Accounting Week 1:

1.1

The basic purpose of financial accounting:

Accounting is the process of identifying, measuring, recording and
communicating economic information to assist users to make informed
decisions.
Accounting systems are often described
as financial accounting systems or
management accounting systems.
Financial accounting measures an
enterprises performance over time and
its status at a certain point in time. In
other terms, financial accounting
measures the financial performance
and financial position of an
enterprise in order to evaluate whether
it has performed well and is in good shape.
Financial performance: generating new resources from day-to-day
operations over a period of time.
Financial position: enterprises set of financial resources and obligations
at a certain point of time.
Financial statements: reports describing financial performance and
position
Notes to the financial statements add explanations to the numbers
and values recorded.
Financial accounting systems are audited (the examination of procedures
required to prepare financial statements, reflecting the true position of the
enterprise) before distributed to its external decision makers.

1.2
Users of accounting information and the decisions they based on
this information.
Stock market investors to determine whether they should buy, sell or
hold shares of companies. Shareholders invest to acquire a return, and
therefore require accounting information to determine if they will attain
one.
Banks and other lenders to decide whether or not to lend money. They
will interpret accounting information to determine if the enterprise is meet
its financial obligations. To review the companys borrowing status.
Management: To make business decisions on day to day operations, to
determine if it is efficient and effective, for control, insurance and as fraud
prevention (embezzlement, etc)
Governments: To monitor the actions of enterprises and to assess taxes
such as income tax and GST. ASIC utilises accounting information to
determine the financial position and performance of a company before its
initial public offering.
Trade Unions: are interested in the profitability of the company in order
to demand or support increased employee wages, demand
superannuation contributions and to assess job security of its members.
Other users:

1.3

To evaluate the CEOs performance by a member of the board of directors

to determine if they are effectively achieving the organisations goals
Used by suppliers to determine if they should establish a supply contract
on the basis of whether the company will be able to pay for its regular
shipments.
Competitors in order to determine if their current actions are successful
and providing them with an advantage over the entity. Competitors may
try to use financial information to try to understand the enterprises
operation and thus attempt to overtake or better them.
Customers: considers if entity is sound and trustworthy, especially in the
cases where customers must pay in advance.
People involved in financial accounting:

The main people involved in financial accounting includes:

The information users (the decision-makers): Makes decisions on the

basis of financial statements, on his or her behalf or on behalf of a
company, bank or other organisation
The main group of users are mentioned in 1.2.
The information users main demand is for the credible (information
appears to be sufficiently trustworthy and competent) periodic
(on a regular basis) reporting of an enterprises financial position and
performance. To make accounting information credible, large sums of
money may be utilised, thus risking the decline of financial performance
and position. The longer the wait for information, the more reliable it
becomes, however users will prefer periodic reports with decision-relevant
information.

The information preparers responsible for putting together the

information to facilitate the users decision making.
- There are three main groups responsible for preparing the information in
financial statements:
1. Manager: responsible for running an enterprise, including their role in
issuing accounting and other information and controlling its financial
affairs.
2. Bookkeepers and clerks: This group works under the direction of
management and are responsible for the enterprises basic record-keeping
and creating transactional data, the basis of accounting reports. Many of
these functions are now performed by computers.
3. Accountants: shape the financial statement by applying the principles of
accounting to the enterprises records under the direction of management.

The auditors who assist the users by enhancing the credibility of the
information and to determine the fairness and appropriateness of the
information.
Verifies financial statements consistent with accepted accounting
principles.
External auditors report on the financial statements on behalf of external
users. They are formally appointed by the owners and are not permitted to
be an owner or manager of the enterprise. This is to ensure that the

1.4

auditor is financially and ethically independent and thus present an

objective perception of the enterprises financial affairs.
Internal auditors work within the enterprise to support the credibility of
information used by management.

Ethics has become a major concern for accounting information and they
are dilemmas for the accountant, auditor and manager.

Accrual Accounting:
Preparing financial accounts is a complex process as transactions may not
have been completed or are in dispute. Examples of this includes:

The value of donations promised to the Red Cross but not yet received depends
on how committed donors are to actually producing the cash.

This complexities are minimised or reduced by accrual accounting.

Accrual accounting: the impact of transactions on the financial statements
is recognised in the time periods during which revenues and expense
occur rather than when the cash is received or paid.

Accrual accounting VS Cash accounting:

Cash accounting: involves recording revenues and expenses at the time

the cash is received or paid. However often the timing of cash flow is in a
different accounting period to the substance (item that money is being
received for or paid for) of the transaction.

Accrual accounting used to prepare financial statements:

Includes all cash receipts and payments that have already happened such
as cash sales and payment for wages
Incorporates future cash receipts and payments that should be expected.
For example credit sales are included despite the cash arriving later
(possibly after the accounting period).
Measure the value of incomplete transactions (account receivables that
will not be collected and thus deducted from the statement)
Estimate figures when amounts are unknown such as the amount of
interest due from the bank at year end.

Estimates and Assessments.

Some figures are unable to be determined accurately, thus estimates and

assessments have to be made in order to reflect a more accurate
perception of the organisation.
Includes: the amount of money owing to employees at the end of each
year. This becomes an estimate as no-one knows for certain when leave
will be taken and at what rate. Another example includes the costs
involved in production and the estimated profits received from this
production.

1.5

The key financial statements

Balance Sheet:

Shows the financial position of an enterprise at a particular point in time. It

shows what the entitys resources are and how they were financed for.
Assesses the financial structure of the organisation and determines its
ability to meet its financial obligations.
Heading shows the companys name, the title of the report and the date at
which the financial position is shown.
Accounting Equation:
Assets = Liabilities + Equity

The three main elements of a balance sheet is assets, liabilities and

shareholders equity (or proprietors equity if the organisation was
a sole trader or partnership)
1. Assets:
- Future economic benefits that are controlled by an organisation as a result
of past transactions or past events.
- Value of assets are recorded in monetary figures.
- Examples of Assets include: Cash held at bank, Accounts receivables (also
called debtors: known as the amount owing from customers for goods or
services provided to them), Inventory and property, plant and equipment
such as motor vehicles, land, buildings, etc.
- Assets are financed in one of two ways: through liabilities or shareholders
equity. Thus the accounting equation above.
2. Liabilities:
- Future sacrifices of economic benefits that an organisation is presently
obliged to make to other organisations as a result of past transactions or
events.
- Liabilities involve the future use of assets, usually cash, or the
performance of future services such as warranty repairs on products sold.
- Includes: legally owed debts such as loans from banks, mortgages and
amounts due to suppliers.
- Account payable (creditors): amount owed to various suppliers for goods
or services they provided to the organisation.
- Wages payable (accrued wages): work done by employees for which they
have not been paid.
- Provision of employee entitlements: superannuation, sick leave or long
service leave
- Long term loans such as mortgages (not repayable within a year).
3. Shareholders Equity:
- Excess of assets over liabilities. The residual claim of the shareholders on
the assets of the organisation.
- Consists of share capital and retained profits.
- Share capital: amount that owners have directly invested in the company
- Retained profits: represents the total cumulative amounts of profits that
the company has retained in the business, separate from the distribution
of dividends.
Income Statement:

Also known as the profit and loss statement

Expresses the financial performance of an enterprise over a period of time.
It shows the results of business operations over a time period.
Assesses whether the organisation has utilised its resources both
efficiently and effectively.
Provides information on an organisations profitability for a period of time.
It matches revenues (inflows of economic benefit that increase OE) during
a period against expenses (use or loss of economic benefits that decrease
OE) incurred in earning the revenue.
The difference is the profit or loss. Profit occurs when the revenue is
greater than expenses whilst Loss occur when the expenses are greater
than the revenue.
Sales (revenue) Cost of goods sold (purchase price of goods that are
sold) = Gross Profit.
Gross Profit Expenses (operational costs, advertising, staff training, etc)
=net profit.
Net profit if the profit received before tax. It is also referred to as profit
before tax.
Profit after tax is referred to as operating profit after tax.

Cash Flow Statement:

Shows the receipt of cash and the payments of cash. Determines the cash
inflows and outflows of the business and the business ability to repay its
debts on time.
Accounting standards require companies to present this information in
their published financial statements.
Individual transactions are split into 3 categories:
1. Operative activities: activities relating to the production and provision
of goods and services
2. Investing Activities: activities related to the acquisition and disposal of
certain assets including property, plant and equipment.
3. Financing Activities: activities relating to changing the size and
composition of the financial structure of the entity, including equity and
certain borrowings.

1.6

Relationships between the financial statements:

Cash flow statements explain the changes in cash in the balance sheet in
the assets column. The change in cash comes from the business
operating, financing and investing activities.
The revenue found in the income statement directly reflects on the
retained profits found in the balance sheet. Thus the source of this
revenue can be found through the income statement.

Demands on the quality of financial accounting information: (conceptual

framework of the Australian Accounting Standards Board (AASB).
1. Accounting information must have relevance. This concept states that
the information in accounting statements is used to assist users in making

decisions about the allocation of scarce resources. It should help them

make, confirm or correct predictions about the outcomes of past, present
or future events.
2. Accounting information must also have Timeliness: This refers to the
need to provide the relevant information in enough time for the decision to
be made.
3. Accounting information must be reliable and free of bias and
subjectivity. The economic substance of events happening in the
company, and the numbers recorded in these statements should be
measured neutrally without overstating or understating their impact.
4. Materiality (significance): This concept is concerned with assessing
whether omission, misstatement or non-disclosure of a piece of
information would affect the decisions of users of the accounting reports.
Generally materiality is judged by the size of a possible error. Most people
would be satisfied if the statements were fair in relation to the important
things and would not mind a few errors, especially if the correction of
these errors involve costs and may cause a delay in their release.
5. GAAP (generally accepted accounting principles). Assures users that
accepted methods have been followed in constructing the financial
statement. GAAP will include several acceptable methods depending on
circumstance. Therefore auditors reports will conclude whether the
companys accounting methods, and its figures, are appropriate for its
circumstance.
6. Prudence: if there is uncertainty in certain figures, assets, revenues and
profit should not be overstated and liabilities, expenses and loss should
not be understated. Prudence involves being cautious about estimation,
however in some instances subjectivity can cause inflations or deflations
in amounts.
7. Disclosure: Financial statements will include a large number of notes and
account descriptions intended to make clear to the reader which important
accounting methods have been followed and to provide supplementary
information on debts, share capital, commitment, law suits and other
relevant information to assist users in understanding the statements.
8. Understandability: Reports should be prepared having regard to the
interest of users who are willing to exercise diligence in examining the
reports, and who possess the skills and abilities to comprehend
contemporary accounting practices.
9. Comparability: the ability to compare the financial accounts of 2 or more
organisations.
10.
Consistency: the principle of maintaining the same accounting
methods. It the company is conforming to GAAP then consistency can be
achieved, or the reader of the statement will be told if a change has been
made and the effects of the changes in the accounting methods.
Framework of AASB is defined by:
1. Understandability
2. Relevance:
- Materiality
3. Reliability:
-Faithful representation: represents what really existed or happened in
the organisation

-Substance over form: transactions and events must be presented in

accordance with their substance and economic reality.
-Neutrality: freedom from bias.
-Prudence: degree in caution in the exercise of judgements involved in
making accounting estimates.
-Completeness: material information is not omitted as it might lead to
misleading information.
4. Comparability.

1.7
Financial Statement assumptions:
1. Accrual Basis: financial reports that are prepared on the accrual basis of
accounting.
2. Going concern: Financial statements are prepared on the premise that
the organisation will continue operations as a going concern for the
foreseeable future. If this is not the case it is necessary to report the
liquidation values of an organisations assets. The assumption that
financial information will be continually distributed.
3. Accounting entity: Separate and distinguishable from its owners.
- A company is a separate entity from its owners or shareholders. That is
the owner or shareholders individual financial activities do not impact the
financial activities of the business.
Economic entity a group of entities where the goals of the controlling
entity are pursued.
4. Accounting period: The life of a business needs to be divided into
discrete periods of equal length to evaluate financial position and
performance for that period. Dividing the life of an organisation into equal
periods to determine profit or loss for that period is known as the
accounting period concept. The periods could be half-yearly, annually,
quarterly and even monthly.
5. Monetary: Accounting transactions need to be measured by a common
denominator, which in Australia is the Australian dollar. This enables
comparisons across periods and across different Australian companies.
This concept also assumes that the value of the monetary unit is constant
over time, ignoring inflation.
6. Historical Costs: Under the historical cost concept, assets are initially
recorded at cost price. In subsequent periods, the asset will continue to be
recorded at this price despite its increased in value. It treats the asset in
term of their use rather than for resale, therefore providing a reliable
amount for the asset or loan.
7. Material assumption: A piece of information is said to be material if its
omission or misstatement could influence the economic decisions of users
made on the basis of financial statements
- No set rules determining materiality, for example auditors use 5% as a
guide to ensure reliable and fair financial reports or statements
- This is especially the case for very large figures, where exact values
cannot be recorded, thus rounding off is required.
1.8
The importance of accounting:
Managers use accounting information to make informed business
decisions
Used by shareholders for decision making purposes

Used by boards in take-over battles

Used by bankers and other creditor groups to determine the risks of
lending
Use by corporative boards in rewarding or removing executives
Used by unions and management in negotiating wage agreements
Impact on employee or jobs if accounting numbers show failure,
downsizing may occur to reduce costs.