MS 15D Financial Accounting

Purpose of Accounting
Financial accounting is a system that involves recording, analysis and communication of financial information. The purpose of accounting is to provide financial information about the current operations and financial condition of a business to individuals, agencies and organizations. In other words, accounting is a system that is used by businesses to monitor their activities and report their performance. The overall objective of accounting is to provide information that can be used in making economic decisions.

Users of Financial Information

Persons outside of the business who have interest in the business, but are not involved in its day to day operation !e"ternal users#, as well as, persons inside the organization who are involved in its day to day operations !internal users#, use financial information. $ome of the main users of financial information are% 1. Investors Investors !both e"isting and potential# need information concerning the safety and profitability of their investment and to decide whether a change of ownership interest is warranted. Trade and Loan Creditors &oth present and potential creditors of the business use financial information to help them in deciding whether or not it is safe to e"tend credit to the business. They need information about the profitability and stability of the enterprise. In other words, they are interested in the solvency of the business i.e. 'an the business pay its debts when they fall due( Statutor Agencies They need this information to assist them in evaluating ta" returns for assessment purposes and to see whether there is compliance with government rules and regulations e.g. Income Ta" department and )egistrar of 'ompanies. "mplo ees and Trade Unions They use financial information to assist in the making of employment decisions and in negotiating contracts and benefits. Financial Anal sts *se financial information to evaluate the soundness of businesses for their clients who may wish to make investment decisions and for $tock +"change purposes. Customers of %usinesses *se financial information to help them in evaluating their relationship with businesses and to make decisions regarding possible future business relationships. 'anagers of %usinesses To assist them in the decision making, controlling and directing the day to day running of the business, as well as, to aid in the formulation of policies and plan for the future of the ,

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enterprise. -anagers have a special interest in the annual financial statements, as these are the statements popularly used by decision makers outside of the organization.

%ranc(es of Accounting
Financial Accounting Provides information for e"ternal users e.g. Potential investors, creditors, ta" authorities, trade unions and financial analysts. 'anagement Accounting Provides information -anagement, board of directors and employees. for internal decision making e.g.

Accounting Associations
.merican Institute of 'ertified Public .ccountants !.I'P.# Institute of 'hartered .ccountants of /amaica !I'./# .ssociation of 'hartered 'ertified .ccountants !.''.# Institute of Internal .uditors !II.# Institute of -anagement .ccountants !I-.#

Accounting )ualifications
'ertified Internal .uditor !*$# .n internal auditor, who has achieved professional recognition by passing the uniform e"amination offered by the II.. 'ertified -anagement .ccountant !*$# .n accountant, who has passed an e"amination offered by the I-. 'ertified Public .ccountant !*$#0'hartered .ccountant !*12 /amaica# . public accountant, who has met certain educational and e"perience re3uirements and has passed an e"am prepared by the .I'P. or .''..

T(e Accounting Process

.ccounting is a system of gathering financial information about a business and reporting this information to users. The si" main steps of the accounting process are% Anal *ing looking at events that have taken place and thinking about how they affect the business +ecording entering financial information about the events in the accounting system. Classif ing sorting and grouping similar items together. Summari*ing bringing the various items of information together to determine a result. +eporting telling the results. Interpreting deciding the meaning and importance of the information in the various reports. This may include percentage analyses and use of ratios to help e"plain how pieces of information are related. 4

T pes of ,-ners(ip Structures

&usinesses are classified according to who owns them and the specific way in which they are organized. Sole Trader or Proprietors(ip . business with a single owner called a proprietor. 5ot re3uired by law to make any of its financial information available to the public. 5o formal document re3uired for formation. 6ow start up cost. The owner is personally responsible for all the decisions made for the business i.e. the owner assumes all risk and makes all decision !owner manages business#. 7wner is responsible for all the debts of the business i.e. the owner8s liability is unlimited and therefore e"tends to his0her personal assets. .lthough the financial records of a business should be kept separately from the owner8s personal financial records, there is no separation of the sole proprietors books and its owner8s books for legal purposes. .ny amount earned from the business is included on the personal ta" return of the owner. Examples include small retail stores, doctor, attorney, accountant, and physician.

Partners(ips 6east common form of organization 7wned by two or more persons e.g. physicians, attorneys and accountants. 6ike the proprietorship, the owners i.e. each of the partners, is responsible for the debts of the business i.e. the liability of a partner is unlimited and therefore e"tends to his0her personal belongings 5o formal document is re3uired for formation. 9etails like how much work each will do and how they will share any earnings from the business are specified in a document called a partnership agreement. 6ike the sole proprietor, earnings by a partner from the partnership are included when filing their own personal ta" returns. Corporation 6egally and financially separate from its owners. .s legal entities, corporations may enter into contracts just like individuals. 7wnership in a corporation is divided into amounts called shares of capital stock, each representing ownership in a fraction of the corporation. .n owner of shares in a corporation is called a stockholder or a shareholder. $tockholders are free to sell some or all of their shares to other investors at anytime !Transferable ownership rights#. 7wner8s risk is limited to their initial investment and they have very little influence on business decisions. -anaged by a &oard of 9irectors *nlike proprietorships and partnerships, corporation pays ta"es on its earnings i.e. an owner in a corporation does not include the income of the corporation in his0her personal ta" returns. Formal documents are re3uired for formation :

Articles of Incorporation This document states, among other things% The name of organization2 where company office will be located2 the objective of the company2 that the liability of the owners is limited if it is not to be unlimited2 how the business plans to ac3uire financing. The rules drawn up to govern the internal working of the company2 regulate the holding of meetings2 regulate the issue of capital2 define powers and duties of directors, rights of shareholders etc. . corporation whose shares of stock are owned by a very small number of people is called a closely held corporation or a private company. For the first couple of weeks we will be focussing on the accounts of the sole proprietorship.

T pes of %usinesses
Service . business that provides a service e.g. travel agency, computer consultant, physician, hospital, law firm, accounting firm. 'erc(andising &uys products from another business and sells to customers e.g. department stores, pharmacies, jewellery stores, supermarkets. 'anufacturing -akes product to sell e.g. automobile manufacturer, furniture maker, toy factory, and garment manufacturing company.

Financial +eporting
+"ternal financial reporting is governed by an established body of standards and principles that are designed to carefully define what information a firm must disclose to outsiders. The Financial .ccounting $tandards &oard !F.$&#, in the *$ has developed a set of standards referred to as ;enerally .ccepted .ccounting Principles !;..P#. ;..P are standards that are adhered to in the preparation of accounting information for investors and creditors. The standards provide the general rules and guidelines to be followed in the accounting and reporting process i.e. they determine the amount of information to be included in the financial statements, as well as, the format of preparation and presentation of such information. The rules provide assurance that business entities are reporting business activities in a similar manner. ;..P are important in ensuring the integrity of financial accounting information, so that financial reports for different entities can be more easily compared. In the same manner than F.$& establishes accounting standards for *.$. entities, other countries have their own standard setting bodies. In an attempt to harmonize conflicting standards, the International .ccounting $tandards 'ommittee !I.$'# was formed in ,<=: to develop worldwide accounting standards. The International .ccounting $tandards &oard !I.$&# replaced the I.$' in 4>>,. $ince then the I.$& has amended some I.$, has proposed to replace some I.$ with new International Financial )eporting $tandards !IF)$# and has proposed certain new IF)$ on topics for which no I.$ ?

previously e"isted. This body, the I.$&, now represents more than ,?: accountancy bodies from more than ,>: countries, including the *nited $tates. The accounting standards produced by the I.$' are referred to as International .ccounting $tandards !I.$s#. I.$s are envisioned to be a set of standards that can be used by all companies, regardless of their physical location. I.$' standards are gaining increasing acceptance worldwide. @owever the $ecurities and +"change 'ommission !$+'#, in the *.$. has so far not recognized the standards of the I.$', and has barred foreign companies from listing their shares on the *.$. stock e"changes unless those companies agree to provide financial statements in accordance with *.$ ;..P. /amaica adopted I.$ on /uly ,, 4>>4. .ote Investors and creditors need relevant and reliable information about an entity. To ensure that this is done, companies are re3uired to have their financial statements audited by independent accountants. An audit is a financial examination of the financial statements of an entity to determine whether these statements give a true and fair view of the financial health of the business. 6ike any other profession, accounting is governed by ethical rules and standards. )ecent scandals in the corporate world point to the importance of ethics. The preparers of financial statements should not only abide by ;..P, but also ethical standards and ensure that accurate and reliable information is provided by the financial statements of the entity. T(e IAS% Frame-or/ The framework describes the basic concepts by which the financial statements are prepared. It serves as a guide to the &oard in developing accounting standards and as a guide to resolving accounting issues that are not addressed directly in an I.$ or IF)$. The I.$& Framework i# defines the objective of financial statement ii# identifies the qualitative characteristics that make financial information useful iii# defines the basic elements of financial statements and the concepts for recognizing and measuring them in financial statements

C(aracteristics of Accounting Information

The objective of financial reporting is to provide useful information. The 3ualitative characteristics of useful accounting information are Understanda0ilit i.e. information should be presented in a way that is readily understandable by users who have a reasonable knowledge of business, economic activities and accounting. +elevance For information to be relevant it must have the following 3ualities i1 Feed0ac/ value 2 Predictive value i.e. feedback on past events help confirm or correct earlier e"pectations. $uch information can be used to help predict future outcomes. ii1 Timeliness. This is important for information to make a difference. Information received after a decision is made is useless, hence for information to be relevant it must A

be provided to users within the time period in which it is most likely to influence their decisions. Materiality is also a component of relevance. Is the item large enough to influence the decision of a user of the financial information Information is said to be material if its omission or misstatement could influence the decision of a user. Managers usually exercise professional judgment in determining whether an item is material or immaterial. +elia0ilit Information should be relatively free from error. )eliability does not mean absolute accuracy, as information that is based on judgment cannot be totally accurate. The information presented should therefore have% 3erifia0ilit i.e. the data should be free from material error and bias and can be verified by other trained accountants. +epresentational Fait(fulness i.e. the economic events are properly measured .eutralit i.e. fairness. Compara0ilit *sers must be able to compare the financial statements to a standard or benchmark such as other firms within the industry or a prior period within the same firm. 'omparability re3uires similar events to be accounted for in the same manner on the financial statements of different companies and for a particular company for different periods. 9isclosure of accounting policies is essential for comparability. True and fair .dherence to the above ensures true and fair view. %enefits greater t(an cost Information like any other commodity must be worth more than the cost of producing it.

T(e Accounting "lements

Three basic accounting elements e"ist for every business entity% assets, liabilities and owner8s e3uity. i1 Assets These are economic resources owned or controlled by an entity and will provide future benefit. +"amples of assets include cash, merchandise, furniture and fi"tures, machinery, building and land. &usinesses may also have an asset called accounts receivable, which represents the amount of money owed to the business by its customers as a result of making sales on account or on credit. .ssets can either be termed current assets or non4current assets. Current assets are assets that the business plans to convert into cash or use to generate earnings in the ne"t ,4 months or within the business8s accounting cycle, whichever is longer. 7perating cycle is the period between the purchasing of goods from supplier to collecting from customers. +"amples of current assets are cash, accounts receivable, short term investments, unsold merchandise !inventory#.

.on4current assets 5also referred to as Long4term assets or Fi6ed assets1 are assets that are not e"pected to be used up in a year. +"amples of fi"ed assets are land, building, furniture and fi"tures, machinery. 7ther categories of 6 T assets include 6 T investments. ii1 Lia0ilities These are debts or obligations the business has incurred to obtain the assets it has i.e. liabilities are amounts the business owes that can be paid with cash, goods or services. 'ommon liabilities are accounts payable, notes payable and short term loans. .n account payable is an unwritten promise to pay a supplier for assets purchased or services received. . formal written promise to pay suppliers or lenders specified sums at definite future dates is known as a note payable. 6ike assets, liabilities can be grouped as current lia0ilities or non4current lia0ilities. Current lia0ilities are amounts to be paid off within the ne"t ,4 months or within the operating cycle of the entity if it is longer. +"amples of current liabilities are accounts payable, notes payable, interest payable and short term loans. .on4current or long4term lia0ilities are amounts owing that will be paid off over a period longer than one year. +.g. -ortgages, long term loans iii1 ,-ner7s "8uit .lso referred to as 5et Corth and 'apital, owner8s e3uity represents the owner8s claim to the assets of the business. It is the amount by which the business assets e"ceed the business liabilities. There are two ways for the owners to increase their claims to the assets of the business &y making contribution &y earning contribution

T(e Accounting "8uation

The relationship between the three basic accounting elements D assets, liabilities and owners e3uity D can be e"pressed in the form of a simple e3uation known as the accounting equation. Assets = Liabilities + Owners Equity .ll business transactions affect the accounting e3uation. &usiness transactions are economic events, which have a direct impact on the business. In financial accounting, all business transactions are 3uantified in monetary terms. +"amples of business transactions are buying goods and services, selling goods and services, making loans and borrowing money. The accounting e3uation must remain in balance after the transaction is completed. "6panding t(e Accounting "8uation +evenues These are amounts the business earns from providing goods or services to customers. +.g. sales from sale of merchandise, consulting fees, rent revenue if the business rents space to others2 interest revenue for interest earned on bank deposits. )evenues increase both assets and owners e3uity. "6penses +"penses are costs incurred to generate revenues. +.g. rent, salaries, supplies used. +"penses decrease assets or increase liabilities and reduce owner8s e3uity. =

If revenues e"ceed e"penses, the difference is referred to as 5et Income. If e"penses e"ceed revenues, the difference is referred to as a 5et 6oss. 9it(dra-als 5:ra-ings1 9rawings are cash or other assets taken by the owner from the business for his0her personal use. 9rawings serve to reduce owner8s e3uity. Assets = Liabilities + [,-ners "8uit ; 5+evenues < "6penses1 < :ra-ings]

Financial Statements
Information relating to a business is usually communicated by way of financial statements. These statements are usually analyzed to evaluate the performance of the business. .s per I.$ ,, a complete set of financial statements include% ,. 4. :. ?. A. Income $tatement $tatement of 'hanges in 7wner8s +3uity &alance $heet !$tatement of Position# $tatement of 'ash Flows 5otes to the Financial $tatements comprising a summary of accounting policies and other e"planatory notes.

The financial statements commonly prepared are the income statement, statement of owner8s e3uity and balance sheet. .ll financial statements must carry a heading. This heading includes% The name of the business The title of the statement The time period covered or the date of the statement. The Income $tatement and $tatement of 7wner8s +3uity provide information concerning events covering a period of time, in this case the month ended. The balance sheet on the other hand, offers a picture of the business on a specific date. 1. T(e Income Statement .lso called $tatement of +arnings, $tatement of 7perations or Profit E 6oss $tatement is a summary of all the revenues !income from sale of goods or services# a company earns minus all the e"penses incurred in earning the revenues, for a specific period D a month, a 3uarter or a year. The Income statement is therefore regarded as an activity statement. The statement tells whether the business earned a net income i.e. total revenues F total e"penses or a net loss i.e. total e"penses F total revenues. There are two !4# types of income statement% $ingle step groups all revenues together and all e"penses together. -ultiple step reports gross profit, net income from operations and net income.

2. Statement of ,-ner7s "8uit 5Sole Proprietors(ip1 This statement shows any change that took place in owner8s e3uity from net income or net loss, withdrawals and other investments during a specific time period. 5et income increases owner8s e3uity, whereas net loss and withdrawals decrease owner8s e3uity. /ohn 9oe $tatement of 7wner8s +3uity I /ohn 9oe, 'apital H ,0,0 .dd additional investment by owner Total Investment 5et Income For Period 6ess Cithdrawals by owner Increase0!9ecrease# in 'apital /ohn 9oe, 'apital :,0,40 I """""" """""" """""" """""" """"""

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3. T(e %alance S(eet The balance sheet, also referred to as $tatement of Financial Position0'ondition, describes the financial position of the business at a specific point in time. It is a position statement, which gives a snap shot of the business at a point in time. The balance sheet reflects the accounting e3uation i.e. .ssets J 6iabilities K 7wner8s +3uity. I.$ , re3uires that an entity must normally present a classified balance sheet, separating current and non current assets and liabilities. The standard does not prescribe the format of the balance sheet. The balance sheet can be arranged in either of two formats )eport format .ssets at the top and liabilities and owners e3uity at the bottom .ccount format .ssets on left and liabilities E owners e3uity on the right. .ssets can be presented current then non current or vice versa and liabilities can be presented current, non current then e3uity or vice versa. . net asset presentation !assets D liabilities# is allowed. The long term financing approach used in the *1 and elsewhere Fi"ed .ssets K 'urrent .ssets D 'urrent 6iabilities J 6ong term 9ebt K +3uity, is also acceptable. .ssets are listed in the balance sheet in order of li3uidity. 6i3uidity is a measure of how easily an asset can be converted into cash. The more li3uid an asset is, the more easily it can be converted into cash. !. Statement of Cas( Flo-s 7ne of the purposes of financial statements is to assist users in making predictions about an entityLs future cash inflows and outflows. *sers can predict the future only if they have sufficient information. *nfortunately the I$ and &$ are not enough to furnish the re3uisite information. The statement of cash flows is very important in understanding an enterprise for purposes of investment and credit decisions. It depicts the ways cash has changed during a designated period D the cash received from revenues and other transactions, as well as, the cash paid for certain e"penses and other ac3uisition during the period. In short, the statement provides information about the nature and sources of an entity8s cash inflows and outflows. The statement classifies the various cash flows into three categories% ,. 7perating .ctivities 4. Investing activities :. Financing .ctivities The information contained in the statement is useful in answering 3uestions such as% ,. 9id the business fund its operations from operations, loans or stockholders investments( 4. Cere funds used for e"pansion2 to reduce or repay outstanding debts, purchase fi"ed assets etc( <

. clear understanding of a borrower8s cash flow is one of the most important components of financial statements analysis in the banking sector. It provides the lender with a picture of the financial health of the business by focusing on receipts and disbursements. ,perating Activities These are activities that are primarily related to the production and sales of goods and services, which enter into the determination of income i.e. items, which affect the income statement. Inflows 7utflows )eceipts from customers, loan interest received, dividends received. Payment for inventory, employeesL wages E salaries, ta"es, interest paid and other business e"penses

Investing Activities These are activities, which involve investment of the resources of a business Inflows )eceipts from sales of stock and bonds held in other businesses and from disposal of long term resources such as land and buildings and receipt of loan principal from borrowers. Payments made to ac3uire long term assets or securities in other businesses, loans made to other businesses etc.

7utflows

Financing Activities These are activities, which provide a business with resources from either owners or creditors, i.e. the owners or creditors investing money in the business and the repayments. . business is financed by either debt !from outsiders# or e3uity !from insiders# Inflows )eceipts from issue of stocks and bonds, cash received from owner to finance operations, and loans 7utflows Payment of loan principal to creditor and dividends paid. Parentheses are used to denote negative cash flows i.e. cash outflows. It is important to note that the financial statements are interlinked as balances derived from one statement are reflected in other statements. The statements are prepared in the following order% Income Statement = Statement of ,-ner7s "8uit = %alance S(eet = Statement of Cas( Flo-s #. .otes Accompan ing Financial Statements

.s a general rule, a company should disclose any facts that an intelligent person would consider necessary for the statements to be properly interpreted. The ade3uate disclosure principle means that the financials should be accompanied by any information necessary for the proper interpretation of the statements. These disclosures appear in what are called notes to the financials at the end of the accounting period. The items to be disclosed are based on a combination of official rules, tradition and the accountant8s professional judgement. Two main items that are always disclosed are the accounting methods used and the due dates of major liabilities. 7ther items to be disclosed include% lawsuits pending against the business2 scheduled plant closings, ;overnment investigations into the safety of the company8s products or the legality of its pricing policies2 significant events occurring after the balance sheet date but before the financials are actually issued2 specific customers that account for a ,>

large portion of the company8s business2 unusual transactions or conflict of interest between the company and its key officers. 'ompanies are not re3uired to disclose information that is immaterial or that does not have a direct financial impact on the business e.g. resignation, firing or death of key officers0e"ecutive.

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