ACT201 Assignment

7/28/2019 ACT201 Assignment

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Question 1

Explain using various examples, how the major accounting concepts are used in preparing

financial statements.

Answer:

Accounting calls for scientific approach towards the recording and preparing the reports of

innumerable business transactions. There are various accounting conventions, principles and

concepts that are meant to serve as guidelines to the whole process of accounting of a business

entity. These are called the Generally Accepted Accounting Principles (GAAP).

Here are the major concepts of accounting and the usage of these in preparing financial

statements:

i. Economic Entity Assumption: Economic Entity Assumption is the most important

concept that is used in preparing financial statements. According to this assumption the

actions of a business entity are kept separate from its owners and all other entities. It

means that all the transactions of the business will always be separated from its owners.

In the proprietorship business while preparing financial statements, the transactions of the

business will have to be different from the owner‟s own transactions. Though there is

only one owner in a Sole Proprietorship business, the financial statements will only bear

the accounts of the business itself. It‟s true that in the time of paying debts, the proprietor

pays the debts from his personal assets. In spite of these, the two entities are different and

distinct while preparing financial statements. Likewise, any capital brought into the

business and withdrawals from the business will be recorded differently than the owner‟s

own income or expenses. For example: if the owner brings in cash or any other asset, it

will result in increase in assets of the business and capital of the firm. This capital

represents firm's liability to the owner. The expenses of the owner paid by the firm assets

are recorded as withdrawals from the business. It represents that the profits and losses

will be related to only the business entity, not the owner‟s own entity. The Partnership

companies and Corporations also follow the same entity assumption in preparing

financial statements.



ii. Monetary Unit Assumption: To make financial statements, the accounting records need

to be expressed in monetary terms i.e., the currency of the country where the business is

to state its functions. It means if the transactions that cannot be measured in monetary

units, will not be recorded as a transaction in financial statements. The assets, liabilities

and owner‟s equity are measured by the monetary units. For this reason, financial

statements show only a limited picture of the business. If there is a situation where there

is a labor strike pending or the business owner‟s health is failing; these situations have a

huge impact on the operations and financial security of the company but this information

is not reflected in the financial statements. For example: Skills and competence of

employees cannot be attributed an objective monetary value and should therefore not be

recognized as assets in the balance sheet. It‟s obvious that money measurement

assumption makes the accounting records clear, simple, comparable and understandable

through the financial statements.

iii. Time Period Assumption: Time period assumption is the accounting rule that time can

be divided into distinct and consecutive periods and that accounting transactions can be

allocated to these periods using criteria laid out by other rules and principles. Under time

period assumption, financial statements are prepared quarterly, half-yearly or annually.

The income statement provides us an insight into the performance of the company for a

period of time. The balance sheet provides us a snapshot of the business' financial

position (assets, liabilities and equity) at the end of the time period. The statement of cash

flows and the statement of changes in equity provide detail of how the company's

financial position changed during the time period. One implication of the time period

assumption is that we have to make estimates and judgments at the end of the time period

to correctly decide which events need to be reported in the current time period and which

ones in the next.



iv. Cost Principle: The accounting laws involving quantities in the accounts and on the

financial statements to be the actual cost rather than the current value. It means, this

principle states that the assets, liability, or owner‟s equity investment need to be recorded

at its original acquisition cost. Accountants can show an amount less than cost due to

conservatism, but accountants are generally prohibited from showing amounts greater

than cost. In subsequent periods when there is appreciation is value, the value is not

recognized as an increase in assets value except where allowed or required by accounting

standards. For example: 100 units of an item were purchased one month back for $10 per

unit. The price today is $11 per unit. The inventory shall appear on balance sheet at

$1,000 and not at $1,100.

v. Going Concern: Going Concern is an accounting guideline of financial statements to

assume that the company will continue on long enough to carry out its objectives and

commitments. In other words, the accountants believe that the company will not liquidate

in the near future. So, it means that the entity has an indefinite or unlimited life or

existence. The going concern assumption facilitates the classification of assets andliabilities into short-term and long-term respectively. Since, this assumption believes in

continuity of the business over indefinite period, it is also known as continuity

assumption. The status of going concern is important because if the company is a going

concern it has to follow the generally accepted accounting standards. But an organization

might not follow “Going Concern” concept in some cases. For example: If a bank is in

serious financial troubles and the government is not willing to bail it out, then the Board

of Directors have to pass a resolution to liquidate the business. The bank is not a going

concern. Experience indicates that in spite of several business failures, enterprises have a

fairly high continuance rate; certain entities have been in existence for more than a

century even though the owners have changed. The business entities are therefore going

concerns in the majority of the cases and it has proved useful to adopt continuity

assumption for accounting purposes.



vi. Dual Aspect: Every business is bound to have too many business transactions to be

counted and each transaction has debit with its corresponding credit. That is to say, every

business transaction has a dual aspect or two fold effect and the same business transaction

is recorded in two separate accounts. One is the receiving aspect and the other is the

giving aspect. The dual aspect causes to increase one account and decrease one or more

other accounts by an equal amount. If both aspects are recorded, then only it is possible to

recognize the double effect of a business transaction. According to this, if one account is

debited, any other account must, in principle, be credited and vice versa. From the journal

these transactions are carried to the financial statements through posting entries.

vii. Objectivity: Objectivity Principle states that accounting will be recorded on the basis of

objective evidence. Objective evidence means that different people looking at the

evidence will arrive at the same values for the transaction. Simply put, this means that

accounting entries will be based on fact and not on personal opinion or feelings. It means

that the accounting should be free from personal bias. Sales transaction is a typical

example. Sometimes accounting data has to depend on estimates. For example

depreciation expense is based on: (i) the cost of the asset (actual data) and (ii) two

estimates namely useful life and scrap value. Objectivity test requires that where

estimates are necessary, accountants must adopt a rational and systematic approach based

on experience and realistic expectations. Verifiability simply means that accounting

information is supported by proper documentary evidence e.g., cash memos, invoices etc.

viii. Conservatism: If a situation arises where there are two acceptable alternatives for

reporting an item, conservatism directs the accountant to choose the alternative that will

result in less net income and/or less asset amount. Conservatism helps the accountant to

"break a tie." It does not direct accountants to be conservative. Accountants are expected

to be unbiased and objective. The basic accounting principle of conservatism leads

accountants to anticipate or disclose losses, but it does not allow a similar action for



gains. For example: potential losses from lawsuits will be reported on the financial

statements or in the notes, but potential gains will not be reported. Also, an accountant

may write inventory down to an amount that is lower than the original cost, but will not

write inventory up to an amount higher than the original cost.

ix. Revenue Recognition Assumption: The revenue recognition principle states that, under

the accrual basis of accounting, one should only record revenue when an entity has

substantially completed a revenue generation process; thus, record revenue when it has

been earned. For example: a snow plowing service completes the plowing of a company's

parking lot for its standard fee of $100. It can recognize the revenue immediately upon

completion of the plowing, even if it does not expect payment from the customer for

several weeks. Under the cash basis of accounting, you should record revenue when a

cash payment has been received. For example: using the same scenario as just noted, the

snow plowing service will not recognize revenue until it has received payment from its

customer, even though this may be a number of weeks after the plowing service

completed all work.

x. Matching Principle: A fundamental concept of accrual basis accounting that offsets

revenue against expenses on the basis of their cause-and-effect relationship. It states that,

in measuring net income for an accounting period, the cost incurred in that period should

be matched against the revenue generated in the same period. It means while journalizing

the debit and credit side must have to be equal or matched.

xi. Consistency: The idea in accounting that once an accounting method is adopted, it

should be followed consistently from one accounting period to the next. If, for any

reason, the accounting method is changed, a full disclosure of the change and an

explanation of its effects on the items of the financial statements must be given. One of



the duties of an auditor is to make sure the consistency principle is being followed

because, without this, any change might make correct interpretation of the financial data.

xii. Materiality Assumption: Accountants follow the materiality principle, which states that

the requirements of any accounting principle may be ignored when there is no effect on

the users of financial information. A classic example of the materiality concept or the

materiality principle is the immediate expensing of a $10 wastebasket that has a useful

life of 10 years. The matching principle directs you to record the wastebasket as an asset

and then depreciate its cost over its useful life of 10 years. The materiality principle

allows you to expense the entire $10 in the year it is acquired instead of recording

depreciation expense of $1 per year for 10 years. The reason is that no investor, creditor,

or other interested party would be misled by not depreciating the wastebasket over a 10-

year period.



Question 2

Critically evaluate the role of financial reporting in aiding the decision making processes of four

different non-management stakeholder groups. Your answer should include explanations of the

decisions each of these stakeholders are likely to be taking in relation to their interactions with a

business.

Answer:

Financial Report is the report or statement Records that outline the financial activities of

a business, an individual or any other entity. Financial statements are meant to present the

financial information of the entity in question as clearly and concisely as possible for both the

entity and for readers. It is a standard practice for businesses to present financial statements that

adhere to generally accepted accounting principles (GAAP), to maintain continuity of

information and presentation across international borders.

Financial statements for businesses usually include:

Income statements,

Balance sheet,

Statements of retained earnings and

Cash flow Statements.

Non-management stakeholder groups of a business are those who communicate with the

business through accounting information usually in the form of financial statements.

These non-management stakeholder groups are called the external users of a business,

who execute their decision making processes through the financial statements.

There are a few kinds of non-management stakeholder groups in a business. Like-

Investors,

Creditors,

Suppliers,

Customers,

Government Regulatory authority and agencies,

Labor unions.



The explanations of the decisions each of these stakeholders are likely to be taking in relation to

their interactions with a business are given below:

Investors:

Investors are those who invest money to a business with the expectation

of financial return. Generally, the primary concern of an investor is to minimize risk while

maximizing return, as opposed to a speculator, who is willing to accept a higher level of risk in

the hopes of collecting higher-than-average profits. They hope to receive a portion of what the

company earns in the form of cash payments called dividends, and they hope to eventually sell

their share of the company at a higher price than they paid.

As capital providers, investors rely on a company‟s financial conditions for both the

safety and profitability of their investments. More specifically, investors need to know where

their money went and where it is now. The financial statement of balance sheet addresses such

issues by providing detailed information about a company‟s asset investments. The balance sheet

also lists a company‟s outstanding debt and equity components, and so debt and equity investors

can better understand their relative positions in a company‟s capital mix.

Financial conditions shown in the balance sheet are snapshots of a company‟s assets,

liabilities and equity at the end of a financial reporting period; they don‟t reveal what happened

during the period from operations that may have caused changes to financial conditions.

Therefore, operating results during the period also concerns investors. The financial statement of

income statement reports operating results such as sales, expenses and profits or losses. Using

the income statement, investors can both evaluate a company‟s past income performance and

assess the uncertainty of future cash flows.

A company‟s profits reported in the income statement are accounting income and m ost

likely contain certain non-cash elements, providing no direct information on a company‟s cash

exchange during the period. Moreover, a company also incurs cash inflows and outflows during

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a period from other non-operating activities, namely investing and financing. To investors, cash

from all sources, not just accounting income from operations, is what pays back their

investments. The importance of the cash flow statement is that it shows the exchange of cash

between a company and the outside world during a period, and so investors can know if the

company has enough cash to pay for expenses and asset purchases.

The statement of shareholders‟ equity is especially important to equity investors because

it shows the changes in various equity components, including retained earnings, during a period.

The amount of shareholders‟ equity is a company‟s total assets minus its total liabilities,

representing the company‟s net worth.

Creditors:

Creditors are an entity (person or institution) that extends credit by giving a business

permission to borrow money if it is paid back at a later date. Creditors can be classified as either

"personal" or "real." Those people who loan money to friends or family are personal creditors.

Real creditors (i.e. a bank or finance company) have legal contracts with the borrower (the

business) granting the lender the right to claim any of the debtor's real assets (e.g. real estate

or car) if he or she fails to pay back the loan.

The relationship between a creditor and the debtor (business) can be positive if everyone

follows the terms that were agreed upon at the onset of the contract, but it doesn't take too much

for sentiment to turn negative if one party fails to hold up the bargain. A retailer and supplier

may represent a debtor and a creditor relationship. While it is the function of a retail outlet to sell

merchandise to customers, business activity would not be possible without a supplier to provide

the inventory. New retail and supplier relationships are developed every day as product

developers seek to obtain the greatest distribution possible.



Creditors need to know where their money went they lent to the business. The financial

statement of balance sheet addresses these by providing information about a company‟s asset

investments. The Creditors would want to know how much the company earns and whether it's

boosting its sales. This can show whether a company is on a growth trajectory or in decline, key

factors that determine how much the company is worth of repaying the loan in time.

Creditors can make decisions by ratio analysis. These ratios include reviewing business'

ability to be profitable, the profit a business generates per item sold, how quickly the business

can convert assets to cash, how long it takes to get a product made and how long it takes

customers to pay. To minimize risk, creditors often restrict certain aspects of the loan when it is

funded. These restrictions include a requirement to maintain accurate and complete records and

provide financial statements; limits on how much debt a company can acquire; restrictions on

payouts to owners or other investors; limiting further capital expenditures; and a requirement to

meet performance standards for specific financial ratios.

Suppliers:

Suppliers are the parties who supply goods or services. They are also called vendors.

All successful companies build strong relationships with their suppliers. Companies are

not isolated entities that simply purchase goods and services from individuals who happen to be

able to supply them at that particular time. Companies typically make larger purchases. In

reality, successful companies recognize the need to build bridges between their organization and

the vendors that they work with by establishing strong buyer-seller relationships.

The Balance Sheet helps the suppliers to predict whether the business would be able to do

the payment of the supplies they bought in credit, because the Balance Sheet shows the amounts

owed to suppliers for prior purchases. The Accounts receivable section describes that how much

cash the business is still looking forward to get. The former financial statements can also help a

new supplier to predict if they should sell their supplies to the business or not.



Government Regulatory Agency:

A Government Regulatory Agency is a government department that has responsibility

over the legislation (acts and regulations) for a given sector. Regulatory agencies exist at the

federal and state level. These agencies can impact a variety of businesses, in a variety of ways -

through regulations on products, antitrust rulings, compliance laws, etc.

Governments and regulatory authorities use financial statements to determine the legality

of a company's fiscal decisions and whether the firm is following correct accounting procedures.

Government agencies, such as the Internal Revenue Service, use financial statement analysis to

decide the correct taxation for the company. Government entities (tax authorities) need financial

statements such as Balance Sheet to ascertain the propriety and accuracy of taxes and other

duties declared and paid



Question 3

Compare and contrast the information provided by the two main financial statements (Balance

Sheet and Income Statement).

Answer:

Balance Sheet:

Balance Sheet is also referred to as a statement of financial position. It shows the current

financial position of the company and is an integral part of the financial statements. It includes

all the assets and liabilities of a company in a sequential order which means that the most liquid

assets are listed first and the most pressing liabilities are first before smaller ones. It is also a

sheet of papers that reflects the solvency of a company. The three most important elements of a

balance sheet thus are assets, liabilities and equity.

The relationship among Assets, Liabilities and Equities is shown below:

Asset= Liability + Owner’s Equity

Assets are financial resources a company has as a result of its past transactions. These

assets translate into cash flow into the company that can be used for business purposes. Some

examples of assets are cash, plant and machinery, furniture, marketable securities, patents,

copyrights and account receivables.

Liabilities are the opposite of assets and are obligations of the company that eventually

result in a cash outflow. Some examples of liabilities are notes and bonds payable, income tax,

interest payable to lenders, dividends payable and warranty liability.

Equity is that part of the assets that are claimed by the owner. It is the net result of assets

after all liabilities have been met. Examples of equity are capital, ordinary and preference share

capital, appropriated and inappropriate retained earnings etc.



Income Statement

The income statement communicates the inflows and outflows of assets, where inflows

are the revenues generated and outflows are the expenses. An excess of inflows over outflows is

called net income, and an excess of outflows over inflows is called a net loss.

The income statement can be expressed as an equation:

Revenue – Expenses = Net Income (Loss)

The income statement is a summary of the sources of revenues and expenses that result in

a profit or a loss for a specified accounting period. Typically that period is one year but it can be

a month or a quarter as well. Income statements are always prepared for a period of time and the

term “for the period ended…” is included in the title.

Revenue: The sources of revenue for any business depend on the type of business being

operated. A company that manufactures or resells a product would generate sales revenue. A

service company on the other hand might generate fees revenue or service revenue.

Expense: Examples of typical expenses encountered are salaries, utilities, rent, insurance

and office supplies. Here again, each entity will have its own unique set of expenses depending

on the type of business being operated.

Net Income/ Net Loss: The difference between revenues and expenses is expressed as a

positive or negative depending on whether revenues were greater or less than expenses.

If revenues for the month are $5000 and expenses are $3500, then the entity has a net income of

$1500. If the expenses were instead $5500, then the entity would have a net loss of $500.



The Differences of Balance Sheet and Income Statement is given below:

Balance Sheet Income Statement

1. Time Frame

The balance sheet reflects

the finances at one specific

point in time. The balance

sheet must be dated and

values expressed on it are

only accurate as of that date.

The income statement represents a

period of time. The length of this

period can vary. For example,

annual statements will contain

information for the entire year while

quarterly statements cover three

months. The time frame should be

clearly indicated on an income

statement.

2. Content The balance sheet provides a

snapshot of the company's

finances. It reports three

items: assets, liabilities and

owners' equity.

The income statement documents all

of a business's income and expenses

over a period of time. Revenue is

documented in the credit account on

the income statement while

expenses are recorded as debits.

3. Purpose Also known as the statementof financial position,

because it gives managers

and investors an overview of

where the company stands

financially

Also known as a profit and lossstatement. The primary purpose of

an income statement is to determine

how much money a company earned

or lost over a period of time.

4. CalculationsTo calculate owners' equity,

subtract the firm's liabilities

from its assets. The firm's

assets must always be equal

to liabilities and owners'

equity on the balance sheet.

Add up the company's revenue and

add up all of its expenses. Subtract

expenses from revenue to reveal the

company's profit or loss.



Question 4

What are the reasons for producing a Cash Flow Statement? Explain at least two differences in

between Cash Flow Statement and Balance Sheet.

Answer:

The cash flow statement was previously known as the flow of Cash statement. The cash

flow statement reflects a firm's liquidity.

The cash flow statement includes only inflows and outflows of cash and cash equivalents;

it excludes transactions that do not directly affect cash receipts and payments. These non-cash

transactions include depreciation or write-offs on bad debts or credit losses to name a few. The

cash flow statement is a cash basis report on three types of financial activities: operating

activities, investing activities, and financing activities. Non-cash activities are usually reported in

footnotes.

Reasons for producing a Cash Flow Statement:

Each section of the cash flow statement gives insight into the business activities and

where the cash came from or where it went to.

The operating section of the cash flow statement gives information on the cash generated

from sales and production activities found on the income statement. The investing section of the

cash flow statement shows how the cash is utilized the business.

The cash flow statement ties together all the details from the income statement and the

balance sheet to give a summary of the overall picture of the cash inflows and outflows for the

business.

Seeing the business in this summarized format helps to understand how the detailed

transactions affect the business. When reviewing the cash flow statement one should be able to

see how the business‟ cash increased or decreased for the period.



The cash flow statement also removes any non-cash transactions that may be on the

income statement like depreciation expense for equipment. This allows looking at how and in

what areas the business is generating cash, or not generating cash. Armed with this information

one will be able to make adjustments to the operations, or investing or financing activities.

Two differences in between Cash Flow Statement and Balance Sheet:

Cash flow statement Balance Sheet

Cash Flow Statement just shows the cash

inflow and outflows in current financial year inthe business.

Balance Sheet shows the overall business

position at any given day of financial year fromstarting day of the business.

A cash flow statement records a business'

financial position like earnings and

disposals/sale of the asset.

Balance Sheet gives managers and investors an

overview of where the company stands

financially.

It has three categories: operating activities,

financing activities and investing activities.

A balance sheet displays the company‟s assets,

liabilities and shareholder‟s equity



Question 5

Michael Robertson is a sole trader whose accounts you have prepared for the last two years.

Michael has recently attended a two day course entitled 'Finance for non-accountants' where he

began to learn the fundamentals of double entry bookkeeping as well as to gain a greater

understanding of his financial statements.

Since his return from this course Michael has spent some time looking at last year's accounts and

he is rather confused about some areas

Michael's queries are as follows:

(1) “On the course that I have just attended two types of expenditure were mentioned, capital

expenditure and revenue expenditure. If revenue is income, how can it also be used to

describe a type of expenditure?”

(2) “My shop has increased in value considerably over the years that I have had it, yet you

have regularly reduced its value on my balance sheet by „depreciation‟ – haven‟t you got

it the wrong way round?”

Required:

Answer each of these questions in terms that Michael will be able to understand

Answer:(1)

It‟s mentioned here that Michael Robertson has attended two types of expenditure

mentioned in the course, those are Capital Expenditure and Revenue Expenditure. But, he‟s

confused that if revenue is income then how it can also be used to describe a type of expenditure.

Generally, when a service or good is provided to the customer, we consider that, the

revenue is gained by the service provider or the seller, not considering if the cash is received. So,

revenue is behaving like income here.

But, revenue is treated as expenses when it‟s incurred from day-to-day activities

companies engage in that affect whether or not they can operate and attempt to generate

revenues. There are various types of revenue expenditures that Michael Robertson might incur in

his business:



Equipments repair costs: Equipments like printers repairing act as revenue expenditure,

because if the printer stops working, it can slow down the company‟s productivity and prevent

the workers from handling their typical tasks. Repairing a printer, a money-generating asset for a

business, is one type of revenue expenditure.

Monthly Rental Expenses: Small businesses like Michael Robertson runs, has to pay

monthly rental expenses on everything from the rent for their physical location to the supplies

and equipment they are leasing from other businesses. These rental expenses are essential to

keep the business moving and bringing in revenue.

Phone and Internet Costs: Utilities such as phone, internet, water and electricity are

necessary for a company to continue generating revenue. Without these resources, businesses

cannot take or process orders efficiently and effectively or communicate with their customers.

(2)

In Accounting, it is described how businesses need to account for the consumption of

fixed assets over time in a way that reflects their reducing value. The term given to this

consumption is depreciation.

Even if when a business starts making profits and the value goes up, the fixed assets of

the business have a fixed lifetime. Within this fixed lifetime it has a amount by which the value

of the asset reduces. For example: if a fixed asset‟s i.e. a desk is purchased for $500. The

expected life is 5 years. The annual depreciation as follows:

$ 500 / 5years = $100/ year

It means, each year for 5 years $100 would be expensed.

So, it‟s not wrong way round. Depreciation is something that is ought to be calculated for fixed

assets in the Balance Sheet.

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