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What is Accounting?

Accounting is the process of recording and summarizing financial information in a


useful way.

You may have already noticed the use of some form of accounting in your daily life.

My mom for example is the chief accountant and treasurer of our house. She
keeps a simple diary to record major home expenses such as grocery, utilities, fees
and so on. It gives her peace of mind knowing where she has spent the monthly
income. The diary also serves as a reminder in case she forgets whether she has
already paid someone. She keeps all the receipts in a folder. At the start of each
month, she prepares a small budget that lists all major payments expected to be
made in the following month. Even though my mom doesn't realize, she is basically
performing functions of accounting to manage the home finances.

Accounting, what we normally refer to, is a more formal, efficient and effective
version of such processes in a business context.

Importance of Accounting

Accounting provides a basis for decisions through the process of recording,


summarizing and presenting historical and prospective information.

The recording part of accounting, often known as book-keeping and financial


accounting, is obviously crucial to ensure that those running a business have a
formal record of business transactions in order for them to know basic information
such:

How much they owe to suppliers, tax authorities, banks, employees and
others?

How much each customer owes the business?

How much capital is invested by the owners in the business?

How profitable is the business?

Such information is necessary for a business to fulfill its legal obligations and
asserting its own legal rights. Without proper accounting, it would be very difficult
for a business to determine for example the exact amount (net of any discounts,
VAT, etc.) it needs to pay a certain supplier (who could be one of dozens of
suppliers for that business) from whom they may have made several purchases in
last month alone. Organizations need to have a reliable way of recording
information relating to transactions and that is where accounting is so vital.
Historical accounting information is summarized to produce financial statements.
Financial Statements provide an overview of financial activities of a business
during a period (e.g. income and expenses) as well as information relating to
its financial position on a certain date (e.g. the amount of cash and inventory).
Financial Statements help owners in assessing the performance and position of
their business can guide their investment decisions (e.g. whether they should
invest more in the business, diversify or dispose their investment).

Read: Purpose of financial statements

Maintaining accounting records and preparing financial statements is often a legal


responsibility for most businesses above a certain size.

Read: What are financial statements?

Accounting nowadays is no longer concerned only with historical information.


Budgeting, appraisal and analysis based on prospective information has become
an important aspect of management accounting.

Management accounting is concerned with providing information to managers


for decisions, planning and control of business. Examples of such information
include:

Variance Analysis

Investment Appraisal

Relevant Cost Analysis

Limiting Factor Analysis

Ratio Analysis

Accounting has evolved into different specialties to address the diverse information
needs of its users.
Objectives of Accounting

Accounting provides the basis for management decisions and accountability


through the process of recording, summarizing and presenting historical and
prospective information.

Key objectives of accounting can be summarized as follows.

Recording

The most basic role of accounting is to record and summarize business


transactions and balances. This process is often referred to as 'book-keeping' and
is fundamental in managing any business.

Business transactions and balances once recorded can be summarized in the form
of financial statements. Financial statements provide key information relating to a
business such as:

How much capital has been invested in the business

How have the funds been utilized in the business

The amount of profit or loss in a period

How much the business owes to others (i.e. liabilities)

The amount of cash, receivables, inventory and other assets

Such information is not only useful for managers (e.g. to keep track of the financial
health and profitability of the business) but is also important for other stakeholders
as discussed in the article: users of financial statements.

Planning

Organizations need to plan how they intend to allocate their limited resources (e.g.
cash, labor, materials, machinery and equipment) towards competing needs in the
future. An effective way of doing so is by using various forms of budgets.

Budgeting is a major component of managerial accounting. Budgets enable


organizations to plan for the future by anticipating business needs and resources. It
also helps in coordinating the different business segments of an organization.

Accounting provides the basis for management decisions and accountability


through the process of recording, summarizing and presenting historical and
prospective information.

Key objectives of accounting can be summarized as follows.


Decision-Making

A key role of accounting is to provide information and analysis for management


decision and control.

Examples of such analysis include:

Variance Analysis

Investment Appraisal

Disinvestment Decisions

Make or Buy Decisions

Limiting Factor Analysis

Ratio Analysis

Accountability

Accounting provides a basis for analysis of the performance over a period of time
which promotes accountability across several tiers of an organization.

Shareholders can ultimately hold the directors responsible for the overall
performance of their company through performance appraisal on the basis of
accounting information published in the financial statements.
Introduction to Accounting

Accountancy is the process of communicating financial information about a


business entity to users such as shareholders and managers (Elliot, Barry & Elliot,
Jamie: Financial accounting and reporting).

Accounting has been defined as:


the art of recording, classifying, and summarizing in a significant manner
and in terms of money, transactions and events which are, in part at least, of
financial character, and interpreting the results thereof.(AICPA)
Users of Accounting Information - Internal & External

Accounting information helps users to make better financial decisions. Users of


financial information may be both internal and external to the organization.

Internal users (Primary Users) of accounting information include the following:

Management: for analyzing the organization's performance and position


and taking appropriate measures to improve the company results.

Employees: for assessing company's profitability and its consequence on


their future remuneration and job security.

Owners: for analyzing the viability and profitability of their investment and
determining any future course of action.

Accounting information is presented to internal users usually in the form of


management accounts, budgets, forecasts and financial statements.

External users (Secondary Users) of accounting information include the


following:

Creditors: for determining the credit worthiness of the organization. Terms


of credit are set by creditors according to the assessment of their customers'
financial health. Creditors include suppliers as well as lenders of finance
such as banks.

Tax Authourities: for determining the credibility of the tax returns filed on
behalf of the company.

Investors: for analyzing the feasibility of investing in the company. Investors


want to make sure they can earn a reasonable return on their investment
before they commit any financial resources to the company.

Customers: for assessing the financial position of its suppliers which is


necessary for them to maintain a stable source of supply in the long term.
Regulatory Authorities: for ensuring that the company's disclosure of
accounting information is in accordance with the rules and regulations set in
order to protect the interests of the stakeholders who rely on such
information in forming their decisions.

External users are communicated accounting information usually in the form


of financial statements. The purpose of financial statements is to cater for
the needs of such diverse users of accounting information in order to assist
them in making sound financial decisions.

Accountancy encompasses the recording, classification, and summarizing of


transactions and events in a manner that helps its users to assess the
financial performance and position of the entity. The process starts by first
identifying transactions and events that affect the financial position and
performance of the company. Once transactions and events are identified,
they are recorded, classified and summarized in a manner that helps the
user of accounting information in determining the nature and effect of such
transactions and events.

Accounting is a very dynamic profession which is constantly adapting itself


to varying needs of its users. Over the past few decades, accountancy has
branched out into different types of accounting to cater for the different
needs of the users.
Types of Accounting

Accounting is a vast and dynamic profession and is constantly adapting itself to the
specific and varying needs of its users. Over the past few decades, accountancy
has branched out into different types of accounting to cater for the diversity of
needs of its users.

Financial Accounting, or financial reporting, is the process of producing


information for external use usually in the form of financial statements. Financial
Statements reflect an entity's past performance and current position based on a set
of standards and guidelines known as GAAP (Generally Accepted Accounting
Principles). GAAP refers to the standard framework of guideline for financial
accounting used in any given jurisdiction. This generally includes accounting
standards (e.g. International Financial Reporting Standards), accounting
conventions, and rules and regulations that accountants must follow in the
preparation of the financial statements.

Management Accounting produces information primarily for internal use by the


company's management. The information produced is generally more detailed than
that produced for external use to enable effective organization control and the
fulfillment of the strategic aims and objectives of the entity. Information may be in
the form budgets and forecasts, enabling an enterprise to plan effectively for its
future or may include an assessment based on its past performance and results.
The form and content of any report produced in the process is purely upon
management's discretion.

Cost accounting is a branch of management accounting and involves the


application of various techniques to monitor and control costs. Its application is
more suited to manufacturing concerns.

Governmental Accounting, also known as public accounting or federal


accounting, refers to the type of accounting information system used in the public
sector. This is a slight deviation from the financial accounting system used in the
private sector. The need to have a separate accounting system for the public
sector arises because of the different aims and objectives of the state owned and
privately owned institutions. Governmental accounting ensures the financial
position and performance of the public sector institutions are set in budgetary
context since financial constraints are often a major concern of many governments.
Separate rules are followed in many jurisdictions to account for the transactions
and events of public entities.

Tax Accounting refers to accounting for the tax related matters. It is governed by
the tax rules prescribed by the tax laws of a jurisdiction. Often these rules are
different from the rules that govern the preparation of financial statements for
public use (i.e. GAAP). Tax accountants therefore adjust the financial statements
prepared under financial accounting principles to account for the differences with
rules prescribed by the tax laws. Information is then used by tax professionals to
estimate tax liability of a company and for tax planning purposes.

Forensic Accounting is the use of accounting, auditing and investigative


techniques in cases of litigation or disputes. Forensic accountants act as expert
witnesses in courts of law in civil and criminal disputes that require an assessment
of the financial effects of a loss or the detection of a financial fraud. Common
litigations where forensic accountants are hired include insurance claims, personal
injury claims, suspected fraud and claims of professional negligence in a financial
matter (e.g. business valuation).

Project Accounting refers to the use of accounting system to track the financial
progress of a project through frequent financial reports. Project accounting is a vital
component of project management. It is a specialized branch of management
accounting with a prime focus on ensuring the financial success of company
projects such as the launch of a new product. Project accounting can be a source
of competitive advantage for project-oriented businesses such as construction
firms.

Social Accounting, also known as Corporate Social Responsibility Reporting and


Sustainability Accounting, refers to the process of reporting implications of an
organization's activities on its ecological and social environment. Social Accounting
is primarily reported in the form of Environmental Reports accompanying the
annual reports of companies. Social Accounting is still in the early stages of
development and is considered to be a response to the growing environmental
consciousness amongst the public at large.
What are Financial Statements?
Definition

Financial Statements represent a formal record of the financial activities of an


entity. These are written reports that quantify the financial strength, performance
and liquidity of a company. Financial Statements reflect the financial effects of
business transactions and events on the entity.

Four Types of Financial Statements

The four main types of financial statements are:

1. Statement of Financial Position

Statement of Financial Position, also known as the Balance Sheet, presents the
financial position of an entity at a given date. It is comprised of the following three
elements:

Assets: Something a business owns or controls (e.g. cash, inventory, plant


and machinery, etc)

Liabilities: Something a business owes to someone (e.g. creditors, bank


loans, etc)

Equity: What the business owes to its owners. This represents the amount
of capital that remains in the business after its assets are used to pay off its
outstanding liabilities. Equity therefore represents the difference between
the assets and liabilities.

View detailed explanation and Example of Statement of Financial Position

2. Income Statement

Income Statement, also known as the Profit and Loss Statement, reports the
company's financial performance in terms of net profit or loss over a specified
period. Income Statement is composed of the following two elements:

Income: What the business has earned over a period (e.g. sales revenue,
dividend income, etc)

Expense: The cost incurred by the business over a period (e.g. salaries and
wages, depreciation, rental charges, etc)

Net profit or loss is arrived by deducting expenses from income.

View detailed explanation and Example of Income Statement


3. Cash Flow Statement

Cash Flow Statement, presents the movement in cash and bank balances over a
period. The movement in cash flows is classified into the following segments:

Operating Activities: Represents the cash flow from primary activities of a


business.

Investing Activities: Represents cash flow from the purchase and sale of
assets other than inventories (e.g. purchase of a factory plant)

Financing Activities: Represents cash flow generated or spent on raising


and repaying share capital and debt together with the payments of interest
and dividends.

View detailed explanation and Example of Cash Flow Statement

4. Statement of Changes in Equity

Statement of Changes in Equity, also known as the Statement of Retained


Earnings, details the movement in owners' equity over a period. The movement in
owners' equity is derived from the following components:

Net Profit or loss during the period as reported in the income statement

Share capital issued or repaid during the period

Dividend payments

Gains or losses recognized directly in equity (e.g. revaluation surpluses)

Effects of a change in accounting policy or correction of accounting error

View detailed explanation and Example of Statement of Changes in Equity

Link between Financial Statements

The following diagram summarizes the link between financial statements.


Statement of Financial Position [Balance Sheet]
Definition

Statement of Financial Position, also known as the Balance Sheet, presents the
financial position of an entity at a given date. It is comprised of three main
components: Assets, liabilities and equity.

Statement of Financial Position helps users of financial statements to assess the


financial soundness of an entity in terms of liquidity risk, financial risk, credit risk
and business risk.

Example

Following is an illustrative example of a Statement of Financial Position prepared


under the format prescribed by IAS 1 Presentation of Financial Statements.

Statement of Financial Position as at 31st December 2013


2013 2012
Notes
USD USD
ASSETS

Non-current assets
Property, plant & equipment 9 130,000 120,000
Goodwill 10 30,000 30,000
Intangible assets 11 60,000 50,000
220,000 200,000
Current assets
Inventories 12 12,000 10,000
Trade receivables 13 25,000 30,000
Cash and cash equivalents 14 8,000 10,000
45,000 50,000
TOTAL ASSETS 265,000 250,000
EQUITY AND LIABILITIES

Equity
Share capital 4 100,000 100,000
Retained earnings 50,000 40,000
Revaluation reserve 5 15,000 10,000
Total equity 165,000 150,000
Non-current liabilities
Long term borrowings 6 35,000 50,000
Current liabilities
Trade and other payables 7 35,000 25,000
Short-term borrowings 8 10,000 8,000
Current portion of long-term borrowings 6 15,000 15,000
Current tax payable 9 5,000 2,000
Total current liabilities 65,000 50,000
Total liabilities 100,000 100,000
TATAL EQUITY AND LIABILITIES 265,000 250,000

Classification of Components

Statement of financial position consists of the following key elements:

Assets

An asset is something that an entity owns or controls in order to derive economic


benefits from its use. Assets must be classified in the balance sheet as current or
non-current depending on the duration over which the reporting entity expects to
derive economic benefit from its use. An asset which will deliver economic benefits
to the entity over the long term is classified as non-current whereas those assets
that are expected to be realized within one year from the reporting date are
classified as current assets.

Assets are also classified in the statement of financial position on the basis of their
nature:

Tangible & intangible: Non-current assets with physical substance are


classified as property, plant and equipment whereas assets without any
physical substance are classified as intangible assets. Goodwill is a type of
an intangible asset.
Inventories balance includes goods that are held for sale in the ordinary
course of the business. Inventories may include raw materials, finished
goods and works in progress.

Trade receivables include the amounts that are recoverable from customers
upon credit sales. Trade receivables are presented in the statement of
financial position after the deduction of allowance for bad debts.

Cash and cash equivalents include cash in hand along with any short term
investments that are readily convertible into known amounts of cash.

Liabilities

A liability is an obligation that a business owes to someone and its settlement


involves the transfer of cash or other resources. Liabilities must be classified in the
statement of financial position as current or non-current depending on the duration
over which the entity intends to settle the liability. A liability which will be settled
over the long term is classified as non-current whereas those liabilities that are
expected to be settled within one year from the reporting date are classified as
current liabilities.

Liabilities are also classified in the statement of financial position on the basis of
their nature:

Trade and other payables primarily include liabilities due to suppliers and
contractors for credit purchases. Sundry payables which are too insignificant
to be presented separately on the face of the balance sheet are also
classified in this category.

Short term borrowings typically include bank overdrafts and short term bank
loans with a repayment schedule of less than 12 months.

Long-term borrowings comprise of loans which are to be repaid over a


period that exceeds one year. Current portion of long-term borrowings
include the installments of long term borrowings that are due within one year
of the reporting date.

Current Tax Payable is usually presented as a separate line item in the


statement of financial position due to the materiality of the amount.

Equity

Equity is what the business owes to its owners. Equity is derived by deducting total
liabilities from the total assets. It therefore represents the residual interest in the
business that belongs to the owners.
Equity is usually presented in the statement of financial position under the following
categories:

Share capital represents the amount invested by the owners in the entity

Retained Earnings comprises the total net profit or loss retained in the
business after distribution to the owners in the form of dividends.

Revaluation Reserve contains the net surplus of any upward revaluation of


property, plant and equipment recognized directly in equity.

Rationale - Why the balance sheet always balances?

The balance sheet is structured in a manner that the total assets of an entity equal
to the sum of liabilities and equity. This may lead you to wonder as to why the
balance sheet must always be in equilibrium.

Assets of an entity may be financed from internal sources (i.e. share capital and
profits) or from external credit (e.g. bank loan, trade creditors, etc.). Since the total
assets of a business must be equal to the amount of capital invested by the owners
(i.e. in the form of share capital and profits not withdrawn) and any borrowings, the
total assets of a business must equal to the sum of equity and liabilities.

This leads us to the Accounting Equation: Assets = Liabilities + Equity

Purpose & Importance

Statement of financial position helps users of financial statements to assess the


financial health of an entity. When analyzed over several accounting periods,
balance sheets may assist in identifying underlying trends in the financial position
of the entity. It is particularly helpful in determining the state of the entity's liquidity
risk, financial risk, credit risk and business risk. When used in conjunction with
other financial statements of the entity and the financial statements of its
competitors, balance sheet may help to identify relationships and trends which are
indicative of potential problems or areas for further improvement. Analysis of the
statement of financial position could therefore assist the users of financial
statements to predict the amount, timing and volatility of entity's future earnings.
Income Statement | Profit & Loss Account
Definition

Income Statement, also known as Profit & Loss Account, is a report of income,
expenses and the resulting profit or loss earned during an accounting period.

Example

Following is an illustrative example of an Income Statement prepared in


accordance with the format prescribed by IAS 1 Presentation of Financial
Statements.

Income Statement for the Year Ended 31st December 2013


2013 2012
Notes
USD USD
Revenue 16 120,000 100,000
Cost of Sales 17 (65,000) (55,000)
Gross Profit 55,000 45,000
Other Income 18 17,000 12,000
Distribution Cost 19 (10,000) (8,000)
Administrative Expenses 20 (18,000) (16,000)
Other Expenses 21 (3,000) (2,000)
Finance Charges 22 (1,000) (1,000)
(15,000) (15,000)
Profit before tax 40,000 30,000
Income tax 23 (12,000) (9,000)
Net Profit 28,000 21,000

Basis of preparation

Income statement is prepared on the accruals basis of accounting.

This means that income (including revenue) is recognized when it is earned rather
than when receipts are realized (although in many instances income may be
earned and received in the same accounting period).
Conversely, expenses are recognized in the income statement when they
are incurred even if they are paid for in the previous or subsequent accounting
periods.

Income statement does not report transactions with the owners of an entity.

Hence, dividends paid to ordinary shareholders are not presented as


an expense in the income statement and proceeds from the issuance of shares is
not recognized as an income. Transactions between the entity and its owners are
accounted for separately in the statement of changes in equity.

Components

Income statement comprises of the following main elements:

Revenue

Revenue includes income earned from the principal activities of an entity. So for
example, in case of a manufacturer of electronic appliances, revenue will comprise
of the sales from electronic appliance business. Conversely, if the same
manufacturer earns interest on its bank account, it shall not be classified as
revenue but as other income.

Cost of Sales

Cost of sales represents the cost of goods sold or services rendered during an
accounting period.

Hence, for a retailer, cost of sales will be the sum of inventory at the start of the
period and purchases during the period minus any closing inventory.

In case of a manufacturer however, cost of sales will also include production costs
incurred in the manufacture of goods during a period such as the cost of direct
labor, direct material consumption, depreciation of plant and machinery and factory
overheads, etc.

You may refer to the article on cost of sales for an explanation of its calculation.

Other Income

Other income consists of income earned from activities that are not related to the
entity's main business. For example, other income of an entity that manufactures
electronic appliances may include:

Gain on disposal of fixed assets

Interest income on bank deposits


Exchange gain on translation of a foreign currency bank account

Distribution Cost

Distribution cost includes expenses incurred in delivering goods from the business
premises to customers.

Administrative Expenses

Administrative expenses generally comprise of costs relating to the management


and support functions within an organization that are not directly involved in the
production and supply of goods and services offered by the entity.

Examples of administrative expenses include:

Salary cost of executive management

Legal and professional charges

Depreciation of head office building

Rent expense of offices used for administration and management purposes

Cost of functions / departments not directly involved in production such as


finance department, HR department and administration department

Other Expenses

This is essentially a residual category in which any expenses that are not suitably
classifiable elsewhere are included.

Finance Charges

Finance charges usually comprise of interest expense on loans and debentures.

The effect of present value adjustments of discounted provisions are also included
in finance charges (e.g. unwinding of discount on provision for decommissioning
cost).

Income tax

Income tax expense recognized during a period is generally comprised of the


following three elements:

Current period's estimated tax charge

Prior period tax adjustments


Deferred tax expense

Prior Period Comparatives

Prior period financial information is presented along side current period's financial
results to facilitate comparison of performance over a period.

It is therefore important that prior period comparative figures presented in the


income statement relate to a similar period.

For example, if an organization is preparing income statement for the six months
ending 31 December 2013, comparative figures of prior period should relate to the
six months ending 31 December 2012.

Purpose & Use

Income Statement provides the basis for measuring performance of an entity over
the course of an accounting period.

Performance can be assessed from the income statement in terms of the following:

Change in sales revenue over the period and in comparison to industry


growth

Change in gross profit margin, operating profit margin and net profit margin
over the period

Increase or decrease in net profit, operating profit and gross profit over the
period

Comparison of the entity's profitability with other organizations operating in


similar industries or sectors

Income statement also forms the basis of important financial evaluation of an entity
when it is analyzed in conjunction with information contained in other financial
statements such as:

Change in earnings per share over the period

Analysis of working capital in comparison to similar income statement


elements (e.g. the ratio of receivables reported in the balance sheet to the
credit sales reported in the income statement, i.e. debtor turnover ratio)

Analysis of interest cover and dividend cover ratios


Statement of Cash Flows
Definition

Statement of Cash Flows, also known as Cash Flow Statement, presents the
movement in cash flows over the period as classified under operating, investing
and financing activities.

Example

Following is an illustrative cash flow statement presented according to the indirect


method suggested in IAS 7 Statement of Cash Flows:

ABC PLC
Statement of Cash Flows for the year ended 31 December 2013
2013 2012
Notes
USD USD

Cash flows from operating activities


Profit before tax 40,000 35,000
Adjustments for:
Depreciation 4 10,000 8,000
Amortization 4 8,000 7,500
Impairment losses 5 12,000 3,000
Bad debts written off 14 500 -
Interest expense 16 800 1,000
Gain on revaluation of investments (21,000) -
Interest income 15 (11,000) (9,500)
Dividend income (3,000) (2,500)
Gain on disposal of fixed assets (1,200) (1,850)
35,100 40,650
Working Capital Changes:
Movement in current assets:
(Increase) / Decrease in inventory (1,000) 550
Decrease in trade receivables 3,000 1,400
Movement in current liabilities:
Increase / (Decrease) in trade payables 2,500 (1,300)
Cash generated from operations 39,600 41,300
Dividend paid (8,000) (6,000)
Income tax paid (12,000) (10,000)
Net cash from operating activities (A) 19,600 25,300
Cash flows from investing activities
Capital expenditure 4 (100,000) (85,000)
Purchase of investments 11 (25,000) -
Dividend received 5,000 3,000
Interest received 3,500 1,000
Proceeds from disposal of fixed assets 18,000 5,500
Proceeds from disposal of investments 2,500 2,200
Net cash used in investing activities (B) (96,000) (73,300)
Cash flows from financing activities
Issuance of share capital 6 1000,000 -
Bank loan received - 100,000
Repayment of bank loan (100,000) -
Interest expense (3,600) (7,400)
Net cash from financing activities (C) 896,400 92,600
Net increase in cash & cash equivalents (A+B+C) 820,000 44,600
Cash and cash equivalents at start of the year 77,600 33,000
Cash and cash equivalents at end of the year 24 897,600 77,600

Basis of Preparation

Statement of Cash Flows presents the movement in cash and cash equivalents
over the period.

Cash and cash equivalents generally consist of the following:


Cash in hand

Cash at bank

Short term investments that are highly liquid and involve very low risk of
change in value (therefore usually excludes investments in equity
instruments)

Bank overdrafts in cases where they comprise an integral element of the


organization's treasury management (e.g. where bank account is allowed to
float between a positive and negative balance (i.e. overdraft) as opposed to
a bank overdraft facility specifically negotiated for financing a shortfall in
funds (in which case the related cash flows will be classified under financing
activities).

As income statement and balance sheet are prepared under the accruals basis of
accounting, it is necessary to adjust the amounts extracted from these financial
statements (e.g. in respect of non cash expenses) in order to present only the
movement in cash inflows and outflows during a period.

All cash flows are classified under operating, investing and financing activities as
discussed below.

Operating Activities

Cash flow from operating activities presents the movement in cash during an
accounting period from the primary revenue generating activities of the entity.

For example, operating activities of a hotel will include cash inflows and outflows
from the hotel business (e.g. receipts from sales revenue, salaries paid during the
year etc), but interest income on a bank deposit shall not be classified as such (i.e.
the hotel's interest income shall be presented in investing activities).

Profit before tax as presented in the income statement could be used as a starting
point to calculate the cash flows from operating activities.

Following adjustments are required to be made to the profit before tax to arrive at
the cash flow from operations:

1. Elimination of non cash expenses (e.g. depreciation, amortization,


impairment losses, bad debts written off, etc)
2. Removal of expenses to be classified elsewhere in the cash flow
statement (e.g. interest expense should be classified under financing
activities)
3. Elimination of non cash income (e.g. gain on revaluation of investments)
4. Removal of income to be presented elsewhere in the cash flow statement
(e.g. dividend income and interest income should be classified under
investing activities unless in case of for example an investment bank)
5. Working capital changes (e.g. an increase in trade receivables must be
deducted to arrive at sales revenue that actually resulted in cash inflow
during the period)
Investing Activities

Cash flow from investing activities includes the movement in cash flow as a result
of the purchase and sale of assets other than those which the entity primarily
trades in (e.g. inventory). So for example, in case of a manufacturer of cars,
proceeds from the sale of factory plant shall be classified as cash flow from
investing activities whereas the cash inflow from the sale of cars shall be presented
under the operating activities.

Cash flow from investing activities consists primarily of the following:

Cash outflow expended on the purchase of investments and fixed assets

Cash inflow from income from investments

Cash inflow from disposal of investments and fixed assets

Financing activities

Cash flow from financing activities includes the movement in cash flow resulting
from the following:

Proceeds from issuance of share capital, debentures & bank loans

Cash outflow expended on the cost of finance (i.e. dividends and interest
expense)

Cash outflow on the repurchase of share capital and repayment of


debentures & loans

Purpose & Importance

Statement of cash flows provides important insights about the liquidity and
solvency of a company which are vital for survival and growth of any organization.
It also enables analysts to use the information about historic cash flows to form
projections of future cash flows of an entity (e.g. in NPV analysis) on which to base
their economic decisions. By summarizing key changes in financial position during
a period, cash flow statement serves to highlight priorities of management. For
example, increase in capital expenditure and development costs may indicate a
higher increase in future revenue streams whereas a trend of excessive investment
in short term investments may suggest lack of viable long term investment
opportunities. Furthermore, comparison of the cash flows of different entities may
better reveal the relative quality of their earnings since cash flow information is
more objective as opposed to the financial performance reflected in income
statement which is susceptible to significant variations caused by the adoption of
different accounting policies.
Statement of Changes in Equity
Definition

Statement of Changes in Equity, often referred to as Statement of Retained


Earnings in U.S. GAAP, details the change in owners' equity over an accounting
period by presenting the movement in reserves comprising the shareholders'
equity.

Movement in shareholders' equity over an accounting period comprises the


following elements:

Net profit or loss during the accounting period attributable to shareholders

Increase or decrease in share capital reserves

Dividend payments to shareholders

Gains and losses recognized directly in equity

Effect of changes in accounting policies

Effect of correction of prior period error

Example

Following is an illustrative example of a Statement of Changes in Equity prepared


according to the format prescribed by IAS 1 Presentation of Financial Statements.

ABC Plc
st
Statement of changes in equity for the year ended 31 December 2012
Share Retained Revaluation Total
Capital Earnings Surplus Equity
USD USD USD USD
Balance at 1 January 2011 100,000 30,000 - 130,000
Changes in accounting policy - - - -
Correction of prior period
- - - -
error
Restated balance 100,000 30,000 - 130,000
Changes in equity for the
year 2011
Issue of share capital - - - -
Income for the year - 25,000 - 25,000
Revaluation gain - - 10,000 10,000
Dividends - (15,000) - (15,000)
Balance at 31 December
100,000 40,000 10,000 150,000
2011
Changes in equity for the
year 2012
Issue of share capital - - - -
Income for the year - 30,000 - 30,000
Revaluation gain - - 5,000 5,000
Dividends - (20,000) - (20,000)
Balance at 31 December
100,000 50,000 15,000 165,000
2012

Components

Following are the main elements of statement of changes in equity:

Opening Balance

This represents the balance of shareholders' equity reserves at the start of the
comparative reporting period as reflected in the prior period's statement of financial
position. The opening balance is unadjusted in respect of the correction of prior
period errors rectified in the current period and also the effect of changes in
accounting policy implemented during the year as these are presented separately
in the statement of changes in equity (see below).

Effect of Changes in Accounting Policies

Since changes in accounting policies are applied retrospectively, an adjustment is


required in stockholders' reserves at the start of the comparative reporting period
to restate the opening equity to the amount that would be arrived if the new
accounting policy had always been applied.

Effect of Correction of Prior Period Error


The effect of correction of prior period errors must be presented separately in the
statement of changes in equity as an adjustment to opening reserves. The effect of
the corrections may not be netted off against the opening balance of the equity
reserves so that the amounts presented in current period statement might be easily
reconciled and traced from prior period financial statements.

Restated Balance

This represents the equity attributable to stockholders at the start of the


comparative period after the adjustments in respect of changes in accounting
policies and correction of prior period errors as explained above.

Changes in Share Capital

Issue of further share capital during the period must be added in the statement of
changes in equity whereas redemption of shares must be deducted therefrom. The
effects of issue and redemption of shares must be presented separately for share
capital reserve and share premium reserve.

Dividends

Dividend payments issued or announced during the period must be deducted from
shareholder equity as they represent distribution of wealth attributable to
stockholders.

Income / Loss for the period

This represents the profit or loss attributable to shareholders during the period as
reported in the income statement.

Changes in Revaluation Reserve

Revaluation gains and losses recognized during the period must be presented in
the statement of changes in equity to the extent that they are recognized outside
the income statement. Revaluation gains recognized in income statement due to
reversal of previous impairment losses however shall not be presented separately
in the statement of changes in equity as they would already be incorporated in the
profit or loss for the period.

Other Gains & Losses

Any other gains and losses not recognized in the income statement may be
presented in the statement of changes in equity such as actuarial gains and losses
arising from the application of IAS 19 Employee Benefit.

Closing Balance
This represents the balance of shareholders' equity reserves at the end of the
reporting period as reflected in the statement of financial position.

Purpose & Importance

Statement of changes in equity helps users of financial statement to identify the


factors that cause a change in the owners' equity over the accounting periods.
Whereas movement in shareholder reserves can be observed from the balance
sheet, statement of changes in equity discloses significant information about equity
reserves that is not presented separately elsewhere in the financial statements
which may be useful in understanding the nature of change in equity reserves.
Examples of such information include share capital issue and redemption during
the period, the effects of changes in accounting policies and correction of prior
period errors, gains and losses recognized outside income statement, dividends
declared and bonus shares issued during the period.
Relationship between Financial Statements
Explanation

Financial Statements reflect the effects of business transactions and events on the
entity. The different types of financial statements are not isolated from one another
but are closely related to one another as is illustrated in the following diagram.
Balance Sheet

Balance Sheet, or Statement of Financial Position, is directly related to the income


statement, cash flow statement and statement of changes in equity.

Assets, liabilities and equity balances reported in the Balance Sheet at the period
end consist of:

Balances at the start of the period;

The increase (or decrease) in net assets as a result of the net profit (or loss)
reported in the income statement;

The increase (or decrease) in net assets as a result of the net gains (or
losses) recognized outside the income statement and directly in the
statement of changes in equity (e.g. revaluation surplus);

The increase in net assets and equity arising from the issue of share capital
as reported in the statement of changes in equity;

The decrease in net assets and equity arising from the payment of dividends
as presented in the statement of changes in equity;

The change in composition of balances arising from inter balance sheet


transactions not included above (e.g. purchase of fixed assets, receipt of
bank loan, etc).

Accruals and Prepayments

Receivables and Payables

Income Statement

Income Statement, or Profit and Loss Statement, is directly linked to balance


sheet, cash flow statement and statement of changes in equity.

The increase or decrease in net assets of an entity arising from the profit or loss
reported in the income statement is incorporated in the balances reported in the
balance sheet at the period end.

The profit and loss recognized in income statement is included in the cash flow
statement under the segment of cash flows from operation after adjustment of non-
cash transactions. Net profit or loss during the year is also presented in the
statement of changes in equity.
Statement of Changes in Equity

Statement of Changes in Equity is directly related to balance sheet and income


statement.

Statement of changes in equity shows the movement in equity reserves as


reported in the entity's balance sheet at the start of the period and the end of the
period. The statement therefore includes the change in equity reserves arising from
share capital issues and redemptions, the payments of dividends, net profit or loss
reported in the income statement along with any gains or losses recognized
directly in equity (e.g. revaluation surplus).

Cash Flow Statement

Statement of Cash Flows is primarily linked to balance sheet as it explains the


effects of change in cash and cash equivalents balance at the beginning and end
of the reporting period in terms of the cash flow impact of changes in the
components of balance sheet including assets, liabilities and equity reserves.

Cash flow statement therefore reflects the increase or decrease in cash flow
arising from:

Change in share capital reserves arising from share capital issues and
redemption;

Change in retained earnings as a result of net profit or loss recognized in


the income statement (after adjusting non-cash items) and dividend
payments;

Change in long term loans due to receipt or repayment of loans;

Working capital changes as reflected in the increase or decrease in net


current assets recognized in the balance sheet;

Change in non current assets due to receipts and payments upon the
acquisitions and disposals of assets (i.e. investing activities)
Purpose of Financial Statements

The objective of financial statements is to provide information about the financial


position, performance and changes in financial position of an enterprise that is
useful to a wide range of users in making economic decisions (IASB Framework).

Financial Statements provide useful information to a wide range of users:

Managers require Financial Statements to manage the affairs of the company by


assessing its financial performance and position and taking important business
decisions.

Shareholders use Financial Statements to assess the risk and return of their
investment in the company and take investment decisions based on their analysis.

Prospective Investors need Financial Statements to assess the viability of


investing in a company. Investors may predict future dividends based on the profits
disclosed in the Financial Statements. Furthermore, risks associated with the
investment may be gauged from the Financial Statements. For instance, fluctuating
profits indicate higher risk. Therefore, Financial Statements provide a basis for the
investment decisions of potential investors.

Financial Institutions (e.g. banks) use Financial Statements to decide whether to


grant a loan or credit to a business. Financial institutions assess the financial
health of a business to determine the probability of a bad loan. Any decision to lend
must be supported by a sufficient asset base and liquidity.

Suppliers need Financial Statements to assess the credit worthiness of a business


and ascertain whether to supply goods on credit. Suppliers need to know if they will
be repaid. Terms of credit are set according to the assessment of their customers'
financial health.

Customers use Financial Statements to assess whether a supplier has the


resources to ensure the steady supply of goods in the future. This is especially vital
where a customer is dependant on a supplier for a specialized component.

Employees use Financial Statements for assessing the company's profitability and
its consequence on their future remuneration and job security.

Competitors compare their performance with rival companies to learn and develop
strategies to improve their competitiveness.

General Public may be interested in the effects of a company on the economy,


environment and the local community.
Governments require Financial Statements to determine the correctness of tax
declared in the tax returns. Government also keeps track of economic progress
through analysis of Financial Statements of businesses from different sectors of
the economy.
Limitations of Accounting & Financial Reporting

Accountancy assists users of financial statements to make better financial


decisions. It is important however to realize the limitations of accounting and
financial reporting when forming those decisions.

Different accounting policies and frameworks

Accounting frameworks such as IFRS allow the preparers of financial statements to


use accounting policies that most appropriately reflect the circumstances of their
entities.

Whereas a degree of flexibility is important in order to present reliable information


of a particular entity, the use of diverse set of accounting policies amongst different
entities impairs the level of comparability between financial statements.

The use of different accounting frameworks (e.g. IFRS, US GAAP) by entities


operating in different geographic areas also presents similar problems when
comparing their financial statements. The problem is being overcome by the
growing use of IFRS and the convergence process between leading accounting
bodies to arrive at a single set of global standards.

Accounting estimates

Accounting requires the use of estimates in the preparation of financial statements


where precise amounts cannot be established. Estimates are inherently subjective
and therefore lack precision as they involve the use of management's foresight in
determining values included in the financial statements. Where estimates are not
based on objective and verifiable information, they can reduce the reliability of
accounting information.

Professional judgment

The use of professional judgment by the preparers of financial statements is


important in applying accounting policies in a manner that is consistent with the
economic reality of an entity's transactions. However, differences in the
interpretation of the requirements of accounting standards and their application to
practical scenarios will always be inevitable. The greater the use of judgment
involved, the more subjective financial statements would tend to be.

Verifiability

Audit is the main mechanism that enables users to place trust on financial
statements. However, audit only provides 'reasonable' and not absolute assurance
on the truth and fairness of the financial statements which means that despite
carrying audit according to acceptable standards, certain material misstatements in
financial statements may yet remain undetected due to the inherent limitations of
the audit.

Use of historical cost

Historical cost is the most widely used basis of measurement of assets. Use of
historical cost presents various problems for the users of financial statements as it
fails to account for the change in price levels of assets over a period of time. This
not only reduces the relevance of accounting information by presenting assets at
amounts that may be far less than their realizable value but also fails to account for
the opportunity cost of utilizing those assets.

The effect of the use of historical cost basis is best explained by the use of an
example

Company A purchased a plant for $100,000 on 1st January 2006 which had a
useful life of 10 years.

Company B purchased a similar plant for $200,000 on 31st December 2010.

Depreciation is charged on straight line basis.

At the end of the reporting period at 31st December 2010, the balance sheet of
Company B would show a fixed asset of $200,000 while A's financial statement
would show an asset of $50,000 (net of depreciation).

The scenario above presents an accounting anomaly. Even though the plant
presented in A's financial statements is capable of producing economic benefits
worth 50% of Company B's asset, it is carried at a historical cost equivalent of just
25% of its value.

Moreover, the depreciation charged in A's financial statements (i.e. $10,000 p.a.)
does not reflect the opportunity cost of the plant's use (i.e. $20,000 p.a.). As a
result, over the course of the asset's life, an amount of $100,000 would be charged
as depreciation in A's financial statements even though the cost of maintaining the
productive capacity of its asset would have notably increased. If Company A were
to distribute all profits as dividends, it will not have the resources sufficient to
replace its existing plant at the end of its useful life. Therefore, the use of historical
cost may result in reporting profits that are not sustainable in the long term.

Due to the disadvantages associated with the use of historical cost, some
preparers of financial statements use the revaluation model to account for long-
term assets. However, due to the limited market of various assets and the cost of
regular valuations required under revaluation model, it is not widely used in
practice.
An interesting development in accounting is the use of 'capital maintenance' in the
determination of profit that is sustainable after taking into account the resources
that would be required to 'maintain' the productivity of operations. However, this
accounting basis is still in its early stages of development.

Measurability

Accounting only takes into account transactions that are capable of being
measured in monetary terms. Therefore, financial statements do not account for
those resources and transactions whose value cannot be reasonably assigned
such as the competence of workforce or goodwill.

Limited predictive value

Financial statements present an account of the past performance of an entity. They


offer limited insight into the future prospects of an enterprise and therefore lack
predictive value which is essential from the point of view of investors.

Fraud and error

Financial statements are susceptible to fraud and errors which can undermine the
overall credibility and reliability of information contained in them. Deliberate
manipulation of financial statements that is geared towards achieving
predetermined results (also known as 'window dressing') has been a unfortunate
reality in the recent past as has been popularized by major accounting disasters
such as the Enron Scandal.

Cost benefit compromise

Reliability of accounting information is relative to the cost of its production. At


times, the cost of producing reliable information outweighs the benefit expected to
be gained which explains why, in some instances, quality of accounting information
might be compromised.

Elements of the financial Statements

Elements of the financial statements include Assets, Liabilities, Equity, Income &
Expenses. The first three elements relate to the statement of financial position
whereas the latter two relate to the income statement.

The first three elements relate to the statement of financial position while the latter
two relate to income statements.
Assets

Definition

Asset is a resource controlled by the entity as a result of past events and from
which future economic benefits are expected to flow to the entity (IASB
Framework).

Explanation

In simple words, asset is something which a business owns or controls to benefit


from its use in some way. It may be something which directly generates revenue
for the entity (e.g. a machine, inventory) or it may be something which supports the
primary operations of the organization (e.g. office building).

Classification

Assets may be classified into Current and Non-Current. The distinction is made on
the basis of time period in which the economic benefits from the asset will flow to
the entity.

Current Assets are ones that an entity expects to use within one-year time from the
reporting date.

Non Current Assets are those whose benefits are expected to last more than one
year from the reporting date.

Types and Examples

Following are the most common types of Assets and their Classification along with
the economic benefits derived from those assets.

Asset Classification Economic Benefit


Used for the production of goods for sale to
Machine Non-current
customer.
Provides space to employees for administering
Office Building Non-current
company affairs.
Used in the transportation of company products
Vehicle Non-current
and also for commuting.
Inventory Current Cash is generated from the sale of inventory.
Cash Current Cash!
Receivables Current Will eventually result in inflow of cash.
Recognition Criteria of Assets
Definition

In order for an asset to be recognized in the financial statements, it must the


following definition laid down in the IASB Framework:

Asset is a resource controlled by the entity as a result of past events and


from which future economic benefits are expected to flow to the entity (IASB
Framework).

It is worth noting that the framework defines asset in terms of control rather than
ownership. While control is generally evidenced through ownership, this may not
always be the case. Therefore, an asset may be recognized in the financial
statement of the entity even if ownership of the asset belongs to someone else. For
instance, if a machine is leased to a company for the entire duration of its useful
life, the machine may be recognized in its Statement of Financial Position (Balance
Sheet) since the entity has control over the economic benefits that would be
derived from the use of the asset. This illustrates the use of Substance Over Form
whereby the economic substance of the transaction takes precedence over the
legal aspects of a transaction in order to present a true and fair view.

Explanation

Since, by definition, an asset must be controlled by the entity in order for it to be


recognized in the financial statements, certain 'Assets' would not qualify for
recognition. Consider a highly dedicated workforce. Generally speaking, a
hardworking and motivated workforce is the most valuable asset of any successful
company. But does an entity has control over its workers? The answer is no,
because an employee may quit an organization any day and seek employment in a
rival firm much to the detriment of the company. Therefore, such 'Assets' may not
be recognized in the financial statements of a company.

Apart from meeting the above definition, the Framework has advised the following
recognition criteria that ought to be met before an asset is recognized in the
financial statements.

The inflow of economic benefits to entity is probable.

The cost/value can be measured reliably.

Recognition Criteria

With regard to the first criteria, it makes sense to only recognize an asset if the
benefits from its use or sale are likely.
The second test ensures that the financial statements present assets that can be
measured objectively. For instance, how does a person place value on something
subjective such as customer loyalty or a dedicated employee?
Liabilities
Definition

According to IASB Frmework liability is defined as follows:

A liability is a present obligation of the enterprise arising from past events,


the settlement of which is expected to result in an outflow from the
enterprise of resources embodying economic benefits (IASB Framework).

Explanation

In simple words, liability is an obligation of the entity to transfer cash or other


resources to another party.

Liability could for instance be a bank loan, which obligates the entity to pay loan
installments over the duration of the loan to the bank along with the associated
interest cost. Alternatively, an entity's liability could be a trade payable arising from
the purchase of goods from a supplier on credit.

Classification

Liabilities may be classified into Current and Non-Current. The distinction is made
on the basis of time period within which the liability is expected to be settled by the
entity.

Current Liability is one which the entity expects to pay off within one year from the
reporting date.

Non-Current Liability is one which the entity expects to settle after one year from
the reporting date.

Types and examples

Following are examples the common types of liabilities along with their usual
classifications.

Liability Classification
Long Term Bank Loan Non-current
Bank Overdraft current
Short Term Bank Loan current
Trade Payables current
Debenture Non-current
Tax Payble Current

It may be appropriate to break up a single liability into their current and non current
portions. For instance, a bank loan spanning two years and carrying 2 equal
installments payable at the end of each year would be classified half as current and
half as non-current liability at the inception of loan.
Recognition Criteria of Liabilities
Definition

In order for a liability to be recognized in the financial statements, it must meet the
following definition provided by the framework:

A liability is a present obligation of the enterprise arising from past events,


the settlement of which is expected to result in an outflow from the
enterprise of resources embodying economic benefits (IASB Framework).

As is clear from the above definition, the obligation must be a present one, arising
from past events. In case of a bank loan for instance, the past event would be the
receipt of loan principal. The obligation to pay off the loan would be present from
the day the entity receives the loan principal (i.e. when an obligating event occurs).
Conversely, a liability may not be recognized in anticipation of a future obligation
such a bank loan expected to be taken in two year's time.

Explanation

The obligation to transfer economic benefits may not only be a legal one. Liability
in respect of a constructive obligation may also be recognized where an entity, on
the basis of its past practices, has a created a valid expectation in the minds of the
concerned persons that it will fulfill such obligations in the future. For example, if an
oil exploration company has a past practice of restoring oil rig sites after they are
dismantled in spite of no legal obligation to do so, and it advertises itself as an
environment friendly organization, then this gives rise to a constructive liability and
must therefore be recognized in the financial statements of the company. This is
because a valid expectation has been created that the company will restore oil rig
sites in the future.

Recognition Criteria

Apart from satisfying the definition of liability, the framework has also advised the
following recognition criteria to be met before a liability could be shown on the face
of a financial statement:

The outflow of resources embodying economic benefits (such as cash) from


the entity is probable.

The cost / value of the obligation can be measured reliably.

With regard to the first test, it is logical to recognize a liability only if it is likely that
the entity will be required to settle it. The second test ensures that only liabilities
that can be objectively measured are recognized in the financial statements.
If an obligation meets the definition of a liability but fails to meet the recognition
criteria, it is classified as a contingent liability. Contingent liability is not presented
as a liability in the statement of financial position but is instead disclosed in the
notes to the financial statements.
Equity
Definition

Equity is the residual interest in the assets of the entity after deducting all the
liabilities (IASB Framework).

Explanation

Equity is what the owners of an entity have invested in an enterprise. It represents


what the business owes to its owners. It is also a reflection of the capital left in the
business after assets of the entity are used to pay off any outstanding liabilities.

Equity therefore includes share capital contributed by the shareholders along with
any profits or surpluses retained in the entity. This is what the owners take home in
the event of liquidation of the entity.

The Accounting Equation may further explain the meaning of equity:

Assets - Liabilities = Equity

This illustrates that equity is the owner's interest in the Net Assets of an entity.

Rearranging the above equation, we have

Assets = Equity + Liabilities

Assets of an entity have to be financed in some way. Either by debt (Liability) or by


share capital and retained profits (Equity). Hence, equity may be viewed as a type
of liability an entity has towards its owners in respect of the assets they financed.

Examples

Examples of Equity recognized in the financial statements include the following:

Ordinary Share Capital

Preference Share Capital (irredeemable)

Retained Earnings

Revaluation Surpluses
Income
Definition

Income is increases in economic benefits during the accounting period in the form
of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity
participants (IASB Framework).

Explanation

Income is therefore an increase in the net assets of the entity during an accounting
period except for such increases caused by the contributions from owners. The first
part of the definition is quite easy to understand as income must logically result in
an increase in the net assets (equity) of the entity such as by the inflow of cash or
other assets. However, net assets of an entity may increase simply by further
capital investment by its owners even though such increase in net assets cannot
be regarded as income. This is the significance of the latter part of the definition of
income.

Types

There are two types of income:

Sale Revenue: Income earned in the ordinary course of business activities


of the entity;

Gains: Income that does not arise from the core operations of the entity.

For instance, sale revenue of a business whose main aim is to sell biscuits is
income generated from selling biscuits. If the business sells one of its factory
machines, income from the transaction would be classified as a gain rather than
sale revenue.

Examples

Following are common sources of incomes recognized in the financial statements:

Sale revenue generated from the sale of a commodity.

Interest received on a bank deposit.

Dividend earned on entity's investments.

Rentals received on property leased by the entity.

Gain on re-valuation of company assets.


Expense
Definition

Expenses are the decreases in economic benefits during the accounting period in
the form of outflows or depletions of assets or incurrences of liabilities that result in
decreases in equity, other than those relating to distributions to equity participants
(IASB Framework).

Explanation

Expense is simply a decrease in the net assets of the entity over an accounting
period except for such decreases caused by the distributions to the owners. The
first aspect of the definition is quite easy to grasp as the incurring of an expense
must reduce the net assets of the company. For instance, payment of a company's
utility bills reduces cash. However, net assets of an entity may also decrease as a
result of payment of dividends to shareholders or drawings by owners of a
business, both of which are distributions of profits rather than expense. This is the
significance of the latter part of the definition of expense.

Types

Following is a list of common types of expenses recognized in the financial


statements:

Salaries and wages

Utility expenses

Cost of goods sold

Administration expenses

Finance costs

Depreciation

Impairment losses

Accruals Principle

Expense is accounted for under the accruals principal whereby it is recognized for
the whole accounting period in full, irrespective of whether payments have been
made or not.
As expense is an element of the income statement, it is calculated over the entire
accounting period (usually one year) unlike balance sheet items which are
calculated specifically for the year end date.

Concept of Double Entry

Every transaction has two effects. For example, if someone transacts a purchase
of a drink from a local store, he pays cash to the shopkeeper and in return, he gets
a bottle of dink. This simple transaction has two effects from the perspective of
both, the buyer as well as the seller. The buyer's cash balance would decrease by
the amount of the cost of purchase while on the other hand he will acquire a bottle
of drink. Conversely, the seller will be one drink short though his cash balance
would increase by the price of the drink.

Accounting attempts to record both effects of a transaction or event on the entity's


financial statements. This is the application of double entry concept. Without
applying double entry concept, accounting records would only reflect a partial view
of the company's affairs. Imagine if an entity purchased a machine during a year,
but the accounting records do not show whether the machine was purchased for
cash or on credit. Perhaps the machine was bought in exchange of another
machine. Such information can only be gained from accounting records if both
effects of a transaction are accounted for.

Traditionally, the two effects of an accounting entry are known as Debit (Dr) and
Credit (Cr). Accounting system is based on the principal that for every Debit entry,
there will always be an equal Credit entry. This is known as the Duality Principal.

Debit entries are ones that account for the following effects:

Increase in assets

Increase in expense

Decrease in liability

Decrease in equity

Decrease in income

Credit entries are ones that account for the following effects:

Decrease in assets

Decrease in expense

Increase in liability

Increase in equity
Increase in income

Double Entry is recorded in a manner that the Accounting Equation is always in


balance.

Assets - Liabilities = Capital

Any increase in expense (Dr) will be offset by a decrease in assets (Cr) or increase
in liability or equity (Cr) and vice-versa. Hence, the accounting equation will still be
in equilibrium.

Examples of Double Entry

1. Purchase of machine by cash

Debit Machine Increase in Asset


Credit Cash Decrease in Asset

2. Payment of utility bills

Debit Utility Expense Increase in Expense


Credit Cash Decrease in Asset

3. Interest received on bank deposit account

Debit Cash Increase in Asset


Credit Finance Income Increase in Income

4. Receipt of bank loan principal

Debit Cash Increase in Asset


Credit Bank Loan Increase in Liability

5. Issue of ordinary shares for cash

Debit Cash Increase in Asset


Credit Share Capital Increase in Equity
Debits & Credits in Accounting
What are debits and credits?

Debit and Credit are the respective sides of an account.

Debit refers to the left side of an account.

Credit refers to the right side of an account.

Explanation

In accounting, every account or statement (e.g. accounting ledger, trial


balance, profit and loss account, balance sheet) has 2 sides known as debit and
credit.

In a typical accounting ledger (often referred to as a T-Account) the debit and credit
sides are split horizontally as shown below:

XYZ Receivable A/C

Date Particulars $ Date Particulars $


01-Dec- 10-Dec-
Sales 12,500 Discount allowed 500
14 14
10-Dec-
Bank 12,000
14

12,500 12,500

Debit Side Credit Side

According to the dual aspect principle, each accounting entry is recorded in 2 equal
debit and credit portions. In other words, the total amount that will be recorded in
the left side (debit) of accounting ledgers will always equal to the total amount
recorded on the right side (credit).

For example, you may consider how the accounting entries have been recorded in
the Receivable A/C shown above.
The ledger has been debited on account of credit sales amounting $12,500 and
(as can be ascertained from the particulars) the same amount has
been credited in the Sales A/C. Similarly, the credit entries in the Receivable A/C
relating to discount allowed and bank receipts are matched with equal amounts
recorded on the debit sides of Discount Allowed A/C and Bank A/C respectively.

In case of any confusion, please refer Accounting for Sales section for more
thorough explanation of the accounting entries discussed above.

Now the question arises, how do we know what to record on the debit side of
an account and what to record on the credit side?

Accounting has specific rules regarding what should be debited and what should
be credited as summarized in the chart below:

Debit Entries account for: Credit Entries account for:

Increase in assets Decrease in assets

Increase in expenses Decrease in expenses

Decrease in liabilities Increase in liabilities

Decrease in income Increase in income

Decrease in equity Increase in equity

Assets, expenses, liabilities, income & equity are the 5 elements of financial
statements. For explanation and examples of the various elements, please
refer elements of financial statements section.

As with accounting ledgers, all accounting statements are based on the rules of
debit and credit. For example, in a balance sheet, assets are reported on the debit
side whereas liabilities and equity are presented on the credit side. Although
traditional accounts and statements are presented in a T-Account format as above
(which makes understanding debits and credits a bit easier for beginners) many
accounts and statements nowadays are reported in a vertical format.

But fear not! As long as you master the rules of debit and credit, you shall have no
problem in understanding their application and presentation.
Example

Record the debit and credit entries of the following transactions:

a) Purchase of an office building for $1 million via funds transfer

b) Bonus payable to various employees amounting $5 million

c) Credit Sales during the period amounting $7 million

d) Issuance of ordinary shares at par for $10 million

a) Purchase of an office building

Account $ Effect

Debit Office Building 1,000,000 Increase in Asset

Credit Bank 1,000,000 Decrease in Assets

b) Performance Bonus

Account $ Effect

Debit Salaries, wages and benefits 5,000,000 Increase in Expense

Credit Bonus Payable 5,000,000 Increase in Liabilities

c) Credit Sales
Account $ Effect

Debit Accounts Receivables 7,000,000 Increase in Asset

Credit Sales Revenue 7,000,000 Increase in Income

d) Issuance of ordinary shares

Account $ Effect

Debit Bank 10,000,000 Increase in Asset

Credit Share Capital 10,000,000 Increase in Equity

If you face any problem in understanding the double entries, please refer double
entry accounting section.
Ledger Accounts

Accounting Entries are recorded in ledger accounts. Debit entries are made on the
left side of the ledger account whereas Credit entries are made to the right side.
Ledger accounts are maintained in respect of every component of the financial
statements. Ledger accounts may be divided into two main types: balance sheet
ledger accounts and income statement ledger accounts.

Balance Sheet Ledger Accounts

Balance Sheet ledger accounts are maintained in respect of each asset, liability
and equity component of the statement of financial position.

Following is an example of a receivable ledger account:

Receivable Account

Debit $ Credit

Balance b/d 1 500 Cash


Sales 2 1,000 Balance c/d
1,500

Balance brought down is the opening balance is in respect of the receivable


at the start of the accounting period.

These are credit sales made during the period. Receivables account is
debited because it has the effect of increasing the receivable asset. The
corresponding credit entry is made to the Sales ledger account. The account
in which the corresponding entry is made is always shown next to the
amount, which in this case is the Sales ledger.

This is the amount of cash received from the debtor. Receiving cash has the
effect of reducing the receivable asset and is therefore shown on the credit
side. As it can seen, the corresponding debit entry is made in the cash
ledger.

This represents the balance due from the debtor at the end of the
accounting period. The figure has been arrived by subtracting the amount
shown on the credit side from the sum of amounts shown on the debit side.
This accounting period's closing balance is being carried forward as the
opening balance of the next period.
Similar ledger accounts can be made for other balance sheet components such as
payables, inventory, equity capital, non current assets and so on.

Income Statement Ledger Accounts

Income statement ledger accounts are maintained in respect of incomes and


expenditures.

Following is an example of electricity expense ledger:

Electricity Expense Account

Debit $ Credit

Cash 1 1,000 Income Statement


1,000

This is the amount of cash paid against electricity bill. The expense ledger is
being debited to account for the increase in expense. The corresponding
credit entry has been made in the cash ledger.

This represents the amount of expense charged to the income statement.


The balance in the ledger has been recycled to the income statement which
is being debited by the same amount. Unlike balance sheet ledger accounts,
there is no balance brought down or carried forward. Instead, the income
statement ledger is closed each accounting period end with the balancing
figure representing the charge to income statement.

Similar ledger accounts can be made for other income statement components.
Accounting Equation

Double entry is recorded in a manner that the accounting equation is always in


balance:

Assets = Liabilities + Equity

Assets of an entity may be financed either by external borrowing (i.e. Liabilities) or


from internal sources of finance such as share capital and retained profits (i.e.
Equity). Therefore, assets of an entity will always equal to the sum of its liabilities
and equity.

The accounting equation may be re-arranged as follows:

Assets - Liabilities = Equity

We may test the Accounting Equation by incorporating the effects of several


transactions to see whether it still balances as theorized in the accountancy
literature. For the purpose of this test, we may classify accounting transaction into
the following generic types:

1. Transactions that only affect Assets of the entity

2. Transactions that affect Assets and Liabilities of the entity

3. Transactions that affect Assets and Equity of the entity

4. Transactions that affect Liabilities and Equity of the entity

Note:

For all the examples on the next pages, it will be assumed that before any
transaction, Assets of ABC LTD are $10,000 while its Liabilities and Equity are
$5,000 each.
Accounting Equation
Transactions that only affect Assets of the entity

These transactions result in an increase in one asset which is equally offset by a


decrease in another asset and vice versa.

Since Assets, and other components of the equation, will be the same as before
the transaction, the Accounting Equation will be in equilibrium.

Example 1

ABC LTD purchases a machine costing $1000 for cash.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $10,000* - Liabilities $5,000 = Equity $5,000

* Assets $10,000 = $10,000 Plus $1,000 (Machine) Less $1,000 (Cash)

Example 2

ABC LTD receives $500 cash from a receivable DEF LTD in respect of goods sold
on credit.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $10,000* - Liabilities $5,000 = Equity $5,000

* Assets $10,000 = $10,000 Plus $500 (Cash) Less $500 (Trade Receivable)