ACC30105 Principles of Accounting

LECTURE 1:Understanding Accounting

Equation Concept

Learning Objectives…After studying this chapter, you should be able to: Explain the nature of accounting and its main

function Identify the users of accounting information Understand the role of accounting in decision

making Understand the differences between accounting for

management and accounting for external users Understand the importance of ethics in business Understand the different areas of the economy in

which accountants work

What is Accounting?

A service activity To provide and interpret financial

information which is useful for making economic decisions

Definition of Accounting…

The process of identifying measuring recording communicating economic information to allow informed judgments and economic decisions by users of the information.

Role of Accounting in Business…

People make decisions

Business transactions happen

Accountants prepare reports to show the results of business operations

Types of Business Entities…

Sole traders Partnerships Companies

Sole Traders… Owned by one person Owners supply cash/assets to business Owners entitled to all profits Owner legally liable for debts Not a separate legal entity But is a separate accounting entity

Partnership… A relationship between two or more people,

carrying on a business with the aim to generate profits

Three main criteria: Must have agreement (oral or written) between

two or more legally competent persons or entities to carry on a business

An aim to earn profits Members must be co-owners of business

Partnership…

Partners supply resources and share profits Not a separate legal entity Individual partners are personally liable Is a separate accounting entity

Characteristics of Partnership…

Mutual agency Unlimited liability

Characteristics of Partnership…

Partnership interest can be sold off legally Limited Life

can be dissolved through death of a partner bankruptcy of partnership or individual partner expiration of period specified in contract judgment by court

Companies…

Limited company by shares personal liability of members is limited to the par

value of their shares and the number of shares taken by them

Advantages and Disadvantages of Different Types of Business

Entity Sole Proprietorship: Advantages easy and least expensive form of business owner in complete control owner receives all income easy to dissolve

Sole Proprietorship: Disadvantages unlimited liability owner personally liable limited source of funds hard to attract talented employees

Advantages and Disadvantages of Different Types of Business

Entity Partnership: Advantages pool resources and multiple skills easier and less costly to establish not subject to much government regulation/supervision flexible – not subject to board of directors tax advantages

Partnership: Disadvantages unlimited liability can be liable for other partner’s actions in relation to the

partnership limited life

Advantages and Disadvantages of Different Types of Business

Entity Companies: Advantages limited liability broad source of capital continuity of existence transferability of shares use of professional management

Companies: Disadvantages greater regulation separation of ownership and management higher cost of incorporation

Basic Accounting Terminologies…

Assets resources controlled by the entity result of past events future economic benefits expected to flow into

the entity the amount can be reliably measured

Basic Accounting Terminologies (con’t)…

Liabilities present obligation of the entity arising from past events settlement expected to result in outflow of

economic benefits from the entity the amount can be reliably measured

Basic Accounting Terminologies (con’t)…

Income/Revenue increase in economic benefits inflows or enhancements of assets decrease in liabilities not including receipts from shareholders/business

owners

Basic Accounting Terminologies (con’t)…

Expenses decrease in economic benefits outflow or depletion of assets

Basic Accounting Terminologies (con’t)…

Capital/Equity resources supplied by the owners/shareholders

Users of Accounting Information… Internal and External Users

Internal Employees Managers Chief Executive Officers (CEO) General Managers Accounts Managers Special Purpose Financial Report

Users of Accounting Information (Con’t)…

External Shareholders Lenders/Bankers Potential Investors Creditors Government General Purpose Financial Report

Management and Financial Accounting

Management Accounting concerned with providing financial and other

information to all levels of management

Financial Accounting concerned with reporting information to users that

are external to an entity/business.

Accounting Concepts…

Established concepts to guide the preparation of financial statements

To ensure objectivity and consistency in the way financial information is prepared

Historical Cost Concept/Cost Concept

Assets are normally shown at cost price and this is the basis for valuation of assets so that every one can agree on the same amount

Meaningful comparison can be made

Money Measurement Concept/

Monetary Assumption Money is used as the common measurement by which economic activity is measured and reported

Accounting information is concerned with the following: measurable in monetary units most people will agree to the measurement used

Business Entity Concept/Accounting Entity Concept

Activities of the entity are separated from both the personal activities of the owners and other entities

The only time when the owners’ resources affect accounting record is: owner brings in new/additional capital drawings (money, inventory, other assets)

Separate Legal Entity Concept

A company is not seen as being exactly the same as its shareholders/owners

A company can sue one or more of its shareholders

A shareholder can sue the company Only apply to Limited Company

not partnership and sole proprietorship

Dual Aspect Concept

There are two aspects of accounting assets of the business claims against those assets

These two aspects are always equal to each other Assets = Capital + Liability

Time Interval Concept/ Period Assumption

Life of an entity can be subdivided into arbitrary time periods of equal length

For periodic determination of financial performance and financial position

Reports can be monthly/annually/quarterly Term

accounting period

Accrual Basis Assumption

The effects of all transactions and other events are recognized in the accounting records during the period in which they occur

Not when cash is received or paid Provides better information for users

Going Concern Assumption/ Continuity Assumption

Financial reports are prepared under the assumption that the entity will continue to operate for the foreseeable future

Foreseeable future 12 months

Disclosure of Accounting Policies…

Accounting policies used must be disclosed in the notes to the accounts

e. g., depreciation methods, valuation of inventory

Qualitative Characteristics of Financial Statements

Understandability Relevance Free or error Substance over form Neutrality Prudence Completeness Comparability

Understandability

Information in financial statements should be readily understandable by users.

Relevance

Information relevant for users’ decision making

Material information are relevant Information is material if its omission or

misstatement could influence decisions of users.

Every information that appears in financial statements should be material

Substance Over Form

The legal form of a transaction is different from its real substance e. g., car on hire-purchase legally, the car belongs to the bank until

installments are fully paid however, the car is used by the business and

generating benefits from it therefore, the business will treat it as an asset

Neutrality & Completeness

Neutrality Information in financial statements is free from

bias Completeness

Information presented in the financial reports should be complete

Prudence

Accountants must exercise caution when dealing with uncertainty

Do not overstate assets and income Do not understate liabilities and expenses

Comparability

Comparability requires consistency Treatment of transactions must be consistent

throughout an entity and over time for that entity

Then only financial information is comparable

Accounting as a Profession…

Public Accounting Auditing and Assurance Services Taxation Services Advisory Services Insolvency and Administration

Accounting as a Profession…

Accountants in Commerce and Industry General Accounting Cost Accounting Accounting Information System Budgeting Taxation Accounting Internal Auditing and Audit Committee