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accounting
concepts Q&A
Peter Baskerville
INTRODUCTION TO ACCOUNTING
WHAT IS ACCOUNTING?
Accounting is a financial recording and reporting system (see Figure 1).
Accounting identifies and classifies financial transactions; it then summarises
these financial transactions into financial reports. Financial reports communicate
relevant financial information to interested persons called stakeholders. This
information allows stakeholders to decide how to best use the economic
resources of the accounting entity (that is, the business or enterprise).
Identify
and classify
financial
transaction
s
Summarise
transaction
s in
financial
reports
Send
financial
reports to
stakeholder
s
Stakeholde
rs decide
how to use
economic
resources
of
accounting
entity
KeyFACTS
Accounting is a system that operates for as long as the accounting entity exists.
Accounting is interested only in the financial or monetary transactions of the accounting entity.
The first phase of accounting is to identify, collect, measure, classify and record financial
transactions; a second phase is to calculate, summarise, report and evaluate financial
information.
The intent of accounting is to communicate the financial information of the accounting entity to
decision makers.
Accounting deals with maintaining and storing financial results.
SUMMARYDEFINITION OF ACCOUNTING
Based on the above definitions and conclusions, accounting can be divided into two broad
elements:
1.
2.
The main reasons why a business has a vital interest in accountancy are listed in
Figure 2.
uFcogBndiGatrlempvCfs
Comparison: Accountancy,
because it is universally applied
using accounting standards,
Figure 2 Main reasons why a business is interested
allows businesses to be
in accountancy
compared. This comparison
accounting cycle
use of journals and ledgers
duality of financial transactions (that is, debits equalling credits, or doubleentry bookkeeping)
formation of account groups: Assets (including Receivables and Inventories),
Liabilities, Owners equity, Income/Revenue, and Expenses
The system Pacioli described in his book has become known as the double-entry
accounting system.
WHAT WAS ACCOUNTING LIKE BEFORE DOUBLE-ENTRY BOOKKEEPING?
Before Pacioli codified the double-entry bookkeeping system, accounting systems
of a sort did exist in some societies. These systems are today described as
primitive accounting. Some of these primitive accounting systems date back
more than 7,000 years to the time of ancient Babylon, Assyria and Sumeria. Over
time, these primitive accounting systems led to the invention of more
sophisticated numerical systems and the accounting principles in use today.
In fact, it has been difficult for comparative philologists (people who study
language) to identify exactly where numbering (and hence accounting) systems
started and where they then separated into uniquely different fields.
EARLY METHODS OF COUNTING
The use of counting systems goes back to the dawn of intelligence among
human beings. Ancient peoples in different parts of the world developed their
own counting systems. Many used their fingers and toes to help them to count.
Hence, the bases of many of these early counting systems were 5, 10 or 20.
For example, the ancient Mexicans used 20 as their number base. The
Peruvians, who used knotted strings called quipus, had a decimal system
(based on 10) as did the early Greeks. The Chinese, Tibetans and Hottentots
used the concepts of ears and hands, respectively, to denote 2 and the
forebears of the Brazilians generally counted by the joints of the fingers,
and consequently counted in lots of 3.
Further developments in numbering systems, and hence accounting, included
the use of:
Pebbles and twigs: Apart from using body parts to help them count, some
people began using pebbles and twigs, where each item represented an
animal or item of economic value.
Bullae and tokens: The bullae were round or cylindrical-shaped clay objects,
either hollow or solid. They were used over 3,000 years ago to help keep
track of shipped goods, or to calculate inventory. The variety of differently
shaped tokens inserted inside the hollow bullae (or described in script on the
outside surface of solid bullae) represented the items being accounted for.
Clay tablets: Over time, the use of tokens and bullae evolved into depicting
symbols on clay surfaces. At first, sellers would imprint their tokens onto wet
clay tablets as a form of recorded accounting. But not all tokens transferred
6
their imprint clearly onto wet clay. So, in time, some merchants began
drawing the token symbols on the clay tablets. This drawing of token symbols
became the first documented accounting system in history.
Abacus: The abacus was invented in ancient China. Its use later spread
throughout the world. The abacus consists of a wooden frame with wires
threaded through strings of beads. Adding, subtracting, multiplying or
dividing calculations were carried out by sliding the beads in certain ways
across the wires. Merchants could not only perform complex calculations on
their abacus this way, but also keep the results of these calculations on their
abacus as a record of financial transactions.
WHAT IS THE DIFFERENCE BETWEEN FINANCIAL ACCOUNTING AND
MANAGEMENT ACCOUNTING?
Financial accounting prepares a limited number of prescribed financial reports in
accordance with statutory standards and the needs of external stakeholders.
Financial accounting summarises the consequences of past decisions on the
performance of the business as a whole.
Management accounting prepares an unlimited number of financial reports in
accordance with business requirements and the needs of management.
Management accounting analyses the performance of units within the business
by comparing results with pre-set budgets. Management accounting thus assists
management in its future planning and control functions.
WHY DO WE HAVE TWO TYPES OF ACCOUNTING?
Business managers need accounting information to help them make sound
decisions about the organisation. Investors look for business profits in the hope
of dividends. Creditors and lenders watch an organisations ability to meet its
financial obligations. Governmental agencies need information to ensure that the
correct tax is collected and to regulate business activities. Brokers and business
analysts use financial information to form an opinion on investment
recommendations. Employees chose successful companies that enhance their
career prospects, and they often have bonuses or share options that are tied to
enterprise performance. These examples are but a small sample of the sorts of
people who are interested in the financial information of an organisation (that is,
the organisations stakeholders). For simplicity in reporting, accountants group
these stakeholders into two main user groups, as shown in Figure 3.
External users
(not directly involved
in daily activities of the
organisation)
Internal users
(directly involved in
daily activities of the
organisation)
government agencies
lenders and investors (owners)
creditors
suppliers and customers
trade associations
society at large
Board of Directors
Chief Executive Officer /Chief Financial
Officer
entrepreneurs
vice-presidents
employees
line managers (for example, business
unit managers, plant and store
managers)
Financial
Management accounting
accounting
Number of financial
reports
Limited number
specifically Balance
Sheet and Income
Statement
Rules governing
preparation of
financial reports
Government-backed
accounting
standards (that is,
GAAP)
No rules
Financial reports
Generally required
Not required
Financial reports
primarily prepared
for ...
External
stakeholders not
involved in day-today operations of the
entity
Yes
No
Financial information
in reports contains ...
Organisational
summaries
Financial information
in reports
emphasises ...
Objectivity,
preciseness and is
verifiable
Financial reports
assist stakeholders
with ...
Evaluation,
assessment and
investment decisions
Frequency of
financial report
preparation
Typically half-yearly
and annually
according to
statutory
requirements
Financial
performance is
compared with ...
Prior periods
Emphasis of financial
performance
Historical, being a
consequence of past
activities and
decisions
A specialised area is
Tax accounting
Cost accounting
To enable
organisations to
comply with the
statutory
requirements of
governments and
other institutions
(e.g. stock
exchanges)
Financial statements prepared for external stakeholders give insights into the
following:
accountability of the managers: (that is, ask the following question: Have the
finances of the business been appropriately used to benefit the business
rather than the personal interests of the managers?)
capital position of the business: (that is, the amount of money distributed to
the owners and the amount of capital remaining to settle the debts of the
business (loan funds, creditors))
valuation of an businesss equity: (that is, to provide enough information for
others to assess the value of an business from their perspective)
financial strength: (that is, the businesss ability to pays its current bills as
they become due, the debt to equity ratio and interest cover)
financial sustainability: (that is, its profitability, its return on investment or
return on assets employed, the efficiency of the asset use by management).
12
Business owners and managers could not track their current financial
performance in an accurate and timely way. A key function of business
management is to ensure that the business will endure. Accountancy
provides a reporting mechanism by way of an Income Statement that details
the revenue, expenses and resulting profit that managers can use to make
informed decisions to ensure the sustainability of the business.
No accounting = ill-informed decisions = poor use of
resources and the failure of the business to survive
Banks as the core component of the global financial system could not facilitate
the means of economic exchange. Trade between entities would therefore
eventually cease. Businesses would not offer credit, turning the efficiency of
our current financial system back to the dark ages of barter and localised
subsistence living.
Business and economic planners would have no instruments with which to fly.
Financial information provided by the accountancy system allows managers
to prepare budgets that become instruments, gauges and benchmarks of
performance and a means of controlling the finances under their control.
No accounting = no ability to plan = end of economic
growth and development
Is the business
currently profitable?
Does it continue to
have the capacity to
endure? Which way is
the profit trending?
BOOKKEEPERS
Bookkeeping is generally the tedious, clerical and exacting role in the accounting
system. Today bookkeepers use computer and accounting software to do much
of this work.
The bookkeeper function is performed primarily by skilled clerical personnel who
may or may not have any formal accounting training. They will, however, have a
basic knowledge of the double- entry system, which ensures that financial
transactions are recorded correctly.
Bookkeepers are required to classify transactions into the correct ledger
accounts as previously determined by the accountant and business owner. A final
check in the bookkeeping process is called a trial balance. This summary
ensures that financial transactions have been correctly recorded. At this point,
the bookkeeper usually hands the system over to the accountant who performs
the second element of the accounting function: analysis and reporting.
ACCOUNTANTS
Quite often the terms bookkeeper and accountant are used interchangeably.
Certainly, they both play a role in the accounting process. However, they each
perform quite different functions.
Lets revisit a definition of accounting to help us understand these differences:
Accounting consists of two key elements:
KeyFACTS
Accountants are responsible for reporting to governments and statutory requirements. These
reports include the Statement of Financial Performance and the Statement of Financial Position.
Accountants also prepare reports and advise business managers in developing their businesss.
This advice may relate to:
16
Wray Rives is a qualified accountant and an active Quora participant. He may well
wish to add to what is said below if contacted on Quora. This is what he says about
becoming an accountant
I studied accountancy at university as part of a degree in business and
quickly saw its value in contributing to the success of my entrepreneurial
dreams. I dont have the temperament to be an accountant but I did see the
value of financial/accounting skills for entrepreneurs in regard to financial
modelling in business plans, structuring corporate/accounting entities,
keeping your own books with computerised bookkeeping, understanding
financial statements, adopting managerial accounting in regard to cash flow
budgets, accessing finance options and conducting valuation analysis. See my
answer on this at: Which specialty within accounting is more beneficial to a
career in entrepreneurshipTax or Audit? So, I didn't work directly in a
recognised accountancy field but I have embraced accountancy skills in all my
entrepreneurial endeavours and in my advisory roles.
If you are interested in working in any of the specialised accounting fields, you
must begin with an understanding of accounting/finance theory via a formal
education. If you wish to eventually become a qualified accountant (rather
than just acquire the accounting skills as I have) you will need to firstly
complete an accounting or business or finance degree at a university and
then complete additional specialised accounting studies as required by the
professional accounting association that you may be required to join.
Check with the peak accounting body in your country in regard to their
membership requirements before choosing your formal education pathway.
Employer role
Career benefits
Requirements
Public accounting
firms
Responsible for
providing accounting
services to
individuals,
businesses and
government. The big
4 in this area are:
PricewaterhouseCoop
Candidates with a
degree in
accounting/finance
18
Responsible for
preparing budgets,
tracking costs and
analysing government
initiatives.
Preferred candidates
generally have 5+
years of big 4
industry experience.
Responsible for
preparing (or helping
to prepare) financial
statements, for
tracking costs, for
handling tax returns
and for working on
major transactions.
Preferred candidates
will generally have
industry experience
and have
membership of a
peak body.
Independent
Entrepreneurship
Prospects for
becoming a valuable
founding member of
any business startup team.
Formal qualifications
and peak body
membership are a
distinct advantage
but not critical.
SUMMARYBEING AN ACCOUNTANT
If you wish to work in any field of accountancy, start with a formal education. This
should preferable be an accounting/finance degree at a university.
20
Going
concern
concept
Monetary
measure
ment
assumpti
on
Time
period
conventi
on
Historic
al cost
convent
ion
Matchin
g (or
accruals
)
principl
e
Realisat
ion of
income
conventi
on
Full
disclosu
re
concept
Material
ity
principl
e
Prudence
(or
conservat
ism)
principle
Consiste
ncy
conventi
on
Dual
aspect
concept
Objectiv
ity
concept
Substan
ce over
form
principl
e
All transactions recorded in the accounts must keep this equation in balance.
To do this, financial transactions are allocated both a debit side and a credit
side of equal amounts.
Objectivity concept: The objectivity concept states that transactions must be
recorded on the basis of objective evidence. This means that accounting
records will initiate from a source document to ensure that the information
recorded is based on fact and not on personal opinion.
Substance over form principle: In accounting, real substance takes precedent
over legal form. This means that accountants consider the economic or
accounting point of view rather than just the legal point of view when
recording transactions. This helps to explain the difference between a legal
entity and an accounting entity.
WHAT IS THE ACCOUNTING ENTITY ASSUMPTION?
It is important to understand the principle of keeping the personal financial
affairs of the business owners separate from the businesses they operate.
Applying the accounting entity assumption helps produce meaningful and
relevant financial reports for decision makers.
LEGAL ENTITY
22
Under the accounting entity assumption, a business entity, regardless of its legal
status, is treated as being separate and distinct from the owners or managers of
that business.
24
An indefinite period means the foreseeable future or long enough for the
business to meet its objectives and to fulfil its commitments. It is important
to note that the going concern concept does not imply or guarantee that the
business is profitable or that it will remain so for the foreseeable future.
In other words, the going concern concept assumes that when a business buys
assets such as land, equipment and buildings, it does so with the intent that
these assets will produce income over a number of years. The business does not
purchase these assets with the intention to close operations soon after purchase
and then resell them.
For example, lets assume that a business recently purchased equipment
costing $5,000, which had 5 years of productive/useful life. Under the going
concern concept, the accountant would write off only 1 years value $1,000
(1/5th) this year, leaving $4,000 to be treated as a fixed asset with future
economic value for the business.
IMPLICATIONS OF THE GOING CONCERN CONCEPT
The going concern concept has significant implications for the valuation of assets
and the liabilities of a business. By applying the going concern concept,
accountants are able to value and include long-term assets in a Statement of
Financial Position (Balance Sheet).
If the going concern assumption was not applied, the accountant would need to
write these assets off as costs within the year of purchase. Applying the going
concern concept also allows accountants to properly allocate transactions that
overlap 2 or more consecutive years. As well, by applying the concept of a going
concern, accountants can record assets at historical costs. Recording assets at
historical cost means the accountant does not need to constantly assess the
liquidated value of business assets when preparing the financial statements.
26
Blake's Furniture Store issues a purchase order for 20 timber chairs @ $125
each in December and includes a check for $500 as a deposit. According to
the agreement, the chairs are to be delivered in January with the remaining
$2,000 to be paid in February.
This financial event takes place over three monthly accounting periods:
December, January and February. So, the question is ... In what month should
the revenue be recorded (recognised) and how much should be recorded?
The answer to this question is determined by the bookkeeping method being
used by the business, and then applying the revenue recognition principle
There are two bookkeeping methods: the cash accounting method and the
accrual accounting method. Large corporations and for-profit companies must
use the accrual accounting method while small businesses and associations
can choose one or the other.
Using the cash accounting method to determine when revenue should be
recognised is relatively easy because under the cash accounting method
revenue is recognised (recorded) when the cash from the customer is actually
received(that is, revenue recorded in the books of the business is $500 in
December and $2,000 in February).
The accrual accounting method records the revenue in the month that it
was earned, without regard to when cash is actually received. Under the
accrual accounting method, revenue is earned when either the goods are
delivered or the service has been performed/completed (revenue recorded in
the books of the business is $2,500 in January).
(Note: The deposit in December is initially treated as a liability because the
deposit money remains owing to the customer until the legal transfer of
ownership of the chairs takes place in January with the delivery of the good.)
28
Earning
Granting permission torevenue
use
recognised at the
agreed/negotiated time intervals
or as the assets are actually used.
One key purpose of accounting is to provide the information needed for sound
economic decision making. Sound economic decisions can be made only if a
business is able to measure and report accurately on its profitability.
Profitability for a business directly determines the sustainability, financial
strength and growth capacity of the business. Profitability is calculated as the
amount remaining after revenue has been offset by all the expenses incurred in
earning that revenue.
30
Unlike the cash accounting method, the accrual accounting method eliminates
the timing mismatches that can occur when expenses paid and revenue received
happen in different accounting periods.
WHEN DOES THE MATCHING PRINCIPLE BECOME AN ISSUE?
The matching principle becomes an issue when accountants wish to report on
the financial performance of a business for a specific period. This specific period
in accounting is created under the accounting period convention.
The accounting period convention incorporates the desire by decision makers to
receive regular and comparable updates on the performance of their business on
a per month, per quarter or on an annual basis (that is, for tax purposes).
The matching principle ensures that the financial reports for these short
accounting periods accurately measure the net income.
APPLYING THE MATCHING PRINCIPLE
So, to apply the matching principle appropriately, an accountant would need to:
Businesses that adopt these principles are able to more accurately evaluate their
actual profitability and financial performance for specific periods of time by
eliminating the disparities in the accounting entry timings.
The following case study presents examples of the matching principle and the
revenue recognition principle under the two bookkeeping methods:
Method
A business is paid $1,000
in January for ABC
consulting work
completed and invoiced in
December.
Cash accounting
method
Records $1,000 as
Consultancy revenue in
January.
Accrual
accounting
method
Records $1,000
as Consultancy
revenue in
December.
Records $500 as
printing expense
in December.
The impact on net income reporting using the cash method is:
The impact on net income reporting using the accrual method is:
net income for December increased by $500 (that is, $1,000 revenue less $500
expense)
no impact on net income for January or February with these transactions
net income for all months accurately stated
matching principle and revenue recognition principle are applied.
Description
Accrued revenue
Accrued expense
32
Example
Deferred
revenue
Transferring to future
periods income
transactions that,
while recorded in the
current period,
actually belong to
future periods. These
amounts become
liabilities of the
business because the
business has not yet
performed the work
and so has no claim to
the customer
payment.
Deferred
expense
Transferring to future
periods expense
transactions that,
while recorded in the
current period,
actually belong to
future periods. These
amounts become
assets of the business
because the value of
the expense has not
yet been used up or
utilised.
business
reports the revenues and the associated expenses incurred in earning that revenue
is closely aligned with the revenue recognition principle and the accounting period
convention
leads to additional accrual transactions being created from the end-of-period
adjustments that need to be made to the accounts of the business before the
34
Daily
Daily sales
sales report
report
for
for aa salesperson
salesperson
Weekly
Weekly gross
gross
profit
profit report
report for
for aa
business
business unit
unit
manager
manager
Quarterly
Quarterly and
and
half-yearly
half-yearly Profit
Profit
and
and Loss
Loss
Statement,
Statement,
Balance
Balance Sheet
Sheet and
and
Statement
of
Cash
Statement of Cash
Flows
Flows reports
reports for
for
shareholders
shareholders
Monthly
Monthly profit
profit and
and
loss
report
for
loss report for aa
company
company CEO
CEO
Yearly
Yearly tax
tax and
and
annual
company
annual company
reports
reports for
for
government
government
agencies
agencies and
and
statutory
statutory authorities
authorities
performance of a business.
assumes that time periods can be set by stakeholders according to their needs (for
example, monthly for managers and yearly for government tax departments)
allows for performance comparisons to be made with like for like periods to
Statement, the Statement of Cash Flows and the Statement of Stockholders Equity
is closely related to the going concern concept, the accrual accounting method,
balance-day adjustments, accruals, and the revenue recognition principle in regard
to accurately reflecting the financial performance of businesses for these specified
time periods.
36
Assets - items of
economic value over
which the firm has
legal control (for
example, land, cash,
equipment)
Liabilities - monies
owed by the firm to
external entities (for
example, trade
creditors, loan
providers,
government
agencies)
Assets are one of the three elements in the accounting equation; the other two,
as mentioned earlier, are liabilities and owners equity.
The accounting equation, as mentioned earlier, states:
Assets = Liability + Owners Equity
Assets
Accounting
equation
Liabilities
Owners
equity
If the business ceases trading and sells its assets, the money from that
sale would be used to first pay out the obligations of the business
(liabilities), with the remaining money going to the owners (owners
equity).
38
items of economic value that the business can use to produce profits for the
owners.
These items are known in accounting as the assets of the business.
Equipment
Inventory
Cash reserves
KeyFACTS
Tangible assets can be touched or handled (for example, land, buildings, equipment, vehicles).
Intangible assets cannot be touched (for example, patents, trademarks, copyrights, franchises,
goodwill, web sites). But intangible assets still have a monetary value and a business can control
them.
Assets can be represented on the Statement of Financial Position (or Balance Sheet) as current
assets or non-current (fixed) assets.
CURRENT ASSETS
Current assets are cash and other assets expected to be converted to cash, sold
or consumed either within 1 year or in the operating cycle (whichever is longer).
These asset values continually change in the normal course of business activity.
There are five major sub-groups detailed in the Figure 13.
Accounts
receivables
Short-term
investments
Sub-groups of
current
assets
Pre-paid
expenses
Inventory
Notes
1. Cash and cash equivalents include currency, petty cash, bank deposit accounts and negotiable
instruments (for example, money orders, cheque, bank drafts).
40
2. Short-term investments include securities bought and held for sale in the near future to
generate income on short-term price differences (trading securities).
3. Accounts receivables is money owed to the business by its customers who purchased goods
and/or services on account.
4. Inventory is merchandise held to sell to customers. Also includes work in progress for a
manufacturing business.
5. Pre-paid expenses are expenses paid in advance. They still have asset value as the value has
not yet been exhausted or used.
KeyFACTS
Fixed asset accounts may include land, buildings, furniture, fixtures, equipment, vehicles,
disposed of in the near future (that is, bonds, common stock, or long-term notes).
Intangible assets are items of economic value that are not physical in nature (that is, patents,
goodwill and trademarks).
Liabilities include credit card debt, overdrafts, accounts payable, term loans and
mortgages.
DEFINITION OF LIABILITIES IN ACCOUNTING
The Australian Accounting Research Foundation defines liabilities as follows:
the future sacrifice of economic benefits that the entity is presently obliged
to make to other entities as a result of past transactions and other past
events.
Liabilities are the monies that a business is obliged to repay to others. Some
characteristics of liabilities are detailed in Figure 14.
Liabilities
Liabilities are
are funds
funds
provided
provided to
to a
a
business
business mostly
mostly by
by
non
non owners
owners..
Liabilities
Liabilities are
are also
also
known
as
the
known as the debts
debts
of
of a
a business.
business.
Liability
Liability funders
funders
are
are not
not entitled
entitled to
to
the
the profits
profits of
of a
a
business.
business.
Liability
Liability funders
funders are
are
sometimes
sometimes entitled
entitled
to
to interest
interest on
on the
the
unpaid
debt.
unpaid debt.
The
The business
business uses
uses
liability
liability funders
funders to
to
purchase
purchase assets.
assets.
Liability
Liability funders
funders
have
have certain
certain claims
claims
over
the
assets
over the assets of
of
the
the business.
business.
Liabilities
Liabilities are
are
typically:
typically:
1.
1. loans
loans owing
owing to
to
financial
institutions
financial institutions
2.
2. money
money owing
owing to
to
suppliers
suppliers (creditors)
(creditors)
3.
3. payments
payments
owning
owning to
to
governments
governments
(taxes)
(taxes)
KeyFACTS
42
Liability funders (debt funders) are not entitled to the profits of the business, are sometimes
entitled to interest on the unpaid debt, and have certain claims over the assets of the business.
Step 3:
Step 2:
Step 1:
investm ent of
funds by
business owners,
called owner's
equity
Business
then
receives
funds from
non-owners,
called
liabilities
Business
uses
owner's
equity
(equity
funds) and
liabilities
(debt funds)
to purchase
assets
Owners equity funds remain in the business until the business ceases to trade.
The business views these funds as belonging to the owners but the business is
not obliged to repay them. Owners equity funds are investment funds.
Investment funds entitle the owners to all the profits that the business makes.
STEP 2FUNDS RECEIVED FROM NON-OWNERS (LIABILITIES)
Soon after the business is created it also receives funds provided by non-owners.
Banks and suppliers are typical non-owners who provide funds to the business.
Funds provided to the business by non-owners are called liabilities. The business
acknowledges that these funds belong to the non- owners and understands that
the business is obliged to repay them.
Liability funds are known as debt funds. Debt funds do not entitle the fund
providers to any profits that the business makes. However, sometimes debt fund
providers will receive an interest payment for the funds provided.
STEP 3USE OF EQUITY AND DEBT FUNDS TO PURCHASE ASSETS
The business uses both the equity funds (owners equity) and the debt funds
(liabilities) to purchase assets. Assets, as we saw earlier, are those items of
financial value that the business will use to make profits for the owners. Typically
assets include equipment, inventory and cash reserves. So, from the business
perspective, the value of the assets the business controls must be equal to the
combined value of the equity funds (owners equity) and the debt funds
(liabilities). The relationship between these three elements assets, liabilities
and owners equity is, as stated earlier, known as the accounting equation.
TYPES OF LIABILITIES IN ACCOUNTING
There are three main types of liabilities in accounting:
current liabilities
non-current liabilities (sometimes known as long-term liabilities)
contingent liabilities.
CURRENT LIABILITIES
Current liabilities are short-term financial obligations. Short term in this context
is defined as obligations that are required to be paid off within one year. Current
liabilities are recorded in the Statement of Financial Position (Balance Sheet).
Typical current liabilities include:
expenses due but not yet paid (wages, taxes, and interest payments)
accounts payable to suppliers
short-term notes
revenues collected in advance.
44
NON-CURRENT LIABILITIES
Non-current liabilities are long-term financial obligations. Long-term liabilities are
not required to be paid off within 1 year. Long-term liabilities often involve large
sums of money that allowed the business to open or expand or to purchase a
significant asset. Non-current liabilities are recorded in the Statement of Financial
Position (Balance Sheet). These debts will typically take the business a long time
to repay. Typical long-term liabilities include:
CONTINGENT LIABILITIES
Contingent liabilities are type of liability that typically affects large public
companies. A contingent liability is a non-measurable liability that a company
has for an adverse event, transaction or incident that has already taken place.
Contingent liabilities are reported in the Notes to the Accounts. Contingent
liabilities are not usually recorded in the Statement of Financial Position (Balance
Sheet) of the business.
Typical contingent liabilities could be:
46
When the assets of a business are liquidated, the debts are paid first. The equity
funders (owners) are entitled to what money is left over.
SUMMARYOWNERS EQUITY
Owners equity represents investment funds that the business in not required to repay.
Under the accounting equation: Owners equity = Assets less Liabilities.
Owners equity is also called net assets, or simply equity, or the book value of the business.
Owners equity is funds provided to a business by its owner/s.
When the assets of a business are liquidated, the debts are paid first. Equity funders are entitled
to what money is left over.
KeyFACTS
A business generates revenue when it exchanges its goods or services with customers in return
for money or other assets.
A business incurs expenses by exchanging its assets for the goods and service activities needed to
generate that revenue.
A business makes a profit if its revenues exceed its expenses. However, if the costs of generating
the revenue (expensed assets and service activities) are greater than the revenue received, the
business makes a loss. (Note: Sometimes a business receives assets (cash) from lenders (loans
provided to the business) or from its owners (capital investment). This receipt of assets is not
revenue. Only those assets received from customers or clients in exchange for goods or services
are treated as revenue in accounting.)
Over the 500 years or so of applied accounting, the terminology of the word
revenue has evolved, being given labels such as turnover, top line, sales,
gross receipts, fees earned or even income. Unfortunately, the term income
also has a meaning in some circumstances of profit (that is, after expenses have
been deducted) and this can be confusing for some.
Revenue is referred to as the top line because thats where revenue is reported
on the Income Statement (Statement of Financial Performance). Net income or
net profit on the other hand is referred to as the bottom line because it is
reported in the last line of this same statement. Non-profit organisations may
refer to revenue as gross receipts.
Revenue in the double-entry bookkeeping system is one of the five account
groups where financial transactions can be recorded. The other four are Assets,
Liabilities, Owners equity, and Expenses. Revenue accounts are created in the
General Ledger to record the various ways that the entity earns revenue.
TYPES OF REVENUE IN ACCOUNTING
Business revenue is gross income generated from the normal/ordinary activities
of a business entity (whatever its type). This revenue may come from:
sale of goods: For businesses such as manufacturers, wholesalers and retailers,
most revenue is generated from the sale of goods.
provision of services: Service businesses (for example, accounting firms,
doctors, hairdressers) generate most of their revenue from providing
(rendering) services.
loan of fees and investment: Financial services businesses, such as car
rentals and banks, receive most of their revenue from fees and interest
generated by lending assets to other organisations or individuals, or from
royalties earned for the use of intellectual property. Investment firms may
receive revenue from dividends paid to them by other companies based on
their shareholdings.
48
One further complication with the concept of revenue is that revenue reported
for a particular period will depend on the accounting method a business has
adopted. This complication is dealt with under the revenue recognition principle
where generally accepted accounting principles or International Financial
Reporting Standards determine what is to be reported as revenue in a given
period.
Each of the accounting methods (cash accounting and accrual accounting) uses
a different approach to measure revenue.
Income is the increase in economic benefit available to the business owners from
the net result of the revenues less the expenses incurred in earning that revenue
for a previous period. Income is also known as net profit or earnings.
50
Generally, the terms turnover, sales and revenue mean the same thing. These
terms refer to the sale of goods or the provision of services that arise from the
core activity of the business.
On the other hand, income (or net income), earnings and profit (or net profit)
generally mean the same thing. These terms refer to the net increase in
economic benefit made available to the business after expenses have been
deducted from the revenue/turnover/sales in a given accounting period.
This item appears as the last entry on the Income Statement, which is why
income is often referred to as the bottom line.
Gains are special revenue items that do not arise from the core activity of the
business (for example, gains from the disposal of a fixed asset or gains from
movements in the exchange rates involving international transactions).
Definition
Explanation
Revenue
Represent other
items considered as
income but that do
not arise in the
ordinary course of
business
The increase in
economic benefit
for the owners of a
business that arises
during an
accounting period
Gross
profit
Net profit
While all expenses are costs, not all costs are expenses.
KeyFACTS
Expenses can take the form of:
54
be a trade or business activity that is continuous, regular and one where profit is
the primary motive.
WHAT ARE EXPENSE CLASSIFICATIONS AND FUNCTIONS IN ACCOUNTING?
By applying expense classifications and functions to financial reports, the
decision maker can identify:
The Balance Sheet provides details about the financial strength or net worth
of the business by presenting the assets, liabilities and owners equity at a
point in time.
The Income Statement provides details about the sustainability or
profitability of the business by presenting the revenue and expenses for a
past accounting period.
Generic classifications for all businesses may include those listed in Table 7.
Description
OPERATING EXPENSES
Cost of goods sold (or Cost of sales
expense)
Selling
General administrative
Depreciation/amortisation
NON-OPERATING EXPENSES
Financing
Extraordinary item
Income tax
A Chart of Accounts sets out all the ledger accounts into which financial
transactions will be recorded.
A Chart of Accounts generally includes the five main account groups (shaded
yellow in Figure 18 below) and are allocated the number of the group. Three
additional groups (and their respective numbers 5, 7 and 8, and shaded green in
Figure 18) are added to help provide meaningful financial information for
decision makers.
ASSETS
LIABILITIES
OWNER'S EQUITY
REVENUE
EXPENSES
NON-OPERATING REVENUE
NON-OPERATING EXPENSES
The financial report at the end of the year would show $5,000 expensed as cost of
goods sold and a $5,000 investment remaining as an Asset.
So, while $10,000 was paid out by the business in total, only $5,000 of it was
expensed in accounting terms (used up in the generation of sales) in that year. A
total of $5,000 continues to have future economic value (an asset).
Only the $5,000 expensed portion of the money spent on merchandise items is
subtracted from the revenue to calculate the profit.
Lets take the case of a business purchase of a $60,000 boat to illustrate the
difference between capitalisation and expensing.
An accountant would normally capitalise the entire asset value of the boat when it
is first purchased but then expense a portion of the boats value each year based
on the useful economic life of the boat. For instance, if the boat was expected to
benefit the business (earn revenue) for say 10 years before it needed to be
replaced, the accountant would expense $6,000 of the boats value each year
($60,000/10 years).
58
Accounting for the loss in value (expensing) of the boat reduces the capitalised
value of the boat as reported in the Balance Sheet as it equally reduces the profits
reported in the Income Statement each year by the same amount. After 10 years
the capital value is reduced to $0 because the entire value of the boat has been
expensed and it has no economic value left to benefit future periods. This expense
in accounting is called Depreciation.
For instance, if the boat was expected to benefit the business (earn revenue)
for say 10 years before it needed to be replaced, the accountant would
expense $6,000 of the boats value each year ($60,000/10 years).
Expenses are those costs used up in generating revenue for the same accounting
period.
For example, if the printing business used only $800 worth of the photocopy paper
in generating revenue for the month, it would, for accounting purposes, need to
record $800 as an expense for the month, with the remaining $200 being recorded
as an asset because it has future economic value. It could be said that the
economic benefit of the photocopy paper stock has decreased as has the potential
60
profit (equity) due to the printer. (This is because expenses reduced the revenue,
which reduced the profit for the owners: Revenue less Expenses = Profit.)
The business John Smith Accountants takes out a 12-month insurance cover
for $12,000 at the beginning of the current month. The cost of insurance was
$12,000.
At the end of the first month, the company has used up 1/12thof the
insurance cover but still has the economic benefit of 11/12th of the insurance
cover. So, in accounting terms, at the end of the first month, the business will
record an expense of $1,000 but will record the remaining cost of the
insurance as an asset of $11,000.
So the cost of insurance consisted of unexpired and expired portions, with the
expired portion being the expense.
So while cost is defined as the monetary value of the utility (or benefit),
expense is defined as the monetary value of the utility that has already
expired in business activities, provided those activities are directed towards
generating income.
This means that a cost when utilised becomes an expense.
So, the $1,000 mentioned above would appear as Insurance Expense in John
Smith Accountants Income Statement (Statement of Financial Performance)
and the $11,000 would appear as Prepaid Expense in the Current Asset
section of the Balance Sheet (Statement of Financial Position).
The used, utilised or expired portion of the insurance cost was expensed while
the unused or unexpired cost of the insurance is recorded as an asset because
it has future economic value.
vary from industry to industry. Most businesses separate their overheads from
their total expenses in order to help business decision makers in areas such as:
Administration/
Administration/
office
office salaries
salaries
Stationery
Stationery and
and
office
office expenses
expenses
Accounting/
Accounting/ audit
audit
fees
fees
Brand
Brand advertising
advertising
and
and some
some selling
selling
expenses
expenses (e.g.
(e.g.
travel,
travel,
accommodation)
accommodation)
Depreciation
Depreciation of
of
fixed
fixed assets
assets
Insurance
Insurance
Interest
Interest of
of loans
loans
Legal
Legal fees
fees
Rent
Rent
T
axes
Taxes
64
Utilities
Utilities costs
costs
A
y
fg
o
s
U
jT
D
le
d
n
c
a
iv
F
p
u
r
t
Y
b
Assets
Liabiliti
es
Owner'
s
equity
Revenu
e
Expens
es
Year-end closing entries: These are the adjusting financial entries that need to
be calculated at the end of an accounting period and included in the financial
statement of the period in review. These transactions ensure that the financial
statements accurately reflect the performance and position of the business (for
example, at the close of every financial year when the income tax needs to be
calculated).
Trial balance: This is an internal check conducted on data entries in the General
Ledger to ensure that the accounting process was accurately completed (that is,
that a debit value and an equal credit value were recorded for every transaction).
This accuracy is confirmed when all the ledger accounts of the business are
listed and the total of the accounts with debit balances equals the total of the
accounts with credit balances.
SUMMARYDOUBLE-ENTRY BOOKKEEPING
SYSTEM
The key things to remember about the double-entry bookkeeping system are:
For every financial transaction recorded in the accounts of a business, there is a
debit entry and a credit entry. Furthermore, the total of the entries on the debit side
must always equal the total of the entries on the credit side.
The double-entry bookkeeping system ensures that the accounting equation always
remains in balance. That is, the total value of the assets of a business must always
equal the total combined values of the liabilities and the owners equity.
Double-entry booking was first documented over 500 years ago, yet its principles
In other words, if an enterprise receives investment money, not only are the
enterprises assets increased (cash) but also the enterprise has an obligation
to investors (owners equity) of equal proportion.
Likewise, the bank secures the purchase of property, the enterprise increases
its assets (property) and liabilities (loan from the bank) in equal amounts:
hence the double-entry system.
Some have humorously suggested that if double entry (writing it down twice) is
good...then triple entry (writing it down three times) must be even better!
Hopefully, the previous paragraph explains that double-entry bookkeeping is not
just about writing something down twice, but rather recognising that when a
financial transaction in a venture takes place, two quite different components of
the ventures financial status are affected (not just one).
The double-entry bookkeeping allows all stakeholders in a venture to get an
accurate picture of the financial performance (Profit and Loss Statement) and
financial position (Balance Sheet) of the venture at any time. Such knowledge of
a ventures financial sustainability and strength allows stakeholders to make
informed decisions about the efficient and effective allocation of scarce
resourcesthe fundamentals of sound business practice. This helps, in turn, to
ensure that businesses remain viable and that the most successful ventures
attract the appropriate amount and quality of resources.
Double-entry bookkeeping is such a big deal because, arguably, we may not
have had the Industrial Revolution nor our current global shareholder-based
corporations and stock exchanges without a financial system like it. The
successful growth of corporations could not have been sustained over time
without being underpinned by such a sound financial system.
HOW IS THE ACCOUNTING EQUATION FORMED?
The accounting equation is an integral part of the double-entry bookkeeping
system. Understanding this will help you to understand one of the first principles
on which accounting is based.
68
At this point, the new accounting entity owns nothing and it owes nothing.
This situation changes when funds are provided to the business by the owners in
the form of capital investment. Other funds may also be supplied to the business
by lenders (that is, bank loans) and/or creditors. Given access to these funds, the
businessas a separate accounting entity can then buy assets which will be
used to make profits for the owners. These funds provided by the funders could
be used/employed by the business to buy land, buildings, plant, equipment,
merchandise inventory (goods to sell) or simply kept as cash reserves to provide
the new entity with working capital (money to pay bills with). These items are
categorised as the assets of the business.
While the business has control over the assets, it actually owns nothing for its
own benefit. If all the assets were sold and business activities ceased, the
liabilities (banks and creditors) would be paid out in full first. Whatever money
was left over from the sale would be then given to the owners. This would leave
the business in the same position as it started: owning nothing and owing
nothing.
THE FIRM AS A SEPARATE ACCOUNTING ENTITY
Remember, a business has nothing when it is created. So, the value of the funds
that the business uses/employs will be equal to the value of the funds provided
to it. In this position, the business, as a separate accounting entity, now owes
money to the funders (that is, owners, banks and creditors) but has been given
control over (or ownership of) assets that it has purchased. The total value of
the assets then must be the same value as the funds provided to the business.
The values of
funds the
business uses
equals ...
Looking again at the business funders, there is a natural category break up, as
shown in Table 8. The accounting system treats these funding providers
differently: funds provided to the business by the owners in the first group is
called owners equity and the funds provided by non-owners in the second group
are called liabilities.
Owners
The formula known as the accounting equation recognises the natural split in
the type of funding provider, and that all the assets of a business are financed by
the funders.
WHAT ARE DEBITS AND CREDITS IN THE BOOKKEEPING SYSTEM?
The terms debit and credit have many different meanings in our society. The
meaning of the term debit in the bookkeeping system has no relationship with
the term debt, which means money that is owed to someone else. Below, by
way of example, are some examples of different meanings for the term credit.
Note that all of these meanings are different from the meaning of the term credit
used in the bookkeeping system:
The word
credit
70
Recognition for
past
achievements:
She already
had several
performances
to her credit.
Grading a level
of academic
achievement:
You received a
credit on that
exam paper.
Requirement to
identify a
source of
information:
You must credit
the original
author of that
work.
Taking goods
now and paying
for them later:
You can have
these goods on
credit.
Recognition for
work:
He gave her
credit for
trying.
The terms debit and credit are used in the bookkeeping system simply as a way
to classify financial transactions. This method provides a way of recording the
changing values in the financial accounts of a business caused by monetary
transactions. It also properly captures, reflects and records the flow of economic
resources from a source to a destination.
At the same time, the debit and credit method of classification and recording
keeps the accounting equation in balance for each new entry; that is:
Assets = Liabilities + Owners Equity.
If you do not clearly understand the how the terms debit and credit are used in
the bookkeeping system, you will find bookkeeping impossible to use and apply.
To make it clear in accounting, Dr [for debit] and Cr [for credit] are used to
show that we are using the meaning of these terms as used in the
bookkeeping system.
use Dr (for debit) and Cr (for credit) in the bookkeeping system. (There is no r in
the English word debit but there is an r in the Latin term debere.)
The Latin term credre means to entrust something; debere means to owe
someone.
For example, if Person (A) entrusts USD$100 to Person (B), Person (B) owes
USD$100 to Person (A).
This example illustrates that financial transactions always have two sides.
Similarly, economic resources flow or transfer from a source to a destination.
Pacioli used the terms credre and debere to describe this principle: that every
financial transaction has two sides, with the source recorded as a Cr, or Credit,
and the destination recorded as a Dr, or Debit.
Traditional definitions of the concepts of debit and credit (in the bookkeeping
system) are as follows:
debit is one side of the entry in the bookkeeping system that is placed on the
left side of a T account
credit is the other side of the entry in the bookkeeping system (the other side
of the financial transaction) that is placed on the right side of a T account.
While this is not a very informative definition of the terms, it is the one you are
most likely to find in dictionaries.
In essence, the debit and credit method used in double-entry bookkeeping
captures and records the flow of economic resources in a financial transaction as
economic resources transfer from a source (credit) to a destination (debit). The
method also ensures that the accounting equation, which is the foundation stone
on which the entire double entry bookkeeping system is built, remains in balance
after each transaction is recorded.
owners equity.
Every financial transaction has two sides: the source of the economic resource and
the destination of the economic resource.
72
Description of action
required
Example
ACCOUNT GROUPS
There are only five account groups in the bookkeeping system. These groups are
broken down into smaller sub-accounts.
Description
Example
Assets
Liabilities
Owners equity
Revenue
Expenses
Asset
(Dr /Debit)
(Cr/Credit)
Liability
(Cr /Credit)
(Dr/Debit)
Account group
74
Owners equity
(Cr/Credit)
(Dr/Debit)
Revenue
(Cr/Credit)
(Dr/Debit)
Expenses
(Dr/Debit)
(Cr/Credit)
So then they ask: Why does my statement from the bank show a
(Cr/Credit) balance when I have money in it and why are my deposits
treated as a (Cr /Credits)?
T
To
o ascribe
ascribe an
an
achievement
achievement to
to
someone
someone
T
To
o obtain
obtain goods
goods and
and
services
services before
before
paying
paying for
for them
them
The
The money
money lent
lent or
or
made
available
made available
under
under a
a credit
credit
arrangement
arrangement
Acknowledgement
Acknowledgement of
of
a
grade
level
in
an
a grade level in an
examination
examination
Source
Source of
of pride
pride that
that
reflects
reflects well
well on
on
another
another person
person or
or
organisation
organisation
KeyFACTS
From an accounting point of view, when a new business is first formed by the owners, the new
(liabilities) or internal funders like owners who invest money in the business (owners equity).
Because all the assets of a business have been supplied by others (namely, through liabilities and
owners equity), these others have an economic claim over that business.
That claim is the equivalent of the value of the total assets that the business controls.
It was obvious to the medieval Venetian merchants that a system was needed to
record the impact of the numerous financial transactions on a business without
upsetting this underlying economic principle explained by the accounting
equation.
Soyou guessed it they came up with the concept of classifying individual
transactions as debits and credits, although they referred to them using the Latin
terms: credre and debere, respectively.
This debit and credit classification method that the Venetians invented to record
individual financial transactions ensured that the fundamental accounting
equation, explained above, always remained in balance.
The debit and credit classification method achieves this by applying the rules
outlined in Figure 24.
Owners equity includes such accounts as Capital, Retained Earnings and Current
Earnings (also known as Net Profit). Current Earnings in the equity accounts is
the final result taken from the Income Statement and is calculated by the
formula:
Net Profit = Revenues Expenses
According to the debit/credit rules below, increases in the equity accounts are
credited. So because an increase in revenue will increase the Net Profit, it must
78
also increase the equity account called Current Earnings in the Balance Sheet.
Because the double-entry bookkeeping system requires that increases in equity
are credited, it follows that the revenue account must be credited when it
increases as well.
DEBIT AND CREDIT RULES
Another way to look at it is to understand that whenever revenue is generated,
assets are always affected.
For example, if a business sells goods in exchange for cash, assets (Cash or
Accounts Receivable) will increase. However, to maintain the basic
accounting equation, either the liability or the equity accounts must
increase by an equal amount. Now since no debt or liability to an external
entity is created when we sell goods, it must be the equity account that
increases. So, an increase in revenue must lead to an increase in equity.
It needs to be noted that sometimes a business will receive assets from lenders
(by way of loans) or from its owners (by way of capital investments). The receipt
of such assets by the business is not treated as revenue but rather as:
assets with a corresponding liability in terms of loans, and
assets with a corresponding owners equity in terms of capital investments.
To clarify, we need to look at these transactions from the point of view of the
business. Remember all accounting transactions are recorded from the
perspective of the business (that is, the business as a separate entity concept).
In a way, the business looks at all transactions in a completely neutral way.
There is no good or bad from the point of view of the business because, in
reality, it owns nothing and does not benefit from the profits generated.
In other words, the revenue received by the business increases the claims of
the owners over the assets.
In keeping the accounting equation in balance we will then increase assets (cash)
with a debit entry and increase equity (revenue) with a credit entry. The revenue
(credit entry) belonging to the owners of the business is reduced by (debit entry)
the costs associated with the activities needed to earn that revenue (that is,
expenses).
THE FINANCE SYSTEM
The final concept you need to fully understand to make sense of debits and
credits in accounting is to understand how this classification method relates to
the finance system.
Finance is a closed system. This means, that money does not just appear in your
bank account from time to time, nor does it just disappear into thin air.
The debits and credits system completes this record of financial funds
movement.
The credit side of the transaction (or the credit entry) represents the
withdrawal from the source.
The debit side of the transaction (or the debit entry) represents a deposit in
the transactions ultimate destination.
80
So, this classification system of debits and credits in accounting is very closely
related to the economic concept of duality in financial transactions (that is, for
every financial transaction, the debit entries must equal the credit entries.
The reason for this is that in a closed system there must be a source and
destination of an equal amount for each transaction.
While it is best to determine the debits and credits classification via the decision
tree shown in Figure 25, as a general rule, the source of a transaction is credited
and the destination is debited.
HOW CAN I BETTER UNDERSTAND DEBIT AND CREDIT?
It is the personal view of the author that fully understanding the debit and credit
concept in accounting is near impossible when you are first confronted with it.
Learning how to apply the debit and credit concept is far easier. You can be an
outstanding bookkeeper or accounting student by just learning the application
rules.
The author of this e-book has taught accounting students for many years and
kept the books for his own businesses. But he says he never really understood
the rationale behind the debit and credit concept in accounting. In his opinion,
the dictionary definitions, as detailed below, do very little to help that
understanding:
Debit: an entry in the left-hand column of an account (T account) or the lefthand side of the Balance Sheet
Credit: an entry in the right-hand side of an account (T account) or the righthand side of a Balance Sheet.
Adding to the confusion, is the fact that the debit and credit concept and
terminology was developed over 500 years ago, with the first accounting
textbook being written in Latin. English as a language has morphed substantially
over the past five centuries since the Venetian method of accounting was first
translated.
Many different meanings have been producing for the terms debit and credit
besides the meanings intended in accounting. Is it any wonder that the debit and
credit concept is a difficult one for students living in the 21st century to fully
grasp!
The following tips may help students trying to better understand the debit and
credit concept.
1.
Do not link the meanings of the terms debit and credit in accounting with any
other meanings of these words in everyday English.
2.
Debit and credit in accounting do NOT mean plus and minus, good and bad
or increasing and decreasing, respectively.
3.
The accounting terms debit and credit acknowledge and record the duality of
financial transactions. In other words, finance is a closed system; money just
doesnt appear or disappear.
For example, if money is received by a business, it must have been given by
others and vice versa. (So, two entries of equal amounts are required to
4.
Debit and credit are accounting concepts that capture in the books of a
business the flow of economic resources from a source (credit) to a
destination (debit).
For example, take a situation where a bank provides funds to a business as
a loan. The bank loan is the source of funds so it is recorded as a credit. The
Bank account of the business is the destination of the funds so it is recorded
as a debit.
5.
Applying this principle will help you identify the credit = source and debit =
destination of every transaction.
Debit and credit is a recording system that ensures that the accounting
equation always remains in balance after each and every transaction; that is:
Assets = Liabilities + Equity
The Venetian merchants who developed this system 500 years ago decided
that increases on the asset side would be called a debit and increases on the
liabilities and owners equity side would be called a creditwith
corresponding debit and credit entries for decreases.
If every transaction is recorded with an equal amount for the debit and the
credit, the accounting equation will always remain in balance.
A balanced accounting equation allows business managers to accurately
calculate and split the claims that all parties have over the assets of the
business (liabilities = external parties such as banks and suppliers; owners
equity = owners).
6. Debits and credits are always recorded from the perspective of the business.
This is why if the Cash at Bank account in the books of the business is a debit
balance then the bank balance on the Bank Statement will be a credit
balance.
This is because while cash is an asset to the business (an item of value that
the business owns), it is a liability for the bank (money owed to a customer).
84
monthly
quarterly
half-yearly
annually (yearly).
It is these shorter and continuing time periods of reporting that have created the
accounting cycle.
KeyFACTS
The accounting cycle is the series of accounting activities that occur within a specific accounting
period.
This series of activities is repeated for each accounting period of time.
The accounting period starts with account balances taken from the Statement of Financial
Position (Balance Sheet) and ends with new balances on the same statement after all the
transactions for the period have been properly accounted forthis makes up the accounting
cycle.
The Statement of Financial Position (Balance Sheet) is the detailed summary of the accounting
equation, where the recorded value of the assets of the business is equal to the combined totals of
its liabilities and the equity (capital investment) of the owners.
1:
1: Start
Start
2:
2:
5.
5. End
End
4.
4.
Statement
Statement
s
s
Transactio
Transactio
ns
ns
3.
3.
Adjustmen
Adjustmen
ts
ts
Key
1.
The accounting cycle starts with the balances from the previous accounting periods
permanent ledger accounts (taken from the Statement of Financial Position (Balance Sheet)).
2.
This step records all financial transactions that occurred in the current period into the books or
accounting system.
3.
This step sees adjustments made at the end of the current period (that is, to match the
expenses with the revenues generated and make adjustments to inventory and accounts
receivable).
4.
The financial statements produced include the Statement of Financial Performance (Income
Statement or Profit and Loss Statement). The bottom line or profit from this statement
becomes the current earnings in the owners equity section of the Statement of Financial
Position. (This is because the profits of the business belong to the owners of the business.)
5.
The current accounting period ends with the new balances for the permanent accounts
detailed in the Statement of Financial Position (Balance Sheet). These closing balances for the
current period now become the opening balances for next periods accounting cycle.
86
Step
9
Step
8
Step
6
Step
7
Post the details from the journals to the general ledger where all
the accounts are kept. Summary details are transferred (posted)
from the journals to the general ledger. Ledgers are kept by
account types (for example, Electricity, Cash, Accounts Payable).
Step
5
Step
4
Step
3
Step
2
Step
1
There are a number of steps in the accounting process. Because these steps are
repeated every accounting period they are also referred to as the accounting
cycle. These steps are detailed in Figure 28.
WHAT ARE THE STEPS IN THE ACCOUNTING PROCESS?
Step
10
Step
11
Step
12
A journal records the debit and credit details of a transaction in a chronological (date and
time) order. It also records the account name and the account number allocated by the Chart
of Accounts. Common journals are: Cash Receipts Journal, Cash Payments (disbursement)
Journal, Sales Journal, Purchased Journal and General Journal.
**
The trial balance lists and summarises all the General Ledger account balances to ensure that
the total of the debit balances equals the total of the credit balances. The sum total is not
meaningful. The important thing is that the totals of both columns (debits and credits) agree.
A balanced trial balance ensures that there were no recording errors. However, it does not
guarantee that the amounts are correct (that is, the right amounts may have been posted to
the wrong accounts). Correct the discrepancies identified from trial balance if required.
Adjusting entries need to be made at the end of each accounting period to match the revenue
earned in that period with the expenses incurred in earning it. These adjustments are called
accruals and deferred items in accrual accounting. These entries are also journalised and
posted to the General Ledger. The source document used to record adjusting entries is
typically a 10-column worksheet.
## Temporary accounts are cleared by transferring the amounts in them to the Income Summary
Account. This account is part of the retained earnings as reported in the owners equity section
of the Statement of Financial Position. Temporary accounts are the revenue, expense,
dividend, owners drawings accounts as well as other gains or losses made. These temporary
accounts begin the next accounting period with a zero balance.
(a) Steps with text shaded green are those steps taken (sequentially) at the start of the
accounting period.
(b) The step with text shaded blue is the step taken at the start of the next accounting period.
88
Source documents is an accounting term; the term describes the original records
that contain the details substantiating the financial transactions entered into the
internal accounting system of a business. Typical source documents include sales
invoices, cash receipts, cash register slips, credit notes and deposit slips. Source
documents provide the documentary evidence of a business deal or accounting
event. Source documents are a critical part of an audit trail that establishes the
authenticity and tracking history of an accounting systems financial records.
BACKGROUND TO SOURCE DOCUMENTS IN ACCOUNTING
All manufacturing systems are identified by their three key elements: inputs,
processes and outputs.
In accounting:
Inputs
Proces
s
Outpu
ts
KeyFACTS
Source documents:
are the essential inputs that provide the details required by internal accounting systems
assist in the internal control of the resources of the business
ensure that there is documentary evidence to support the purchase or sale of items of value and
The details from the source document should be recorded in the appropriate
accounting journal as soon as possible after the transaction has occurred. After
recording the details, all source documents should be filed in a document system
from which they can be readily retrieved at a later date if required.
Government tax law requires that these source documents are kept for a number
of years (typically from 3 to 7years depending on the country).
In the event of an audit, these source documents should support the data
recorded in the accounting journals and the General Ledger by providing an
indisputable audit trail from source documents to journals to General Ledger to
trial balance to financial statement.
A source document should describe all the key aspects of the transaction such
as:
Source documents
Memorandum
satisfy the requirements of the tax law in regard to proof of income and
expenditure.
the
the
the
the
account group
account sub-group
relevant cost centre
specific project or program.
Journals in accounting were traditionally called the day book. This is due to the
origins of the English word journal. The English word comes from the French word
jour, which means day. It was also traditionally expected that journals would
record all of the financial transactions that occurred on each particular day.
Journals recorded transactions as they occurred (or as soon as possible
afterwards) in date and time order.
Journals became known as the books of original entry because they were the
point at which financial information entered the accounting information system.
The financial information system manages the financial data as it is:
Description/purpose
Sales Journal
Purchases Journal
General Journal
KeyFACTS
Business transactions are those events that will change the value of the assets and/or liabilities
Journal entries are recorded in chronological order while applying the doubleentry bookkeeping system at all times and for each entry. Each journal entry will
include debit and credit amounts and will identify the ledger accounts (from the
Chart of Accounts) that the transaction has affected, as well as the date that the
transaction was recorded.
To assist reviewers of the entries (for example auditors), comments are also
included to detail the source of the financial information being recorded and any
relevant reasons for the entry (transaction). The initial journal entry is an
important component of the audit trail that stretches from the source document
all the way to the Balance Sheet.
Step 1
Financial
transaction
details
recorded in
journals where
principles of
double-entry
bookkeeping
applied via the
debit and credit
rules
Step 2
Ledger accounts
receive
information from
the journals via
process known
as posting
Step 3
Debit details
from journals
recorded on left
of the
T
account and
credit details on
the right
Step 4
By subtracting
one side of the
T
account from
the other, one
can assess if a
specific account
has a current
debit or credit
balance*
* An account has a debit balance where the total of the debit amounts is greater than the total of
the credit amounts. It has a credit balance where the total of the credit amounts is greater than
the total of the debit amounts. Normally the Liabilities, Revenue and Owners equity ledger
accounts have a credit balance and the Assets sand Expense ledger accounts have a debit
balance.
ACCOUNTS
RECEIVABLE
ACCOUNTS
PAYABLE
Accounts receivables
deals with the creation
and management of
debtor accounts that
allows customers to
purchase goods and
services from the
business on credit.
accounts. Recording all this information in just one account in the General Ledger
would make managing these functions very difficult.
So the accounting system sets up specialised journals and ledgers. These
specialised journals and ledgers make it easy to manage the goods and services
sold to individual customers on credit in the debtors subsidiary system and to
manage the goods and services purchased from individual suppliers on credit in
the creditors subsidiary system.
The debtors subsidiary system includes a Sales journal and a Debtors ledger
that is used to manage the sales on credit and the payments made by
individual customers in relation to their account.
The creditors subsidiary system includes a Purchases journal and a Creditors
ledger that is used to manage the purchases on credit and the payments
made by the business to the individual supplier accounts.
It is imperative that the total of all the individual account balances in the
subsidiary ledger is equal to the amount reported in the control account in the
General Ledger. The process used to verify this balance is known as a subsidiary
ledger reconciliation.
Discrepancies between the total of the subsidiary ledgers and the General
Ledger control accounts can occur because every transaction that deals with
sales/purchases on credit and cash received/paid on these accounts must be
recorded in two places, namely:
subsidiary ledgers (for example, the Sales journal and the Purchases journal).
Apart from the general journal, all other journals need to post their details to both the
individual accounts in the subsidiary ledgers and the control accounts in the General
Ledger.
Customer payments processed through the Cash Receipts journal will need to be posted
to the Debtors ledger, while cash sales and other cash received like owners capital
Ledger account.
The subsidiary ledgers are not part of the main accounting process but are simply a
listing of the individual accounts that explain and justify the total amount reported in
is.
the total of the individual customer account balances must equal the Accounts
The journals record the details of the transaction chronologically in date and time
order. The accounting process then transfers the details contained in the journals
to those accounts specifically affected by the transaction. That is, the transaction
of paying an electricity bill would reduce the amount the business had in its Bank
account and increase the Electricity Expense account. Collectively, all these
accounts make up the General Ledger of the business.
The accounts of the General Ledger are the building blocks that produce the
financial reports of the business. The process of transferring the details of the
financial transaction recorded in the journals into the relevant accounts in the
General Ledger is called posting in accounting.
In todays computerised accounting world, posting to the General Ledger takes
place automatically the moment that the transaction is correctly journalised and
A Sales journal records those sales made to customers that have an account
that allows them to pay for the goods and services at a later date.
A Purchases journal records purchases made by the business of goods and
services for which it has taken possession but not yet paid for.
KeyFACTS
The General Ledger is where all of the financial transactions of a business are categorised and
of Accounts.
The General Ledger contains a permanent history of all the financial transactions that have taken
The Income Statement is prepared from the closing balances of the Revenue
and Expense accounts.
The Balance Sheet is prepared from the closing balances of the Assets,
Liabilities and Owners equity accounts.
All the financial transactions of a business (or financial entity) are categorised and
a business.
With computerisation, General Ledgers have become digital databases of financial
information.
Journals post (transfer) all data captured to the General Ledger.
General Ledger accounts are grouped according to the account type (that is, Assets,
The General Ledger is sometimes known as the nominal ledger and often
abbreviated as GL.
The General Ledger makes it easy to track information and to quickly see account
balances.
Transactions cannot be recorded directly into the ledger; they must be routed
all financial transaction must have at least one [Dr/Debit] entry and one
[Cr/Credit] entry and for each financial transaction
the total of the [Dr/Debit] entries must equal the total of the [Cr/Credit]
entries.
The trial balance, then, is a summary report that tests whether all the financial
transactions entered into the accounting system over a specific period of time
have followed the double-entry bookkeeping rules in regard to [Dr/Debit] and
[Cr/Credit] entries.
prepared for both internal and external stakeholders, the trial balance is
prepared for, and used by, only the internal accounting team.)
The trial balance is simply a listing of all the accounts from the General Ledger
with their balances. The balances of the accounts will be either a [Dr/Debit] or a
[Cr/Credit] depending on their nature and financial activity.
For example, Asset and Expense accounts will most likely have a [Dr/Debit] balance
while Liabilities, Owners Equity and Revenue accounts will most likely
have[Cr/Credit] balances.
The total of accounts with [Dr/Debit] balances should be the same at the total of
accounts with [Cr/Credit] balances, provided that the double-entry bookkeeping
system was correctly applied. So, in essence, the trial balance is prepared to
confirm the accuracy of the postings to the General Ledger.
In a manual accounting system, it is necessary to prepare a trial balance
because of the many ways that the General Ledger could be out of balance (that
is, where the total of the [Dr/Debits] do not equal the total of the [Cr/Credits]).
Modern computerised accounting software systems enforce the double-entry
bookkeeping requirements at the data-entry level making it impossible for either
the General Ledger or the trial balance statement to be out of balance.
PRESENTATION OF THE TRIAL BALANCE
The trial balance statement consists of the header rows followed by a list of all
the general ledger accounts. The current balances of these general ledger
accounts are place in either the [Dr/Debit] or the [Cr/Credit] column. The
[Dr/Debit] and the [Cr/Credit] columns are then totalled and compared. They
should be the same.
KeyFACTS
An audit trail is a complete step-by-step history of every transaction in the accounting system.
An audit trail comprises a chronological sequence of records and source documents that provide
the evidence an auditor needs to reconstruct previous steps in the accounting system.
An audit trail facilitates defect analysis and so helps to verify the accuracy and reliability of
financial reports.
Merchandise
inventory
To make adjustments
to reflect the physical
or
Fixed assets
To make allowances
for their depreciation
Accounts
Receivable
Supplies or
stores
To record adjustments
to the supplies
stocktake valuation
according
debts
stores values
to the end-of-period
stocktake
cash accounting
accrual accounting.
Under the cash accounting method, financial transactions are recorded in the
accounts of a business only when the cash is actually exchanged.
For example, revenue is recorded when the money is received and
expenses are recorded only when the actual payment is made.
Businesses using the accrual accounting method are required to record revenue
when a legal obligation on the customer/client is created and record expenses
when the business incurs a legal liability to payregardless of when the cash is
actually exchanged.
So by applying the accrual accounting method, the income earned in a given
accounting period will accurately match the expenses incurred in earning that
revenue. This is known in accounting as the matching principle. The matching
principle ensures that the financial reports accurately reflect the financial
performance and the financial position of the business for the given accounting
period.
The matching principle applied in accrual accounting requires that adjusting
entries are made to the accounts to ensure that all the revenue earned in an
accounting period, together with all the expenses incurred in earning that
revenue, are recorded and reported in the same accounting period.
END-OF-PERIOD ADJUSTMENTSACCRUALS AND DEFERRALS
The two key end-of-period adjustments that need to be made under the
matching principle are accruals and deferrals.
ACCRUALS
Accruals are end-of-period adjustments made under the matching principle that
recognise (bring to account) those revenues that have been earned and those
expenses that have accumulated in the current period but which have not yet
been recorded in the books of the business.
DEFERRALS
Deferrals are end-of-period adjustments made under the matching principle that
transfer to future accounting periods those revenues and expenses recorded in
the current period but which, in fact, belong to these future periods.
The different types of end-of-period adjustments are detailed in Table 14.
End-of-period adjustment
Accrued revenue
Accrued expense
Deferred revenue
Deferred expense
there may be revenue earned by the business that has not yet been recorded
(for example, unpaid sales invoices)
there may be expenses owed by the business that are not yet recorded because
the bill has not yet been received or paid (for example, an electricity bill or
rent for the past month)
there may be payments made by customers that should not yet be recorded as
revenue (for example, deposits paid by customers for future work)
there may be purchases for inventory that have not yet been sold and remain in
stock (under the cash accounting method, this amount would be expensed
even though the inventory asset remained)
there may have been payments made by the business for some expenses that
still have future economic benefit (for example, insurance paid for 12 months
in advance).
Every cash-based small business could experience any or all of the above
situations, which would distort the net income results presented in their financial
statements. Government tax departments and accounting standards accept this
possible profit distortion for small cash-based business using the cash accounting
system because the extra cost and time required to use the accrual accounting
method cannot be commercially justified for them.
Large businesses, however, that reach certain legislated sales thresholds (for
example, $5 million per year of sales in the United Stated) are required by tax
law to record financial transactions and prepare financial reports based on the
more complicated accrual accounting method.
Accrual accounting
method
Records $1,000 as
Consultancy revenue in
January
Records $1,000 as
Consultancy revenue in
December
A business pays an
electricity bill of$500 in July
for electricity used in June.
does not adhere with the matching principle or the revenue recognition principle of
accounting
is not a reliable measure of net income when calculated for shorter time periods like
months.
is also known as the cash basis when describing how the financial reports were
prepared (that is: They were prepared using the cash basis).
CASH ACCOUNTING
METHOD
Revenue and expenses are
recorded ONLY when the cash
is exchanges (that is, when
revenue is received as cash
The accrual accounting method also properly applies the accounting concept of
the matching principle; the cash accounting method does not. Applying the
matching principle in accounting, requires accountants to record, in the same
period, the revenue and all expenses incurred in earning that revenue. The
matching principle ensures that profits (revenue less expenses) are accurately
reported for each accounting period (that is, that revenue earned in one period is
accurately matched against the expenses that correspond to that period), so a
truer picture of net profit for each period is calculated.
The accrual accounting method therefore requires end-of-period adjustments to
be made to the business revenues and expenses while the cash accounting
method does not. These end-of-period adjustments create transactions known as
accruals.
Over the longer term, both the accrual accounting method and the cash
accounting method will produce similar total profit results. The key difference
between the two methods occurs in the different profit outcomes reported over
the shorter accounting periods (monthly, for example).
These different approaches can still create significant variances in annual results
as well. The cash accounting method will distort profit calculations significantly in
the shorter accounting periods if the business sells/buys on credit and/or keeps
an inventory of saleable products.
Accrual accounting
method
Purpose
Used by
Small businesses
Public companies,
businesses with Accounts
Payables and Accounts
Expense
recognition/recording
Judgement
Accrual accounting
method
Records $1,000 as
Consultancy revenue in
January
Records $1,000 as
Consultancy revenue in
December
A business pays an
electricity bill of $500 in July
for electricity used in June.
accounting period
involves end-of-period adjustments to ensure that the revenue recognition principle
and the matching principle are appropriately applied to the financial statements
accurately measures and reports on the net income of a business
often referred to as the accrual basis when describing how the financial statements
were prepared
is an option for small businesses but is the ONLY bookkeeping method allowed
under tax laws and accounting standards for large corporations and for-profit public
companies
has various advantages and disadvantages relative to the cash accounting method.
Accrual accounting
More transactions are required to
record the same number of
financial events.
It is more complicated, with the need
to calculate and manage the
end-of-period adjustments.
If often requires the additional
expense of an accountant to
help prepare the financial
statements.
There is a more stringent
requirement to keep all source
documents to help identify the
timing and scope of revenues
and expenses.
Financial reports take longer to
prepare due to the
income/expense adjustments
While profit plans could be based easily on accrual basis reports, the cash flow
budget would require the management accountant to analyse the cash
implications of accrual basis reports in order to set sound cash flow predictions.
While this does require extra work, the general consensus by stakeholders and
governing authorities is that if the costs are not too prohibitive, accrual basis
accounting is the preferred option when wanting accurate reports on the profit
performance and financial strength of a business.
tnightly payroll was 28June. So 2 days of wages were incurred between 28 and 30 June but not yet record
Involves recording expenses incurred in the current period but has not yet recorded in the books of accou
ACCRUED
EXPENSE
partial earning of income by creating an accrued revenue to ensure the financial reports reflect the true pi
t to build something. While the invoice may be raised at the end of the 3-month contract period, the reven
Involves recording revenue earned in the current period but not as yet recorded in the books of accou
ACCRUED
REVENUE
been entered into the accounts of the business. Over time, the concept of
accruals in everyday practice has come to mean processing all the end-of-period
adjustmentsthat also includes deferrals and asset value adjustments. The two
types of accruals are detailed in Figure 35.
Other end-of-period adjustments are often included in the accruals process and
these are detailed in Table 18.
Comment
Example
Deferred revenue
Deferred expense
Depreciation
Bad/doubtful debts
Inventory
adjustment
Prepaid expenses are payments made for goods or services in the current
accounting period that will be used to generate revenue in a future
An account is preparing the financial statements for a small business for the year
ended 30 June 2011. The accountant notices that the small business owner paid a
$1,200 insurance premium on 1 June 2011; she includes it in the books for the
year as Insurance Expense: $1,200.
After reviewing the insurance contract, the accountant notices that the insurance
cover is for a 12-month period ending on 31 May 2012.
Applying the matching principle and the accrual method of accounting, the
accountant calculates that only 1/12th of the insurance costs has been used up by
30 June 2011 and that there is still 11 months of economic benefit remaining in
the policy as at 30 June 2011.
So, the accountant leaves $100 in the Insurance Expense account, which
represents 1 months worth of insurance cover that has been used up or expensed
by 30 June 2011.
The accountant then transfers the remaining $1,100representing future
economic benefit that has not yet been used up or expensedto a current asset
account called Prepaid Expense or Prepaid Insurance. To have left the books of the
business as they were presented to the accountant by the small business person
would have understated the profits and the assets of the business for the financial
year ended 30 June 2011.
The use of the Prepaid Expenses account has helped ensure that the financial
statements now represent a true and fair view of the financial performance and
position of the business.
Treating the reporting in this way gives stakeholders a more informed view of the
financial performance of the business (that is, that there is a 95% customer
satisfaction with the items sold by the business). This information would
otherwise be hidden if not for this special offset account treatment.
This offset or negative account (that is, sales returns in this example) is
known in accounting as a contra account.
In terms of how the contra account is reported in the financial statements, here
is how the above situation would be reported:
Revenue
Gross sales
$100,000
Less sales returns $5,000
Net sales
$95,000
EXAMPLES OF A CONTRA ACCOUNT IN ACCOUNTING
There are five classifications of accounts in accounting:
(Assets
Liabilities
Owners Equity
Revenue
Expenses.
All five of these accounts can have contra accounts. If the Assets account (debit
balance by nature) has a contra, then the contra account will have a credit
balance.
On the other hand, if a Liabilities account (credit balance by nature) has a contra
account, the contra account will have a debit balance.
The contra account is not an asset or liability in itself, but is, in fact, an account
used to adjust the gross amount of the related Assets or Liabilities account. The
key effect of a contra account is to reduce the value of the gross account it is
offsetting.
Generally, any account that is reported in the Income Statement or Balance
Sheet that begins with Less is a contra account.
Some of these are described in Table 19.
Offset
Explanation
Accumulated
Depreciation
Offset/negative/contra
Assets
Offset/negative/contra
Liabilities
Owners Drawings
Offset/negative/contra
Owners Equity
Sales Returns
Offset/negative/contra
Revenue
Discounts Received
Offset/negative/contra
Expenses
covering the estimate useful economic life of the intangible assets. Intangible
assets typically include intellectual property costs and incorporation costs.
BACKGROUND TO AMORTIZATION IN ACCOUNTING
The term amortisation is used in both accounting and finance.
Not all the assets of a business are physical or tangible. Some assets are nonphysical and are called intangible assets.
For example, patents, trademarks, brands, goodwill, copyrights, licenses,
computer software, costs of incorporation and internet domains are all
intangible assets.
Even though these assets are invisible (or cannot be touched), they still
contribute to the revenue growth of a business and so must be expensed against
the revenues as they are earned. Intangible assets are treated in the same way
as physical assets that are depreciated (expensed) and so their value is
systematically transferred from an asset on the Balance Sheet item to an
expense item (Amortisation) on the Income Statement.
KeyFACTS
The matching principle in accounting ensures that the financial reports of the business give an
accurate view of the financial position and performance of the business to the decision-making
stakeholders of a business.
Under the matching principle, accountants are required to match the revenue for each accounting
period with the actual expenses incurred in earning that revenue for the period.
In the example in the for example box on the next page, it would not give an
accurate view of the profitability of the business if the patent costs were
expensed only in the year the costs were paid. Also, a Balance Sheet that
showed a patent still worth $20,000 in the 19th year would not give an accurate
view of the value of that asset, given that its value is just 12 months away from
being worthless. So, instead of taking either of the two options listed above,
accountants will amortise the cost of the intangible asset over the estimated
useful economic life of the intangible asset.
The process of amortisation, then, gives a more accurate view of the financial
performance and position of the business to the decision-making stakeholders of
the business.
APPLICATION OF AMORTISATION IN ACCOUNTING
Under International Financial Reporting Standards, guidance on accounting for
the amortisation of intangible assets is contained in IAS 38.
Not all intangible assets are amortised. Some intangible assets may be
considered to have an indefinite useful economic life and are considered to offer
continual earning potential to the business for the foreseeable future. A domain
name and brands could be included in this category. Either way these intangible
assets with an indefinite useful economic life still need to be assessed each year
to make sure that their value in the Balance Sheet is not overstated. This
checking process is called the impairment test.
The method used to amortise those intangible assets with a set useful economic
life is the straight-line methodthat is, where the cost of acquiring the intangible
asset is written off (amortised) over the estimated useful economic life of the
asset.
For example, if the business had spent $20,000 in legal fees to secure a patent that
gave the business certain rights over the next 20 years, the value of the intangible
asset (Patents) would be expensed or amortised by $20,000/20years = $1,000 each
year for the next 20 years. This means that $1,000 would appear each year in the
Income Statement as Amortisation expense, with a corresponding adjustment being
made directly to the intangible asset Patents in the Balance Sheet. (Note: Unlike
depreciation of tangible assets, intangible assets do not have a contra account
called Accumulated Amortisation. The unamortised/unimpaired cost of intangible
assets is positioned in a separate section of the Balance Sheet immediately
following Property, Plant and Equipment.)
Trademarks/brands/internet
domains have fairly short legal
lives; however, because they
can be continually renewed,
they are deemed to have an
indefinite life.
government tax agency in identifying those items to include in the COGS and
those to include as overheads.
Sometimes the accounting standards to which accountants adhere may even
include different COGS items from those required under tax law.
COGS - INVENTORY
However, there are general principles that all parties follow:
1. Firstly, COGS only applies where there is a sale of inventory. So those
business that sell only services (like, for instance, lawyers and accountants)
do not usually have COGS.
2. Secondly, COGS are the total direct cost incurred in acquiring or converting
inventories for sale (that is, in getting products into inventory and then
getting them ready for sale).
3. Finally, COGS expenses change in proportion to changes in sales or
production (as opposed to fixed costs/overheads/indirect costs such as rent
that do not change in proportion to changes in sales and production). So, if
the expense is likely to change in relation to changes in sales or production,
it is most likely a COGS.
Retail businesses will usually include the cost of buying inventory for resale plus
the freight inwards costs in the COGS. Manufacturing businesses will include the
cost of raw materials, cost of parts and direct labour costs used to manufacture
the product ready for sale.
By deducting COGS from the sales for a given accounting period, we can
determine the gross profit of the business.
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the profit expectation of the business by increasing the expenses in the
Income Statement.
The decision to write off bad debts is usually determined by the organisations
credit policy. This may be done in the month that the debt is recognised as bad,
or the bad debt may be written off systematicallyquarterly, half yearly or
annually. Publicly listed companies will usually write off bad debts on a 6-monthly
cycle to coincide with their corporate governance and reporting requirements.
RECOGNISING BAD DEBTS IN ACCOUNTING
How long a debt has been outstanding and unpaid can be one indicator of bad
debt. Many businesses consider that a debt that is overdue by more than 6
months should be considered a bad debt. The truth is, any debt can become bad
at any time particularly if there is a liquidation of a companys business due to,
say, unforseen natural disasters.
Recognising bad debts is a judgement of the management of the business. That
judgement is applied on an account-by-account basis. Deciding on and
recognising bad debt generally follows one or more of the guidelines listed in
Figure 38.
the debtor has died leaving no, or insufficient, assets out of which the debt may
be satisfied
the debtor cannot be traced and the creditor has been unable to ascertain the
existence of, or whereabouts of, any assets against which action could be taken
where the debt has become statute barred and the debtor is relying on this
defence (or it is reasonable to assume that the debtor will do so) for nonpayment
if the debtor is a company, it is in liquidation or receivership and there are
insufficient funds to pay the whole debt, or the part claimed as a bad debt
where, on an objective view of all the facts or on the probabilities existing at
the time, the debt, or a part of the debt, is alleged to have become bad, there
is little or no likelihood of the debt, or the part of the debt, being recovered.
history and current trends, businesses may estimate the value of doubtful debts
in a number of ways as shown in Figure 39.
Accounts Receivables
$xx,xxx
Less Provision for Doubtful Debts
$x,xxx
This statement tells the stakeholders of the business that while $xx,xxx is the
amount of money that is owed to the business from customers, based on past
experience and current trends the business expects that $x,xxx of that money
will not be collected and will eventually become bad debts.
It should be noted that while doubtful debts are recognised as an expense of the
business when preparing financial reports for most stakeholders, tax laws do not
allow doubtful debts to be claimed as a cost until they become bad debts (that
is, until it is certain that they cannot be collected).
WHAT IS THE DIFFERENCE BETWEEN BAD DEBTS AND DOUBTFUL DEBTS
IN ACCOUNTING?
A bad debt is the ultimate recognition of loss created when a specific debtor(s) is
acknowledged as being unable to pay the debt they owe to the business. This
loss, recorded in the Income Statement of a business assesses that, at this point
in time, the money owed to the business will never be received.
Doubtful debts on the other hand are an interim recognition of possible losses
caused by an irrecoverable (bad) debt that may take place sometime in the
future.
Bad debts will be linked to specific debtors and written off in the period in which
the revenue was earned. Doubtful debts are an estimate only, and a provision for
future business lossesusually based on previous history.
BACKGROUND TO BAD DEBTS AND DOUBTFUL DEBTS IN ACCOUNTING
Accounting is a process of recording financial transactions so that financial
reports can be produced for the stakeholders of a business. Stakeholders use
these reports to make decisions about the allocation of the scarce resources
within their control. For this reason, it is important that the financial reports are
accurate and present a true picture of the financial performance and financial
position of the business. A key requirement for accountants then is to ensure
that the assets of the business are not overstated.
One asset that is looked at closely by accountants before preparing the financial
reports is the Accounts Receivable account or Debtors. Before producing the
financial reports, accountants want to make sure that the Accounts Receivable
(the money the business expects to collect from its debtors) is not overstated.
As we have already seen, many businesses need to extend credit to their
customers to keep their custom. Otherwise, businesses may lose them,
particularly if other business competitors are able to extend generous credit
In this situation accountants will record the irrecoverable money as a loss in the
Income Statement to offset the revenue and will write-off the value of that
particular debt from the Accounts Receivable asset as reported in the Balance
Sheet.
When preparing accurate financial reports that present a true picture of the
financial performance and financial position of the business, accountants must
also consider the previous history of the business in relation to the debt
collection of the account receivables. If previous history indicates that, typically,
bad debts represent, say, 5% of the Accounts Receivable balance, it would not be
accurate to report 100% of the Accounts Receivable as an asset. So, accountants
provide for this potential loss from Accounts Receivables that history suggests
will ultimately turn into bad debts.
This involves creating an expense for doubtful debts to reduce the profit reported
for the period as well as making a provision for doubtful debts to the Accounts
Receivable to show that it is not expected that 100% of the accounts receivable
will be collected.
Providing or allowing for doubtful debts is an attempt to match the costs of
offering credit to customers with the revenue that a credit policy generates.
Doubtful debts
debt.
Compared with spreadsheets, databases have very limited analysis functions and
are not suited for demonstrating on one form the effect of multiple transactions.
Apart from budget variance analysis and financial ratio analysis, you will often
see electronic spreadsheets being used by accountants and bookkeepers in
areas such as:
depreciation schedules
asset registers
end-of-period adjustments.
Comment
Trial balance
End-of-period adjustments
Income Statement
Balance Sheet
EMPLOYEES
Stakeholders engaged, for various
time periods, to help a business
achieve its objectives. Financial
statements help employees decide
their long-term commitment to the
business. A growing, profitable and
financially strong business is more
likely to attract and keep highly
valued employees. Financial
statements also help employees
when negotiating collective
bargaining agreements with
management.
Figure 40 Internal
MANAGERS AND
OWNERS/OPERAT
ORS
BOARD OF
DIRECTORS
Stakeholders who set the
strategic direction and
objectives for the business
and who engage managers
to achieve them. Financial
statements allow the Board
of Directors to review the
performance of the
management in respect to
achieving objectives.
Stakeholders of a business:
are vitally interested in knowing about the present condition and future
prospects of the business
need to make decisions about their involvement with the business
want to know how strong and sustainable the business is financially so they
can make good decisions.
Investors
Lenders
Suppliers and
customers
Suppliers are stakeholders who
provide products and services
to the business on credit terms
that allows the business to pay
for the goods and services at a
later time. Suppliers use
financial statements to assess
the creditworthiness of the
business.
help investors assess the viability and financial performance of the business
that they have invested in, particularly in relation to the profit/loss trends
help creditors/lenders determine their credit limits and loan exposures with
the business
help the internal managers respond to current opportunities and pinpoint
unexpected expense increases and to predict future performance via the
budgetary process
provide a basis for calculating the income tax liability of the business by the
government tax office.
A positive result is profit, which increases the net worth of the business and
makes the business more sustainable.
A negative result is a loss, which decreases the net worth of the business and
makes the business less sustainable.
In other words, the Income Statement measures the change in net worth and
sustainability of the business.
The Income Statement also provides information relating to the adequacy of the
selling prices (via the gross profit %) and the sufficiency of the profit in relation
to the owners investment (via a Return on Investment calculation). The net
profit for the period appears in the equity section of the Balance Sheet as
Current Earnings.
The Income Statement is produced annually so that the income tax owed by the
business to the tax office can be calculated. However, Income Statements are
also often produced monthly or quarterly to update management regularly and
help them with their decision making.
However frequently it is produced, the Income Statement is prepared for a past
period (yearly, quarterly or monthly). The statement is headed with the line: for
the [period] ending [date].
EXTRA THINGS TO CONSIDER
While accounting attempts to produce a true and fair picture of the financial
performance of a business via the Income Statement, there are some issues that
will impact of this goal. Some examples are given below.
There are some valuable items that while very relevant to a business are not
measured by the accounting system and so are not reported on the Income
Statement. These items could include such things as brand recognition,
organisational reputation or customer loyalty.
Different valuation methods allowable in accounting will produce different
profit results. For example the valuation of inventory using the FIFO (first in,
first out), LIFO (last in, first out) or Item Cost method will each produce a
different profit result.
Some values reported on the Income Statement depend on judgments and
estimates. For example, depreciation expense is calculated based on the
estimated useful life and estimated salvage value of the fixed asset.
he strength of a business is
represented by the percentage of
the assets that are controlled by
the ownersand not by others.
Analysis of the Balance Sheet gives significant insights into the management of
the business. These ratios include liquidity, solvency and efficiency.
While the Balance Sheet looks back on a prior trading period (last month, last
quarter, last year), the Profit and Loss Statement looks at a business as a
snapshot in time. This is why the Balance Sheet is headed up with the line: as
at [date].
CASH FLOWS STATEMENT
Any movement of cash in or out of a business is referred to as cash flow.
The Cash Flows Statement ties together all the details from the Income
Statement and the Balance Sheet to summarise the overall picture of cash
inflows and outflows over a given period. In particular, it reports on the inflow
and outflow of cash in relation to operating activities, investing activities and
financing activities. It compares the opening balances with the closing balances
on cash or cash equivalent accounts.
One of the key interests by stakeholders is the net worth, and changes in net
worth of a business. Net worth is also known as owners equity (or equity) or net
assets. (Net worth is the money that would be left over if all the assets of the
business were sold and the liabilities fully repaid.)
The Cash Flows Statement informs decision makers about the movement of cash
funds between where the cash funds came from and how those funds have been
used.
This movement of cash in an organisation is calculated by comparing the
financial statements of two consecutive periods. By ignoring the non-cash
activity (that is, depreciation, credit sales and purchases, bad and doubtful debt,
prepayments and so on), the Cash Flows Statement is able to show in detail how
and where the cash balance of the business increased and decreased.
A Cash Flow Statement is usually prepared alongside the Income Statement and
Balance Sheet. While the latter reports are about an organisations financial
sustainability and financial strength, respectively, the Cash Flow Statement
reports on the organisations ability to continue to pay its bills as they fall due.
HOW DO YOU READ AND UNDERSTAND A BALANCE SHEET?
As explained earlier, a Balance Sheet is a financial report supplied to the internal
and external stakeholders of the business. The Balance Sheet helps stakeholders
to determine a businesss financial strength. The Balance Sheet presents the
financial status of the business at a specific point in time.
BALANCE SHEET BASICS
The Balance Sheet is a financial statement or report that:
It is called a Balance Sheet (or Statement of Financial Position) because the total
value of the Assets will always equal the total value of the Liabilities and the
Owners Equity combined. This formula is known as the accounting equation.
The Assets and Liabilities listed on the Balance Sheet are further subdivided as:
current
non-current.
(Retained Earnings) and the profits earned from the current trading period
(Current Earnings).)
FINANCIAL RATIOS
Understanding the financial strength of a business from reading a Balance Sheet
generally requires a certain amount of analysis and comparison. It also requires
access to the Income Statement (also known as the Statement of Financial
Performance).
This analysis of the Balance Sheet is called the Financial Ratio and Trend
Analysis. By comparing this periods calculated financial ratios with those of prior
periods, with industry benchmarks and with generally accepted sound operating
levels, healthy/unhealthy trends in the financial strength of the business can be
identified.
Whether
Whether returns
returns from
from the
the business
business are
are competitive
competitive with
with
other
other investment
investment options
options
Whether
Whether the
the company
company is
is becoming
becoming more
more or
or less
less
profitable
profitable
Whether
Whether the
the company
company is
is becoming
becoming more
more or
or less
less
dependent
dependent on
on external
external funders
funders
Whether
Whether the
the company
company is
is becoming
becoming better
better or
or less
less able
able to
to
meet
meet its
its financial
financial obligations
obligations when
when they
they become
become due
due or
or
more
more or
or less
less efficient
efficient at
at managing
managing the
the assets
assets of
of the
the
company.
company.
Liquidity/solvency ratios
Leverage ratios
Types of financial
ratios
Profitability ratios
Operational ratios
LIQUIDITY/SOLVENCY RATIOS
These ratios calculate the businesss ability to pay its debts as they become due.
Some businesses might be profitable but unable to pay critical payments, such
as staff salaries, loan repayments or rent, because the money of the business is
tied up in debtors (money owned to the company by customers) or in inventory.
The most common Liquidity/Solvency ratio is the quick ratio.
For example, assume that current assets total $355,000, Inventory totals $250,000
and current liabilities total $150,000. The quick ratio would be ... (Current assets
(355,000) less inventory (250,000) / Current liabilities (150,000) = 0.70.What this
means is this: for every $1 due for payment in the next month or so, the business
has $0.70 in liquid (cash or soon to be cash) assets. Generally a quick ratio of 1.00
is considered a safe operating ratio.
OPERATIONAL RATIOS
These ratios calculate the efficiency of a businesss management operations and
use of assets. Typical ratio efficiencies deal with stock turn and debtor days.
Stock turn measures the optimum amount of stock required to achieve sales
targets.
Debtor days measure how many days it takes for the business to get paid by
its customers.
Generally, a business would not want to overstock and would want its debtors to
pay in the shortest possible time.
PROFITABILITY RATIOS
These ratios calculate the profitable return on sales and capital tied up in the
business. These ratios are usually expressed as a % and monitored over timeconsecutive periods to help identify healthy or unhealthy trends. Typical
profitability ratios are:
By comparing Balance Sheet report ratios with those for prior periods, with
commonly agreed safe operating levels and with industry benchmarks, the
changing financial strength/health of the business can be more easily
understood.
HOW DO YOU READ AND UNDERSTAND THE INCOME STATEMENT?
As indicated earlier in this section, the Income Statement, along with the Balance
Sheet, is a key financial report produced by the accounting information system.
These financial reports convey to management and other stakeholders a concise
picture of the profitability and financial position of a business.
The Balance Sheet reports on the financial position, strength and net worth
(Owners Equity) of a business at a specific point in time.
The Income Statement reports on the viability, profitability and bottom line
(net profit/loss) of a business for a given accounting period. These
accounting periods are typically monthly, quarterly or annually.
So, while net profit results from deducting from the revenue the expenses
incurred in earning that revenue, net earnings for a period further deducts the
interest and tax expense and adds/subtracts gains/losses from non-core business
activities (for example, foreign exchange, asset sales). The net earnings amount
from the bottom line of the Income Statement is reported in the account Current
Year Earnings, which is part of the Owners Equity section of the Balance Sheet.
KeyFACTS
An Income Statement describes:
firstly, the outcomes derived from a business generating revenue as it exchanges goods or
These expenses are totalled and subtracted from the gross profit to produce the
net profit or EBIT. (Earnings Before Interest and Tax). This result is often called
Income from Operations. Net earnings (after interest and taxes have been
deducted) is the amount that is reported as Current Earnings in the Owners
Equity section of the Balance Sheet.
liquidity ratios
debt ratios
profitability ratios
efficiency ratios
value ratios.
The calculated ratio for a particular period has only limited value in terms of
insight into the financial performance of a company, but when it is compared to
(a) prior years (b) same industry benchmarks (c) cross-industry benchmarks and
(d) company budgets, it can provide insights into both the immediate,
developing and structural problems of a company and the opportunities that
should be exploited.
There are hundreds of financial ratios that can be calculated; however, most can
be grouped into the one of the following aspects of diagnostics described below.
Liquidity: These ratios measure how quickly a company can convert assets
into cash to meet its immediate financial obligations.
Debt: These ratios measure the companys reliance on debt funds and its
ability to meet the obligations of those funds.
These ratios should not be interpreted on a stand-alone basis, but each should
be assessed in combination with other ratios to help establish a picture of the
current and developing financial position and performance of the company.
TYPES OF FINANCIAL RATIO ANALYSIS
ANALYSING LIQUIDITY RATIOS
The most common financial ratios used when analysing a businesss liquidity are:
WIP: work-in-progress
Working capital ratio: current ratio
Written-down value: carrying value, book value
Year-of-end adjustments: end-of-period adjustments, balance day
adjustments, adjusting journal entries.
(that is, Assets = Liabilities + Owners equity). It is one of the basic financial
statements used to assess the financial condition of a business.
Balance day adjustments: the procedure to ensure that all items of revenue
and expense are recorded in their correct accounting periods. Typically these
include accruals, depreciation, actual stocktakes, bad and doubtful debts.
Bank statement: a statement supplied by the bank that details the monies
received and paid for a customers account.
Bank reconciliation: a process that demonstrates how the cash details
recorded in the books of the business match the statement supplied by the bank.
Bookkeeping: the physical recording of the financial transactions of the
business.
Books of original entry: specially designed forms on which transactions are
initially recorded.
Book value: the historical cost of an asset less the value of the accumulated
depreciation. Also referred to as the written down value.
Business firm: an organisation established to earn a profit by the selling of
goods or services.
Capital expenditure: the expenditure on fixed assets that are expected to
provide economic benefits over several accounting periods (for example, the
purchase of a building, an upgrade to equipment).
Cash accounting: a simplified form of bookkeeping for small businesses that
delays the recording of revenue and expenses until the cash is actually
exchanged (that is, when cash for goods or services provided is actually received
or paid).
Cash at bank: an account kept in the books of a business that records the
amount of money held in the bank account.
Cash Flow Statement: a financial statement that reports cash flows from
operating, financing and investing activities.
Cash on hand: an account kept in the books of a business that records the
amount of money held on the business premises (usually undeposited funds or
cash register floats).
Cash register float: a term used to describe the amount of money perpetually
held in cash registers to provide change in relation to customer sales.
Chart of Accounts: a complete listing of every account in the accounting
system.
Company: a separate legal entity owner by shareholders that is created for the
purpose of conducting business activities.
Contra account: an account created in the same account group that is an offset
to another account (for example, accumulated depreciation, sales discounts).
Control account: an account held in a general ledger that summarises the
balance of all the accounts in the subsidiary ledger (for example, the Accounts
Receivable control account is the total of all the customer accounts held in the
Debtors Subsidiary Ledger).
Corporation: a common form of limited liability firm that is created and
recognised as a separate legal entity by the corporations law of the country.
Cost of goods sold: a formula for working out the direct costs of stock sold over
a particular period. The formula is: Opening stock + purchases closing stock; it
calculates all the direct costs associated with selling goods (inventory).
Credit: one of the two aspects of a double-entry bookkeeping system. For every
entry into the books of a business, there must be a credit entry and it must equal
the debit entry amount made to another account.
Creditors: a list of suppliers to whom the business owes money, typically listed
in the Creditors Ledger.
Current assets: assets that could be converted into cash easily (for example,
inventory, accounts receivable).
Current liabilities: monies owed to external parties and due for payment within
the next 12 months (for example, credit cards, trade creditors, tax payable).
Debit: one of the two aspects of a double-entry bookkeeping system. For every
entry into the books of a business, there must be a debit entry and it must equal
the credit entry amount made to another account.
Debtors: a list of the customers who owe money to the business, typically listed
in the Debtors Ledger.
Deferred revenue: cash collected from customers or clients before the delivery
of goods and services.
Depreciation expense: accounting for the loss of economic value of a fixed
asset . This is done by expensing (writing off) a portion of the fixed asset
according to its useful life. Also the portion of an assets cost allocated to the
current accounting period.
Direct costs: expenses that can be directly tracked to a specific job. If the job
did not happen, the direct costs would not have been incurred (for example,
materials, delivery costs, stock purchases).
Dissolution: the disposal of the assets of a sole trader that has ceased trading.
Dividends: cash distributions from corporate profits to the corporations
shareholders.
Fixed Asset Schedule: a record of a firms assets that tracks acquisition dates
and costs, depreciation methods used and cumulative amounts of depreciation
taken.
Functional classification: a term to describe the grouping of expenses into
classifications when presenting the financial statements (for example, Financial,
Sales and distribution, Administration).
General Ledger: a place in the accounting system where all the individual
accounts from the Chart of Accounts are collected. Also, the collection of all
accounts used by a firm to record changes in assets, liabilities, revenue, expense
and equity.
Generally Accepted Accounting Principles: abbreviated as GAAP; the most
widely accepted rules of financial accounting.
Going concern: an assumption that a business will continue to sell products
and/or provides services into the foreseeable future.
Going concern value: the combined value of a firms assets that would be paid
by a purchaser who intended to continue operating the business.
Goodwill: the difference between a firms going concern value and its liquidating
value.
Gross margin: how much money is left after the direct costs are subtracted
from the selling price: when this calculation is expressed as a percentage, it is
called the gross margin. It is the difference between sales and cost of goods sold.
Historical cost: describes an accounting practice where assets are recorded in
the books of a business at the prices for which they were acquired. It is the
listing of asset values based upon their acquisition price rather than their current
market value.
Imprest: an amount of cash provided in advance to an authorised person that
allows them to make cash payments for incidental expenses (for example, petty
cash).
Income Statement: also known as the Profit and Loss Statement, the P&L or
the Statement of Financial Position. The Income Statement is a financial report
that shows the changes in the equity of the business as a result of its operations.
It lists the revenues, subtracts the expenses and so measures the economic
performance (profit or loss) of the business for a given accounting period.
Incurred: describes the act of becoming legally liable for something.
Indirect cost: also known as an overhead; an expense that is not directly
related to the services provided to customers.
Partnership: a form of unlimited liability firm with more than one owner.
Periodic inventory method: a method of recording inventory purchases that
reflects adjustments to the inventory account only at the end of an accounting
period.
Perpetual inventory method: a method of recording inventory purchases that
changes the inventory account balance as purchases are made.
Petty cash: a system designed to ensure the simple management of incidental
payments (for example, purchasing emergency stationery supplies or staff lunch
room supplies).
Posting: an accounting term used to describe the transfer of entries from one
part of the accounting process to the next (that is, from the journals to the
ledgers). Also, the process of transferring transaction information recorded in
books of original entry to general ledger T accounts.
Provisions: one or more accounts set up to account for expected future costs
(that is, provision for doubtful debts to provide for possible non-payment of
customer debts).
Prepaid expenses: an accrual account created during the balance day
adjustment process that recognises as assets those expense amounts that still
have future economic value (for example, insurance paid in advance). Also, a
firms payment to vendors for goods and services to be provided at some later
point.
Profit: the excess of revenues over expenses.
Ratio analysis: a collection of calculations performed on the financial
statements that gives insights into the liquidity, profitability and management
efficiency of a business (for example, current ratio, gross profit %, inventory
stockturn).
Reconciling: the process of checking entries made in the books of a business
with those on a statement sent by a third person (that is, checking a bank
statement against a businesss own financial records).
Retained earnings: the amount of net income owed to the owners but still
retained by the business, usually to fund expansion of the business. Also, the
undistributed profits of a corporation.
Retainers: a form of deferred revenue collected by attorneys or other service
businesses.
Residual value: the estimated value of an asset that is likely to remain at the
end of its useful life.
Revenue: the monies received by a business for the goods and services
provided (that is, merchandise sales, fees earned, interest received from