Accounting Concepts Andrew Graham Queens University School of Policy Studies

Canadian Publci Sector Financial Management 2 “Accounting is the fairest invention of the human mind.” - Goethe

Canadian Publci Sector Financial Management 3 "It's not the economy anymore, stupid. It's the accounting." Source: Browning, E.S. and Jonathan Weil. "Burden of Doubtful:Stocks Take a Beating As Accounting Worries Spread Beyond Enron." The Wall Street Journal, January 30, 2002, pp. A1.

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5 The Accounting Module The module will focus on: A set of principles for the creation of accounting practice –What is accounting –Users of accounting information –Financial accounting and Managerial accounting –Generally Accepted Accounting Principles Accrual Accounting and Budgeting A set of financial statements –Understanding financial statements –Using financial statements

Canadian Publci Sector Financial Management 6 A History of Accounting Some scholars claim that writing arose in order to record accounting information. Account records date back to the ancient civilizations of China, Babylonia, Greece, and Egypt. The rulers of these civilizations used accounting to keep track of the cost of labour and materials used in building structures like the great pyramids. The need for accounting has existed as long as there has been activity involving money or resources.

Canadian Publci Sector Financial Management 7 Accounts Table with Cuneiform Script, circa 2400 BC by Mesopotamian Bookkeeper

Canadian Publci Sector Financial Management 8 A History of Accounting Accounting developed further as a result of the information needs of merchants in the city-states of Italy during the 1400s. The monk Luca Pacioli, a mathematician and friend of Leonardo da Vinci, published the first known description of double-entry bookkeeping in 1494.

Canadian Publci Sector Financial Management 9 Each financial event is called a transaction The effect of a transaction is recorded in the accounts by an entry Each entry will affect at least two parts of the accounting record to balance the record This does not mean that the financial event is recorded twice – rather it is balanced against either costs, increased or reduced liability, changes in inventory, etc. Double-Entry Accounting

Canadian Publci Sector Financial Management 10 Double Entry Accounting The double-entry system provides checks and balances to ensure that your books are always in balance. In double-entry accounting, every transaction has two journal entries: a debit and a credit. Debits must always equal credits. Because debits equal credits, double-entry accounting prevents some common bookkeeping errors. Errors that aren't prevented are easier to find. Double-entry accounting is the basis of a true accounting system.

Canadian Publci Sector Financial Management 11 You provide consulting services, on account, to one of your regular customers, Betty Fry, for $1,500. When you write up the invoice, you would make the following bookkeeping entry in your sales journal: DebitCredit Accounts receivable (Fry)1,500 Consulting revenue1,500 Upon receipt of the invoice, your customer sends you a check for $1,500 in payment of her account. When you receive the check, make the following entry in your cash receipts journal: DebitCredit Cash1,500 Accounts receivable (Fry)1,500

Canadian Publci Sector Financial Management 12 A History of Accounting In the Industrial Revolution of the nineteenth century, the growth of corporations spurred the development of accounting. The corporation owners—the shareholders—were no longer necessarily the managers of their business. Managers had to create accounting systems to report to the owners how well the company was performing

Canadian Publci Sector Financial Management 13 What is Accounting? Accounting and its boundaries are dynamic in nature, always responding to new needs as they arise. The boundaries of accounting are fuzzy and changeable as a result Accounting is both an art and a science that involves judgement and molding information to the demands of the situation while being to claim objectivity and independence.

Canadian Publci Sector Financial Management 14 What is Accounting? Identifies, measures and communicates financial information Focuses on economic entities Provides this information to interested parties, these being the users of financial information Provides this information with the purpose to assist the organization in reaching its stated goals Enhances the understanding of what is being measured as well as providing information for decision making.

Canadian Publci Sector Financial Management 15 Managerial and Financial Accounting  Managerial Accounting: Internal Focus.  Plan  Implement  Control  Financial Accounting: External Focus.  Record events or transactions.  Report financial position and results of operations.

Canadian Publci Sector Financial Management 16 Managerial and Financial Accounting Financial accounting has tended to concentrate on ensuring that their legislative and stakeholders interests of external users are met through reporting at clearly defined frequencies, with high level information oriented toward meeting their general information needs. Management accounting will be highly flexible in format

Canadian Publci Sector Financial Management 17 Managerial and Financial Accounting Management accounting information is designed to meet the needs as they emerge within the organization. Financial accounting will be considerably less flexible in format, often conforming to government-wide reporting formats.

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Canadian Publci Sector Financial Management 19 Accounting for Management Planning Optimal Management of Allocated Resources – Cash Management Performance Reporting FuturePresent Past

Canadian Publci Sector Financial Management 20 Managerial and Financial Accounting Both forms of accounting information have to derive from the same basic financial information, They use the same chart of accounts and the same financial accounting technology that is in use in the organizations. At times, internally reported information has to be reconciled with external reporting.

Canadian Publci Sector Financial Management 21 Chart of Accounts – An example Budgetary Accounts Expenditures –Economic Compensation of Employees Use of Goods and Services Consumption of Fixed Capital Interest Subsidies Grants Social Benefits All Others

Canadian Publci Sector Financial Management 22 Chart of Accounts - Continued Expenditures (continued) –Functional (10 major classes) General Public Services Defense Public Order and Safety Economic Affairs Environmental Protection Housing and Community Amenities Health Recreation, culture, and religion Education Social Protection

Canadian Publci Sector Financial Management 23 Chart of Accounts - continued Revenues (4 major classes) –Taxes –Social Contribution –Grants –All Others Assets Liabilities Net Assets

Canadian Publci Sector Financial Management 24 Managerial and Financial Accounting External financial reporting requirements by law and generally set as a matter of governmental policy, even for the voluntary sector Highly unlikely that it will be used actively within the organization : why: timeliness, level of generality, gathered for differing purposes Senior levels of management, however, and also at the political level, the organization has to be able to explain and defend the financial reports as they are made public

Canadian Publci Sector Financial Management 25 The Financial Statements – More to Follow n Balance Sheet - a snapshot of the resources, obligations, and worth of an organization at a specific point in time ( think stock). n Income Statement - measures the cumulative resource inflows and outflows for an organization over some specified period of time. It is the reporting equivalent of an operating budget (think flow). n Cash Flow Statement - measures the cumulative cash inflows and outflows for an organization over some specified period of time. It is the reporting equivalent of a cash budget (think flow).

Canadian Publci Sector Financial Management 26 Users of Public Sector Financial Statements The public – who cares and why? The opposition Legislative auditors Interest groups Other governments in the country Foreign governments Foreign firms International monitoring agencies Credit rating organizations

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Canadian Publci Sector Financial Management 28 Users of Public Sector Financial Statements Internal and external users of accounting information that is generated for an organization differ in their use of it in the following areas: Access Frequency Detail Timing Required expertise and understanding, and Response

Canadian Publci Sector Financial Management 29 Users of Public Sector Financial Statements Access: –for internal users, it is direct, unlimited and detailed –for outsiders, it is summary, higher level

Canadian Publci Sector Financial Management 30 Users of Public Sector Financial Statements Frequency: –for internal users, as needed, depending on level of focus –for outside users, it is generally on a quarterly or annual basis Detail: –for internal users, as micro as needed, –for external users, higher level and generally summarized

Canadian Publci Sector Financial Management 31 Users of Public Sector Financial Statements Timing: –for internal users, the information is current or recent and focused on decision –making and short-term adjustments –For external users, the information is retrospective and applicable for assessing performance against plans

Canadian Publci Sector Financial Management 32 Users of Public Sector Financial Statements Required expertise –For internal users, the financial information is complex, requiring a detailed appreciation of its significance for operations, performance and results –For external users, it requires an understanding of the organization, but not in detail

Canadian Publci Sector Financial Management 33 Users of Public Sector Financial Statements Response –Internally, the information will lead to action and decisions –Externally, it will depend on the perspective of the user, but it will generally be associated with forming a view of the performance of the organization

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Canadian Publci Sector Financial Management 35 GAAP

Canadian Publci Sector Financial Management 36 Generally Accepted Accounting Principles (GAAP) n Provide guidance on the creation of financial reports n Set out by the Canadian Institute of Chartered Accountants: CICA Handbook n American and International equivalents n Originally focused on private sector accounting but now there are separate public and not-for- profit handbooks

Canadian Publci Sector Financial Management 37 Governments and GAAP Does not have the force of law (in Canada – recent American legislation imposes a form): created on basis of general acceptance For senior governments in Canada, these standards are “generally accepted” in the true sense of that phrase. The federal, provincial and territorial governments are sovereign governments. They can’t be forced to follow the standards. Yet, there is a very high voluntary compliance with the standards in the CICA PSA Handbook.

Canadian Publci Sector Financial Management 38 GAAP Principles Entity Concept –Requires that you define the organizational component for which you are trying to account –The unit standards apart from other organization and individuals as a separate economic nut –From an accounting perspective, sharp boundaries are drawn around each entity so as not to confuse its affairs with those of other entities

Canadian Publci Sector Financial Management 39 GAAP Principles Money Denominator/Stable Monetary Unit Concept –Requires that all items included on the financial statements be measurable in dollar (yen, Euro) terms –Generally ignores effect of inflation on value of currency unit within a specific time period unless it is material

Canadian Publci Sector Financial Management 40 GAAP Principles Objective Evidence/ Reliability Principle –Require that values be based on an objective valuation of resources –Reliable data are verifiable –Verifiable by an independent observer

Canadian Publci Sector Financial Management 41 GAAP Principles Cost Convention –When there is a dispute over value, cost is used –Acquired assets and services should be recorded at their actual or historical cost –Accounting records should maintain the historical cost of an asset for as long as the business holds the asset

Canadian Publci Sector Financial Management 42 GAAP Principles n Conservatism n Says that you should anticipate losses but not gains n Need to give due regard for risk and risk management n Role of prudence in predicting and reporting

Canadian Publci Sector Financial Management 43 GAAP Principles n Going Concern Concept n Assumes that the organization will continue in operation n Assume the business will remain in operation long enough to use existing assets for their intended purpose n Bankruptcy values may be lower

Canadian Publci Sector Financial Management 44 GAAP Principles Materiality –Reporting only needs to contain the level of detail necessary for decision making –Don't need to be accurate to the penny or even the nearest $1,000 in some cases –A piece of information is material if it would affect a decision maker’s decision

Canadian Publci Sector Financial Management 45 GAAP Principles Accrual Concept –Revenues are recorded when the organization is entitled to them –Expenses are recorded when resources are used to generate revenues

Canadian Publci Sector Financial Management 46 GAAP Principles: Constraints on Providing Financial Information Benefits must exceed costs – Benefits of the information produced should exceed the costs of producing the information –Financial (and all managerial) information is not costless

Canadian Publci Sector Financial Management 47 A “clean” audit report on the financial statements. This means that an external auditor has expressed no reservations or concerns about the information reported in the financial statements, how the information is reported or whether any information appears to be missing. A note to the financial statements (generally Note 1) outlines the accounting policies a government has used in preparing the statements. This note may also tell you if a government’s financial statements are prepared in accordance with GAAP. What to look for to assure GAAP Compliance: