as a percentage of historical cost or using a given lifetime. Eg. A building Diminishing Value Depreciation Assumes the (consumption) of More is depreciated in early years. economic benefits the asset is Usually based on a percentage of greatest in the first years of the carrying amount. assets useful life. Eg a computer would become obsolete over time and/or and its repairs and maintenance cost would be greater in later years. Units of Use Depreciation Assumes the (consumption) of economic benefits the asset is related to the amount the asset is used rather than age. EG a motor vehicles economic life is measured in kilometres travelled or a machine in operating hours. The assets economic benefit is limited by the amount it is used. Depreciation Year 12 Accounting – Definition Booklet Depreciation for the year is shown as an expense in the income Statement. Accumulated depreciation is shown in the Balance Sheet, subtracted from the asset. Cost is allocated each year based on the portion of lifetime (measured in units) that have been used. Eg. This may be kilometers traveled for a motor vehicle, number of copies for a photocopier. 10 Term Definition Purpose/Application Periodic Inventory Measurement Inventory is given an accurate value once per year via a stocktake. - the inventory is physically counted and given a value. This is the most common system among small businesses. The inventory figure on hand at the beginning of an accounting period is included in the Cost of Goods Sold section in the Income Statement. This is thus an expense of that accounting period. Perpetual Inventory Measurement The inventory figure on hand at the end of the accounting period is included as a Current Asset in the Balance Sheet. This is thus an asset of that accounting period. Inventory records are kept constantly. As inventory is purchased and sold, a running balance of exactly how much inventory is ‘on hand’ is maintained – lends itself to computerisation and automation and more often used by larger businesses. This method of inventory valuation has three ways to calculate the inventory value: Specific Identification First in First Out (FIFO) Weighted Average Cost (WAC) Specific Indentification inventory measurement This method is used for large e.g. Motor Vehicle Dealers items of inventory. Each specific item of inventory is identified with its relevant historical cost. The closing amount of inventory is calculated by adding the historical cost of all individual items. Fifo Inventory Measurement This method assumes that the first inventory purchased is the first to be sold. The value of closing inventory will consist of the most recent items purchased. Year 12 Accounting – Definition Booklet 11 Terms Definition Application/Purpose Weighted Average Inventory Measurement This method calculates the value of closing inventory at the average price paid during the accounting period. Used where different batches are not identifiable e.g. petrol station. Cost Versus Net Realisable Value Measurement If inventory becomes out of date it may be necessary to reduce the selling price to clear the inventory. Currently this inventory is valued at Historical Cost. The amount shown in the Balance Sheet would not be reliable as it does not represent the future economic benefit of that asset, i.e. the business is likely to receive less cash when the inventory is sold. In this situation where it is probable that the selling price of inventory will be less than cost we apply the rule “lower of cost or net realisable value”. This avoids total assets being overstated and is an application of the Prudence concept. Accounting Cycle The sequence of accounting procedures for processing transactions during the accounting year: Transactions recorded from Source documents, Journals, ledgers, trial balance, Income Statement and then a Balance Sheet. Used to ensure that transactions are recorded in the correct sequence. Source Documents A document evidencing a business transaction or event. Examples of source documents are Bank statements, receipts, till strips, sales dockets, invoices, credit notes, cheque butts. A journal is a chronological record (ie in date order), of the transactions of a business. Often referred to as the books of first entry. There are seven journals, a general journal, two cash journals and four credit journals. The business uses these documents to record transactions in their journals and ledgers. Journal Year 12 Accounting – Definition Booklet Transactions of a similar nature are recorded in each journal, e.g. Cash Receipts journal. 12 Term Definition Application/Purpose General Ledger (ledger account) A ledger is a set of accounts. Transactions of a like nature are recorded in the ledger accounts in order to find out their balances e.g. wages account, rent account. A listing of the accounts in the ledger and total of their respective debit and credit balances. It is important to carry out this step to check the accuracy of the ledger accounts before proceeding further in the accounting cycle. The chart of accounts is a list of all the accounts contained in a businesses records. They are all allocated a number for easy reference. They are usually grouped together in Assets, Liabilities, Owners Equity, Revenue and Expense accounts. The ledger accounts record the transactions and then balanced and the final balances are used to make up the trial balance before preparing the Income Statement and Balance Sheet Trial Balance Chart of Accounts Year 12 Accounting – Definition Booklet This is updated using the balance day adjustments and is then used to prepare the Income Statement and Balance Sheet Is merely used for easy reference for a business. Is especially useful in computer account. 13 Term Definition Purpose/Application Balance Day Adjustment An adjustment made to revenue and expenses at balance day to ensure that all transactions are recorded in the correct reporting period in order to calculate an accurate profit figure. Accrued Expense In order to match all revenue with expenses for the accounting period these must be added on to existing expenses. These are expenses which are owing/due/accrued e.g. wages owing, but have not yet been paid at Balance Day. In order to match all revenue with expenses for the accounting period these must be taken away from existing expenses. Expenses which have been paid in that accounting period but relate to the following accounting period (or have not yet been consumed). In order to match all revenue with expenses for the accounting period these must be added on to existing revenues. Revenues which have been earned in that accounting period but have not yet been received. In order to match all revenue with expenses for the accounting period these must be taken away from existing revenues. Revenues which have been received in that accounting period but have not yet been earned. The recognition of assets and liabilities at the end of the period and to adjust the revenue and expense balances accordingly. The expense or revenue is recorded accurately in the Income Statement and the adjustment account, e.g. Prepayments are recorded in the Balance Sheet. These are recorded as a Current Liability in the Balance Sheet. Prepayments Accrued Income Income Received in Advance Year 12 Accounting – Definition Booklet These are recorded as a Current Asset in the Balance Sheet e.g. Prepayments (insurance paid in advance). These are recorded as a Current Asset in the Balance Sheet e.g. Accrued Revenue (interest due on term deposit). These are recorded as a Current Liability in the Balance Sheet e.g. Revenue in Advance (Rent Received in Advance). 14 Term Definition Purpose/Application Accounts Receivable These are amounts owing to the business - customers have purchased goods on credit. The business has issued invoices to customers. These are accounts owing by the business - the business has purchased goods on credit and have received an invoice. Accounts Receivable are a Current Asset and are recorded in the Balance Sheet. On receipt of a Bank Statement it is necessary for a business to compare their cash records with those of the bank. Often there are transactions in the bank statement that have not yet been recorded in the cash records. Also there are often items recorded in the cash records that the bank has not yet recorded. An indirect tax imposed on good and services. A business must charge GST on revenue, this is in turn paid to the Inland Revenue Department. However they are able to claim back GST on business expenses. This reduces the liability to the Inland Revenue Department. EFTPOS stands for ‘Electronic Funds Transfer at Point of Sale’. Many businesses sell to customers using this method. A major advantage over a cheque is that if there is insufficient funds in the customers bank account the transaction is declined. This is necessary in order to ensure that the cash records are completely up to date. In other words all bank transactions have been accounted for, e.g. interest, direct debits, direct credits etc. Accounts Payable Bank Reconciliation GST EFTPOS Year 12 Accounting – Definition Booklet Accounts Payable are a Current Liability and are recorded in the Balance Sheet. If the GST account is in debit it means that it is treated as a Current Asset (the business is owed GST by the IRD). If it is in credit then it is treated as a Current Liability (the business owes GST to the IRD). The current rate is 12.5%. Any sales made through EFTPOS will be recorded as a cash sale. 15