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Introduction to Financial 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)

Accountancy therefore 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.
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 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 of accounting information include the following:

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


of credit are set 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 supplier which is
necessary for 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.

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 specialized areas 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 specialized areas to cater for the different
needs of the users.
Main types of accounting are as follows:
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.

What are Financial Statements

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


entity. These are written reports that quantify the financial strength and
performance of a company.
Financial Statements reflect the financial effects of business transactions and
events on the entity.
Types of Financial Statements
The four main types of financial statements are:

Statement of Financial Position (Balance Sheet)


Income Statement (Profit and Loss Account)
Cash Flow Statement
Statement of Changes in Equity

Statement of Financial Position

Statement of Financial Position, or Balance Sheet, presents the financial position


of an entity at any given date. A Statement of Financial Position has three main
components:

Assets: Something a business owns or controls.


Liabilities: Something a business owes to someone

Equity: What the business owes to its owners. This represents the amount
of capital that is left in the business after its assets are used to pay off its
outstanding liabilities.

Following is an Example of Statement of Financial Position (Balance Sheet):


Statement of Financial Position as at 31st December 2011
Assets
Property, Plant & Equipment
Cash 10,000
Inventory 10,000
Receivable5,000
Total Assets

120,000

Equity

Share Capital

80,000

Retained Reserves

Total Equity

20,000

100,000

100,000

Liabilities
Payables 5,000
Bank Loan15,000
Total Liability

20,000

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, its no surprise that in the above example total Assets worth
$120,000 equal to the sum of Equity ($100,000) and Liabilities ($20,000).

This leads us to the Accounting Equation:

Assets = Liabilities + Equity


The Equation may be re-arranged as follows:
Equity = Assets - Liabilities
Liabilities = Assets - Equity

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.

Accounting Concept and Principles

Accounting Concepts and Principles are a set of broad conventions that have
been devised to provide a basic framework for financial reporting. As financial
reporting involves significant professional judgments by accountants, these
concepts and principles ensure that the users of financial information are not
mislead by the adoption of accounting policies and practices that go against the
spirit of the accountancy profession. Accountants must therefore actively
consider whether the accounting treatments adopted are consistent with the
accounting concepts and principles.
In order to ensure application of the accounting concepts and principles, major
accounting standard-setting bodies have incorporated them into their reporting
frameworks such as the IASB Framework.
Following is a list of the major accounting concepts and principles:
Relevance
Reliability
Neutrality
Faithful Representation
Substance over Form
Prudence
Completeness
Comparability/Consistency
Understandability
Materiality
Going Concern
Accruals

Business Entity
In case where application of one accounting concept or principle leads to a
conflict with another accounting concept or principle, accountants must consider
what is best for the users of the financial information. An example of such a case
would be the trade off between relevance and reliability. Information is more
relevant if it is disclosed timely. However, it may take more time to gather
reliable information. Whether reliability of information may be compromised to
ensure relevance of information is a matter of judgment that ought to be
considered in the interest of the users of the financial information.

Relevance:
Information should be relevant to the decision making needs of the user.
Information is relevant if it helps users of the financial statements in predicting
future trends of the business (Predictive Value) or confirming or correcting any
past predictions they have made (Confirmatory Value). Same piece of
information which assists users in confirming their past predictions may also be
helpful in forming future forecasts.
Example:
A company discloses an increase in Earnings Per Share (EPS) from $5 to $6
since the last reporting period. The information is relevant to investors as it may
assist them in confirming their past predictions regarding the profitability of the
company and will also help them in forecasting future trend in the earnings of
the company.
Relevance is affected by the materiality of information contained in the financial
statements because only material information influences the economic decisions
of its users.

Example:
A default by a customer who owes $1000 to a company having net assets of
worth $10 million is not relevant to the decision making needs of users of the
financial statements.
However, if the amount of default is, say, $2 million, the information becomes
relevant to the users as it may affect their view regarding the financial
performance and position of the company.

Reliability
Information is reliable if a user can depend upon it to be materially accurate and
if it faithfully represents the information that it purports to present. Significant
misstatements or omissions in financial statements reduce the reliability of
information contained in them.
Example:
A company is being sued for damages by a rival firm, settlement of which could
threaten the financial stability of the company. Non-disclosure of this
information would render the financial statements unreliable for its users.
Reliability of financial information is enhanced by the use of following
accounting concepts and principles:

Substance Over Legal Form

Meaning
Substance over form is an accounting concept which means that the economic
substance of transactions and events must be recorded in the financial
statements rather than just their legal form in order to present a true and fair
view of the affairs of the entity.
Substance over form concept entails the use of judgment on the part of the
preparers of the financial statements in order for them to derive the business
sense from the transactions and events and to present them in a manner that best
reflects their true essence. Whereas legal aspects of transactions and events are
of great importance, they may have to be disregarded at times in order to
provide more useful and relevant information to the users of financial
statements.

Example:
There is widespread use of substance over form concept in accounting.
Following are examples of the application of the concept in the International
Financial Reporting Standards (IFRS).
IAS 17 Leases requires the preparers of financial statements to consider
the substance of lease arrangements when determining the type of lease for
accounting
purposes.
For example, an asset may be leased to a lessee without the transfer of
legal title at the end of the lease term. Such a lease may, in substance, be
considered as a finance lease if for instance the lease term is substantially
for entire useful life of the asset or the lease agreement entitles the lessee
to purchase the asset at the end of the lease term at a very nominal price

and it is very likely that such option will be exercised by the lessee in the
given circumstances.
IAS 18 Revenue requires accountants to consider the economic substance
of the sale agreements while determining whether a sale has occurred or
not.
For example, an entity may agree to sell inventory to someone and buy
back the same inventory after a specified time at an inflated price that is
planned to compensate the seller for the time value of money. On paper,
the sale and buy back may be deemed as two different transactions which
should be dealt with as such for accounting purposes i.e. recording the sale
and (subsequently) purchase. However, the economic reality of the
transactions is that no sale has in fact occurred. The sale and buy back,
when considered in the context of both transactions, is actually a financing
arrangement in which the seller has obtained a loan which is to be repaid
with interest (via inflated price). Inventory acts as the security for the loan
which will be returned to the 'seller' upon repayment. So instead of
recognizing sale, the entity should recognize a liability for loan obtained
which shall be reversed when the loan is repaid. The excess of loan
received and the amount that is to be paid (i.e. inflated price) is recognized
as finance cost in the income statement.

Importance
The principle of Substance over legal form is central to the faithful
representation and reliability of information contained in the financial
statements. By placing the responsibility on the preparers of the financial
statements to actively consider the economic reality of transactions and events to
be reflected in the financial statements, it will be more difficult for the preparers
to justify the accounting of transactions in a manner that does fairly reflect the
substance of the situation. However, the principle of substance over form has so
far not been recognized by IASB or FASB as a distinct principle in their

respective frameworks due to the difficulty of defining it separately from other


accounting principles particularly reliability and faithful representation.

Comparability/Consistency

Financial statements of one accounting period must be comparable to another in


order for the users to derive meaningful conclusions about the trends in an
entity's financial performance and position over time. Comparability of financial
statements over different accounting periods can be ensured by the application
of similar accountancy policies over a period of time.
A change in the accounting policies of an entity may be required in order to
improve the reliability and relevance of financial statements. A change in the
accounting policy may also be imposed by changes in accountancy standards. In
these circumstances, the nature and circumstances leading to the change must be
disclosed in the financial statements.
Financial statements of one entity must also be consistent with other entities
within the same line of business. This should aid users in analyzing the
performance and position of one company relative to the industry standards. It is
therefore necessary for entities to adopt accounting policies that best reflect the
existing industry practice.

Example:
If a company that retails leather jackets valued its inventory on the basis of
FIFO method in the past, it must continue to do so in the future to preserve
consistency in the reported inventory balance. A switch from FIFO to LIFO
basis of inventory valuation may cause a shift in the value of inventory between
the accounting periods largely due to seasonal fluctuations in price.

Understandability
Transactions and events must be accounted for and presented in the financial
statements in a manner that is easily understandable by a user who possesses a
reasonable level of knowledge of the business, economic activities and
accounting in general provided that such a user is willing to study the
information with reasonable diligence.
Understandability of the information contained in financial statements is
essential for its relevance to the users. If the accounting treatments involved and
the associated disclosures and presentational aspects are too complex for a user
to understand despite having adequate knowledge of the entity and accountancy
in general, then this would undermine the reliability of the whole financial
statements because users will be forced to base their economic decisions on
undependable information.
Example:
One of the main problems with the financial statements of ENRON was that it
contained a very complicated structure of special purpose entities that were
presented in a manner that concealed the financial risk exposure of the company.
The accounting treatments of ENRON were not comprehensible by the capital
market participants who consistently overvalued its worth until the inevitable
collapse of its share price in 2001 upon the news of its bankruptcy.

Materiality
Information is material if its omission or misstatement could influence the
economic decisions of users taken on the basis of the financial statements (IASB
Framework).
Materiality therefore relates to the significance of transactions, balances and
errors contained in the financial statements. Materiality defines the threshold or
cutoff point after which financial information becomes relevant to the decision
making needs of the users. Information contained in the financial statements
must therefore be complete in all material respects in order for them to present a
true and fair view of the affairs of the entity.
Materiality is relative to the size and particular circumstances of individual
companies.
Example - Size
A default by a customer who owes only $1000 to a company having net assets
of worth $10 million is immaterial to the financial statements of the company.
However, if the amount of default was, say, $2 million, the information would
have been material to the financial statements omission of which could cause
users to make incorrect business decisions.
Example - Nature
If a company is planning to curtail its operations in a geographic segment which
has traditionally been a major source of revenue for the company in the past,
then this information should be disclosed in the financial statements as it is by
its nature material to understanding the entity's scope of operations in the future.
Materiality is also linked closely to other accounting concepts and principles:
Relevance: Material information influences the economic decisions of the
users and is therefore relevant to their needs.

Reliability: Omission or mistatement of an important piece of information


impairs users' ability to make correct decisions taken on the basis of
financial statements thereby affecting the reliability of information.
Completeness: Information contained in the financial statements must be
complete in all material respects in order to present a true and fair view of
the affairs of the company.

What is a Going Concern?


Going concern is one the fundamental assumptions in accounting on the basis of
which financial statements are prepared. Financial statements are prepared
assuming that a business entity will continue to operate in the foreseeable future
without the need or intention on the part of management to liquidate the entity
or to significantly curtail its operational activities. Therefore, it is assumed that
the entity will realize its assets and settle its obligations in the normal course of
the business.
It is the responsibility of the management of a company to determine whether
the going concern assumption is appropriate in the preparation of financial
statements. If the going concern assumption is considered by the management to
be invalid, the financial statements of the entity would need to be prepared on
break up basis. This means that assets will be recognized at amount which is
expected to be realized from its sale (net of selling costs) rather than from its
continuing use in the ordinary course of the business. Assets are valued for their
individual worth rather than their value as a combined unit. Liabilities shall be
recognized at amounts that are likely to be settled.
What are possible indications of going concern problems?
Deteriorating liquidity position of a company not backed by sufficient
financing arrangements.
High financial risk arising from increased gearing level rendering the
company vulnerable to delays in payment of interest and loan principle.

Significant trading losses bieng incurred for several years. Profitability of


a company is essential for its survival in the long term.
Aggressive growth strategy not backed by sufficient finance which
ultimately leads to over trading.
Increasing level of short term borrowing and overdraft not supported by
increase in business.
Inability of the company to maintain liquidity ratios as defined in the loan
covenants.
Serious litigations faced by a company which does not have the financial
strength to pay the possible settlement.
Inability of a company to develop a new range of commercially successful
products. Innovation is often said to be the key to the long-term stability of
any company.
Bankruptcy of a major customer of the company.

Accruals Concept
Financial statements are prepared under the Accruals Concept of accounting
which requires that income and expense must be recognized in the accounting
periods to which they relate rather than on cash basis. An exception to this
general rule is the cash flow statement whose main purpose is to present the
cash flow effects of transaction during an accounting period.

Under Accruals basis of accounting, income must be recorded in the accounting


period in which it is earned. Therefore, accrued income must be recognized in
the accounting period in which it arises rather than in the subsequent period in

which it will be received. Conversely, prepaid income must be not be shown as


income in the accounting period in which it is received but instead it must be
presented as such in the subsequent accounting periods in which the services or
obligations in respect of the prepaid income have been performed.

Expenses, on the other hand, must be recorded in the accounting period in which
they are incurred. Therefore, accrued expense must be recognized in the
accounting period in which it occurs rather than in the following period in which
it will be paid. Conversely, prepaid expense must be not be shown as expense in
the accounting period in which it is paid but instead it must be presented as such
in the subsequent accounting periods in which the services in respect of the
prepaid expense have been performed.

Accruals basis of accounting ensures that expenses are "matched" with the
revenue earned in an accounting period. Accruals concept is therefore very
similar to the matching principle.

Business Entity Concept


Financial accounting is based on the premise that the transactions and balances
of a business entity are to be accounted for separately from its owners. The
business entity is therefore considered to be distinct from its owners for the
purpose of accounting.
Therefore, any personal expenses incurred by owners of a business will not
appear in the income statement of the entity. Similarly, if any personal expenses
of owners are paid out of assets of the entity, it would be considered to be
drawings for the purpose of accounting much in the same way as cash drawings.

The business entity concept also explains why owners' equity appears on the
liability side of a balance sheet (i.e. credit side). Share capital contributed by a
sole trader to his business, for instance, represents a form of liability (known as
equity) of the 'business' that is owed to its owner which is why it is presented on
the credit side of the balance sheet.

Elements of the financial Statements


There are five main elements of the financial statements:
Assets
Liabilities
Equity
Income
Expense
The first three elements relate to the statement of financial position while the
latter two relate to income statements.
Assets
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).
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).

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

Classification Economic Benefit

Machine

Used
for
the
Non-current production of goods
for sale to customer.

Office Building

Provides space to
employees
for
Non-current
administering
company affairs.

Vehicle

Used
in
the
transportation
of
Non-current company
products
and
also
for
commuting.

Inventory

Current

Cash
from

is generated
the sale of

inventory.

Cash

Current

Cash!

Receivables

Current

Will eventually result


in inflow of cash.

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.

Liabilities
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).

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.

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.

Following are examples of some of the common types of liabilities along with
their usual classification:

Liability

Classification

Long Term Bank Loan

Non-current

Bank Overdraft

Current

Short Term Bank Loan

Current

Trade Payble

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.
Liability

Classification

Long Term Bank Loan

Non-current

Bank Overdraft

current

Short Term Bank Loan

current

Trade Payble

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.

Equity
Equity is the residual interest in the assets of the entity after deducting all the
liabilities (IASB Framework).
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 of Equity recognized in the financial statements include the
following:
Ordinary Share Capital
Preference Share Capital (irredeemable)
Retained Earnings
Revaluation Surpluses

Income
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).
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.
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.
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.
Income is accounted for under the accruals principal whereby it is recognized
for the whole accounting period in full, irrespective of whether payments have
been received or not.
As income 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.

Expense
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).
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.
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
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
Credit

Machine (Increase in Asset)


Cash (Decrease in Asset)

2. Payment of utility bills


Debit
Credit

Utility Expense (Increase in Expense)


Cash (Decrease in Asset)

3. Interest received on bank deposit account


Debit
Credit

Cash (Increase in Asset)


Finance Income (Increase in Income)

4. Receipt of bank loan principal


Debit
Credit

Cash (Increase in Asset)


Bank Loan (Increase in Liability)

5. Issue of ordinary shares for cash


Debit
Credit

Cash (Increase in Asset)


Share Capital (Increase in Equity)

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

3 500

Sales

2 1000

Balance c/d

4 1000

1500

1500

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

Cash

1 1,000
1,000

Credit
Income Statement

$
2 1,000
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:
Transactions that only affect Assets of the entity
Transactions that affect Assets and Liabilities of the entity
Transactions that affect Assets and Equity of the entity
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.

Depreciation
Depreciation is systematic allocation the cost of a fixed asset over its useful life.
It is a way of matching the cost of a fixed asset with the revenue (or other
economic benefits) it generates over its useful life. Without depreciation
accounting, the entire cost of a fixed asset will be recognized in the year of
purchase. This will give a misleading view of the profitability of the entity. The
observation may be explained by way of an example.
Example
ABC LTD purchased a machine costing $1000 on 1st January 2001. It had a
useful life of three years over which it generated annual sales of $800. ABC
LTD's annual costs during the three years were $300.
If ABC LTD expensed the entire cost of the fixed asset in the year of purchase,
its income statement would present the following picture the end of the three
years:

Income Statement

2001

2002

2003

Sales

800

800

800

Cost of Sales

(300)

(300)

(300)

Fixed Asset Cost

1000

Net Profit (Loss)

(500)

500

500

As you can see, income statement of ABC LTD shows net loss in the first year
even though it earned the same revenue as in the subsequent years. Conversely,
no fixed asset will appear in ABC LTD's balance sheet although it had earned
revenue from the machine's use through out its useful life of 3 years.
If ABC LTD, instead of charging the entire cost of fixed asset at once,
depreciates the capital expenditure over its useful life, its income statement and
balance sheet would present the following picture at the end of the three years:

Income Statement

2001

2002

2003

Sales

800

800

800

Cost of Sales

(300)

(300)

(300)

Fixed Asset Cost

333.3

333.3

333.3

Net Profit (Loss)

(166.7)

(166.7)

(166.7)

Balance Sheet (Extract)

2001

2002

2003

Fixed Assets

1,000

1,000

1,000

Accumulated Depreciation

(333.3)

(666.7)

(1,000)

Net Book Value

666.7

333.3

Nill

As you can see, the process of relating cost of a fixed asset to the years in which
the economic benefits from its use are realized creates a more balanced view of
the profitability of the company. Hence, depreciation is an application of the
matching principle whereby costs are matched to the accounting periods to
which they relate rather than on the basis of payment.
Accounting Entry
Double entry involved in recoding depreciation may be summarized as follows:
Debit

Depreciation Expense (Income Statement)


Credit

Accumulated Depreciation (Balance Sheet)

Every accounting period, depreciation of asset charged during the year is


credited to the Accumulated Depreciation account until the asset is disposed.
Accumulated depreciation is subtracted from the asset's cost to arrive at the net
book value that appears on the face of the balance sheet. Using the last example,
following double entries will be recorded in respect of depreciation:
Depreciation Expense Account
Debit

Credit

2001 Accumulated Depreciation

333.3 2001 Income Statement

333.3

2002 Accumulated Depreciation

333.3 2002 Income Statement

333.3

2003 Accumulated Depreciation

333.4 2003 Income Statement

333.4

Accumulated Depreciation Account


Debit
2001

Balance c/d

Credit

333.3

2001

$
Depreciation Expense

333.3
2002

Balance c/d

666.6

333.3
2002

Balance b/d

333.3

2002

Depreciation Expense

333.3

666.6
2003

Balance c/d

1000

333.3

666.6
2003

Balance b/d

666.6

2003

Depreciation Expense

333.4

1000

1000

Reducing Balance Depreciation Method


Reducing Balance Method charges depreciation at a higher rate in the earlier
years of an asset. The amount of depreciation reduces as the life of the asset
progresses. Depreciation under reducing balance method may be calculated as
follows:
Depreciation per annum = (Net Book Value - Residual Value) x Rate%
Where:
Net Book Value is the asset's net value at the start of an accounting period.
It is calculated by deducting the accumulated (total) depreciation from the
cost of the fixed asset.
Residual Value is the estimated scrap value at the end of the useful life of
the asset. As the residual value is expected to be recovered at the end of an

asset's useful life, there is no need to charge the portion of cost equaling
the residual value.
Rate of depreciation is defined according to the estimated pattern of an
asset's use over its life term.
Example:
An asset has a useful life of 3 years.
Cost of the asset is $2,000.
Residual Value is $500.
Rate of depreciation is 50%.
Depreciation expense for the three years will be as follows:
NBV

R.V

Rate

Depreciation

Accumalated Depreciation

Year1: (2000 - 500) x 50% = 750

750

Year2: (1250 - 500) x 50% = 375

1125

Year3: (875

1500

- 500) x 50% = 375*

*Under reducing balance method, depreciation for the last year of the asset's
useful life is the difference between net book value at the start of the period and
the estimated residual value. This is to ensure that depreciation is charged in
full.
As you can see from the above example, depreciation expense under reducing
balance method progressively declines over the asset's useful life.
Reducing Balance Method is appropriate where an asset has a higher utility in
the earlier years of its life. Computer equipment for instance has better
functionality in its early years. Computer equipment also becomes obsolete in a
span of few years due to technological developments. Using reducing balance
method to depreciate computer equipment would ensure that higher depreciation
is charged in the earlier years of its operation.

Methods of Depreciation
Cost of fixed asset must be charged to the income statement in a manner that
best reflects the pattern of economic use of the asset. Most common methods of
depreciation include Straight Line Method and Reducing Cost Method.

Straight Line Depreciation Method


Straight line method depreciates cost evenly through out the useful life of the
fixed asset. Straight line depreciation is calculated as follows:
Depreciation per annum = (Cost - Residual Value) / Useful Life
Where:
Cost includes the initial and any subsequent capital expenditure.
Residual Value is the estimated scrap value at the end of the useful life of
the asset. As the residual value is expected to be recovered at the end of an
asset's useful life, there is no need to charge the portion of cost equaling
the residual value.
Useful Life is the estimated time period an asset is expected to be used
from the time it is available for use to the time of its disposal or
termination of use. Useful life is normally calculated in units of years but
it may be calculated based on an alternative basis. Useful life of an oil
extraction company may for example be the estimated oil reserves.

Accruals and Prepayments


Accruals Basis of Accounting
Financial statements are prepared under the Accruals Basis of accounting which
requires that income and expense must be recognized in the accounting periods
to which they relate rather than on cash basis. An exception to this general rule
is the cash flow statement whose main purpose is to present the cash flow
effects of transaction during an accounting period.
Under accruals basis of accounting, an entity must account for the following
types of transactions:
Accrued Income
Accrued Expense
Prepaid Income

Prepaid Expense

Accrued Income
Accrued income is income which has been earned but not yet received.
Income must be recorded in the accounting period in which it is earned.
Therefore, accrued income must be recognized in the accounting period in
which it arises rather than in the subsequent period in which it will be received.

As income will be credited to record the accrued income, a corresponding


receivable must be created to account for the debit side of the transaction. The
accounting entry to record accrued income will therefore be as follows:
Debit

Income Receivable (Balance Sheet)


Credit

Income (Income Statement)

Example
ABC LTD receives interest of $10,000 on bank deposit for the month of
December 2010 on 3rd January 2011. ABC LTD has an accounting year end of
31st December 2010.
ABC LTD will recognize interest income of $10,000 in the financial statements
of year 2010 even though it was received in the next accounting period as it
relates to the current period. Following accounting entry will need to be
recorded to account for the interest income accrued:
$
Debit

Interest Income Receivable


Credit

Interest on Bank Deposit (Income)

10,000
10,000

On the date of receipt of interest (i.e. 3rd January of the next year) following
accounting entry will need to be recorded in the subsequent year:

$
Debit

Bank
Credit

10,000

Interest Income Receivable

10,000

Accrued Expense
Accrued expense is expense which has been incurred but not yet paid.
Expense must be recorded in the accounting period in which it is incurred.
Therefore, accrued expense must be recognized in the accounting period in
which it occurs rather than in the following period in which it will be paid.

As expense will be debited to record the accrued expense, a corresponding


payable must be created to account for the credit side of the transaction. The
accounting entry to record accrued expense will therefore be as follows:
Debit

Expense (Income Statement)


Credit

Expense Payable (Balance Sheet)

Example
ABC LTD pays loan interest for the month of December 2010 of $10,000 on 3rd
January 2011. ABC LTD has an accounting year end of 31st December 2010.
ABC LTD will recognize interest expense of $10,000 in the financial statements
of year 2010 even though it was paid in the next accounting period as it relates
to the current period. Following accounting entry will need to be recorded to
account for the interest expense accrued:

$
Debit

Interest Expense
Credit

10,000

Interest Payable

10,000

On the date of payment of interest (i.e. 3rd January of the next year) following
accounting entry will need to be recorded in the subsequent year:
$
Debit

Interest Payable
Credit

10,000

Cash

10,000

Prepaid Income
Prepaid income is revenue received in advance but which is not yet earned.
Income must be recorded in the accounting period in which it is earned.
Therefore, prepaid income must be not be shown as income in the accounting
period in which it is received but instead it must be presented as such in the
subsequent accounting periods in which the services or obligations in respect of
the prepaid income have been performed.
Entity should therefore recognize a liability in respect of income it has received
in advance until such time as the obligations or services that are due on its part
in relation to the prepaid income have been performed. Following accounting
entry is required to account for the prepaid income:
Debit

Cash/Bank
Credit

Example

Prepaid Income (Liability)

ABC LTD receives advance rent from its tenant of $10,000 on 31st December
2010 in respect of office rent for the following year. ABC LTD has an
accounting year end of 31st December 2010.
ABC LTD will recognize a liability of $10,000 in the financial statements of
year 2010 in respect of the prepaid income to acknowledge its obligation to
make the office space available to the tenant in the following year. Following
accounting entry will be recorded in the books of ABC LTD in the year 2010:
$
Debit

Cash
Credit

10,000

Prepaid Rent Income (Liability)

10,000

The prepaid income will be recognized as income in the next accounting period
to which the rental income relates. Following accounting entry will be recorded
in the year 2011:
$
Debit

Prepaid Rent Income (Liability)


Credit

Rent Income (Income Statement)

10,000
10,000

Prepaid Expense
Prepaid expense is expense paid in advance but which has not yet been incurred.
Expense must be recorded in the accounting period in which it is incurred.
Therefore, prepaid expense must be not be shown as expense in the accounting

period in which it is paid but instead it must be presented as such in the


subsequent accounting periods in which the services in respect of the prepaid
expense have been performed.
Entity should therefore recognize an asset in respect of expense it has paid in
advance until such time as the services that are due in relation to the prepaid
expense have been performed by the suppliers/contractors. Following
accounting entry is required to account for the prepaid expense:
Debit

Prepaid Expense (Asset)


Credit

Cash

Example
ABC LTD pays advance rent to its landowner of $10,000 on 31st December
2010 in respect of office rent for the following year. ABC LTD has an
accounting year end of 31st December 2010.
ABC LTD will recognize an asset of $10,000 in the financial statements of year
2010 in respect of the prepaid expense to recognize its right to use office space
in the following year. Following accounting entry will be recorded in the books
of ABC LTD in the year 2010:
$
Debit

Prepaid Rent
Credit

10,000

Cash

10,000

The prepaid expense will be recognized as expense in the next accounting


period to which the rental expense relates. Following accounting entry will be
recorded in the year 2011:
$
Debit

Rent Expense (Income Statement)


Credit

Cash/Bank

10,000
10,000

What is a Trial Balance?


Trial Balance is a list of closing balances of ledger accounts on a certain date
and is the first step towards the preparation of financial statements. It is usually
prepared at the end of an accounting period to assist in the drafting of financial
statements. Ledger balances are segregated into debit balances and credit
balances. Asset and expense accounts appear on the debit side of the trial
balance whereas liabilities, capital and income accounts appear on the credit
side. If all accounting entries are recorded correctly and all the ledger balances
are accurately extracted, the total of all debit balances appearing in the trial
balance must equal to the sum of all credit balances.
Purpose of a Trial Balance
Trial Balance acts as the first step in the preparation of financial
statements. It is a working paper that accountants use as a basis while
preparing financial statements.
Trial balance ensures that for every debit entry recorded, a corresponding
credit entry has been recorded in the books in accordance with the double
entry concept of accounting. If the totals of the trial balance do not agree,
the differences may be investigated and resolved before financial
statements are prepared. Rectifying basic accounting errors can be a much
lengthy task after the financial statements have been prepared because of
the changes that would be required to correct the financial statements.

Trial balance ensures that the account balances are accurately extracted
from accounting ledgers.
Trail balance assists in the identification and rectification of errors.
Example
Following is an example of what a simple Trial Balance looks like:
ABC
Trial Balance as at 31 December 2011
Account Title

LTD
Debit

Credit

Share Capital

15,000

Furniture & Fixture

5,000

Building

10,000

Creditor

5,000

Debtors

3,000

Cash

2,000

Sales

10,000

Cost of sales

8,000

General and Administration Expense

2,000

Total

30,000

30,000

Title provided at the top shows the name of the entity and accounting
period end for which the trial balance has been prepared.
Account Title shows the name of the accounting ledgers from which the
balances have been extracted.

Balances relating to assets and expenses are presented in the left column
(debit side) whereas those relating to liabilities, income and equity are
shown on the right column (credit side).
The sum of all debit and credit balances are shown at the bottom of their
respective columns.

Limitations of a trial balance


Trial Balance only confirms that the total of all debit balances match the total of
all credit balances. Trial balance totals may agree in spite of errors. An example
would be an incorrect debit entry being offset by an equal credit entry. Likewise,
a trial balance gives no proof that certain transactions have not been recorded at
all because in such case, both debit and credit sides of a transaction would be
omitted causing the trial balance totals to still agree. Types of accounting errors
and their effect on trial balance are more fully discussed in the section on
Suspense Accounts.

How to prepare a Trial Balance


Following Steps are involved in the preparation of a Trial Balance:
All Ledger Accounts are closed at the end of an accounting period.
Ledger balances are posted into the trial balance.
Trial Balance is cast and errors are identified.
Suspense account is created to agree the trial balance totals temporarily
until corrections are accounted for.
Errors identified earlier are rectified by posting corrective entries.
Any adjustments required at the period end not previously accounted for
are incorporated into the trial balance.

Closing Ledger Accounts


Ledger accounts are closed at the end of each accounting period by calculating
the totals of debit and credit sides of a ledger. The difference between the sum of
debits and credits is known as the closing balance. This is the amount which is
posted in the trial balance.
How closing balances are presented in the ledger depends on whether the
account is related to income statement (income and expenses) or balance sheet
(assets, liabilities and equity). Balance sheet ledger accounts are closed by
writing 'Balance c/d' next to the balancing figure since these are to be rolled
forward in the next accounting period. Income statement ledger accounts on the
other hand are closed by writing 'Income Statement' next to the residual amount
because it is being transferred to the income statement as revenue or expense
incurred for the period.
The steps involved in closing a ledger account may be summarized as below:
Add the totals of both sides of a ledger
The higher of the totals among the debit side and credit side must be
inserted at the end of BOTH sides.Closing balance is the balancing figure
on the side with the lower balance.
In case of ledger accounts of assets, liabilities and equity, 'balance c/d' is
written next to the closing balance whereas in case of income and
expenses ledger accounts, 'Income Statement' is written next to the closing
balance.
The closing balances of all ledger accounts are posted into the trial
balance.
Next sections contain examples illustrating how the various types of ledger
accounts are closed at the period end 31 December 2011.

Posting Closing ledger balances into Trial Balance:


Closing Balance of all ledger accounts are posted into the trial balance. It is
important to remember that a debit closing balance in the ledger account appears
on the credit side but in the trial balance it is presented in the debit column and
vice versa.
Posting of closing balances should be done carefully as many errors may occur
during the posting process such as Posting Error, Transposition Errors and Slide
error.
Following is an example of a trial balance prepared from the closing balances of
the ledgers detailed above.
ABC
Trial Balance as at 31 December 2011
Account Title

LTD
Debit

Credit

Share Capital

10,000

Bank Loan

10,000

Cash

30,000

Salaries Expense

5,000

Sales Revenue
Total

15,000
35,000

35,000

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