ACC402- Foundation Accounting 1 Week 2 – Lecture Topic 1: The Accounting Environment- introduction of accounting elements and concepts

Lecture Objective After the completion of this lecture, student should be able to: Evaluate the applications of various concepts, conventions, principles and assumptions commonly adopted in accounting. Determine the characteristics of financial reports of business organization Explain the criteria use for identifying and recognition of assets, equities, revenues and expenses as stated in the conceptual framework.  

Accounting Assumptions (Convention) Is something which is generally accepted or taken for granted without a proof. It serve as a boundary lines within which all accounting concepts are defined and within which profit and financial position are determined. The accounting assumptions commonly accepted are:

Assumptions/Concepts/conventions Going concern Monetary Accrual basis Economic Substance Disclosure Accounting Period Historical cost Accounting Equation Matching Double entry Consistency Legal entity Accounting Entity Realization Materiality Objectivity Conservatism/Prudence

Accounting Entity Assumption It regards the business as being an entity or body separate from owners. As Accountants, we record the transactions from the viewpoint of the business and treat the owners as outsiders.Thus the business is the accounting entity.We keep the book of the business, not of the owners.The accounting entity may not always be the same as the legal entity, i.e the body which the law recognises as being responsible for debts and action of business

Monetary Assumption It assumes that all transactions are recorded in the common monetary unit in use, i.e in dollars and cents. Thus transactions that cannot be quantified in financial terms are not recorded in the main records. Such items may simply be disclosed by way of a footnote to the financial reports.

Historical Assumption Assumes that the business transactions are recorded in terms of their cost at the time the transaction occurred. It means that asset purchased a year ago are still recorded at their original cost even though their value is considerably higher now. This assumes that the dollar value remains unchanged over time. It is not true of course. It is now common practice to revalue assets regularly in order to overcome the deficiencies of historical cost.

Continuity (going concern)Assumption It assumes that the business is going to continue its operations indefinitely and is not likely to be liquidated in the foreseeable future.

Accounting Period Assumption It assumes that the life of the business is divided into arbitrary time periods.

Characteristics of Financial Reports Relevance It means applying the matter in hand. Therefore to be relevant an item must be meaningful, significant and / or substantial. For information to be relevant it must be assist users in decision making and evaluating decision. Also information is relevant if it confirms past information through feedback or helps to predict future information.

Reliability To be reliable, financial information must be credible, trustworthy and dependable. It must faithfully represent events, and be free from bias and error. Accounting data is neutral or free from bias when it is not altered, influenced or designed to suit the needs of a particular individual or group of users. Information which is reliable is supported by adequate documentation such as source documents.

Materiality It refers to the importance of an item to the particular entity. Information may be reliable and relevant, but for reporting purposes immaterial to the entity because of the relative size of the event, and so would not be reported. Materiality is a relative concept and so it needs to be determined with a particular organization in mind. What is material for one entity may be immaterial for another entity.

Comparability It is desirable to compare aspects of an entity over a period of time. It is also desirable to compare one entity with others and/ or with industry averages at a point in time or over a period of time. Consistent measurement and display is important if proper comparability is to be achieved.

Understandability Accountants should present information so that it is clear as possible without sacrificing relevance or reliability. Accounting is complex, and preparers should not misstate information by trying to over simplify its presentation. Given that preparers work under this assumption, users must exercise some diligence and proficiency in reviewing reports and seek advice where necessary

Basic Financial Elements of CF The financial elements are fundamental to the preparation of the statement of financial position and the statement of financial performance. The five elements are: Assets Liabilities Owners equity Expenses Revenues

Assets Are service potential or future economic benefits controlled by the entity as a result of a past transaction. This definition has three elements. To be an asset there must be some benefit that will accrue to the business in the future. For eg Motor vehicles will provide transport, and debtors will eventually turn into cash. The benefit must come about as a result of a past transaction

Assets cont’………… These benefit must be under the control of the business. This means the business must either be own or lease the asset so that the business has the right to decide how the asset will be used.

Liabilities Are the future sacrifices of service potential or of future economic benefits that the entity is presently obliged to make to other entities as a result of a past transaction or other past events. The definition has three elements: The obligation must have come about as a result of a past transaction. The obligation to make the sacrifice must exist at the date the liability is put on the statement of financial position.

Liabilities ………cont’ To be liability there must be a need to sacrifice economic benefits or service potential in the future. This means the business will be required to give up something in the future, usually cash. An eg repay mortgage in the future using cash generated by the business.

Owners equity It consists of the residual interests in the assets of the entity after the deduction of its liabilities.

Expenses Are consumptions or losses of service potential or future economic benefits in the form of reductions in assets or increases in liabilities of the entity other than those relating of reductions in assets or increases in liabilities of the entity other than those relating to the distributions to owners that result in a decrease in equity during the reporting period.

Revenues Are inflows or other enhancements or savings in outflow of service potential or future economic benefits in the form of increases in assets or reductions in liabilities of the entity other than those relating to contributions by owners that result in an increase in equity during the reporting period.

ACCOUNTING SYSTEMS Two Basis Commonly Used: Cash Basis Accounting System Recording only cash transactions No credits involved ‘cash’, ‘by cheque’, ‘paid’, ‘full settlement’, etc. Accrual Basis System Involves cash & credit transaction both “debtor’s& creditors’ names’, ‘on Account”, ‘ credit’,etc.

Basic Financial Statements Financial Position Economic condition Financial Performance Operating efficiency Cash flows Operating activities Investing activities Financing activiti

BASIC FINANCIAL REPORTS STATEMENT OF FINANCIAL POSITION STATEMENT Of FINANCIAL PERFORMANCE STATEMENT CHANGES IN OWNERS EQUITY STATEMENT Of CASH FLOW STATEMENT of DISCLOSURE NOTES

The Elements in Balance Sheet Assets Resources controlled by the entity as a result of past transactions or events from which future economic benefits are expected to flow to the entity Liabilities Present obligations of an entity arising from past transactions or events, the settlement of which is expected to result in an outflow of resources from the entity

The Elements in Balance Sheet (cont’d) Equity The residual interest of the owner/s in the assets (less liabilities) of the entity Assets - Liabilities = Equity or Net Assets = Equity

Assets = Liabilities + Equity STATEMENT OF FINANCIAL POSITION - The Balance Sheet Presentation (T-Account Format) DON’S AUTO REPAIRS Balance Sheet as at 30 June 2007 ASSETS LIABILITIES Cash at Bank $ 50 340 Accounts payable $ 20 760 Accounts receivable 17 790 Mortgage payable 201 000 Repair supplies 14 610 221 760 Repair equipment 110 700 Land 60 000 EQUITY Building 255 000 Don Brady, Capital 286 680 $508 440 $508 440 Assets = Liabilities + Equity

Assets – Liabilities = Equity Balance Sheet - Vertical Format ASSETS Cash at Bank $ 50 340 Accounts receivable 17 790 Repair supplies 14 610 Repair equipment 110 700 Land 60 000 Building 255 000 TOTAL ASSETS 508 440 LIABILITIES Accounts payable 20 760 Mortgage payable 201 000 TOTAL LIABILITIES 221 760 NET ASSETS $ 286 680 EQUITY Don Brady, Capital 286 680 TOTAL EQUITY $ 286 680 Assets – Liabilities = Equity

The Elements in Income Statement Inflows of or savings in outflows of economic benefits that result in an increase in equity during the reporting period Expenses Decreases in equity representing the consumption or loss of economic benefits in the form of reductions in assets or increases in liabilities other than distributions to owners

Statement of Financial Performance - The Income Statement DON’S AUTO REPAIRS Income Statement for the year ended 30 June 2007 INCOME Repair revenue $442 500 EXPENSES Advertising expense $ 20 250 Repair supplies expense 91 710 Salaries and wages expense 127 800 Rent expense 40 260 Telephone expense 20 190 Light and Power expense 47 940 348 150 PROFIT $ 94 350

Statement of Changes in Equity DON’S AUTO REPAIRS Statement of Changes in Equity for the year ended 30 June 2007 Don Brady, Capital - 1 July 2006 $ 237 330 Net profit for the year 94 350 331 680 Less: Drawings 45 000 Don Brady, Capital - 30 June 2007 $ 286 680

Thank you 