Summary Notes 1.1 Framework of Accounting

7/29/2019 Summary Notes 1.1 Framework of Accounting

1/11

MS 15D Financial Accounting

Purpose of Accounting

Financial accounting is a system that involves recording, analysis and communication of financialinformation. The purpose of accounting is to provide financial information about the current operations

and financial condition of a business to individuals, agencies and organizations. In other words,accounting is a system that is used by businesses to monitor their activities and report theirperformance. The overall objective of accounting is to provide information that can be used in makingeconomic decisions.

Users of Financial InformationPersons outside of the business who have interest in the business, but are not involved in its day-to-dayoperation (external users), as well as, persons inside the organization who are involved in its day-to-day operations (internal users), use financial information. Some of the main users of financialinformation are:

1. Investors

Investors (both existing and potential) need information concerning the safety andprofitability of their investment and to decide whether a change of ownership interest iswarranted.

2. Trade and Loan Creditors

Both present and potential creditors of the business use financial information to help themin deciding whether or not it is safe to extend credit to the business. They need informationabout the profitability and stability of the enterprise. In other words, they are interested inthe solvency of the business i.e. Can the business pay its debts when they fall due?

3. Statutory Agencies

They need this information to assist them in evaluating tax returns for assessment purposesand to see whether there is compliance with government rules and regulations e.g. IncomeTax department and Registrar of Companies.

4. Employees and Trade Unions

They use financial information to assist in the making of employment decisions and innegotiating contracts and benefits.

5. Financial Analysts

Use financial information to evaluate the soundness of businesses for their clients who may

wish to make investment decisions and for Stock Exchange purposes.

6. Customers of Businesses

Use financial information to help them in evaluating their relationship with businesses andto make decisions regarding possible future business relationships.

7. Managers of Businesses

To assist them in the decision making, controlling and directing the day-to-day running ofthe business, as well as, to aid in the formulation of policies and plan for the future of the

1


2/11

enterprise. Managers have a special interest in the annual financial statements, as these arethe statements popularly used by decision makers outside of the organization.

Branches of Accounting

Financial Accounting Provides information for external users e.g. Potential investors,

creditors, tax authorities, trade unions and financial analysts.

Management Accounting Provides information for internal decision making e.g.

Management, board of directors and employees.

Accounting Associations

American Institute of Certified Public Accountants (AICPA)

Institute of Chartered Accountants of Jamaica (ICAJ)

Association of Chartered Certified Accountants (ACCA)

Institute of Internal Auditors (IIA) Institute of Management Accountants (IMA)

Accounting Qualifications

Certified Internal Auditor (US)

An internal auditor, who has achieved professional recognition by passing the uniformexamination offered by the IIA.

Certified Management Accountant (US)

An accountant, who has passed an examination offered by the IMA

Certified Public Accountant (US)/Chartered Accountant (UK; Jamaica)

A public accountant, who has met certain educational and experience requirements and haspassed an exam prepared by the AICPA or ACCA.

The Accounting Process

Accounting is a system of gathering financial information about a business and reporting thisinformation to users. The six main steps of the accounting process are:

Analyzing looking at events that have taken place and thinking about how they affect

the business Recording entering financial information about the events in the accounting system.

Classifying sorting and grouping similar items together.

Summarizingbringing the various items of information together to determine a result.

Reporting telling the results.

Interpreting deciding the meaning and importance of the information in the various reports.

This may include percentage analyses and use of ratios to help explain how pieces ofinformation are related.

2


3/11

Types of Ownership StructuresBusinesses are classified according to who owns them and the specific way in which they areorganized.

Sole Trader or Proprietorship A business with a single owner called a proprietor.

Not required by law to make any of its financial information available to the public.

No formal document required for formation.

Low start-up cost.

The owner is personally responsible for all the decisions made for the business i.e. the owner

assumes all risk and makes all decision (owner manages business).

Owner is responsible for all the debts of the business i.e. the owners liability is unlimited and

therefore extends to his/her personal assets. Although the financial records of a business shouldbe kept separately from the owners personal financial records, there is no separation of the soleproprietors books and its owners books for legal purposes.

Any amount earned from the business is included on the personal tax return of the owner.

Examples include small retail stores, doctor, attorney, accountant, and physician.

Partnerships

Least common form of organization

Owned by two or more persons e.g. physicians, attorneys and accountants.

Like the proprietorship, the owners i.e. each of the partners, is responsible for the debts of the

business i.e. the liability of a partner is unlimited and therefore extends to his/her personalbelongings

No formal document is required for formation.

Details like how much work each will do and how they will share any earnings from the

business are specified in a document called a partnership agreement.

Like the sole proprietor, earnings by a partner from the partnership are included when filing

their own personal tax returns.

Corporation

Legally and financially separate from its owners. As legal entities, corporations may enter into

contracts just like individuals.

Ownership in a corporation is divided into amounts called shares of capital stock, each

representing ownership in a fraction of the corporation.

An owner of shares in a corporation is called a stockholder or a shareholder. Stockholders arefree to sell some or all of their shares to other investors at anytime (Transferable ownershiprights).

Owners risk is limited to their initial investment and they have very little influence on

business decisions.

Managed by a Board of Directors

Unlike proprietorships and partnerships, corporation pays taxes on its earnings i.e. an owner in

a corporation does not include the income of the corporation in his/her personal tax returns.

Formal documents are required for formation

3


4/11

Articles of Incorporation

This document states, among other things:-

The name of organization; where company office will be located; the objective of the

company; that the liability of the owners is limited if it is not to be unlimited; how thebusiness plans to acquire financing.

The rules drawn up to govern the internal working of the company; regulate the holdingof meetings; regulate the issue of capital; define powers and duties of directors, rights ofshareholders etc.

A corporation whose shares of stock are owned by a very small number of people is called a closelyheld corporation or a private company.

For the first couple of weeks we will be focussing on the accounts of the sole proprietorship.

Types of Businesses

ServiceA business that provides a service e.g. travel agency, computer consultant, physician, hospital, lawfirm, accounting firm.

Merchandising

Buys products from another business and sells to customers e.g. department stores, pharmacies,jewellery stores, supermarkets.

Manufacturing

Makes product to sell e.g. automobile manufacturer, furniture maker, toy factory, and garmentmanufacturing company.

Financial Reporting

External financial reporting is governed by an established body of standards and principles that aredesigned to carefully define what information a firm must disclose to outsiders. The FinancialAccounting Standards Board (FASB), in the US has developed a set of standards referred to asGenerally Accepted Accounting Principles (GAAP). GAAP are standards that are adhered to in thepreparation of accounting information for investors and creditors. The standards provide the generalrules and guidelines to be followed in the accounting and reporting process i.e. they determine theamount of information to be included in the financial statements, as well as, the format of preparationand presentation of such information. The rules provide assurance that business entities are reporting

business activities in a similar manner. GAAP are important in ensuring the integrity of financialaccounting information, so that financial reports for different entities can be more easily compared.

In the same manner than FASB establishes accounting standards for U.S. entities, other countries havetheir own standard setting bodies. In an attempt to harmonize conflicting standards, the InternationalAccounting Standards Committee (IASC) was formed in 1973 to develop worldwide accountingstandards. The International Accounting Standards Board (IASB) replaced the IASC in 2001. Sincethen the IASB has amended some IAS, has proposed to replace some IAS with new InternationalFinancial Reporting Standards (IFRS) and has proposed certain new IFRS on topics for which no IAS

4


5/11

previously existed. This body, the IASB, now represents more than 143 accountancy bodies frommore than 103 countries, including the United States. The accounting standards produced by the IASCare referred to as International Accounting Standards (IASs). IASs are envisioned to be a set ofstandards that can be used by all companies, regardless of their physical location. IASC standards aregaining increasing acceptance worldwide. However the Securities and Exchange Commission (SEC),in the U.S. has so far not recognized the standards of the IASC, and has barred foreign companies from

listing their shares on the U.S. stock exchanges unless those companies agree to provide financialstatements in accordance with U.S GAAP. Jamaica adopted IAS on July 1, 2002.

Note

Investors and creditors need relevant and reliable information about an entity. To ensure that this isdone, companies are required to have their financial statements audited by independent accountants.An audit is a financial examination of the financial statements of an entity to determine whether these

statements give a true and fair view of the financial health of the business.

Like any other profession, accounting is governed by ethical rules and standards. Recent scandals inthe corporate world point to the importance of ethics. The preparers of financial statements should not

only abide by GAAP, but also ethical standards and ensure that accurate and reliable information isprovided by the financial statements of the entity.

The IASB Framework

The framework describes the basic concepts by which the financial statements are prepared. It servesas a guide to the Board in developing accounting standards and as a guide to resolving accountingissues that are not addressed directly in an IAS or IFRS.

The IASB Frameworki) defines the objective of financial statementii) identifies the qualitative characteristics that make financial information usefuliii) defines the basic elements of financial statements and the concepts for recognizing and

measuring them in financial statements

Characteristics of Accounting Information

The objective of financial reporting is to provide useful information. The qualitative characteristics ofuseful accounting information are

Understandability i.e. information should be presented in a way that is readily understandable

by users who have a reasonable knowledge of business, economic activities and accounting.

Relevance

For information to be relevant it must have the following qualitiesi) Feedback value & Predictive value i.e. feedback on past events help confirm or correct

earlier expectations. Such information can be used to help predict future outcomes.

ii) Timeliness. This is important for information to make a difference. Informationreceived after a decision is made is useless, hence for information to be relevant it must

5


6/11

be provided to users within the time period in which it is most likely to influence theirdecisions. Materiality is also a component of relevance. Is the item large enough toinfluence the decision of a user of the financial information? Information is said to be

material if its omission or misstatement could influence the decision of a user.

Managers usually exercise professional judgment in determining whether an item is

material or immaterial.

Reliability

Information should be relatively free from error. Reliability does not mean absolute accuracy,as information that is based on judgment cannot be totally accurate. The information presentedshould therefore have:

- Verifiability i.e. the data should be free from material error and bias and can beverified by other trained accountants.

- Representational Faithfulness i.e. the economic events are properly measured- Neutrality i.e. fairness.

Comparability

Users must be able to compare the financial statements to a standard or benchmark such asother firms within the industry or a prior period within the same firm. Comparability requiressimilar events to be accounted for in the same manner on the financial statements of differentcompanies and for a particular company for different periods. Disclosure of accounting policiesis essential for comparability.

True and fair

Adherence to the above ensures true and fair view.

Benefits greater than cost

Information like any other commodity must be worth more than the cost of producing it.

The Accounting Elements

Three basic accounting elements exist for every business entity: assets, liabilities and owners equity.

i) Assets

These are economic resources owned or controlled by an entity and will provide future benefit.Examples of assets include cash, merchandise, furniture and fixtures, machinery, building and land.Businesses may also have an asset called accounts receivable, which represents the amount of money

owed to the business by its customers as a result of making sales on account or on credit.Assets can either be termed current assets or non-current assets.Current assets are assets that the business plans to convert into cash or use to generate earnings in thenext 12 months or within the businesss accounting cycle, whichever is longer. Operating cycle is theperiod between the purchasing of goods from supplier to collecting from customers. Examples ofcurrent assets are cash, accounts receivable, short-term investments, unsold merchandise (inventory).

6


7/11

Non-current assets (also referred to as Long-term assets or Fixed assets) are assets that are notexpected to be used up in a year. Examples of fixed assets are land, building, furniture and fixtures,machinery. Other categories of L-T assets include L-T investments.

ii) Liabilities

These are debts or obligations the business has incurred to obtain the assets it has i.e. liabilities are

amounts the business owes that can be paid with cash, goods or services. Common liabilities areaccounts payable, notes payable and short-term loans. An account payable is an unwritten promise topay a supplier for assets purchased or services received. A formal written promise to pay suppliers orlenders specified sums at definite future dates is known as a note payable.

Like assets, liabilities can be grouped as current liabilities or non-current liabilities.Current liabilities are amounts to be paid off within the next 12 months or within the operating cycleof the entity if it is longer. Examples of current liabilities are accounts payable, notes payable, interestpayable and short-term loans.

Non-current or long-term liabilities are amounts owing that will be paid off over a period longer than

one year. E.g. Mortgages, long-term loans

iii) Owners Equity

Also referred to as Net Worth and Capital, owners equity represents the owners claim to the assets ofthe business. It is the amount by which the business assets exceed the business liabilities. There aretwo ways for the owners to increase their claims to the assets of the business

- By making contribution- By earning contribution

The Accounting Equation

The relationship between the three basic accounting elements assets, liabilities and owners equity can be expressed in the form of a simple equation known as the accounting equation.

Assets = Liabilities + Owners Equity

All business transactions affect the accounting equation. Business transactions are economic events,which have a direct impact on the business. In financial accounting, all business transactions arequantified in monetary terms. Examples of business transactions are buying goods and services, sellinggoods and services, making loans and borrowing money. The accounting equation must remain inbalance after the transaction is completed.

Expanding the Accounting EquationRevenues

These are amounts the business earns from providing goods or services to customers. E.g. sales fromsale of merchandise, consulting fees, rent revenue- if the business rents space to others; interestrevenue for interest earned on bank deposits. Revenues increase both assets and owners equity.

Expenses

Expenses are costs incurred to generate revenues. E.g. rent, salaries, supplies used. Expenses decreaseassets or increase liabilities and reduce owners equity.

7


8/11

If revenues exceed expenses, the difference is referred to as Net Income.If expenses exceed revenues, the difference is referred to as a Net Loss.

Withdrawals (Drawings)

Drawings are cash or other assets taken by the owner from the business for his/her personal use.

Drawings serve to reduce owners equity.

Assets = Liabilities + [Owners Equity + (Revenues Expenses) Drawings]

Financial Statements

Information relating to a business is usually communicated by way of financial statements. Thesestatements are usually analyzed to evaluate the performance of the business. As per IAS 1, a completeset of financial statements include:

1. Income Statement2. Statement of Changes in Owners Equity3. Balance Sheet (Statement of Position)4. Statement of Cash Flows5. Notes to the Financial Statements comprising a summary of accounting policies and other

explanatory notes.

The financial statements commonly prepared are the income statement, statement of owners equityand balance sheet.

All financial statements must carry a heading. This heading includes:

- The name of the business- The title of the statement- The time period covered or the date of the statement.

The Income Statement and Statement of Owners Equity provide information concerning eventscovering a period of time, in this case the month ended. The balance sheet on the other hand, offers apicture of the business on a specific date.

1. The Income Statement

Also called Statement of Earnings, Statement of Operations or Profit & Loss Statement is a summaryof all the revenues (income from sale of goods or services) a company earns minus all the expenses

incurred in earning the revenues, for a specific period a month, a quarter or a year. The Incomestatement is therefore regarded as an activity statement. The statement tells whether the businessearned a net income i.e. total revenues > total expenses or a net loss i.e. total expenses > total revenues.There are two (2) types of income statement:

Single step groups all revenues together and all expenses together.

Multiple step reports gross profit, net income from operations and net income.

8


9/11

2. Statement of Owners Equity (Sole Proprietorship)

This statement shows any change that took place in owners equity from net income or net loss,withdrawals and other investments during a specific time period. Net income increases owners equity,whereas net loss and withdrawals decrease owners equity.

John Doe Statement of Owners Equity

John Doe, Capital @ 1/1/-Add additional investment by ownerTotal InvestmentNet Income For PeriodLess Withdrawals by ownerIncrease/(Decrease) in CapitalJohn Doe, Capital 31/12/-

$

xxxxxxxxxxxx

$xxxxxxxxxxxxxxxxxx

xxxxxxxxxxxx

3. The Balance Sheet

The balance sheet, also referred to as Statement of Financial Position/Condition, describes the financial

position of the business at a specific point in time. It is a position statement, which gives a snap shot ofthe business at a point in time.

The balance sheet reflects the accounting equation i.e. Assets = Liabilities + Owners Equity. IAS 1requires that an entity must normally present a classified balance sheet, separating current and non-current assets and liabilities. The standard does not prescribe the format of the balance sheet. Thebalance sheet can be arranged in either of two formats- Report format Assets at the top and liabilities and owners equity at the bottom- Account format Assets on left and liabilities & owners equity on the right.Assets can be presented current then non-current or vice versa and liabilities can be presented current,non-current then equity or vice versa. A net asset presentation (assets liabilities) is allowed. Thelong-term financing approach used in the UK and elsewhere- Fixed Assets + Current Assets CurrentLiabilities = Long-term Debt + Equity, is also acceptable.

Assets are listed in the balance sheet in order of liquidity. Liquidity is a measure of how easily an assetcan be converted into cash. The more liquid an asset is, the more easily it can be converted into cash.

4. Statement of Cash Flows

One of the purposes of financial statements is to assist users in making predictions about an entity'sfuture cash inflows and outflows. Users can predict the future only if they have sufficient information.Unfortunately the IS and BS are not enough to furnish the requisite information. The statement of cashflows is very important in understanding an enterprise for purposes of investment and credit decisions.It depicts the ways cash has changed during a designated period the cash received from revenues andother transactions, as well as, the cash paid for certain expenses and other acquisition during theperiod. In short, the statement provides information about the nature and sources of an entitys cashinflows and outflows. The statement classifies the various cash flows into three categories:

1. Operating Activities2. Investing activities3. Financing Activities

The information contained in the statement is useful in answering questions such as:1. Did the business fund its operations from operations, loans or stockholders investments?2. Were funds used for expansion; to reduce or repay outstanding debts, purchase fixed assets etc?

9


10/11

A clear understanding of a borrowers cash flow is one of the most important components of financialstatements analysis in the banking sector. It provides the lender with a picture of the financial health ofthe business by focusing on receipts and disbursements.

Operating Activities

These are activities that are primarily related to the production and sales of goods and services, which

enter into the determination of income i.e. items, which affect the income statement.

Inflows Receipts from customers, loan interest received, dividends received.Outflows Payment for inventory, employees' wages & salaries, taxes, interest paid and other

business expenses

Investing Activities

These are activities, which involve investment of the resources of a business

Inflows Receipts from sales of stock and bonds held in other businesses and from disposal oflong-term resources such as land and buildings and receipt of loan principal from

borrowers.

Outflows Payments made to acquire long-term assets or securities in other businesses, loans madeto other businesses etc.

Financing Activities

These are activities, which provide a business with resources from either owners or creditors, i.e. theowners or creditors investing money in the business and the repayments. A business is financed byeither debt (from outsiders) or equity (from insiders)

Inflows Receipts from issue of stocks and bonds, cash received from owner to financeoperations, and loans

Outflows Payment of loan principal to creditor and dividends paid.Parentheses are used to denote negative cash flows i.e. cash outflows.

It is important to note that the financial statements are interlinked as balances derived from onestatement are reflected in other statements. The statements are prepared in the following order:Income Statement Statement of Owners Equity Balance Sheet Statement of Cash Flows

5. Notes Accompanying Financial Statements

As a general rule, a company should disclose any facts that an intelligent person would considernecessary for the statements to be properly interpreted. The adequate disclosure principle means thatthe financials should be accompanied by any information necessary for the proper interpretation of thestatements. These disclosures appear in what are called notes to the financials at the end of theaccounting period. The items to be disclosed are based on a combination of official rules, tradition andthe accountants professional judgement. Two main items that are always disclosed are the accountingmethods used and the due dates of major liabilities. Other items to be disclosed include: lawsuitspending against the business; scheduled plant closings, Government investigations into the safety ofthe companys products or the legality of its pricing policies; significant events occurring after thebalance sheet date but before the financials are actually issued; specific customers that account for a

10


11/11

large portion of the companys business; unusual transactions or conflict of interest between thecompany and its key officers.

Companies are not required to disclose information that is immaterial or that does not have a directfinancial impact on the business e.g. resignation, firing or death of key officers/executive.

11

Documents

Summary Notes 1.1 Framework of Accounting