OVERVIEW OF FINANCIAL ACCOUNTING

UNIT 1: OVERVIEW OF FINANCIAL ACCOUNTING

By the end of this unit, you should be able to:

• Know what accounting is
• Know who are the main users of accounting information
• Know the types of business
• Know the types of financial statements
• Understand common accounting terminology
• Understand what is accounting equation
• Differentiate between generally accepted accounting principles (GAAP) and international
financial reporting standards (IFRS)

1.1 WHAT IS ACCOUNTING?

Accounting is the language of business. Just as a man expresses himself through
words – spoken or written, business information is expressed through accounting
statements. A business needs to record all that is received and all that is paid out, both
in terms of cash or goods.

1.2 FINANCIAL ACCOUNTING DEFINITION

Accounting is the art of recording, classifying, and summarising in a significant
manner and in terms of money transactions and events, which are in part at least of
financial character, and interpret the results thereof.

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From the earlier definition, it can be observed that financial accounting comprises
mainly of four main activities:

• Recording - means to document or systematically put down all transactions taking

place in a business in accordance with accepted principles.
• Classifying - means grouping together transactions of similar nature.
• Summarising - involves preparation of trial balance and financial statements.
• Interpretation - this is the process of analysing, evaluating or getting some
information from the financial statements.

1.3 USERS AND USES OF ACCOUNTING INFORMATION

The following users group use financial accounting for the following purposes:

A) Owners of the business, to ascertain:

• Profitability of the firm
• Security of capital
• Return on their investment (ROI)
• Resources owned
• Financial stability
• Whether to increase or decrease their existing ownership in the firm

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B) Managers, to know:
• Profitability
• Return on investment
• Operational efficiency (day-to-day operation)
• Ensure security of investment
• Basic functions like planning, budgeting, decision-making and control
purposes.

C) Prospective investors, to ascertain:

• Earning capacity of the business
• Solvency or financial strength of the business
• Ability of the management
• Decision to invest in a business

D) Creditors/ Banks, to find out:

• The borrower's capacity for repayment
• Whether to grant a credit or advance money to a business
• The limits of advance, or credit limits for a customer

E) Employees/ Unions
• To discuss and arrange labour contracts
• To be assured of steady employment
• To determine the ability of the business to pay higher wages

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F) Tax inspectors/ Government

• To evaluate tax returns to calculate tax payable by the business
• To check that the business is following the government rules and
regulations
G) General Public
• To know the effect of pricing on customers
• To judge the ability of the firm to survive and honour it's product
warranties

1.4 TYPES OF BUSINESS

Any business can be operated as a sole trader, a partnership, or a company.

a) Sole Trader
Features
• This is a one-man show
• Capital put in by the owner
• Business is run by the proprietor
• Profits and losses at the year-end are taken over by the proprietor
• Usually small retail establishments
• Unlimited liability

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b) Partnership
Features
• Minimum 2 people, maximum 10 or 20, depending upon the type of
partnership
• Capital contributed by all partners
• Every partner has a right to participate in the business
• Each partner acts as the principal and agent of the firm
• Profits or losses at the end of the year are shared in the agreed ratio
• Usually professionals like doctors, lawyers, accountants, etc
• Unlimited liability

c) Company
Features
• Largest form of business organisation
• Capital contributed by the public, who are joint owners of the company
• Can be public or private
• Separate legal entity
• Registered under the company's act
• Ownership and management is usually separate
• No limit to the maximum amount of members
• Accounts must be prepared and audited yearly under the company's act

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1.5 COMMON ACCOUNTING TERMINOLOGY

Key terms Definition

Capital Resources supplied by the owners to the business.
Assets Resources owned by the business.
Liabilities What the business owes for the assets supplied.
Purchases Goods bought by the business for processing and selling
again.
Sales Goods sold by the business.
Purchase return/ Goods returned by the business to its suppliers.
Return outwards
Sales return/ Goods returned to the business by its customers.
Return inwards
Creditor A person to whom the business has to pay for goods and
services rendered.
Debtor A person from whom the business has to receive money for
goods and services supplied.
Inventories/ stock Unsold goods
Expenses Cost of operating the business
Revenue Money received for goods and services supplied by the
business.
Profit Revenue is more than expenses.
Loss Revenue is less than expenses.

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1.6 ACCOUNTING EQUATION

The concept of a balance Sheet is based on the accounting equation.

The Accounting Equation:

Assets = Liabilities + Owner's Equity

Business transactions are analysed according to their effect on the accounting

equation. The accounting equation must balance after each transaction is recorded.

1) Owners’ investment of cash increases both assets and owner’s equity.

2) Purchase of an asset (machinery) for cash increases assets (machinery) and
decreases assets (cash) (no effect on total assets).
3) Purchase of an asset on credit (on account) increases both assets and
liabilities.
4) Receipt of cash for service revenue increases both assets and owner’s equity.
5) Performance of services on account increases both assets and owner’s
equity.
6) Cash payment of expenses decreases both assets and owner’s equity.
7) Payment on account decreases both assets and liabilities.
8) Personal transactions of the owner do not affect the business, per the entity
concept.

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9) Collection of cash on account (debtors) increases assets (cash) and decreases

assets (debtors).
10) Sale of an asset (building) at a price equal to its cost increases assets (cash)
and decreases assets (building).
11) Declaration and payment of cash dividends decreases both assets and
owner’s equity.

1.7 TYPES OF FINANCIAL STATEMENTS

Under the company's act, the following 3 financial statements must be prepared and
audited yearly:
1) Income Statement or Trading, Profit and Loss Account
2) Statement of Financial Position or Balance sheet
3) Cash flows statement

An income statement records all the expenses and revenue for the year and shows the
net profit and net loss at the end of the year.

The statement of financial position is a statement that shows the value of assets and
liabilities at the end of the year. The statement of financial position is always "as on"
the last date of the financial year.

The items in the statement of financial position are classified as assets, liabilities or
owners’ equity. Assets are those items that are owned by the business, like building,
land, stock, etc. Liabilities are those items that are owed by the business, like

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creditors, loans, debentures, etc. Owners’ equity is the claim that the owner has on
the assets of the business, like capital, accumulated profits, etc.

A cash flow statement records all inflow and outflow of cash during a certain period.
It explains the difference between opening and closing cash.

1.8 COMPARING GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

(GAAP) AND INTERNATIONAL FINANCIAL REPORTING STANDARDS
(IFRS)

Accounting professions over the centuries has developed standards that are generally
accepted and practiced. This common set of practice standards is called generally
accepted accounting principles (or GAAP) and prescribed how economic events
should be recognised, measured and recorded in the financial statements.

Besides GAAP, most countries would have adopted International Financial

Reporting Standards (IFRS) that prescribed how various types of business
transactions should be recorded. Financial Reporting Standards are given legal status
under the Companies Act. This ensures that there is no conflict between the law and
accounting standards. Anyone preparing financial statements which are intended to
show a ‘true and fair view’ must observe the rules laid down in the accounting
standards.

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These IFRS is produced by the International Accounting Standards Board (IASB) to

achieve convergence in accounting standards around the world and IASB is
committed to developing a single set of global accounting standards that require
transparent and comparable information in financial statements.

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REVIEW QUESTIONS

Question 1.1

Classify the following into assets and liabilities:

a) Plant and machinery

b) Stock of goods

c) Loan from Mr. John

d) Motor vehicles

e) Creditors for goods

f) Owing to bank

g) Bank loan

h) Bank

i) Debtors

j) Prepaid rent

k) Premises

l) Cash

m) Bank overdraft

n) Repairs owing

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Question 1.2

Complete the following gaps:

Assets Liabilities Capital

£ £ £

10200 1500 ?

13000 ? 7000

16800 10500 ?

27600 ? 14320

? 4200 16800

? 9720 42780

Question 1.3

Draw up a simple statement of financial position using the accounting equation from the

following:

Debtors 7,425

Capital 35,625

Creditors 3,675

Furniture 8,550

Plant 8,250

Bank 13,200

Cash 1,875

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Question 1.4

David has the following assets and liabilities on 30 June 2011:

Cash 100

Bank 18,200

Debtors 14,425

Stock 15,375

Plant 15,725

Machinery 28,750

Creditors 9,875

Required:

Ascertain the capital

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