Professional Documents
Culture Documents
OBJECTIVES
Knowledge
• Explain why a business needs an accounting system.
• Identify the three classes of users of accounting information.
• Explain the various forms of ownership and the different types of business.
• Explain the initial definition of Accounting.
• Explain the qualitative features of accounting and the underlying assumptions in
the recording of transactions and the preparation of financial statements.
• Explain the difference between the viability of a business and the need for a proper
cash flow in order to meet the immediate cash needs of the business.
• Have an initial understanding of the role of the three major financial statements.
• Explain the concept and understand the logic of the accounting equation.
Analytical skills
▪ To analyse the transactions using the accounting equation and to draw up a
simple statement of comprehensive income and Statement of Financial
Position
Communication skills
▪ Present logical ,structured discussion on the need for financial information
▪ Explain why a business would choose a certain form of ownership
Introduction
In order to survive, every business needs to ensure that the business is viable
and that it has sufficient cash resources to continue in business. To be viable
a business must ensure that the price of the goods or services it provides to its
customers is sufficient to cover the cost of those goods or services and provide
an acceptable return to the providers of capital. In other words the business
must make a profit.
The owners and managers of a business will never know if the business is
making a profit or if it has sufficient cash resources unless there is an orderly
system of accounting capable of producing timely and accurate reports. In fact,
accounting has no other function but to produce reports on which economic
decisions can be made.
1. Primary users.
Investors
These are the providers of risk capital and they would be concerned with
the risk and return of their investment. These are persons or institutions
with an ownership interest in the business. They may or may not have a
management role in the business but as owners they are interested in their
investment in the business and the accounting reports will be part of the
information they need to make decisions on whether to hold, invest or sell
their investment. Potential primary users would have similar information
needs and this would aid their decision to invest or not invest in the
business.
2. Secondary users.
Those with a financial but not an ownership interest. This would include
management, lenders, employees, suppliers and customers. Although
these groups are classed together, their needs and the level of information
would differ greatly. For example, management would receive detailed
information on a daily, weekly or monthly basis. Customers on the other
hand, may not be interested in any information at all unless they are large
customers buying a critical product from the business. In this case, their
continued existence may be bound to the continued existence of their
supplier and a regular examination of financial reports may alert them to
potential problems in the future.
3. Tertiary users.
The financial statements interrelate because they reflect different aspects of the
same transaction or event.
Financial statements prepared for this purpose meet the common needs of
most users. However they do not provide all the information since they portray
past events and do not necessarily provide non-financial information.
So what is accounting?
▪ IFRS and IAS are a set of rules and regulations that have been developed
over the years between industry and the profession.
▪ IFRS and IAS are a standard or benchmark – these standards can be
defined as authoritative and generally accepted guidelines for the recording
and measuring of financial information in the annual financial statements.
These standards are documents issued by standard setting bodies.(IASB)
▪ IFRS and IAS aids comparisons and fair presentation.
▪ IFRS and IAS are a common set of rules which make comparisons and
conclusions acceptable.
The profession in South Africa has moved towards total harmonization with
International Finance Reporting Standards (IFRS).
All financial statements are produced using two basic underlying assumptions:
Another aspect of the entity convention is that drawings by the owner are not
considered to be business expenses, but cash or other assets taken by the
owner for his personal use. We will learn later how other business forms viz.
the close corporation and limited liability company overcome the legal problems
of the entity convention.
Qualitative characteristics are the attributes that make the information provided
useful to the users.
These notes will not go into such statements in detail but below is a summary
of what these statements are attempting to achieve:
• Materiality
The relevance of information is affected by its nature and materiality.
Business transactions are a seamless operation taking place day after day in
the life of a business. Accounting however has to introduce the concept of time
periods mainly to compare the results of one period with another. All
businesses are required to have a “year end”, to comply with tax regulations, or
the requirements of the Companies Act , or the Stock Exchange in the case of
listed companies.
Thus the longest financial reporting period for a business is a year; within that
year it may also prepare financial statements for each month, each quarter or
for the half year.
All businesses whether large or small, need to keep records of their financial
transactions. Not all will keep their records in the precise way we shall explain
in the next chapter, but most will have some sort of record, especially of their
cash transactions, sales to customers and details of amounts owing to them by
customers. For goods or services purchased they will keep the invoice or till
slip.
Even from such records, it is possible to draw up financial statements that will
measure the profit or loss made in a particular financial period and show the
net worth of the business at the end of that period. It will also be possible to
show where the cash has come from and how it has been spent during that
period.
To illustrate these concepts we will take a very simple business and follow it
through from its start-up through to its first month of trading.
Jack was a young man in his early twenties who had worked for a large
pharmaceutical company. He was retrenched during the global economic crisis
and had received a payment of R30 000 and some guidance on running a small
business before leaving the pharmaceutical company.
Informal traders were allowed to operate in the precincts of the stock exchange
but had to register with the property administrators and pay a rental of R300
per month. In return they were provided with a space within a covered area
and the number of informal traders was restricted.
• A few days before he started trading, Jack registered with the property
administrators and paid R300 for the first month’s rental.
• He gave R6 000 of his package (from the pharmaceutical company) to
his sister to help pay for her wedding gown and her wedding cake. Soon
he would be a wealthy businessman and would be able to throw her an
exquisite wedding!
• He bought some chairs and a specially constructed reflexology bed with
a built-in cupboard for his equipment. This all cost R1 440.
• He also paid R195 for some bottles of aromatherapy oils. These were
fully used in the first few days of trading, so more oils would be needed
• In a rash moment after seeing an advert, he bought a second-hand cell-
phone for R900 and a Vodago two-month airtime voucher for R300. He
rationalised that this would enable his clients to phone him for
appointments.
• The balance he put into a savings account at the nearby Capitec Bank.
At the course he attended he was advised to keep a notebook of all his
receipts and payments.
• He charged R20.00 for a foot massage.
At the end of the first month, Jack was dismayed to find that he had less money
in his savings account than he started with and he asks Solly (as a valued
customer) to tell him where he has gone wrong. Solly gets Jack’s notebook and
discovers the following (in addition to the information above):
- Money received for massages R2520
- Bought more essential oils (oils fully used for the month) R960
- Taken for personal use R1800
Activity
From the information above, draw up a "cash book" showing all the receipts and
payments to date, and the balance in Jack's savings account. Think of reasons why
he should or should not be dismayed at what he sees.
Solution
Cash received
Received from customers 2 520
Cash payments
Rental paid (300)
Oils (195+960)
Airtime (300)
Profit 765
Drawings (1800)
is a cash paymnet
and should be under Furniture/Equipments (1440)
"cash received"
Cellphone (900)
Capital (30k-6k) 24 000
The first thing Solly does is draw up a statement showing where the cash has
come from and where it has gone. Later in the course we will learn about the
cash flow statement and how this should be drawn up.
He made …………..
R2520
cash from the reflexology operation and together with the
initial …………… he started with, would have given him …………..
R20 865 R23 385
He won’t have to buy any beds or cellphones next month, but if he draws more
money for his personal use than he is making from the operation, he will soon
have no money left.
Obviously the cash statement shown above shows only the cash movements
for the month, but if we are to draw up a statement showing how much profit
Jack has made, we must use the accrual basis. This means that we must show
all the transactions for the month that affect the income and expenditure
regardless of when the cash was paid.
(6000)
(1440)
195
900
300
960
1800
20 656
*Jack reckons that the furniture will last about five years and will not be worth
anything after that. The cellphone will last about three years after which he can
probably sell it for R144. So the use of the furniture for the first month is R1440
/ 60, and the use of the cellphone is R900-144/36. Later in the course we will
look in more detail at the concept of writing off long-term (or fixed) assets.
From this statement we can see that Jack earned ………… using the accrual
basis of accounting. This is the measure that he should use to gauge how much
he can draw out for his personal use. If he draws out more he will in time
exhaust all his capital; if he draws less he will build up his capital and personal
wealth.
R
Assets
Furniture (1440 – 24) 1 416
Cellphone (900 – 21) 879
Airtime voucher (300 – 150) 150
Savings account
Liabilities -
Net worth of business
Original capital
Profit
Drawings (1 800)
If Jack had drawn out only R870, the net worth of his business at the end of the
first month would be R……………, i.e. the original capital put into the business.
However, he drew out R……………. more than the profit made and this reduced
the net worth of the business to R………….
▪ Cash flow statement reflects the ability of the entity to generate cash and
cash equivalents and the needs of the entity to utilise those cash flows
For an item to be incorporated into the financial statements it must meet the
definition of an element of the financial statements and must satisfy the
following
• that it is probable that any future economic benefit associated with the item
will flow to or from the business
• the item has a cost or value that can be measure reliably.
Note that for any business, the only sources of finance are owner’s equity
and/or borrowings from third parties (i.e. liabilities).
If the owner’s equity is the difference between assets and liabilities, then we
can state the above three elements in an equation:
Assets are represented by a number of different items from non current assets
such as property, plant and equipment (land and buildings, plant and machinery
and motor vehicles), to current assets such as inventory, accounts receivable
and cash.
Liabilities consist of amounts owing to third parties such as banks and finance
houses, and suppliers of goods and services.
Income is defined as
▪ increases in economic benefits during the accounting period in the form of:
• inflows or enhancements of assets,
• that result in increases in equity, other than those relating to contributions
from owners.
▪ Owner introduces cash to start the business; increase an asset (cash) and
increase the owner’s capital.
▪ Business buys a motor vehicle for cash; increase one asset (motor vehicles
and decrease another asset (cash).
▪ Business buys a motor vehicle by using bank finance; increase assets
(motor vehicles) and increase liabilities (bank loan)
▪ Owner brings his motor vehicle into the business; Increase assets (motor
vehicles) and increase owner’s equity (capital).
▪ Business sells goods for cash; increase asset cash, and increase income
(under owner’s equity)
▪ Business buys stock on credit; increase asset stock, and increase liability
accounts payable.
There are obviously many more examples that could be given, in fact as many
examples as there are business transactions. In the next chapter we will deal
with the accounting procedures that deal with such transactions in a way that
keeps the accounting equation in balance at all times.