BASIC ACCOUNTING
CONCEPTS AND REPORTS
U1
A C C O U N T I N G
CHARACTERISTICS USERS
FINANCIAL
STATEMENTS
ACCOUNTING
INFORMATION
1. INTERNAL
2. EXTERNAL 1. COMPARABILITY
2. UNDERSTANDABILITY
3. RELEVANCE
4. RELIABILITY
1. STATEMENT OF FINANCIAL
PERFORMANCE
2. STATEMENT OF FINANCIAL POSITION
3. STATEMENT OF CHANGES IN EQUITY
4. CASH FLOW STATEMENTS
Unit 1 Concept Map This map represents the core concepts that we will be
covering in this unit, and the relationships between them.
U1: Basic Accounting Concepts and Reports 1.3
Study organiser
Topic Learning Outcomes Activities
1.1 The Nature and
Purpose of
Accounting
Explain the nature of accounting and its main
function
1.2 Users of Accounting
information
Identify the potential users of accounting information
Activity1.1
1.3 Accounting
Assumptions,
characteristics of
information and
the Accounting
Equation
Explain the main assumptions made and the
characteristics of
information to be used in
the preparation of financial
statements
Analyse the effects of the business transactions on
the accounting equation
and on the financial
statements
Activity 1.2
1.4 Financial Reports Identify the basic financial statements used in business
to report to users for
decision-making purposes
Activity1.3
Activity1.4
Activity1.5
1.5 Double Entry
Record Keeping
Explain how the double entry system works
Activity1.6
1.6 Ethics and
Accounting
Understand the importance of ethics in business and
accounting and how to
recognize and handle
ethical dilemmas as part of
the decision making
process.
Activity 1.7
You should spend approximately 10 hours in this unit.
U1: Basic Accounting Concepts and Reports 1.4
Introduction In this unit, we introduce you to the area of accounting known as financial
accounting, and to some important assumptions and definitions that accountants
use to produce reports on the outcome of business activities. These reports
explain how well off a business is at a particular point in time and how successfully it has performed over a given period. We also explain briefly why accounting is an important social and business activity and how accounting
numbers are useful to people. We end by showing you a simple arithmetical
model (called the accounting equation) which is useful to record transactions (of
buying and selling) and from which the rules of double entry record keeping are
derived.
This is the first of three units in this Study Guide that deal with the accounting
cycle. The accounting cycle is the logical sequence of accounting procedures that
take place during each accounting period. It begins with the recording of business
transactions using the rules of double entry, and ends with the preparation of a set
of financial statements (reports). Some of these procedures are repeated a number
of times during the accounting period and others are carried out only at the end of
the period. These procedures are illustrated in your textbook (Figure 3.2, p. 69,
Figure 3.8, p. 79, Figure 4.1, p. 126 and Figure 5.1, p. 178).
To give you an overview of the steps in the accounting cycle and of what is
covered in this and the next two units we reproduce Figure 5.1 from the textbook,
in a slightly different format, as Figure 1.1 on the following page. Keep referring
to it as you work through this and the next two units.
U1: Basic Accounting Concepts and Reports 1.5
Figure 1.1: The Complete Accounting Cycle
STEPS IN THE
ACCOUNTING
CYCLE
ACCOUNTING
RECORDS
1 Recognise and record
transactions
Source documents
2 Journalise
transactions
General journal
3 Post to general ledger
accounts
General ledger
4 Prepare unadjusted trial
balance of general ledger
Trial balance
(unadjusted)
5 Determine adjusting
entries
and journalise
General journal
6 Post to general ledger
accounts
General ledger
7 Prepare adjusted trial
balance
of general ledger
Trial balance (adjusted)
8 Journalise closing entries
General journal
9 Post closing entries
to general ledger
and balance accounts
General ledger
(revenue/expense
accounts closed)
10 Prepare post-closing trial
balance of general ledger
Trial balance
(post closing)
11 Prepare
financial statements
Worksheet
(optional)
Financial statements
(reports)
12 Journalise reversing
entries
General journal
13 Post reversing entries
to general ledger
General ledger
U1: Basic Accounting Concepts and Reports 1.6
Steps 1 to 4 are repeated monthly, while steps 5 to 13 are only carried out at the
end of the financial year.
You will learn all of these procedures and the accounting records involved in the
first three units of this Study Guide (which is the first five chapters of the
textbook). We present them to you progressively during the first five weeks of
study. Together with the new concepts and terminology they make up the
foundation on which all subsequent accounting units are developed. We have
spaced activities throughout the units so that you can see how well you are
keeping up to date and whether you have mastered this foundation.
References Textbook
1. Chapter 1 & 2
Accounting, Hoggett, J., Edwards, L., Medlin, J., & Tilling, M. 8th ed.,
John Wiley & Sons Australia Ltd
Additional Reading
1. Chapter 17
Accounting, Hoggett, J., Edwards, L., Medlin, J., & Tilling, M. 8th ed.,
John Wiley & Sons Australia Ltd
1.1 The Purpose and Nature of Accounting
A commonsense starting point for learning a new discipline is to reflect on what
it is really about and why it is worth learning. Accounting is important because it
is concerned with the way in which individuals, managers of businesses and other
types of organisations use and control their economic resources (look up
economic resources in the textbook!). Thus, accounting is to do with a widespread social activity involving the use and exchange of money and of other
resources that can be measured in money terms.
At its simplest and least technical level it is a way of record keeping which allows
individuals, families and small social groups to keep track of how they spend
their wages or other income, and how they can plan to save for a new car or
house, for retirement, or for some type of social activity. At its most complex it is
a means used by managers in large business organisations to:
plan and budget for future activities;
record how their business resources are affected by activities of buying and selling goods and services; and
report the outcomes of these business activities to individuals and other businesses that have contributed or lent money or have granted credit.
U1: Basic Accounting Concepts and Reports 1.7
Business managers are also obliged by law to report on their financial activities to
a range of government agencies, such as the Australian Tax Office (and the Tax
Office in your own country), and sometimes to other organisations like the
Australian Stock Exchange. To people untrained in accounting, these reports are
complicated, are expressed in a highly technical language and are difficult to
understand. Get hold of a set of financial statements for any business and see if
this is true for you!
The numbers or monetary amounts in accounting reports are important for other
reasons too. People find them useful and base their business dealings and private
investment decisions on these numbers. For example, research into how
accounting numbers are used shows that:
the general body of investors in the stock market use reported profit amounts as one factor in deciding whether to buy or sell shares;
individual investors use accounting numbers, such as interest rates, as signs or signals which help them decide how to invest their own resources
efficiently; and
business managers, shareholders and lenders use accounting numbers about profit and business resources as a basis for making contracts for
managerial salary packages, and borrowing and lending money.
You will learn a lot more about the importance of accounting numbers if you go
on to study Accounting Theory.
This particular subject will focus on accounting from a business point of view. Its
primary purpose is to identify, measure and record transactions for a business and
communicate this information to people and other organisations. These people
and organisations need it to make informed judgements and decisions about how
best to use their own financial resources. This implies that the information should
be in some way useful for its users. It also implies that accountants will keep to
high ethical standards when they process the information and prepare reports
(otherwise the information may be misleading and not useful).
So from this point of view, accounting is a process in which accountants:
identify and record the effects of transactions (the exchanges of money for goods and services) that have actually taken place, and measure these in
terms of money (dollars);
analyse and classify the monetary transactions into categories (headings) that are meaningful for users; and
summarise the transactions to get rid of unnecessary or unhelpful detail, and present them in the form of financial reports.
In this way, accountants and business managers communicate to users. In
classifying, summarising and reporting financial information, accountants have
U1: Basic Accounting Concepts and Reports 1.8
developed a special terminology, comprising words and symbols (the textbook
glossaries and our own Key Terms and Concepts!), which is used so extensively
that it is often called the language of business.
Reading 1.1
1.2 Users of Accounting Information We can sort accounting information by considering who uses it.
Internal information is prepared for managers and employers and owners of small businesses to assist in the daily operations and control of business
activities. It may be produced as often as it is needed, in as much detail as
is needed, and in whatever format best suits the users. Some of these
special managerial reports can be confidential to managers at various
levels. Providing internal information to managers is known as
management accounting.
External information is prepared for people who are not employees or managers. They are outsiders who have, or are likely to have, dealings
with the business. Reports for these external users are produced less
frequently, usually once a year (annually), and contain highly summarised
information in very formal formats. They are general-purpose documents
and are usually widely available to a range of users. This is the field of
financial accounting.
Internal users of information, as mentioned above, are clearly managers and owners of small business who can get special purpose reports and
information for their special needs, and managers of large businesses who
need it to plan, control and monitor financial activities. These users have
access to detailed records and transactions.
External users are persons who have no rights to demand special information and who dont have access to business records. These users must rely on general-purpose reports usually in the form of annual
financial statements.
Read Chapter 1, pp. 5 19 of your textbook.
Look at Figure 1.3 on page 9 of the textbook. It is a good
illustration showing the various users of accounting
information. Note especially who gets special-purpose reports
and who gets general-purpose reports.
U1: Basic Accounting Concepts and Reports 1.9
A list of external users will include:
shareholders of large companies and potential shareholders,
creditors and lending institutions,
employees through their trade unions,
customers and competitors, and
the general public concerned with the environment and consumer affairs.
Governments (and their agencies), strictly speaking, are external users but can
demand special purpose reports for taxation, statistical and other regulatory
purposes.
Financial accounting, which is what this subject is about, tries to meet the diverse
needs of the many external users and can do this only by providing general-
purpose financial reports. Apart from the government, external users only get
some of the information they want or need. From their viewpoint this is clearly
unsatisfactory, but it is a practical and cost effective compromise that is feasible
for businesses. Can you imagine the cost and unproductive effort for a business
trying to give detailed (and commercially confidential) information to hundreds
of customers, creditors and shareholders?
Reading 1.2
Now do a quick exercise to reinforce your understanding (do not spend more than
a couple of minutes on it).
Complete the following table by listing beside each of the external users:
a) Several types of decisions each user might want to make, and
b) The type of information they may require in order to make such
decisions.
Activity 1.1
Read: Chapter 1, pp. 9 - 10 of your textbook,
U1: Basic Accounting Concepts and Reports 1.10
User Types of Decisions Information Requirements
Small
shareholders
Potential
shareholders
Creditors and
lending
institutions
Customers/
competitors
Employees/
trade unions
1.3 Accounting Assumptions, Characteristics of Information and the Accounting Equation Accounting, like other disciplines, is based on a number of simplifying concepts,
conventions, principles and assumptions (these terms are often treated as being
the same (synonymous) that evolved over a long period of time. Some of these
are described, in this section and again in more detail in Chapter 17.
To avoid confusing you at this early stage we introduce these concepts gradually.
We begin by considering the accounting entity assumption because it is the basis
of a primary financial report, the statement of financial position (sometimes
called a balance sheet). We also look at the accounting equation, which
expresses the relationships and links between the various components of a position statement in a way that permits a special system of record keeping.
Accounting Entity Assumption
For the purpose of recording and reporting transactions accountants always treat
the business as an entity separate from its owner(s). (If you think about it, a
business or entity is just an idea or something we imagine to exist! Three types
business entities are described on pp. 17 -18 in your textbook) .
From this accounting viewpoint, if we pretend that it is the business entity (not
the owner or owners) that owns the money and other resources (assets), incurs
debts (liabilities) and carries out transactions with third parties (which can
include the owner/s). This viewpoint or idea is formally known as the accounting
entity assumption.
U1: Basic Accounting Concepts and Reports 1.11
The accounting entity assumption leads to the derivation of accounting equations,
which is discussed shortly.
The Accrual Basis Assumption
According to the framework under accrual basis the effects of all transactions and
events are recognised in accounting records when they occur, and not the cash is
received or paid.
The Going Concern Assumption
This assumption pretends that the entity will not wound up in the future, but will
continue its activities and so the liquidation values of the entitys assets are not generally reported.
The Period Assumptions
This assumption divides the life of a business into equal time intervals for the
purpose of preparing financial statements.
The Characteristics of Accounting Information
1. Relevance means that the information can influence the economic decisions made by users.
2. Reliability- means that the user is assured that the information presented represents faithfully, without bias or undue error, the underlying transactions
and events being reported in the financial statements.
3. Comparability allows users to identify similarities and differences between two sets of data.
4. Understandability - users are able to comprehend the meaning of accounting information.
Reading 1.3
Accounting Equation
Since all business assets must be provided by the owner or financed by creditors
or lenders, the total value of all assets (economic resources)owned by the business must be exactly equal to the total claims of the owner (owners equity or capital) plus those of creditors (liabilities). This basic relationship between assets, liabilities and owners equity that follows from the accounting entity assumption can be expressed in the form known as the accounting equation:
Read Chapter 2, pp. 36 - 40 of your textbook.
U1: Basic Accounting Concepts and Reports 1.12
ECONOMIC RESOURCES = SOURCES OF FINANCE or
ASSETS = LIABILITIES + OWNERS EQUITY (ENTITY VIEWPOINT)
or
ASSETS LIABILITIES = OWNERS EQUITY (PROPRIETARY VIEWPOINT)
This equation is a descriptive model of the firm because it describes what assets the firm has and who has provided or financed them. It is used for preparing the position statement (balance sheet), which is a listing of assets, liabilities and
owners equity. The concept of owners equity (another accounting idea) as a special type of creditor is very important because it ensures that all position statements must balance arithmetically (without the owners equity the equation would not exist). We will learn more about position statements in section 1.4 of
this unit, and how to make use of the accounting equation in section 1.5.
The accounting entity assumption holds for any business regardless of its legal
form. The fact that a business may be organised as a sole trader or partnership
that has no separate legal existence from its owner(s) does not affect the
accounting viewpoint. The assumption also enables the business to record
transactions with the owner. As examples, the owner can contribute (invest)
assets in the business and withdraw (disinvest) assets from the business.
Withdrawals of assets by the owners of sole proprietorships or partnerships are
also called drawings. So, to this extent the owner is able to transact with the business (the position is somewhat different for the shareholders of a company).
Reading 1.4
You can now attempt Problem 2.3 on page 52 of your textbook.
Activity 1.2
Read Chapter 2, pp. 41 - 45 of your textbook.
U1: Basic Accounting Concepts and Reports 1.13
1.4 Financial Reports In this section we look at the three primary general-purpose accounting reports
that are derived from the relationships between the items in the accounting
equation, and at a fourth one that gives special information about the asset cash:
The statement of financial position
The statement of financial performance
The statement of owners equity
The cash flow statement
The relationship between the first three of these statements is shown in Figure 2.6
on page 40 of your textbook. Study this carefully and note how the statement of
owners equity links the other two.
Statement of Financial Position This statement provides reports on the wealth or financial position (hence its title) of a firm at one particular point in time. It comprises the three major
components, or elements, of the accounting equation:
Assets: Resources of economic value (expressed as future
economic benefits) to the business.
Liabilities: Debts or obligations (expressed as future sacrifices of
economic benefits) owed to outside parties (excluding
owners).
Owners equity: This represents the obligation of the business to the
owner (or the owners residual interest in the net assets, being the value of total assets less the value of all
liabilities).
These components are set out to reflect the equality, in money terms, of the
relationship expressed in the accounting equation as shown in Figure 2.2 on p. 32
of your textbook.
Assets: Future Economic Benefits At this stage it is worth concentrating again on what accountants mean when they
refer to the value of assets. Assets are economic resources of various types that an
organisation uses to conduct its business. They are acquired for their future
usefulness, which is defined as future economic benefits. These future economic
benefits are usually measured by the amounts of cash or other resources
U1: Basic Accounting Concepts and Reports 1.14
exchanged for them, so acquisition costs are the amounts recorded. This idea that
assets should, in the first instance, be recorded and valued at their historical
acquisition cost is known formally as the cost assumption or cost principle.
This concept of value in use is highly abstract and is not always understood or
shared by users who do not have special knowledge of accounting. These users
often mistakenly (but perhaps understandably) interpret the values of assets as
being value in exchange or market-selling prices. Do you? For example, if you
own a motorcar is its value to you what you paid for it, what you can sell it for or
its usefulness in transporting you from place to place? Accountants choose the
latter!
The value in use concept is also a problem because a resource or asset will not
always have the same usefulness for different individuals or businesses. This in turn presents other problems, for example when calculating depreciation or the
amount of fuel or supplies used (the decrease in usefulness). Also, not all future
economic benefits have a physical form and some may not even be owned by the
business, for example when a business leases an asset under a financial lease or
wishes to record an asset called goodwill.
Now let us put the three components of financial position together. A very simple
position statement is illustrated in your textbook on page 32. The second one is
page 33.
Keep these points in mind as you progress through the unit. We will keep
coming back to this abstract future economic benefits concept.
U1: Basic Accounting Concepts and Reports 1.15
Figure 1.2: Sample Balance Sheet
DONS AUTO REPAIRS
STATEMENT OF FINANCIAL POSITION
AS AT 30 JUNE 2012
Current Assets
Cash at bank $50 340
Accounts receivable 77 790
Repair supplies 14 610
Total Current Assets 142 740
Non-Current Assets
Land 60 000
Building 455 000
Repair equipment 110 700
Total Non-Current Assets 825 700
Total Assets
$968 440
Current Liabilities
Accounts payable 80 760
Total Current Liabilities 80 760
Non-Current Liabilities
Mortgage payable 401 000
Total Non-Current Liabilities 401 000
Total Liabilities 481 760
Net Assets 486 680
Owners Equity
Don Brady, Capital 486 680
Total Owners Equity 486 680
Total Liabilities
& Owners Equity
$968 440
The values on this
statement are true
for this date only
The heading expresses the accounting entity
assumption by identifying the business entity
ASSETS (except cash and
accounts receivable) are
recorded at the amounts paid
to acquire them, thus
conforming with the cost
assumption. The asset
amounts represent the future
usefulness or economic
benefits to the business.
LIABILITIES are the
obligations the business
presently has to creditors
and lenders. The liability
amounts represent future
sacrifices of economic
benefits
OWNERS EQUITY
represents the firms
obligation to the owner
(his residual interest).
It enables the equality
between the two sides
of the accounting
equation. Both segments (lists) show equal totals as
required by the accounting equation. The
statement thus balances or is in balance.
U1: Basic Accounting Concepts and Reports 1.16
This format, and the one in Figure 2.2 in your textbook reflect the entity
viewpoint (A=L+OE), which regards liabilities and owners equity as joint contributors of finance, both with claims against the assets owned by the
business. Figure 2.2 in the textbook shows the proprietary viewpoint, which
emphasises the claim of the owner (the proprietor) to the net assets of the
business. This proprietary theory of accounting considers that the focus of
accounting records and reports should be on the interests of the owner(s) or
proprietor(s), that is, on the proprietors net worth (AL=OE).
NB:
The format in Figure 1.2 (the entity viewpoint) is the format that you are
expected to use for all position statements that you prepare in Units One to Three
because it shows the equality between the two sides of the accounting equation.
Please disregard any other formats you may have learned.
There is another point regarding format. The numbers (dollar values) on the
position statement are shown in single columns with sub-totals and totals shown
in bold type. This conforms to modern practice, does not take up the space that
the insetting of numbers requires, and makes it easier to compare several columns
of numbers (statements with lots of money columns can be confusing). You must
set out your numbers in the same way.
Classifying Assets & Liabilities as Current & Non-current
You will note that on the position statement in Figure 1.2 that the assets and
liabilities and owners equity have been separated into two categories described as current and non-current. This distinction follows from the going concern and
accounting period assumptions. The going concern assumption expresses the
observation that normally a business will keep operating for an unknown period
of time covering several accounting periods. The accounting period assumption
holds that twelve months is the normal time period for recording, measuring and
reporting transactions.
Based on these assumptions, the business is seen to be an ongoing concern with a
normal operating and reporting cycle of twelve months, or one year. These
assumptions are both important because accountants can record transactions that
overlap more than one accounting period and it allows asset and liability values
to be carried over from one accounting period to another.
Current assets are cash and other types of assets that have a short life. This is
because accountants reasonably expect them to be used up, converted to cash,
sold or consumed (economic benefits used up) within one year after the position
statement date. Similarly current liabilities are debts that are to be paid or settled
in the next twelve months (or within the firms operating cycle).
On the other hand, accountants expect non-current assets to be used (render
economic benefits) over several accounting periods and consider that they are not
held for resale. In the same way accountants view non-current liabilities as those
debts that do not have to be paid within the next year. These distinctions are
U1: Basic Accounting Concepts and Reports 1.17
summarised below in Table 1.3 and are described in more detail in your textbook
on pages 146-147.
Figure 1.3: A time basis for classifying assets and liabilities
Current Non-current
Assets
For use and/or resale
within one year of the
position statement date.
For use over several
accounting periods. Items
not held for resale.
Liabilities
To be paid or settled
within one year of the
position statement date.
To be paid or settled over
several accounting periods.
Reading 1.5
Can you see the usefulness of this current and non-current distinction? If we
compare the totals for current assets and the totals for current liabilities we will
get one indication that a business can or cannot meet its short-term debts from
assets that can be converted into cash in the short term. We call this a measure of
short-term liquidity. Compare the two totals in Figure 1.2. Do you think that
Dons Auto Repairs is liquid? Now take time to attempt Activity 1.3 to demonstrate your understanding of the subject matter we have covered above.
You should spend 15 minutes on this activity.
J. Jackson has worked for some years as a technical manager for a film
processing company. In his spare time he has often undertaken private
photographic work, such as weddings and portraits, and over a period has
acquired his own equipment and materials.
At the end of 2007 Jackson resigned from the company to establish his own
full-time business, Jacksons Photographic Studio. He started business on 1 January 2008 and contributed the following personal possessions for use in the
business:
Activity 1.3
Read Chapter 2, pp. 30 34, of your textbook.
U1: Basic Accounting Concepts and Reports 1.18
1 Super SLR camera, valued at 900
Darkroom equipment which had cost 1 600
Second hand van bought for 2 400
Films, chemicals, photographic paper that had cost 200
Personal cash savings (deposited in a current banking
account in the name of the business) 1 400
Amount owing by customer for photographs taken
in 2007 540
$7 040
As he needed to buy more sophisticated equipment, Jackson persuaded his uncle,
P Wilks, to lend him $2,000 for business use. This sum, which is interest free,
and is repayable at the end of 2009, was banked in the business banking account
on 1 January.
The business is also to be responsible for the $2, 200 that Jackson still owes on
the van and $840 that he owes to the supplier of the photographic equipment.
Both amounts must be paid before the end of April 2008.
Required
Prepare the statement of financial position for Jacksons business at 1 January 2008, using the format shown in Figure 1.2. To make the position statement
balance, you will have to calculate the amount of J. Jacksons owners equity (capital).
Now attempt Activity 1.4.
Spend 15 minutes on this activity.
Below is a list of position statement items for Micks Plumbing Services as at 30 June 2008. For each item listed you should identify whether it is an asset,
liability, or owners equity item and place the amount in the corresponding column. State beside each asset or liability, whether it is current (c) or non-
current (n). If you are correct the column totals should balance using the
accounting equation.
Activity 1.4
U1: Basic Accounting Concepts and Reports 1.19
Assets = Liabilities + Owners Equity
$ $ $ $
Cash in bank 2 930 2 930
Money owed to suppliers
(accounts payable)
2 300
Equipment 9 450
Mick Daniels capital 56 270
Land 18 000
Building 56 500
Bank loan 34 000
Supplies of plumbing fittings 1 720
Money owed from customers
(accounts receivable)
3 970
= +
Required
Prepare a statement of financial position using the above information.
Statement of financial performance
For an example of the set out of a statement of financial performance, see Figure
2.3 on page 34 of your textbook. Remember that you should show all the figures
in a single column.
The report shows the results of the trading and service activities of the business
over a given period of time. As we saw in the previous section, this period is
known as the accounting period, which normally is one year. The statement of
financial performance introduces two more elements you must understand and
remember:
Revenue refers to earnings by the business from trading activities (sales),
for performing specific services (commissions), or from
investment activities (rents, interest and dividends). Revenues
cause assets to increase, or stop them from decreasing, and are
therefore inflows, or savings in outflows of future economic
benefits.
Expenses are costs incurred by the business in the process of earning
revenue and which have been consumed or used up during the
U1: Basic Accounting Concepts and Reports 1.20
year. They include wages, advertising, insurance, rent paid,
telephone, stationery and power charges. These are all losses
or consumptions of future economic benefits that decrease the
values of assets.
The notion of earning revenue and incurring expenses will be discussed in more detail in Unit 3 of this Study Guide.
There is also a relationship between revenues and expenses:
REVENUES EXPENSES = NET PROFIT (OR LOSS)
Net profit represents the net earnings of the firm during the reporting period and
represents an increase in the owners equity (the proprietary viewpoint!). If expenses exceed revenue a net loss will result in a decrease in owners equity. These revenue and expense effects on the owners equity are illustrated in Figure 1.4 later in this unit. Revenues, expenses and net profit are all abstract concepts
that accountants use to explain how resources are received and used, and
ultimately increased or decreased, through business operations.
Figure 1.3: Central concept of value
OWNERS EQUITY
The residual interest in
the assets of the entity
after deducting its
liabilities
ASSETS
The future economic
benefits
REVENUES
The inflows or savings
in outflows of
economic benefits
LIABILITIES
The future sacrifices of
economic benefits
EXPENSES
The consumption or
losses of economic
benefits
FUTURE
ECONOMIC BENEFITS
CENTRAL
CONCEPT
OF VALUE
U1: Basic Accounting Concepts and Reports 1.21
Take the time now to attempt Activity 1.5
Spend 15 minutes on this activity.
Now try the same thing with the following list of revenues and expenses. When
you have completed the table work out the net profit and then prepare a statement
of financial performance using this information.
Revenue Expenses
$ $ $
Wages 15 000
Petrol for work vehicle 2 750
Telephone 1 300
Interest received on business account 1 500
Maintenance of equipment 490
Gas cylinder rental 160
Receipts from plumbing 48 000
Advertising 1 800
Rent received 2 500
Interest paid on bank loan 2 250
Statement of changes in equity
This statement reveals the changes in the owners equity for the period over which the financial performance statement has been prepared. (See Figure 2.4 on
page 35 of your textbook.) Specifically it shows:
the owners equity at the beginning of the period;
any further investment by the owner during the period;
Revenue Expenses = Net Profit
AAActiviActy 1.5
U1: Basic Accounting Concepts and Reports 1.22
the amount of net profit or net loss made;
withdrawals (drawings) made by the owner; and
the owners equity at the end of the period.
This statement provides the link between two successive position statements and
the statement of financial performance. (This link is illustrated in Figure 2.5 on
page 35 of your textbook. The net profit, determined by the statement of financial
performance, is included in the statement of changes in equity and therefore is
also represented in the position statement as part of the increase in the owners equity.
NB:
The changes to the owners equity are not shown on the position statement itself. Only the total amount is shown. If you are in the habit of showing the detail in
the position statement you should drop it immediately.
Statement of cash flows
The previous three statements are all products of the accounting equation and
how it is affected by transactions. Only cash at bank in Figure 1.2 represents cash
and cash equivalents. (See Figure 2.6 on page 36 of your textbook.) The
existence of accounts receivable and accounts payable also implies that Dons Auto Repairs buys and sells services on credit as well as for cash. This means
that not all revenues for a period are necessarily received in cash or expenses for
a period paid in cash, and that net profit will not necessarily result in an increase
in cash of an equal amount. However, the changes in cash are considered to be so
important for an entitys liquidity that accountants produce a special statement to show them.
NB:
Cash flows are shown under the headings of operating activities, investing activities and financing activities.
Operating activities are those concerned with profit making.
Net cash from operating activities is not the same as the net profit shown in the performance statement.
The statement gives information not available from the other three statements.
Reading 1.6
Read Chapter 2, pp. 30 36 of your textbook.
U1: Basic Accounting Concepts and Reports 1.23
1.5 Double Entry Record Keeping In section 1.3 we briefly discussed the accounting equation, saying that it is a
descriptive model of a business that shows the relationship between assets,
liabilities and the owners equity. In this section we will show you how we can use the accounting equation to record transactions and apply double entry
accounting!
In accounting, transactions are defined as events that make up the economic
activities of a business. Examples are the payment or collection of cash, a
purchase or sale made on credit, or the contribution or withdrawal of assets by the
owner.
Transactions between the business and outside parties, such as other businesses
and customers, are called external transactions and involve the exchange of
economic resources. However, some events such as using up existing assets
within a business do not involve outside parties and are thus called internal
transactions. It is the internal transactions that cause measurement problems, as
you will learn in later chapters.
The task facing the accountant is to devise a way of recording, analysing,
classifying and summarising this transaction data for an accounting period that
will produce the information needed for the statement of financial position, the
statement of financial performance and the statement of the owners equity.
If you look back to the position statement for Dons Auto Repairs (Figure 1.2) you will see that:
it distinguishes assets from liabilities and the owners equity;
it balances because the value of assets must always be exactly equal to the value of liabilities plus the owners equity; and
the set of values reported on the position statement are true for that particular date only.
It follows logically that any transaction that occurs after that date must alter at
least two position statement values if the next position statement is to balance,
which it must. Consider these examples for Jacksons business, which took place on, say, 1 July:
U1: Basic Accounting Concepts and Reports 1.24
Transaction Effect on Position Statement
The firm paid $1, 000 in part
settlement of debts owed to its
creditors.
The effect of this transaction is to
decrease the asset cash at bank by
$1, 000 and to decrease the
liability accounts payable by
$1, 000.
An amount of $500 owed by
debtors was received and banked.
This transaction will increase the
asset cash at bank by $500 and
decrease the asset accounts
receivable by $500.
Repair supplies to the value of
$100 were found to be damaged
and hence worthless.
This transaction will have the
effect of decreasing the asset
repair supplies by $100 and
decreasing owners equity by the same amount.
Make sure you can understand the logic behind these effects. Note that the first
two transactions are external and the third one internal.
It is conceivable that the business could record the arithmetical effects of these
transactions by preparing a new position statement after each transaction, or at
the end of each day, but the reality is that there are too many transactions for this
to be feasible. In any case position statements are not needed that frequently.
An alternative approach is to list the asset, liability and owners equity items on a table or worksheet set out in the form of the accounting equation.
Reading 1.6
This example for Darrens Lawn and Gardening Services sets up the basis for the dual recording process known as double entry record keeping (accounting) and
the reasoning for each of the ten transactions is spelt out in your textbook.
However, it is important enough to spend more time on. Consider Figure 1.4,
which shows the completed worksheet at the end of January (without the sub-
totals after each transaction).
Read: pp. 41 45 of your textbook, Chapter 2
U1: Basic Accounting Concepts and Reports 1.25
Figure 1.4: Worksheet showing double entry record keeping
Once again, be sure that you follow the logic for the revenue and expense
transactions. As shown in Figure 1.4, the worksheet itself has all the attributes of
an accounting system in that it is used to:
Record the economic effects of transactions (the + and - effects);
U1: Basic Accounting Concepts and Reports 1.26
Analyse transactions into various types of assets, liabilities and owners equity (by adding extra columns and column headings);
Summarise transactions for a period (deriving column totals); and
Produce accounting reports (by rewriting the column totals in financial position format and analysing the transactions in the cash at bank and
capital columns for cash flow and performance information).
The worksheet also provides checks on the arithmetical accuracy of what is
recorded because the equality of the equation can be checked line by line for each
transaction and in total at the end of the period (the sum of the assets column
totals must equal the sum of the liability plus owners equity column totals).
Furthermore all column totals should be positive or normal. A negative asset or
liability total would be abnormal and would usually indicate that a recording
error has been made (what would a negative Cleaning equipment column mean?
There is no definition for a negative asset).
The financial reports for Darrens Lawn and Gardening Services in your textbook (Figure 2.7, p. 45) were all produced from the information on the worksheet. As
Figure 1.2 shows, the position statement is prepared from the column headings
and column totals. The statement of financial performance is prepared by
analysing the revenue and expense effects in the owners equity or capital column. These revenue and expense effects reinforce the concept of net profit as
an increase in capital (and the converse for a net loss). The cash flow statement
is prepared from information in the cash at bank column and the statement of
owners equity is also derived from the owners equity column. The latter shows all changes arising from Darren Jones investment transaction with the business, the increase from profit earning activities and the decrease from his drawings.
The worksheet on the previous page gives a perfectly adequate accounting system
for a small business with relatively few asset and liability items and very few
transactions. However, most businesses have a large number of transactions and
need more analysis columns than a worksheet can accommodate, so the
accounting system must be expanded to cope with these. One-way of doing this is
to set aside a page or account for each asset, liability and owners equity item. This use of accounts is developed in the next unit.
Now attempt Activity 1.6.
U1: Basic Accounting Concepts and Reports 1.27
Spend 15 minutes on this activity.
After 10 years experience as an officer in military transport, Joe Chan decided to
start up his own transport business, to be called JC Transporters, operating out of
Suva. The purpose of the business is to sell transport services to customers
throughout the island. Customers will be given credit and they will be billed at the end of each month and allowed 10 days to pay their debts.
Joe started up the business on 1 January 2003 by paying $112, 000 of his
personal cash savings into a business banking account. He immediately employed
four of his former army colleagues as drivers.
The firms transactions for the 2003 financial year were:
1) On the first day of the financial year Joe, as the firms proprietor and manager:
a) Bought a property consisting of an area of land and a small warehouse.
The firm paid $40, 000 in cash to the seller.
b) Bought a Macintosh desktop computer to keep the business records and
paid $10, 000 in cash.
c) Bought 3 new trucks for $50, 000 each. The firm paid $30, 000 in cash
and raised a bank loan for the remaining $120, 000.
The loan is for 4 years and is secured by a mortgage over Joes home. Interest at 11% per year plus one quarter of the debt must be paid on the last
day of each year. Joe estimates that the trucks will run efficiently for 5 years.
2) Customers are billed $450, 000 for trucking fees, for services provided on
credit during the year.
3) Bought spare parts $2, 000 and a bulk supply of diesel fuel $18, 000, and
paid cash.
4) Paid normal operating expenses for the year in cash $206, 400. The operating
expenses paid were for:
Property rates $2 000
Telephone 1 000
Stationery 1 000
Repairs and licences 8 200
Wages 181 000
Interest on loan 13 200
$206 400
5) Received $330, 000 cash from credit customers and banked this amount.
Activity 1.6
U1: Basic Accounting Concepts and Reports 1.28
6) Joe Chan withdrew $48, 000 cash during the year for his personal living
expenses.
7) Paid $30, 000 on the last day of the year for the instalment owing on the
loan.
8) At the end of the year Joe worked out the following:
Spare parts used 800
Diesel fuel still in bulk storage 12 000
Depreciation of trucks 30 000
Depreciation of office computer 1 000
Required
1) Record the above eight transactions on the worksheet on the next page, total
all columns and check that totals of assets columns equal the totals of
liability plus capital columns. (Record transaction (4) as $206 ,400 and
ignore the detail for expenses.)
2) Using the column totals, and details in the capital and cash at bank columns
prepare the following accounting reports for 2003:
a) Statement of financial position
b) Statement of financial performance
c) Statement of owners equity d) Statement of cash flows
U1: Basic Accounting Concepts and Reports 1.29
U1: Basic Accounting Concepts and Reports 1.30
1.6 Ethics and Accounting
An ethical behaviour is very important for all types of businesses to function
effectively. That is all the people working in the entity have to be honest, abide
by the rules and do the right thing. In early 2000s there were a number of large business and financial institution collapses which had lead to monetary losses and
hardships to shareholders and policy holders. Thus there was an increased
pressure from the community to improve the ethics of all people working in
business. All entities have some forms of code of ethics which establishes the
main principles of professional ethics and provides a conceptual framework for
applying those principles. Some of the ethical principles that members are
expected to adhere to are integrity, objectivity, independence and confidentiality
of client information.
Reading 1.7
Now take the time to attempt Activity 1.7
Spend 15 minutes on this activity.
Attempt the ethical case given on pp.27 in chapter 1 of your text book
Important Notes
It is also important for you to go over Chapter 17 of your text book to see what a
Conceptual Framework is and everything you will find in the framework. After
looking at this chapter you will notice that the components of the framework have
been discussed in the above sections.
Activity 1.7
Read: pp. 20 21 of your textbook, Chapter 1
U1: Basic Accounting Concepts and Reports 1.31
Summary This unit has led you very rapidly through some important and complex ideas.
Assets, liabilities, owners equity, revenues and expenses are the five essential elements of three accounting reports, namely the statement of financial position,
statement of financial performance and the statement of changes in equity. You
have also been shown how the elements are linked through the value in use
concept of future economic benefits. You have also been introduced to the cash
flow statement.
The unit has also put forward four important assumptions which underpin
accounting record keeping and reporting and it has introduced an arithmetical
model which can be used to record the effects that transactions have on the three
key elements making up the position statement. This model would be an effective
and complete accounting system if a business had only a few transactions each
accounting period. But, in real life, there are too many transactions and too many
types of assets, liabilities, expenses and revenues.
The next unit shows how this simple accounting system is developed and
expanded, using ledger accounts, to deal with the large number of transactions
which businesses really have to record, analyse, summarise and report.
End of Unit Exercise Attempt the following exercises and problems from your textbook by Hoggett,
Edwards & Medlin:
Exercise 2.5, p. 47
Problem 2.10, p.55
Problem 2.15, p. 58
Solutions to End of Unit Exercise
Exercise 2.5
(a) Investing [I]
(b) Operating [O]
(c) Financing [O]
(d) Financing [O]
(e) Investing [O]
(f) Operating [O]
(g) Financing [I]
(h) Operating [I]
U1: Basic Accounting Concepts and Reports 1.32
Problem 2.10
A. and B. Assets = Liabilities + Equity
Cash at
Bank
+
Accounts
Receivable
+
Office
Supplies
+
Office
Equipment
=
Accounts
Payable
+
Loan
Payable
+
Xiu
Miao,
Capital
. $16 000 + $26 500 + 2 000 + $39 750 = $4 850 + $17 500 + $61 900
(1) -4 720 - 4 720
11 280 + 26 500 + 2 000 + 39 750 = 130 + 17 500 + 61 900
(2) +14 800 -14 800
26 080 + 11 700 + 2 000 + 39 750 = 130 + 17 500 + 61 900
(3) -3 000 + 12 400 + 9 400
23 080 + 11 700 + 2 000 + 52 150 = 130 + 26 900 + 61 900
(4) + 11 640 + 11 640
23 080 + 23 340 + 2 000 + 52 150 = 130 + 26 900 + 73 540
(5) + 680 + 680
23 080 + 23 340 + 2 680 + 52 150 = 810 + 26 900 + 73 540
(6) -9 300 - 9 300
13 780 + 23 340 + 2 680 + 52 150 = 810 + 26 900 + 64 240
(7) - 1 440 - 1 440
13 780 + 23 340 + 1 240 + 52 150 = 810 + 26 900 + 62 800
(8) + 13 500 - 13 500
27 280 + 9 840 + 1 240 + 52 150 = 810 + 26 900 + 62 800
(9) -1 200 - 1 200
26 080 + 9 840 + 1 240 + 52 150 = 810 + 26 900 + 61 600
U1: Basic Accounting Concepts and Reports 1.33
C.
XIU MIAO- SOLICITOR
Income Statement
for the month ended 31 July 2013
INCOME
Legal services earned $11 640
EXPENSES
Wages expense $4 100
Rent expense 4 000
Advertising expense 1 200
Supplies expense 1 440
10 740
PROFIT $900
XIU MIAO SOLICITOR
Statement of Changes in Equity
for the month ended 31 July 2013
Xiu Miao, Capital 1 July 2013 $61 900
Add: Profit for the month 900
62 800
Less: Drawings during the month 1 200
Xiu Miao, Capital 31 July 2013 $61 600
U1: Basic Accounting Concepts and Reports 1.34
XIU MIAO SOLICITOR Balance Sheet
as at 31 July 2013
ASSETS LIABILITIES
Cash at bank $26
080
Accounts payable $810
Accounts
receivable
9 840 Loan payable 26 900
Office supplies 1 240 EQUITY
Office equipment 52 150 Xiu Miao, Capital 61 600
$89
310
$89
310
Problem 2.15
A.
FIT PRO
Income Statement
for the six months ended 28 February 2014
INCOME
Fitness income earned $9 800
EXPENSES
Rent expense $750
Electricity expense 850
Telephone expense
Water expense
560
350
Advertising expense 500
3 010
PROFIT $6 790
U1: Basic Accounting Concepts and Reports 1.35
B.
FIT PRO
Balance Sheet
as at 28 February 2014
ASSETS LIABILITIES
Cash at bank $16
500
Accounts payable $460
Accounts
receivable
800 EQUITY
Fitness equipment 4 000 Ryan Stallard,
Capital
$20
840
$21
300
$21
300
FIT PRO
Statement of Changes in Equity
for the six months ended 28 February 2014
Ryan Stallard, Capital 1 September 2013 $15 000
Add: Profit for the six months 6 790
21 790
Less: Drawings during the six months 950
Ryan Stallard, Capital 28 February 2014 $20 840
C. The income statement shows that Ryan made a profit for the six months of
$6,790. Although he has only drawn out $950 in this period, he does still have
$16,500 in the business bank account at the end of the first 6 months. Whether
he continues with his business venture or not depends on whether he believes
he will be able to improve the profits in the future, and also on what
alternatives he has available. It is common for businesses starting out to make
losses initially, or to start with very modest profits until they build up a client
base and a reputation. At this stage there is no reason why Ryan shouldnt persevere for a while longer and try to build his business. On the other hand,
Ryan may have determined that, given the maximum number of hours he can
work each day, it is not possible for him to generate sufficient profits to give
him the income he was hoping to get from his business, and he may decide to
close it down and seek alternative employment or business opportunities.
U1: Basic Accounting Concepts and Reports 1.36
Solutions to Activity
Activity 1.1
User Types of
Decisions
Information
Requirements
Small shareholders Buy, sell or hold shares Future earnings/profit
Potential shareholders Buy shares Future earnings/profit
Creditors and lending
institutions (e.g. banks)
To offer credit or lend
money
Debtors or borrowers ability to pay the debt;
also type of security
offered
Customers/competitors Customers to continue to shop there
Competitors to try and outperform the
business
Customers services offered; profit levels
Competitors all available information
Employees/trade unions Security of
employment
Ability of the business
to pay higher wages
Profits
Future plans (expansion
or down sizing)
The above are only some of the possible decisions that external users could make,
and the information they may need. You may have come up with different
examples that are just as acceptable.
Activity 1.2
Case
Total
Assets
Total
liabilities
Total
equity
Total
income
Total
expenses
Profit
(loss)
A $120 000 $69 000 $51 000 $123 000 $66 000 $57 000
B $135 000 $49 500 $85 500 $124 500 $96 000 $28 500
C $151 500 $66 000 $85 500 $135 000 $150 000 ($15 000)
D $75 000 $43 500 $31 500 $22 500 $34 500 ($12 000)
E $144 000 $60 000 $84 000 $84 000 $48 000 $36 000
U1: Basic Accounting Concepts and Reports 1.37
Activity 1.3
Jacksons Photographic Studio
Statement of Financial Position
As at 1 January 2008
$
Current Assets
Cash at bank 3 400
Accounts receivable 540
Photographic supplies 200
Total Current Assets 4 140
Non-Current Assets
Motor vehicle 2 400
Photographic equipment 2 500
Total Non-Current Assets 4 900
Total Assets
$9 040
Current Liabilities
Accounts payable 3 040
Total Current Liabilities 3 040
Non-Current Liabilities
Loan 2 000
Total Non-Current Liabilities 2 000
Total Liabilities 5 040
Owners Equity Capital, P Jackson 4 000
Total Owners Equity 4 000
Total Liabilities and Owners Equity
$9 040
This form of position statement shows the entity viewpoint of the firms resources and obligations. It illustrates clearly the relationship Assets = Liabilities +
Owners Equity. Later in the subject we will switch to the more usual proprietorship form of presentation.
Make sure that you understand the criterion for distinguishing between current
and non-current assets and liabilities. Also note the order (sequence) in which the
current assets are listed.
U1: Basic Accounting Concepts and Reports 1.38
Activity 1.4
Micks Plumbing Services
Statement of Financial Position
As at 30 June 2008
$
Current Assets
Cash at bank 2 930
Accounts receivable 3 970
Plumbing supplies 1 720
Total Current Assets 8 620
Non-current Assets
Land 18 000
Building 56 500
Equipment 9 450
Total Non-current Assets 83 950
Total Assets
$92
570
Current Liabilities
Accounts payable 2 300
Total Current Liabilities 2 300
Non-current Liabilities
Bank loan 34 000
Total Non-current Liabilities 34 000
Total Liabilities 36 300
Owners Equity Capital, Mick Daniels 56 270
Total Owners Equity 56 270
Total Liabilities and Owners Equity
$92
570
Assets = Liabilities + Owners Equity
92
570
= 36 300 + 56 270
U1: Basic Accounting Concepts and Reports 1.39
Activity 1.5
Micks Plumbing Services
Statement of Financial Performance
For the year ended 30 June 2003
$
Revenues
Plumbing 48 000
Interest 1 500
Rent 2 500
52 000
Less Expenses
Advertising 1 800
Gas cylinder rental 160
Interest 2 250
Maintenance of equipment 490
Petrol 2 750
Telephone 1 300
Wages 15 000
23 750
Net Profit
$28 250
Note: When there are the sub-headings revenues and expenses you need not write revenue and expense for each line item. The repetition is not necessary (this
is different from the textbook illustrations!).
U1: Basic Accounting Concepts and Reports 1.40
Activity 1.6
JC Transporters
Statement of Financial Position
As at 31 December 2003
JC Transporters
Statement of Financial
Performance
For the year ended
31 December 2003
$ $
Current Assets Revenues
Cash at bank 57 600 Transport fees 450 000
Accounts receivable 120 000
Fuel and spares 13 200 Expenses
Total Current Assets 190 800 Rates 2 000
Telephone 1 000
Non-Current Assets Stationery 1 000
Land & building 40 000 Repairs & licenses 8 200
Office equipment 9 000 Wages 181 000
Motor vehicles 120 000 Interest on loan 13 200
Total Non-Current
Assets
169 000 Spares & fuel 6 800
Total Assets
$359 800
Depreciation 31 000
244 200
Current Liabilities
Current portion of
bank loan
30 000 Net profit $205 800
Total Current
Liabilities
30 000
Non-Current
Liabilities
Bank loan 60 000
Total Non-Current
Liabilities
60 000
Total Liabilities
90 000
Owners Equity
Capital, J Chan 269 800
Total Owners Equity 269 800
Total Liabilities
and Owners Equity
$359 800
Teaching points
1) If your schedule does not give the same numbers as in the position statement
check it for mistakes.
2) Expenses are shown in detail.
U1: Basic Accounting Concepts and Reports 1.41
3) Remember that these two separate reports are still linked together
(articulated) by the statement of owners equity.
JC Transporters
Statement of Owners Equity
For the year ended 31 December 2003
Capital, J Chan $
Invested 1 January 112 000
Add: Net profit 205 800
317 800
Less: Drawings 48 000
Balance at 31 December
$269 800
JC Transporters
Statement of Cash Flows
for the year ended 31 December 2003
$
Cash flows from operating activities
Receipts from customers 330 000
Payments to suppliers and employees (213 200)
Interest paid (13 200)
Net cash provided by operating activities 103 600
Cash flows from investing activities
Payment for land and building (40 000)
Payment for new equipment (10 000)
Payment for new vehicles (30 000)
Net cash used in investing activities (80 000)
Cash flows from financing activities
Investment by owner, J Chan 112 000
Drawings, J Chan (48 000)
Repayment of debt (30 000)
Net cash flows provided by financing
activities
34 000
Net increase in cash held 57 600
Cash at beginning of year NIL
Cash at end of year 57 600
U1: Basic Accounting Concepts and Reports 1.42
Teaching point
The above report is a cash basis report. Compare the net cash provided by
operating activities $103 600 with the accrual basis net profit $205 800. Can you
see at least two reasons why the numbers do not agree? (Revenue is $120, 000
more than receipts from customers and depreciation and fuel & spares used are
not in the cash flow statement).
Activity 1.7
Ethical practice among friends
A. The stakeholders or the involved parties in this situation are Mickey and Minnie.
B. Mickey has gained $15 by acquiring the text at a price lower than the bookshop text price of $80. He has misled his friend Minnie by failing to
disclose the cost price of $65 which represents what he paid for the textbook.
His friend has lost the benefit of the reduced price cost saving of $15. He
has not acted honestly by retaining the $15 cash saving. He has not acted
ethically nor has he acted as a friend.
Mickey has not told Minnie the economic value of the book. He has
breached his duty to his friend by not buying the new book at $65 and
offering $15 balance in return.
C. Mickeys alternatives are:
tell Minnie what happened and give her the correct change; or
buy a brand-new textbook for $80 as listed by the bookshop.
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