Lecture 1
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Aims of the Lecture
 What is Accounting and the purpose of Accounting.
 The use of Financial Statements
 Users of Financial Statements
 Accounting cycle during a period
 The accounting equation
 Generally accepted accounting principles
 Solution of exercises
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What is Accounting?
A
service that is systematically recording and
summarizing the financial (economic) transactions of
a business and then analyzing, verifying (confirming) and
reporting the results.
 The person in charge for the execution of accounting is
known as an Accountant, and this individual is typically
required to follow a set of rules and regulations of
the IFRS (International Financial Reporting Standards).
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Purpose of Accounting
 Accounting allows a company to analyze the financial
performance of the business and look at statistics such
as net profit. Therefore the management is able to make
informed judgment and better decision.
 Also Accounting aims to show the relationship of the
business with its environment which includes its
customers (debtors), suppliers (creditors), employees
owners and lenders.
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Accounting is concerned with:
1. Identification and recording of transactions:
A transaction is an economic event which affect the financial
situation of the business. A transaction could be: a sale of a
product, the purchases of raw materials , purchase of a machine,
payment of salaries or the receive of a loan. The accounting
system must be well organized so as all transactions are
recognized when they take place and then are recorded in the
books of the business using the book-keeping function.
A double-entry bookkeeping system is a set of rules for recording financial
information in a financial accounting system in which every transaction or
event affects at least two different nominal ledger accounts. The accounting
process includes the bookkeeping function, but is just one part of the
accounting process
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2. Classification and measurement of transactions after
they have been recorded. Economic events may create assets
(items which the business owns) or liabilities (what is due by
the business to others) or revenues (income from sales) or
costs/expenses (amounts incurred to make products or operate
the business). Therefore correct classification is important.
Measurement follows the classification and by this we mean:
how mush of the costs or revenues concern this year and how
mush must be carried forward to the next year.
3. Summarization and communication. Since the
Accountant has record all the transactions a summary is
extracted which show the performance of the business during
a period – a month or a year . This summary is shown through
the financial statements which they communicate information
regarding the financial position of the business to a wide range
of users.
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Financial Statements
 The Accounting service is analyzing data with the
preparation of financial statements. The most widely
used financial statements are:
The Statement of Financial Position (Balance Sheet)
and
The Income Statement (Trading and Profit & Loss
account).
To achieve its goals, an accounting system may make use of
computers and video displays as well as handwritten records
and reports printed on paper
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Financial Statements
 1. Balance Sheet: is a statement of the assets, liabilities and owners’ equities as at
a specific point in time (next day things could be different).
 Assets – are things owned by the business such as motor vehicles, machinery,
inventory (goods manufactured or purchased for resale), money owed by debtors,
balance at bank and prepaid expenses.
Assets are divided into fixed assets: A long-term tangible piece of property that a
firm owns and uses in the production of its income and is not expected to be
consumed or converted into cash any sooner than at least one year's time, and
current assets: the value of all assets that are reasonably expected to be
converted into cash within one year in the normal course of business.
.
Goodwill is an Intangible F.A.
 Liabilities – are amounts owed such as money due to creditors, bank overdrafts,
short term loans.
 Owners’ equity – is a type of liability but this amount is due to the owner of the
business rather than to ‘outsiders’. It increases by any new capital brought in and
by the net profit made by the business and reduces by any amounts withdrawn by
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the owner.
Statement of Financial Position (Balance Sheet) as at 31st December 20YY
Fixed Assets
€
Land and Buildings
X
Furniture and Fittings
X
Motor Vechicles
X
Goodwill
Current Assets
Stock
Debtors
Prepayment of Expenses
Ban
k
Cash
X
€
Capital
Add Net Profit
Less Drawings
X
X
X
Long-term Liabilities
(repayable later than one year)
X
X
Long-term Loan
X
X
X
X
Current Liabilities
(amounts due within a year)
Creditors
Accrued Expenses
Bank Overdraft
Short Term Loan
X
X
X
X
X
X
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X
9
Balance Sheet as at 31 December Year 20XX
Fixed Assets
€
€
Land and Buildings
Furniture and fittings
Motor Vehicles
Goodwil
x
x
x
x
x
x
x
x
x
Current Assets
Closing Inventory
Debtors
Prepayments
Bank
Cash
xxxxxx
Capital Account
Add Net Profit
Less Drawings
x
x
x
x
x
x
x
x
X
Long-trrm Liabilities
Long term loan
Current Liabilities
Creditors
Accruals
Bank Overdraft
Short term loan
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xxxxxx
10
The Accounting Equation
 Assets = Liabilities + Capital
Or otherwise :
Capital=Assets-Liabilities
The balance sheet must always balance which means
must always satisfy the above equation, at any time
assets equals liabilities plus the capital .
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 2. Income Statement:
Presents the results of operations for a period of
time. It usually covers a year of business activity in contrast to balance sheet
which is as at a specific point in time.
The income statement is prepared following the accruals
concept: the income and expenses are recorded as they
occurred regardless of whether cash has been received or
paid .
 Income – the sales revenue shows the income from goods/services sold
in the year.
 Expenses – in order to make revenues we must incur expenses: an
outflow of money to pay for an item or service e.g. wages, rents, electricity
e.t.c
The income statement is split into two parts a) the Trading
account which gives the gross profit and b) the Profit & Loss
account which givesChara
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the Net Profit.
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Trading and Profit & Loss account
€
€
Opening Stock
X
Add Purchases
X
X
Less Purchases Return
Less Closing stock
X
X
X
Gross Profit c/d
Wages and Salaries
Insurance
Rent
Depreciation of motor vehicles
and Furniture's
Bad Debts
Discount allowed
Net Profit
X
X
X
X
Cost of Sales
Office Expenses
Sales
Less Sales Returns
X
X
X
Gross Profit b/d
Discounts Received
X
X
X
X
X
X
X
X
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 The above layout of the income statement is not mainly
useful but is assists the appreciation of the actual double
entry processes and the realization that the income
statement is part of the double entry.
 The modern-vertical layout is as follows:
Income statement: Trading and Profit & Loss account
Sales
x
Less Cost of Sales:
Op. Stock
x
Purchases
x
Less Closing stock
(x)
(x)
GROSS PROFIT
xx
Less Expenses
(x)
NET PROFIT
xxx
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The modern-vertical layout of Income Statement is as follows:
Income statement: Trading and Profit & Loss account
Net Sales
x
Less Cost of Sales:
Op. Stock
x
Purchases
x
Less Closing stock
(x)
(x)
GROSS PROFIT
xx
Plus Other income
xx
Less Operating Expenses:
 Wages / Salaries
x
Heating & Lighting
x
 Rent
x
 Insurance
x
 Advertising
x
 Bad Debts
x
 Depreciation
x
 Stationery
x
 Commission Paid
x
 Bank interest & charges
x
 Cleaning
x
 Office Expenses
x
(x)
NET PROFIT
xxx
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USERS
OF
FINANCIAL
STATEMENTS
The financial accounts provide a wealth of information that is useful
to various users of financial information
INVESTORS
CUSTOMERS
MANAGEMENT
OWNERS
SUPPLIERS
EMPLOYEES
USERS
LENDERS
THE PUBLIC
COMPETITORS
GOVERNMENT
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Managers: need information on a monthly basis to control the
business, plan for the future and evaluate profitability. They
prepare budgets based on past performance and they compare it
to actual results.
Owners: The financial Statements tell the owners just how
successful the business has been and also summarise in brief form
its present financial position
Investors: are concerned with how secured and the profitable is
their investment in the specific company. This is shown in the
income statement.
Employees: are interested to know if an employer can offer secure
employment, possible salary increases and retirement benefits.
They are also interested in the pay and benefits obtained by senior
management!
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Lenders: Banks and other financial institutions who lend
money to a business require to know if they will be repaid. This
is shown in the balance sheet which displays the solvency of the
firm.
Government: need to know how the economy is performing so
as to plan financial policies. Also the tax authorities evaluate the
tax witch is payable by the companies with the use of financial
statements.
Suppliers: need to know if the business is able to pay shortterm debt when it falls due.
Competitors: wish to compare their own performance against
that of other firms that are operating in the same sector.
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Accounting Cycle During Period
Also known as “bookkeeping cycle ”, is the process of recording
and processing the accounting events of a company. The series of
steps begin when a transaction occurs and end with its inclusion
in the financial statements.
The main steps of
the accounting cycle are:







Collecting and analyzing data from transactions and events.
Posting entries to the general ledger.
Adjusting entries appropriately.
Preparing an adjusted trial balance.
Organizing the accounts into the financial statements.
Closing the books.
Preparing a post-closing trial balance to check the accounts.
.
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Main Types of Business Transactions
Duality Concept: Each and every transaction that the business
makes has two aspects and has a double effect on the business
and accounting equation.
B/ce Sheet
 1. SALES OF GOODS: If with cash
If with credit
 2. PURCHASES:
If with cash
If with credit
Incm Stat.
cash
debtors
cash
creditors
 3. PURCH. OF FIXED ASSETS: If with cash
If with credit
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sales
sales
stock
stock
cash
creditors
F. A
F.A
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B/ce Sheet
 4. PAYMENT OF EXPENSES: cash
 5. BRING NEW CAPITAL:
 6. DRAWINGS:
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cash
cash
Incm Stat
expense
capital
capital
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The business entity concept
 Accepted accounting principles require that a set of
financial statements describe a specific business body,
which is called business entity.
 Financial Accounting information relates only to the
activities of the business entity and not to the activities
of its owner. For e.g. if the owner buys a car for him
and his family to use personally this transaction will
not influence the balance sheet elements at all.
 The business entity is treaded as separate from its
owners.
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Forms of business organizations
Sole Trader: Owned and operated by one person,
although there might be any number of
employees. A Sole Trader is fully and personally
liable for any losses that the business might take.
Partnership: Owed and operated by two or more
people called the ‘partners’.
Partners are ‘jointly and severally’ liable for any losses that
the business might make.
Traditionally the big accounting firms have been
partnerships
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Company: Owned by many people (shareholders) and
operated by many people (thought not necessarily the same).
•
•
•
•
•
There can be one shareholder or many thousands of
shareholders.
Each shareholder owns part of the company.
As a group, they elect the directors who run the business.
Directors often own shares in theirs companies.
Not all shareholders are directors.
Companies are almost always limited companies (This
means that the shareholders will not be personally liable
for any losses the company incurs).
• Their liability is limited to the nominal value of the
shares that they own.
•
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Capital
For all three types of organization, the money
contributed by the individual, the partners or the
shareholders is referred to as the business capital.
In the case of a company the capital is divided into
shares.
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Statement of Standard Accounting
Practice (SSAP)
Is concerned with the disclosure (notification ,
communication) of accounting policies – the guidelines
and rules that must followed when preparing the
financial statements.
The 4 fundamentals accounting concepts mentioned by
the standard are:
a. The going-concern concept
b. The accruals concept
c. The consistency concept
d. The prudence concept
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a. Going concern: the business for which we are preparing
the financial statements is going to continue in operation
for an undetermined period. Before the accounts are
certified as showing a true and fair view , the auditor must
be satisfied that the company is a going concern and that it
will continue to function successfully in the future. The
auditor in order to assume that the company is a going
concern is based on the following factors: the demand of
the company’s product in the market , if the company have
sufficient cash to respond to its liabilities in the future and
if it is profitable. Also if the company has sound capital to
face any future unexpected events and finally if the
company is competive enough regarding its products, its
ability to acquire raw materials and labor.
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b. The income statement for a period is prepared following
the accruals concept: the income and expenses are
recorded as they happened in the period regardless of
whether cash has been received or paid :
Costs which are paid but they are concerning a future period
must be carried forward as a prepayment and charged in the
period they concern not in the current profit and loss
account. The same for income: if there is an income received
but it regards a future period for e.g. next year it will not
included in the income statement of this period but of the
next and for the current year it will consider as prepayment
Expenses of the period not yet paid and not entered in the
books must be estimated and inserted as accruals.
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c. Prudence concept: Business transactions are sometimes
uncertain. While making judgment we need to be careful
and prudent. Prudence is a key accounting principle
which makes sure that assets and income are not
overstated and liabilities and expenses are not
understated. Accountants must not be very optimism and
overstate profits and causing by this unrealized profits to
be paid out of capital in the form of dividends. Because
there is a danger that the profit might not finally realised
since some of the clients of the company might declared
bankruptcy and not pay. Therefore Accountants must be
strict with profits but take in mind all possible losses.
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d. Consistency: with many accounting transactions there
is more than one method which can be used. For
example the depreciation method and policy.
Accountants must use their judgment to select the most
appropriate method, but once that choice is made the
same method must be used with consistency (stability)
in forthcoming periods. Such consistency enables users
to make a useful comparison of results over time. Thus
investors can see the level of profit or loss, comparing
this year with the last year , and make their investment
decisions accordingly. The methods used should only be
changed if the new method selected improves the true
and fair value given by the accounting statements.
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Exercises
Exercises of the handout
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