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Chapter Introduction to accounting 1 Objectives • Develop knowledge and understanding of the underlying principles and concepts relating to financial accounting • Preparation of basic financial statements 2 Contents • The purpose of financial reporting • Types of business entity • Nature, principle and scope of financial reporting • Users’ and stakeholders’ needs • Governance • The main elements of financial reports 3 The purpose of financial reporting • Financial reporting is a way of recording, analysing and summarising financial data 4 The purpose of financial reporting • Financial data is collected through actual transactions (sales, purchase, payment ) • Financial reporting is carried out by all business, regardless their size or structure 5 Types of business entity • Business is an organisation which uses economic resources (inputs) to create goods or services (outputs) which customers will buy • Businesses exist to make a profit (Income > expenditure) 6 Types of business entity • Businesses exist to make a profit 7 Types of business entity Sole traders Partnerships Limited liability companies 8 Types of business entity Sole trader Advantages Disadvantages - Limited paperwork - Complete control - Owner is entitled to profits and assets - Less reporting obligations - Highly flexible - Unlimited liability - Personal property may be vulnerable -Less capital -Long working hours -Continuity of business 9 Types of business entity Partnerships Advantages Disadvantages - Less reporting obligations - Additional capital - Division of roles and skill set - Sharing of risk -No company tax - Unlimited liability (unless LLP) - Costs associated with setting up -Continuity of business -Slower decision making -Dissolved when one partner leaves 10 10 Types of business entity Limited liability companies Advantages Disadvantages -Limited liability -Raise finance easier -Separate legal identity from shareholders -Tax advantages -Easy to transfer shares -Publish financial statements -Comply with legal and accounting requirements -FS to be audited -Share issues difficulty 11 11 Nature, principle and scope of financial reporting Financial performance and Financial position 12 12 Nature, principle and scope of financial reporting 13 13 Users’ and stakeholders’ needs • Who are they? • Is a person or entity having an interest in the performance of the business For example: – – – – – – – – Managers Shareholders Creditors (banks, suppliers) Customers Tax authorities Employees Financial analyst and advisers Government and their agencies 14 14 Governance • Those charged with governance of a company are responsible for the preparation of the financial statements • Means: – Preparation of FSs in accordance with the applicable financial reporting framework – Internal control – Prevention and detection of fraud 15 15 The main elements of financial reports • Statement of financial position: – Assets – Liabilities – Equity (or capital) At a particular moment • Statement of profit or loss: – Income – Expenses Over a given period 16 16 The main elements of financial reports • Asset: – A resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity • Liability: – A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits 17 17 The main elements of financial reports • Revenue: – The increases in economic benefits during the accounting period in form of inflows or enhancement of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants • Expense: – The decreases in economic benefits during the accounting period in 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 18 18 The main elements of financial reports • Also include: – Statement of profit or loss and other comprehensive income – Statement of cash flows – Notes 19 19 Chapter The regulatory framework 1 Objectives Introduce the regulatory system run be the IASB and IASB’s operation Familiarise with the IASB’s relationship with other bodies 2 The regulatory system Contents The International Accounting Standards Board (IASB) The International Financial Reporting Standards (IFRSs) 3 1 The regulatory system Factors that have shaped financial accounting: – National/local legislation – Accounting concepts and individual judgement – Accounting standards – Other international influences – GAAP – Fair presentation National/local legislation – LLCs’ accounts are required to publish yearly – Form and content of the accounts in regulated primarily by national legislation 5 Accounting concepts and individual judgement • FSs are prepared on the basis of: – Fundamental accounting assumptions: going concern, accounting period – Accounting conventions: disclosure, materiality Conclusion Fact Judgement Conclusion Conclusion 6 Accounting standards • Developed at both national level and an international level • IFRSs are produced by the International Accounting Standards Board (IASB) 7 Other international influences • Accounting firms • Nations contributions – In 2013 contributions were £21.4 million, an increase of 7% from 2012 • International events 8 GAAP GAAP (Generally Accepted Accounting Principles) US GAAP UK GAAP –Accounting concepts developed from GAAP: Business Entity Concept, Historical Cost, Accounting Period, Going Concern, Consistency –Accountants follow GAAP in preparing reports By this, these reports could be compared from one business to another What are control accounts? Control account: • An impersonal account • Used to keep total record of a number of individual items (personal accounts) Control account is mainly for trade receivables and payables Personal accounts are not part of the double entry system 4 What are control accounts? Personal Account Personal Account Personal Account Impersonal Account Personal Account 5 Discounts • There are two main kinds of discounts: – Trade discount (bulk purchase orders/big quantity or amount) Ex: $1/ per unit for a particular item; but $0.95 per unit if bought in quantities of 100 or more a time – Cash or settlement discount (in case of prompt/early payment) Ex: A supplier might charge $1,000 for goods but offers a discount of 5% if cash paid immediately (or within a number of days of the invoice date) 6 Discounts Trade discounts received Deduct from the cost of purchases Trade discounts allowed Deduct from the sales price This is the matter of trading policy 7 Discounts • Cash discount received is shown as other income in the statement of profit or loss • Cash discount allowed is shown as expenses in the statement of profit or loss 8 Discounts • Supplier usually send a supplier statement, on a monthly basis, showing invoices issued, credit notes (reduce the initial price), payments received and discounts given • Any differences (between this statement and payables ledger) need to be identified and any errors corrected 9 Discounts 10 10 Discounts • Steps for supplier statement reconciliation: – Step 1: Tick of the items which appear in both the statement and the payables ledger – Step 2: Agree (check) the opening balance on the supplier’s statement – Step 3: Allocate payments to invoices after allowing for any credit notes – Step 4: Indentify diffreneces 11 11 Discounts • Errors could be found when reconcile supplier statement: – Payments in transit – Omitted invoices and credit notes – Other errors (ex: misposted) 12 12 The operation of control accounts • The two most important control accounts are those for receivables and payables They are part of the double entry system 13 13 The operation of control accounts Invoice Credit sales Month End Sales day book Receipt Payment receive Receivable Account Month End Receivable Account Cash book Personal Accounts are memorandum accounts, they are not a part of the double entry system Payment + Discount (if any) 14 14 The operation of control accounts Invoice Credit purchase Month End Purchase day book Receipt Payment made Payable Account Month End Cash book Payable Account Personal Accounts are memorandum accounts, they are not a part of the double entry system Payment + Discount (if any) 15 15 The operation of control accounts • Opening credit balance of receivables control account could be a result of the over-payment of debts from customer or for advance payments of debts for which no invoices have yet been sent • Opening debit balance in the payables control account could be a result that business has overpaid to supplier or a credit note is awaited for returned goods 16 16 The operation of control accounts • Contra entries (offset entries) are used when same business may be both a receivable and a payable • For example: Mr A buys goods from business and business buys stationery from Mr A Mr A owes business $500 and business owes Mr A $350 Thus, an agreement could be reached to offset these: Dr Payable Control Account Cr Receivable Control Account 350 350 17 17 The purpose of control accounts ✓ Check the accuracy of entries made in the personal accounts ✓ Locate the errors ✓ Provide an internal check ✓ Speed up the preparation of TB or statement of financial position 18 18 The purpose of control accounts Causes of imbalance between control accounts and receivables/payables ledgers: › › › › Posted incorrect amount Transposition error (123 → 321) Transaction are not recorded in ledger Miscast 19 19 Chapter 15 Bank reconciliations Objectives Understand the purpose of bank reconciliations Identify the differences between the cash book and the bank statement Correct cash book errors and omissions Prepare bank reconciliation statements Contents Bank statement and cash book The bank reconciliations Worked examples 1 Bank statement and cash book • The ending balance on the bank statement and the ending balance on the cash book should be the same • However, some of the following errors might happen: – Error in calculation (Usually in the cash book) – Omissions (Bank charges not posted in the cash book) – Time differences (Not yet been cleared cheques) • These difference could be found by engaging bank reconciliation Bank statement and cash book • These differences could be found by engaging bank reconciliation The bank reconciliations • A bank reconciliation is needed to identify the difference between cash book and the bank statement • These following items could be found: – Corrections and adjustments to cash book – Item reconciliation the corrected cash book 2 The bank reconciliations • Corrections and adjustments to cash book: – Items haven’t been recorded in the cash book: • Payments from bank account • Dividend received • Bank interest or bank charges – Errors in the cash book that need to be corrected The bank reconciliations • Item reconciliation the corrected cash book balance (bank balance shown in the statement of financial position) to the bank statement: – Cheques paid but not yet been cleared (unpresented cheques or outstanding cheques) – Cheques received but not yet been cleared (outstanding lodgements) – Electronic payments that have not yet been cleared Worked examples • Example 1: At 30 September 20X0, the balance in the cash book of the business was $805.15 debit A bank statement on 30 September 20X0 showed business to be in credit by $1,112.30 • On investigation, it was found that: – Cash book had been short of $90.00 on the debit – Cheques paid in not yet credited by the bank amounted to $208.20 (Outstanding lodgements) – Cheques drawn not yet presented to bank amounted to $425.35 (Unpresented cheques) 3 Worked examples • Example (Cont): – Show the correction to the cash book – Prepare a statement reconciling the balance per bank statement to the balance per cash book 10 Worked examples • Example 2: On 31 January 20X1, cash book showed a credit balance of $150 In performing the reconciliation the following points came to light: • Not recorded in the cash book: – Bank charges ($36) – Transfer from deposit account to current account ($500) • Not recorded on the bank statement: – Unpresented cheques ($116) – Outstanding lodgements ($630) • Bank also had debited bank account with a cheque for $400 in error What was the original balance on the bank statement? 11 Chapter 16 Correction of errors 1 Objectives • Identify the types of error which may occur in bookkeeping systems • Prepare journal entries to correct errors • Understand the purpose of a suspense account • Identify errors leading to the creation of a suspense account • Record entries in a suspense account 2 Contents Types of error in accounting The correction of errors 3 1 Types of error in accounting • Five frequent types of error: – Errors of transposition – Errors of omission – Errors of principle – Errors of commission – Compensating errors 4 Types of error in accounting • Errors of transposition This error could be detected if the difference between debit and credit can be divided exactly by 5 Types of error in accounting • Errors of omission: – Not recording a transaction at all; or – Making a debit or credit entry, but not the corresponding double entry 6 Types of error in accounting • Errors of principle – Transaction is recorded in wrong accounts (accounting entries breaks the ‘rules’ of an accounting principle or concept) – Ex: $150 cost of repairing the machine is added to the cost of the machine (capitalised); or $200 withdraw cash of the owner is recorded at a reduction of cash sales 7 Types of error in accounting • Errors of commission – Putting a debit entry or a credit entry in the wrong account; or – Errors of casting (adding up) 8 Types of error in accounting • Compensating errors are errors which are, coincidentally, equal and opposite to one another (One error is cancelled out by another error or more errors) 9 Types of error in accounting • Among above types of error, only: – Errors of transposition – Errors of omission (one-sided) – Errors of commission (two debit entries are made) Could be detected by a extracting trial balance 10 10 The correction of errors Errors that make the trial balance still balance Use journal entries Errors that make the trial balance does not balance Use suspense accounts 11 11 The correction of errors • Journal entries Date Account to be debited Account to be credited (Narrative to explain the transaction) Debit X Credit X Remember this? 12 12 The correction of errors • Suspense account is used when: – The errors lead to an imbalance in the trial balance; or – It is not known where to post an amount; and • Suspense account is a temporary account; therefore, when the mystery is solved, the suspense account is closed by using a journal entry 13 13 The correction of errors • Under no circumstances should there still be a suspense account when it comes to preparing the statement of financial position of a business In other words, the suspense account must be cleared and all correcting entries made before the final accounts are drawn up • Note: The exam question could focus on the effect of corrections of errors on profit for the year and total assets 14 14