PowerPoint® slides to accompany

Financial Accounting: An Introduction 5e

ISBN 978 0 19 042552 4

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 Chapter 2

The purpose of accounting

 Learning outcomes
Understand
• the key business decisions made by the owner
• how a business makes the owner wealthier
• how the information is communicated in financial
reports
Basic identification of
• assets and liabilities
• income and expenses
Prepare basic financial reports
• Statement of financial position (SOFP)
• Statement of profit/loss and other comprehensive
income (SPLOCI)
 Accounting

What is accounting?
Accounting consists of two basic activities
• What is recording?
-What is the objective of recording?
• What is reporting?
-What is the objective of reporting?

5
 Objective of a business

What is the primary objective of a

business?
Can a business have other objectives?
Who cares whether a business
achieves its primary objective?
To whom specifically does financial
reporting report?
6
 Objective of a business
The objective of a business is to make
the owner (s) wealthier

So how does a business achieve this

objective?

What key decisions must the business

make – and make well
 Financing decision
• Where have the funds come from

EQUITY DEBT

Owner contributes funding Funding from third

to the business parties:
- Capital - Banks
- Other lenders

Business now has funding in the form of CASH or other

ASSETS
Investing decision
Funding in the form of cash

SWAP

Assets purchased
 Operating decision

ASSETS PROFIT/LOSS

USE

Business uses assets to make profit (or loss)

 So what is profit?

If the business earns more from

providing the service or product
(income) than it costs to provide the
service or product (expenses), the
business will make a profit.

PROFIT = INCOME - EXPENSES

 Distribution decision
PROFIT

What the owner chooses to do with profit

Take profit out of Leave profit in the

business business

Dividend/drawings Retained profit

 Key business decisions
 Financing decision
• Where have the funds come from?
• Owner (equity)
• Borrow from third parties (liabilities)

 Investing decision
• What have we done with the funding?
• Purchased assets for the business

 Operating decision
• Use assets to make profit

 Distribution decision
• What do we do with the profit?
• Leave in or take out?
 BIG PICTURE
Where have the funds come from

EQUITY DEBT

EQUALS

Assets purchased
USE
PROFIT

LEAVE IN TAKE OUT

 Entity concept
The accounting records are from the point of view
of the business. The affairs of the business are
kept SEPARATE to the affairs of the owner

Business records Personal information

EQUITY
Capital

Capital contribution

Drawings/Distribution

Owner makes initial

investment in the
business
 Have these transactions made
Judy wealthier?
Money received Money paid
Day Information Amount Day Information Amount
1 Deposited start-up 8 000 1 Purchased cellphone 1 200
capital
1 Borrowed money 2 000 1 Purchased trestle 950
from my sister table and chair

5 Sold 2 briefcases 600 1 Purchased 30 large 3 600

briefcases
5 Sold 1 handbag 60 4 Purchased 20 small Nil
black handbags −
still owe R600
6 Sold 4 briefcases and 3 Nil 7 Withdrew cash for 300
handbags − must still personal use
be paid R1 380
 Transaction 1
1 Deposited start-up capital 8 000

ASSETS EQUITY

Bank +8 000 Capital +8 000

Judy’s personal funds decreased by R8 000.

Her claim on the business assets amounts to R8 000
No change in wealth - change in type of investment (cash
in personal bank account to a claim on a business)
 Transaction 2
1 Business borrowed money from Judy’s 2 000
sister

ASSETS EQUITY
Capital 8 000
Bank (+ 2 000)10 000
LIABILITIES
Loan +2 000

The total assets of the business have increased by R2 000

Judy’s sister has a claim on the assets of R2 000
Judy’s (the owner’s) claim is still R8 000
 Transaction 3
1 Purchased cellphone 1 200
1 Purchased trestle table and chair 950

ASSETS EQUITY
Bank (- 2 150) 7 850 Capital 8 000
Cell phone +1 200
Furniture +950
LIABILITIES
Loan 2 000

The total amount of assets has not changed – the type of

assets have changed
Judy’s sister still has a claim on the assets of R2 000
The owner’s claim still amounts to R8 000
 Transaction 4
1 Purchased 30 large briefcases 3 600

ASSETS EQUITY
Bank (- 3 600) 4 250 Capital 8 000
Cell phone 1 200
Furniture 950
Inventory +3 600 LIABILITIES
Loan 2 000

The total amount of assets has not changed – the type of

assets have changed
Judy’s sister still has a claim on the assets of R2 000
The owner’s claim still amounts to R8 000
 Transaction 5
4 Purchased 20 small black handbags − still owe
R600

ASSETS EQUITY
Bank (- 3 600) 4 250 Capital 8 000
Cell phone 1 200
Furniture 950
Inventory (+600) 4 200 LIABILITIES
Loan 2 000
Trade Payables 600

The total assets have increased by R600

Judy’s sister has a claim on the assets of R2 000
Trade payables have a claim on the assets of R600
The owner’s claim still amounts to R8 000
 Transaction 6
5 Sold 2 briefcases 600
5 Sold 1 handbag 60
PROFIT = INCOME − EXPENSES
Income (How much we earned)
[2 × R300 + 1 × R60] 660
Expenses (How much it cost us)
[2 x R120 + 1 x R30] (270)
Profit 390

The cost of selling the 2 briefcases is R240 (2 ×

R120) and NOT R3 600 (30 × R120), which is
the cost of all the briefcases purchased
 Transaction 6
5 Sold 2 briefcases 600
5 Sold 1 handbag 60
EQUITY
ASSETS Capital 8 000
Bank (+660) 4 910 Retained profit (+profit) +390
Cell phone 1 200
Furniture 950
Inventory (-270) 3 930 LIABILITIES
Loan 2 000
Trade Payables 600

Total assets have increased by R390 (+660 – 270)

Judy’s sister has a claim on the assets of R2 000
Trade payables have a claim on the assets of R600
The owner’s claim has increased by R390
 Transaction 7
6 Sold 4 briefcases and 3 handbags − must still be N
i
paid R1 380 l

EQUITY
ASSETS Capital 8 000
Bank 4 910 Retained profit (+profit)
Cell phone 1 200 1 200
Furniture 950
Inventory (-570) 3 360 LIABILITIES
Trade Receivables +1 380 Loan 2 000
Trade Payables 600

Total assets have increased by R810 (+1 380 – 570)

Judy’s sister has a claim on the assets of R2 000
Trade payables have a claim on the assets of R600
The owner’s claim has increased by R810
 Transaction 8
7 Withdrew cash for personal use 300

EQUITY
ASSETS Capital 8 000
Bank (- 300) 4 610 Retained profit
Cell phone 1 200 (+profit - drawings) 900
Furniture 950
Inventory 3 360 LIABILITIES
Trade Receivables 1 380 Loan 2 000
Trade Payables 600

The owner takes cash to use in her personal capacity -

referred to as a distribution/drawings
This is a transaction with the owner (not an expense)
The owner’s claim on the business assets decreases
How was the profit calculated?
Cash increased Sales
Trade receivables Sales
increased
Inventory decreased Cost of sales

Sales R2 040 Why do the drawings of

COS (R840) R300 NOT affect the
Profit R12 00 profit calculation?
What assets does the business have and
how where they funded
EQUITY
ASSETS Capital 8 000
Bank 4 610 Retained profit
Cell phone 1 200 (+profit - drawings) 900
Furniture 950
Inventory 3 360 LIABILITIES
Trade Receivables 1 380 Loan 2 000
Trade Payables 600

Total assets 11 500 Total E and L 11 500

Assets of R11 500 funded by the owner (R8 900)

and liabilities of R2 600
So what assets does the business have
and how where they funded
ASSETS EQUITY
Capital 8 000
Bank 6 700
Retained profit (160 – 100) 60

Inventory 3 360 LIABILITIES

Loan 2 000

Total assets 10 060 Total E and L 10 060

 Financial reports

How will the business communicate the

business’ information to users?
Financial reports – the basics
• Statement of financial position
-‘Photograph’ of the business at a specific date
 Statement of comprehensive income
• How the business performed over a period
 Statement of cash flows
 How the business used or generated cash over a period
 Financial reports

Prepare at least ONCE a year

Financial year-end [12 month period] SOFP
 1 January to 31 December prepared
at 31/12
 1 March to 28 February
 1 July to 30 June
1/1 31/12
SOCI & SCF
prepared for the
period 1/1 –
31/12
Financial period
 Statement of financial position
Assets Intention of generating
Non-current assets benefit from their use for
Furniture and equipment 950 more than a year
Cell phone 1 200
Current assets In the form of cash,
Inventory 3 600 converted into cash, or
Bank balance 4 250 used within one year
Total assets 10 000

Equity and liabilities

Capital 8 000
Repayable over a period of
Non-current liabilities
more than one year
Loan 2 000
Current liabilities Repayable within one year
Total equity and liabilities 10 000
Statement of financial position

A photograph of the business at a point in time

A list of assets and how these assets have been
funded - equity or liabilities.
Equity
 Resources provided by owners
 Direct contribution - capital or profit left in the business -
retained income
Liability
 Resources provided by outside parties
 Assets
 An asset
• is a resource owned or controlled by a business,
• due to a past event,
• that is expected to generate future benefit for the business.
 Assets can be tangible
• (things we can see and touch), such as vehicles, land and
buildings, equipment and handbags
 Assets include claims on other people, such as
trade receivables
 Assets can be intangible
• (no physical substance) such as patents
 Assets

An asset is something that will be used in

the future to generate economic benefit for
the business.

When the economic benefit has been used

(or the resource has been sacrificed or
consumed), we say that the asset has been
expensed (used).
 How do we use up an asset?
 Prepaid airtime vouchers used to make phone calls.
COST of airtime vouchers used recognised as an
EXPENSE
 Cash used to pay for operating expenses e.g. wages.
COST of wages recognised as an EXPENSE
 Inventory sold to customers. COST of inventory is
recognised as an EXPENSE
 The furniture and cellphone used over a period.
The COST of using the cellphone each year is
recognised as an EXPENSE. This expense
(depreciation) will be covered in more detail in
Chapter 6.
 Liabilities
A liability
• is an obligation to settle an amount owing by the
business.
• The obligation must have arisen due to a past event.
• And will lead to the outflow of economic benefit from
the business.
 For example
• Where a business has received goods (such as
inventory) or services (such as using electricity) and has
not paid for it as yet.
 Liabilities

 Liabilities, often settled in cash (repaying loan or

paying for inventory bought on credit).
 Liabilities can be settled by providing a service
 An example
• Judy’s business received a deposit of R120 for a bag to be selected
and collected at a later date
• Until the bag is selected and collected, the business has an obligation
- offer bag/refund deposit.
• Business received R120 cash BUT will NOT recognise sales income
until client selects and collects the bag.
• The R120 is recognised as a liability i.e. unearned income.
 EQUITY

Direct contributions by the Profits generated by the

owner business and left in the
- Capital business
- Cash - Accumulated Profit, or
- Other assets Retained Income

Equity also referred to as the NET ASSET VALUE

Equity = Assets – Liabilities
OR
The residual value
 When is income recognised

When there is an increase in the NAV of the

business NOT as a result of a transaction
with the owner.
For example
• Sales income, rental income, interest income
 When are expenses recognised

When there is decrease in the NAV of the

business NOT as a result of a transaction
with the owner.
 For example
• Cost of sales expense, electricity expense,
salaries and wages expense
 Accrual Basis
Incomes – earned
• Are we entitled to receive payment
• Have we provided the service/product
• Has NAV increased not due to a transaction with the
owner
Expenses – incurred
• Have we used the benefit of the resource i.e. Cash to
pay expenses, inventory that has been sold (COS
expense)
• Has NAV decreased not due to a transaction with the
owner
 Accrual Basis

 If Judy’s business sells handbags to a customer

on credit, the business still records Sales income
even though it has not received cash – income is
earned and will be recognised.

 Judy’s business has a telephone. Every month

Telkom sends an account. The business has
incurred an expense (Telephone expense) even if
the account is not settled immediately.
 Accrual basis
6 Sold 4 briefcases and 3 handbags − must still be N
i
paid R1 380 l

EQUITY
ASSETS Capital 8 000
Bank 4 910 Retained profit (+profit)
Cell phone 1 200 1 200
Furniture 950
Inventory (-570) 3 360 LIABILITIES
Trade Receivables +1 380 Loan 2 000
Trade Payables 600

Trade receivables increase by R1 380. They owe us for the

goods. Income (sales) of R1 380 recognised
 Statement of comprehensive
income or SPLOCI

Two components:
 Profit/loss
• Income earned during the period less expenses incurred
during the period
 Other comprehensive income
• Specified losses and gains shown separately in this section
i.e. revaluation gains/losses
 Statement of comprehensive
income
SALES/TURNOVER
Rent received
Interest received
LESS COST OF SALES
GROSS PROFIT
Rent expense
ADD OTHER INCOME
Electricity
LESS OPERATING EXPENSES
Wages and
PROFIT BEFORE INTEREST salaries
Finance costs (interest expense) Depreciation
PROFIT FOR THE YEAR
OTHER COMPREHENSIVE
INCOME
Revaluation gain
TOTAL COMPREHENSIVE
INCOME
 Understanding profit

When do you calculate profit?

Various profit classifications
 Gross profit
 Operating profit
 Profit for the period
Statement of changes in equity
Capital Retained Total
profit
Balance as at 1 Jan X1 X X XX
Profit for the period X XX
OCI XX
Total comprehensive Movement X XX
income
Capital X during the year XX
Distributions/drawings (X) (XX)
Transactions with the X (X) XX
owner
Balance as at 31 Dec X1 XX XX XXX

47
 Accrual vs cash basis

 Accrual basis – recognises income when earned,

and expenses when incurred (regardless of when
the cash is received or paid)
 Cash basis – amounts are only shown in the cash
flow statements when the cash is ACTUALLY
received or paid (regardless of when earned or
incurred)
 Statement of cash flows - only statement NOT
prepared on the accrual basis
 Cash flow statement

SOFP – ‘photograph’ of the business on a

particular date
SOCI – performance of the business over a
period
SOCE – Reconciles the balance of the equity
accounts at the start of the year with the balance
at the end of the year
Statement of cash flows – shows the cash
inflows and outflows of the business
 Cash flow statement
 Provides an analysis of the business’ bank account
 Cash received (inflows)
• Cash from customers (sales)
• Cash from the owner (capital)
• Cash from lenders (liabilities)
 Cash paid (outflows)
• Buying assets i.e. inventory or vehicles
• Paying for expenses
• Repaying loans
• Drawings/distributions
 Profit = cash in the bank??

Cash
Profit
• Cash Sales
• Cash and credit • Expenses paid for,
sales regardless of used or
• Expenses incurred not
• Cash paid to purchase
assets
• Cash to/from owner
• Cash to/from lenders
 Cash flow statement
 Example:
Judy receives a telephone account on 30 January for R 1
500. She pays Telkom on 2 February.
 At 31 January:
 What expense has Judy incurred?
 What amount has Judy paid?
 At 28 February:
 What expense has Judy incurred?
 What amount has Judy paid?
 Cash flow statement

The business as a year end of 31 January

Judy receives a telephone account on 30 January X2
for R 1 500. She pays Telkom on 2 February X2.
 At 31 January X2:
• What amount will be recognised on the SOCI?
• What amount will be recognised on the SCF?
 At 31 January X3:
• What amount will be recognised on the SOCI?
• What amount will be recognised on the SCF?