1 and 2 - Fundamentals of Accounting

Financial Accounting
An Introduction
Financial Accounting 2010 - Helena Isidro
Topics covered by the course

1 - The background of accounting
Background of financial reporting Users of accounting information International harmonization of financial reporting
2 - Fundamental accounting concepts and financial reports

Characteristics and components of financial information The concept of profit and the income statement The concepts of asset and liability and the balance sheet Recording business transactions The double-entry bookkeeping Cash versus accrual Impairment and provisions
Topics covered by the course

3 Current and non-current assets
The concept of inventory The perpetual and permanent system of recording inventory transactions Cost of sales under different cost flow assumptions The concept of non-current asset Depreciation Disposal of non-current assets
Assessement
Exam 80%
Class participation and exercise preparation 20%
The power of accounting numbers
The power of accounting numbers
Accounting and business

Resources: Materials, labour, services Outputs: Products, services
Business
Cash out: Payment of resources acquired Cash in: Receipt for goods and services sold
Decisions & Actions
Accounting: Help making decisions about business
Accounting definitions
Definition of accounting
Accounting is a decision-support tool for users: Identifies, measures and communicates financial information about an entity to permit informed judgements and decisions by users of the information
Two types of accounting

Financial accounting: designated to users external to the entity Managerial accounting: designated to users internal to the entity
Accounting regulation
Accounting regulation (standards)
Set of rules defining how to measure and report information about the entity economic activity GAAP Generally accepted accounting principle is a generic term that refers to the set of rules and standards issued by various regulatory bodies which companies are expected to comply with
Why do we need accounting standards?

For efficient decision-making investors, creditors, auditors and users in general must have reliable, transparent and comparable financial information
Accounting standards have two objectives:
Define how to record individual business transactions. What methods to use Define how to summarise these transactions into a form understandable and useful to users. This involves the definition of: Types and formats for financial statements, namely for the balance sheet and profit and loss account (income statement) Disclosure requirements of relevant information
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Who sets the rules?
Economic and business conditions evolved differently in different countries and consequently accounting systems of rules have also evolved differently across countries
Sources of accounting regulation:

Legislation such as Commercial Code, Tax Code, Companies Act Rules issued by departments of the government (e.g. Ministry of Finance) Rules from the stock exchange entity (e.g. CMVM) Accounting standards issued by the accountancy profession Accounting standards issued by private organisations acting for the public bodies
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Accounting standard setting

In most countries accounting regulation is set through: code/law and a standard setting body Examples of standard setting bodies:
Portugal: Comissao Normalizacao Contabilistica www.cnc.min-financas.ptThe U.S.: Financial Accounting Standards Board (FASB) www.fasb.org International Accounting Standard Board (IASB) www.iasb.org
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Accounting standards. Does it matter?
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In 2002, Is BCP profitable? If an investor wants to compare ROE from BCP with other investments. How much is ROE? The business is unique. Different rules result in different performances? Negative market reaction in the US market to BCP earnings announcement. The company decided to delist
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Portugal's biggest bank to drop Wall Street listing
11 January 2003 Agence France-Presse
Portugal's largest private bank, Banco Comercial Portugues (BCP), will delist from the New York Stock Exchange because differences between US and European accounting rules require it to present different sets of financial results, BCP president Jorge Jardim Goncalves said in an interview published on Saturday. "In some circumstances we had to present reports and numbers which, no matter how many explanations were offered, were disturbing
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Accounting harmonisation
European (EC) Directives (4th, 1978 and 7th,1983)
European Commission gave support to the increasingly important IASB by requiring listed firms to prepare consolidated financial statements in
accordance with IFRS, from 1 January 2005 onwards
Currently, there are two major international sets of rules: IFRS and US GAAP Likely to converge November 2007, SEC (Securities and Exchange Commission) announced the decision to eliminate the reconciliation requirement for IFRS companies (effective March 2008) IFRS is expected to be mandatory in the US in the near future (3-5 years)
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Objective of financial information

Accounting standards identify usefulness to users as the main objective of financial reporting
Provide information about the financial position, performance and changes in the financial position of an enterprise that is useful to a wide range of users in making economic decisions
IASB, framework
Provide information that is useful to present and potential investors, creditors and other users in making rational investment, credit and similar decisions
FASB, Statement of Financial Accounting Concepts No 1
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Characteristics of financial information

According to IASB framework, useful financial information has the following attributes:
Understandability Relevance Reliability Comparability
Materiality
Faithful representation Substance over form
Consistency
Predictive value Feed-back value
Neutrality Prudence Completeness
Timeliness
Constrains on reliable and relevant information
Balance benefit/cost
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Components of financial reporting

Narrative information (e.g. auditors report, directors report, governance report) Financial statements (IAS 1) Balance Sheet Profit and Loss Account/Income Statement Cash Flow Statement Notes Statement of Movements in Shareholders Funds
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Balance sheet
A balance sheet is a summary of the financial position of the business at a particular point in time It is a list of the business resources (assets) and the financing of those resources (liabilities and equity)
Example: open a bank account to start a mobile-phone business
Resources / Investments Cash in bank 100,000 Sources / Financing Own money 100,000
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Balance sheet
Buy inventory (mobile-phones) to the business on credit
Resources / Investments Sources / financing Own money 100,000 Credit to invent supplier 20,000
Assets
Cash in bank 100,000 Inventory 20,000
Equity Liabilities
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Balance sheet equation

Resources / Investments Sources / financing Own money 100,000 Credit to invent supplier 20,000
Assets
Cash in bank 100,000 Inventory 20,000
Equity Liabilities
Investments Assets 100,000 + 20,000 = =
Financing Equity + Liabilities 100,000 + 20,000

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Balance sheet equation

The fundamental accounting equation is
Assets = Equity + Liabilities
Total investments are financed by own capital and borrowed capital
Or
Assets - Liabilities = Equity
In other words, Equity (Shareholders funds) is a residual interest which is a claim on all assets after meeting the business liabilities
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Brisa
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Brisa
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Balance sheet elements

Assets
(a) Resources controlled by the business as a result of past events (b) from which future economic benefits are expected to flow to the business (c) can be measure with reliability Current versus non-current (fixed) assets Are these assets? Brisa has built highways that will revert to the State at the end of the concession contract without any compensation (note 2.6) Brisa is developing an environmental project with Companhia das Lezirias to create bird observation zone in Ponta da Erva/Salinas de Saragoca (Environmental report note 6)
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Balance sheet elements

Liabilities (a) present obligation of the entity arising from past events, (b) the settlement of which is expected to result in an outflow of resources, (c) measured with reliability Current versus non current liabilities
Is this a liability? The group (Brisa) has assumed the commitment to provide its employees with retirement pensions supplement under a defined benefits plan, having constituted autonomous pension funds for the purpose (note 2.16) Equity Residual interest in the assets of the entity after deducting all its liabilities
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Profit concept
Sell all inventory to clients by 35,000 cash
Assets Cash in bank 100,000+35,000 Equity Share capital Profit 100,000 +15,000 115,000
Liabilities Inventory 20,000-20,000 135,000 Accounts payable 20,000 135,000
Profit (15,000) is the difference between revenues (35,000) and expenses (20,000) Profit is the income generated by the business activity and it is part of owners funds (equity)
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Income statement
The income statement (or profit and loss account) is a summary of the financial performance of the business over a particular period in time I/S reports the detailed elements of profit:
Revenues (gains) Sales turnover, interest revenue, extraordinary gains Expenses (costs) Cost of sales, personnel expenses, interest expense, extraordinary losses, tax expense Profit = Revenues - Expenses
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Brisa
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The fundamental equation revisited

Recall the fundamental accounting equation:
Assets = Liabilities + Equity
Extending equity into components:

Assets = Liabilities + [ Capital&OthEquity + Profit ]
Assets
Liabilities + [Capital&OthEquity + Revenues Expenses ]
Assets
Liabilities + [ Capital&OthEquity + Revenues Expenses ]
For each individual transaction this relation is also true
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Recording transactions
Paul&Mary FineFood restaurant
Transaction 1: Paul and Mary deposit 1,000 in a bank account to start the business Assets + 1000 (Bank) = = Liabilities + Equity + 1000 (Share capital)
Transaction 2: Purchase of 250 cash of goods for stock Assets + 250 (Inventory) - 250 (Bank) Corresponds to the exchange of one asset (cash in bank) by another (inventory) = Liabilities + Equity
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Transaction 3: Purchase of restaurant equipment on credit for 300 Assets + 300 (Fixed assets) = = Liabilities + Equity + 300 (Accounts payable)
Transaction 4: Payment of 80% of the equipment bill Assets - 240 (Bank) = = Liabilities + Equity - 240 (Accounts payable)
Part of accounts payable (liabilities) disappear from the balance sheet
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Transaction 5: Sale of meals for 150 cash which cost 100 Assets - 100 (Inventory) + 150 (Bank) = = Liabilities + Equity + 50 (profit)
In Income Statement: Sales revenue Cost of sales Profit 150 (100) 50
Transaction 6: Weekly salaries of 30 are paid to Paul and Mary Assets - 30 (Bank) = = Liabilities + Equity - 30 (profit)
In Income Statement: Salaries expense (30) Profit
(30)
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Recording transactions in a worksheet

ASSETS = Transactions Fixed Assets 1 2 3 4 5 5 6 Stock Cash& Bank +1000 -250 -240 +150 -100 -30 +300 -240 +150 -100 -30 LIABILITIES Accounts Share Payable Capital +1000 EQUITY Retained Profit Profit (I/S)
Initial capital Purchase pizzas Purchase of equi Payment equip Sales pizzas Cost of sales Salaries
+250 +300
Use profit column to prepare the income statement
Closing balances
300
150
630
60
1000
Use this column to prepare the cash flow statement
Use closing balance row to prepare balance sheet
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Profit retention
Profit retention means that profit should be transferred from the
income statement to the balance sheet
Specifically, the profit is transferred from profit for the year, a I/S
account, and stocked in retained profit, which as an account within equity
Sometimes this is recorded at year (U.K, U.S.) sometimes in the

following year (European countries) Equity Retained profit Profit for the year +20
-20
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Profit retention
ASSETS = Transactions Fixed Assets 1 2 3 4 5 5 6 Inventory LIABILITIES + Cash& Accounts Share Bank Payable Capital +1000 -250 -240 +150 -100 -30 +20 +300 -240 +150 -100 -30 -20 +1000 EQUITY Retained Profit Profit (I/S)
Initial capital Purchase pizzas Purchase of equi Payment equip Sales pizzas Cost of sales Salaries Transfer to Retained profit Closing balances
+250 +300
300
150
630
60
1000
+20
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Accounting principles
In order to achieve the financial reporting objectives of providing useful information for economic decision, financial statements must be prepared in accordance with fundamental accounting principles (IASB framework)
Going Concern
Assumes that business will continue to operate for the foreseeable future
Accrual Basis
Revenues and expenses are recognised when earned/incurred, not when money
is received/paid
In most cases this will be achieved through matching revenues with

corresponding expenses
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Accrual principle: Cash and Profit

Why is Cash different from Profit ?
Brisa (2007) Profit = 255 m Cash = 103 m
Accounting numbers focus on the concept of economic profit Income statement provides information on generation and consumption of economic resources rather than on cash generation and expenditure Timing of receipt/payment of income/expense is irrelevant - what matters is when revenue (income) and expenses are recognised In one reporting period: PROFITS AND CASH ARE NOT THE SAME
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Cash and Accounting Profit

Example:
Period 1 purchase of merchandise worth 10,000 on cash
Period 2 sale of all merchandise on credit for 15,000
Period 3 receipt of 15,000 from client
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Cash and Accounting Profit

Period 1 Period 2 Sale Purchase merchandis merchandise on credit e on cash Revenue Expense Profit Cash inflow Cash outflow Net cash 10,000 (10,000) 15,000 15,000 10,000 5,000 15,000 Period 3 Receipt from client End of business
15,000 10,000 5,000 15,000 10,000 5,000 Profit = Cash At end of the business
In individual periods cash is not equal to profit
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Prudence (Conservatism)
A degree of caution should be applied in exercising judgment and making the
necessary estimates
In particular, gains should be treated as realized only when realized in the form of
cash. Losses are recognized faster (in profit) than gains
Examples:
Doubts about the capability of a client to pay Reduce profit immediately as if the client would not pay Stocks bought for 1,000 have now a market value of 1,500 Do not recognize the gain until stock is actually sold
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Deferrals and accruals

Four major transactions create differences between cash and profits:
1. Expenses paid but not consumed Prepayment or deferred expense 2. Expenses consumed but not paid Accrued expense 3. Revenues/income received in cash but not earned Unearned revenue/income or deferred revenue/income 4. Revenues/income earned but not received in cash Accrued revenue/income
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Prepayments (deferred expenses)
Prepayment is generated when a cash payment is made (or any other asset given up) for an expense, which relates to a future accounting period
Example: Suppose that on 1 September 2008, a company pays an insurance premium of 1.200 for the year ending 30 August 2009. If the company produces accounts with a year-end of 31 December, how should this item be treated?
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Prepayments
1 Sept 31 Dec 2008 1 Jan 30 Aug 2009
Insurance usage/expense 1,200/12 months x 4 = 400 Payment = 1,200 800
Insurance usage/expense 1,200/12 months x 8 = 800 Payment Cancel prepayment = = 800
Prepayment/deferred = expense
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Accounting for prepayments

In the B/S worksheet
Assets Deferred Cash expenses (1,200) 800 800 800 (800) 0 (1,200) (1,200) (800) (1,200) (800) Equity Profit (I/S) (1,200) 800 (400)
current assets 2008 Payment of insurance Defer to 2008 Closing balance 2008 2009 Opening balance Insurance expense Closing balance 2009
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Accounting for prepayments

In the journal (excl. profit appropriation)
Year 2008 Dr insurance expense Cr cash Dr deferred expense Cr insurance expense Year 2009 Dr insurance expense Cr deferred expense 800 800 1,200 1,200 800 800
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Accrued expenses
The accrual principle requires that we record a liability for all expenses which have been incurred but not paid If a bill/invoice is received, usual to classify liability as a trade creditor/accounts payable if no bill/invoice received, classify as an accrued expense/liability
Example: Company A closes account on 31 Dec. At the end of December 2008, the company received the electricity bill for Nov/Dec 2008 which will be paid in January 2009, in the amount of 500. Company A did not received the telephone bill for the last quarter of 2008 but estimates a cost of 1,000
48
Accounting for accrued expenses

Electricity bill
Assets Cash 2008 Electricity expense 2009 Payment of bill (500) (500) Liabilities Accounts payable 500 Equity Profit (I/S) (500)
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Telephone expense
Assets Cash 2008 Telephone expense 2009 Receipt of bill Payment of bill (1,000) (1,000) 1,000 (1,000) Liabilities Accrued Accounts expense payable 1,000 Equity Profit (I/S) (1,000)
current liabilities
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What if the telephone bill is 1,100?
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What if the telephone bill is 1,100?
Assets Cash 2009 Receipt of bill Payment of bill (1,100) (1,000) 1,100 (1,100) (100) Liabilities Accrued Accounts expense payable Equity Profit (I/S)
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Unearned or deferred revenue

Cash received prior to the goods/service have been provided We need to record the cash receipt but not the revenue in the I/S, as the accrual principle requires revenue to be recognised when earned not when receipt occurs The way to do this is to set up a category of liability called unearned or deferred revenue (income)
Example: Homes plc, a letting agency, closes accounts on 31 Dec. At end of December 2008, the company received rents of Jan and Feb 2009 in the amount of 2,000
53
Accounting for deferred revenue

Assets Cash 2008 Receipt of 2009 rents 2,000 2,000 Liabilities Deferred revenue Equity Profit (I/S)
2009 Rents revenue of 2009 (2,000) 2,000
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Accrued revenue
Revenue is earned but cash will be received only in future periods Following the accrual principle, we recognise revenue but a cash inflow cannot be recorded The way to do this is to set up a category of asset called accrued revenue (income)
Example: At 1 Oct 2008, Gameover plc invested 100,000 in Government Bonds. The bonds pay annual interests at 5% rate every 30 Sept. The company prepares annual reports at 31 Dec.
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Accounting for accrued revenue

Interests earned in 2008 = (100,000 x 5%) / 12 x 3 = 1,250 Interests earned in 2009 = (100,000 x 5%) / 12 x 9 = 3,750
Assets Cash 2008 Interests earned 1,250 1,250 Accrued revenue Equity Profit (I/S)
2009 Receipt of interests earned in 2008 Interests earned and received in 2009 1,250 (1,250)
3,750
3,750
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Impairment
Recall the prudence concept: A degree of caution/conservantism should be applied in exercising judgment and making the necessary estimates An asset is impaired and impairment losses are incurred if there is objective evidence of a loss event that has an impact on the estimated future cash flows
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Impairment of receivables
For receivables, consider the following events:
(a) significant financial difficulty of borrower (b) a breach of contract, such as a default or delinquency in interest or principal payments (c) the lender granted to the borrower a concession that the lender would not otherwise consider (d) becomes probable that the borrower will enter bankruptcy or other financial re-organisation
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Consider the following example:
In period X1, company Zett plc sold goods to a client in the amount of 15,000, giving the client three-month credit During X1, the client paid only 14,000. Despite being contacted several times by the company the client did not to pay the remaining 1,000 At X2, the client reported financial difficulties and the debt was declared difficult to collect When should the loss be recognised in Zett plc accounts? In X2 only? Recognition of the expense only in X2 and doing nothing in X1 is not a prudent attitude. As a consequence, accounts in period X1 would reflect: - Overstatement of assets (accounts receivable) by 1,000 - Overstatement of profit (no recognition of the loss) by 1,000
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The accounting entries are:
Cash Period X1 Sale Receipt from sales Impairment Closing balance 14,000 14,000 (1,000) (1,000) 1,000 15,000 (14,000) (1,000) 14.000 15,000 Assets Impairment of receivables(*) Acc receivable Equity Profit (I/S)
(*) also referred to as provision for doubtful debts
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Note that in the B/S the impairment reduces the accounts receivable
account. Sometimes is referred to as adjustment to asset or contraasset
Accounts receivable Less Impairment (1,000) 1,000
Note also that in the I/S the impairment loss is a separate operational
expense and is not deducted from sales revenue
Sales revenue Impairment loss 15,000 (1,000)
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What happens in period X2?
Client financial troubles are resolved and he agrees to pay 60% of the debt. The remaining 40% will not be collected (becoming a bad debt)
The credit is solved and there no need to keep the impairment in the B/S: reverse the impairment loss
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Reverse impairment loss

Part of the credit is collected (600), part is transferred to bad debt expense (400), the B/S allowance for impairment is cancelled (1,000) against the I/S (revenue)
Cash Period X2 Opening balance Cash received Reversion impair. 14,000 600 1,000 (1,000) 1,000 (1,000) (400) 1,000 14,000 Bad debt expense Operational revenue Assets Impairment Acc receivable Equity Profit (I/S) Retained profit
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Provisions
Provisions are represented in B/S as liabilities. These include:
Restructuring provisions (e.g. future termination of a line of business, a
business in a country)
Environmental provisions (e.g. environmental liabilities, such as remediation

costs, related to past mining activities)
Decommissioning provisions (e.g. oil rig or nuclear power station needs to be

dismantled at the end of its life)
Litigation and other legal claims
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Provisions for legal disputes

Example Alfa plc is preparing 2005 financial statements. The company is
engaged in a legal suit concerning compensation of former employees. The legal advisors estimated the required settlement to be around 100,000
Although the company is not yet contractually obliged to make this

settlement, the prudence concept requires that a provision is established to record the best estimate of the future liability
Assume that in 2006, the dispute is settled and the company agreed to
pay 90,000.
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Provisions for legal disputes

Assets Cash 2005 Recognition provision Closing balance 2006 Opening balance Settlement / cancel provision Closing balance Liabilities Provision Equity Profit (I/S) (100.000) (100.000) Retained profit
100.000 100,000 100.000 (90.000) (90.000) (100.000) 0
10.000 (90.000)
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Provisions: British Airways plc

The Associated Press Published: August 1, 2007
LONDON: British Airways PLC was fined almost US$550 million (400 million) on Wednesday by U.S. and British regulators after the airline admitted to colluding with rival Virgin Atlantic over fuel surcharges on long-haul flights Suppose BA has recognized a provision of US$450 million in 2006 accounts concerning these overcharge penalties. What accounting entries should BA do in 2007 accounts (after regulators issued the fines of $US550)?
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Provisions: British Airways plc

The Associated Press Published: August 1, 2007
In addition, U.S. officials said BA and Korean Air Lines were involved in a conspiracy with German carrier Lufthansa AG to fix charges for international cargo shipments. "When British Airways, Korean Air and their co-conspirators got together and agreed to raise prices for passenger and air cargo fares, American consumers and businesses ended up picking up the tab for their illegal conduct," said Acting Associate Attorney General William W. Mercer. In May, British Airways set aside US$710 million to pay for any possible fines as a result of the investigations What accounting entries should BA do in 2007 accounts in light of the prudence principle?
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1 and 2 - Fundamentals of Accounting

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1 and 2 - Fundamentals of Accounting

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Financial Accounting

Financial Accounting 2010 - Helena Isidro

Topics covered by the course

2 - Fundamental accounting concepts and financial reports

Topics covered by the course

Financial Accounting 2010 - Helena Isidro

Class participation and exercise preparation 20%

Financial Accounting 2010 - Helena Isidro

The power of accounting numbers

Financial Accounting 2010 - Helena Isidro

The power of accounting numbers

Financial Accounting 2010 - Helena Isidro

Accounting and business

Decisions & Actions

Accounting: Help making decisions about business

Financial Accounting 2010 - Helena Isidro

Two types of accounting

Financial Accounting 2010 - Helena Isidro

Why do we need accounting standards?

Financial Accounting 2010 - Helena Isidro

Financial Accounting 2010 - Helena Isidro

Sources of accounting regulation:

Financial Accounting 2010 - Helena Isidro

Accounting standard setting

Financial Accounting 2010 - Helena Isidro

Accounting standards. Does it matter?

Financial Accounting 2010 - Helena Isidro

Accounting standards. Does it matter?

Financial Accounting 2010 - Helena Isidro

Accounting standards. Does it matter?

Financial Accounting 2010 - Helena Isidro

Objective of financial information

Financial Accounting 2010 - Helena Isidro

Characteristics of financial information

Faithful representation Substance over form

Predictive value Feed-back value

Neutrality Prudence Completeness

Constrains on reliable and relevant information

Financial Accounting 2010 - Helena Isidro

Components of financial reporting

Financial Accounting 2010 - Helena Isidro

Financial Accounting 2010 - Helena Isidro

Cash in bank 100,000 Inventory 20,000

Financial Accounting 2010 - Helena Isidro

Balance sheet equation

Cash in bank 100,000 Inventory 20,000

Investments Assets 100,000 + 20,000 = =

Financing Equity + Liabilities 100,000 + 20,000

Balance sheet equation

Total investments are financed by own capital and borrowed capital

Financial Accounting 2010 - Helena Isidro

Financial Accounting 2010 - Helena Isidro

Financial Accounting 2010 - Helena Isidro

Balance sheet elements

Financial Accounting 2010 - Helena Isidro

Balance sheet elements

Liabilities Inventory 20,000-20,000 135,000 Accounts payable 20,000 135,000

Financial Accounting 2010 - Helena Isidro

Financial Accounting 2010 - Helena Isidro

Financial Accounting 2010 - Helena Isidro

The fundamental equation revisited

Extending equity into components: