CHAPTER 1

Introduction to accounting
EXAM FOCUS
Although this chapter is an introduction to accounting there are some very examinable areas, such as the users of accounts and the regulatory system. The proformas given in this chapter will go forward with you throughout your studies.

SYLLABUS AND STUDY GUIDE COVERAGE

This chapter covers the following elements of the ACCA study guide: Define accounting recording, analysing and summarising transaction data Explain types of business entity - sole trader - partnership - limited liability company Explain users of financial statements and accounting information Explain the main elements of financial statements: - balance sheet - income statement Explain the purpose of each of the main statements Explain the nature, principles and scope of accounting Identify the desirable qualities of accounting information and the usefulness of each Explain the regulatory system: - International Accounting Standards Board (IASB) Explain the difference between capital and revenue items Explain how and why assets and liabilities are disclosed in the balance sheet Draft a simple balance sheet in vertical format Explain how and why revenue and expenses are disclosed in the income statement Illustrate how the balance sheet and income statement are interrelated Draft a simple income statement in vertical format Explain the significance of gross profit and the gross profit as a percentage of sales

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1.1

Introduction to accounting
The stages of accounting

Accounting has been defined as: the classification and recording of monetary transactions, and the presentation and interpretation of the results of those transactions in order to assess performance over a period and the financial position at a given date, and the monetary projection of future activities arising from alternative planned courses of action.

Accounting therefore has three distinct stages: Recording the day-to-day transactions of a business using double entry bookkeeping the method of documenting and recording financial information in a business which is a refinement of a system developed in the 12th century. Summarising the information recorded in a standard format. This standard format will be used in various levels of detail across all types of business entities. Analysis by users. The users of published sets of accounts will analyse them to learn how well or poorly the business is performing. The accounting system

1.2

The accounting system must be able to determine the following: Whether the business is operating at a profit Whether the business can meet its financial commitments as they fall due.

It must produce answers to the following questions: 1.3 Profitability how well is the business doing? Assets what does the business own? Creditors to whom does the business owe money? Debtors who owes money to the business? Business entities

As the chart below shows, the business world encompasses several forms of business organisation. The most commonly encountered are those mentioned in detail below.
Business entities

Sole trader

Partnership

Registered company

Private company (Ltd)

Public company (plc)

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Introduction to accounting

1.4

Sole trader

A sole trader is one person who carries on business on his or her own. Legally, the business affairs of a sole trader are not distinguished in any way from his personal affairs. If he incurs a debt in his business dealings and the earnings of that business are not adequate to pay the debt then the creditor can require payment out of the traders non business property (eg his house). 1.5 Partnership

A partnership is two or more persons associated for the purpose of carrying on a business or profession, but their business and personal affairs are not separate. Like a sole trader, a partners nonbusiness assets and income may have to be used to pay the debts of the partnership business. 1.6 Private and public companies

A company is a distinct artificial person created in order to separate legal responsibility for the affairs of a business from the personal affairs of the individuals who own or operate the business. Since a company exists only to establish legal responsibilities, it can only be created, operated and dissolved in accordance with the legal rules governing it (eg the Companies Acts in the UK). Consequently, the business debts and liabilities are those of the company and not those of its members (shareholders). In other words, if the assets owned by the business are not sufficient to pay off the debts incurred by the business, the owners cannot be compelled to make up the deficit from their private resources. The point is that the business debts are not the owners responsibility. They belong to the company, which is regarded as a separate person in its own right. The owners of a company therefore have a limited liability for the companys debts, which is why a company can be called a limited liability company. Companies can be either public companies, where the shares can be bought and sold by the public on a stock exchange, or private companies where the shares are not publicly traded. 1.7 Nature, principles and scope of accounting

The nature of accounting was described earlier. It can be useful to distinguish between financial accounting and management accounting. Financial accounting is concerned with the preparation of accounting statements for use by persons external to the business. This syllabus is primarily concerned with financial accounting. Management accounting is concerned with the delivery of accounting information to those internal to the business, ie the management of a business. Other exams in the ACCA syllabus cover management accounting. The generally accepted accounting principles (GAAP, also referred to as generally accepted accounting practices) are explained below. The scope of accounting refers to the types of information that are captured in accounting statements. Most accounting is concerned with monetary matters only, so that non-monetary matters which are important to the business (eg, having a healthy workforce, having a good reputation in the marketplace, etc) are not shown in accounting statements unless a monetary value can easily be ascribed to them.

1.8

The entity concept

For accounting purposes the individual business is regarded as an entity in its own right it is separate from the owner. It is necessary to know how the business itself is doing as distinct from the owners personal affairs. In a company this is easy to achieve: the entity has a separate legal personality. However, with a sole trader and a partnership the business entity must keep separate records of business as distinct from the owners private and personal affairs. The profit is made by the business; the resulting increase in its assets is under its control and any financial report should represent a statement of affairs of the state of that business. 1.9 Accounting concepts

Generally accepted accounting principles (GAAP) have been developed over time to assist comparability between companies and to enable users and producers of financial information to follow similar guidelines. To help achieve this objective accounting standards have been developed whose primary aim is to narrow the areas of difference and variety in the accounting treatment of the matters with which they deal. You may wonder why this is necessary. Surely the information presented in accounts is entirely objective? In fact, though, this is not the case. Often there will be more than one possible way of recording and presenting accounting information. In such cases, the preparers of accounts must exercise judgement to determine which method is most appropriate. The danger then is that a set of accounts becomes a purely subjective creation. Users of accounts would then be unsure of the message conveyed by the accounts. This explains the purpose of publishing accounting standards. They reduce the element of subjectivity by prescribing which methods are permissible in different circumstances.

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2.1

Users of financial statements

Introduction

There are many users of financial statements, some internal to the business, some external. The internal users are the managers responsible for running the business. They need accounting information to help them make good decisions. 2.2 Internal users Use information to Assist in decisions affecting the longterm future Assist in monitoring performance and making decisions to enable the organisation to achieve short to medium-term targets Assist in decisions concerning activities (may be nonmonetary) daytoday

Levels of management Strategic (top management) Tactical (middle management)

Operational (lower management)

2.3

External users

The external users are a little more far reaching as shown below.

Chapter 1

Introduction to accounting

User groups 2.4 Investors Loan creditors Employees Analysts/advisers Business contacts Government/Tax authorities The general public

Use information about Performance, socio-economic policies Ability to pay interest, longerterm valuation of any secured assets. growth,

Ability to pay wages and pensions, future (job security) Performance, particularly to advise investors as to how their investment is doing Ability to provide goods/services, to pay for goods/services Taxationrelated matters and statistics Policies and how they affect the community

Characteristics of good information

In providing information to the users of financial statements there are certain characteristics that you should consider. Information should: Enable its recipient to make effective decisions Be adequate for taking effective action to control the organisation or provide valuable details relating to its environment Be compatible with the responsibilities and needs of its recipient Be produced at optimum cost Be easily understood by its recipient Be timely Be sufficiently accurate and precise for the purpose of its provision.

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3.1

The main financial statements

Introduction

As we said earlier, the financial information recorded and summarised is presented to the users in a fairly standard format regardless of the type of business entity. It is only the level of detail and supporting schedules and notes which vary from a sole trader to a large limited company. 3.2 The income statement

This statement reflects the performance of a company over a period. It explains the movement between the position at the beginning and at the close of the period, by matching the revenue for the period (eg, from sales of goods) with the expenses for the period, in order to calculate the profit for the period.

3.3

The balance sheet

This statement shows the position of a company at one point in time, ie what the business owns (assets) and what it owes (liabilities) as at that moment. For this reason it is often referred to as a snapshot of the business at a moment in time. The link between the balance sheet and income statement is as follows:

Start of period

End of period

Opening balance sheet

Income Statement

Closing balance sheet

3.4

Proforma financial statements

Below are proformas for both of the main financial statements in a form suitable for a sole trader as an example. The format for partnerships and limited companies will be covered in greater detail in later chapters. BALANCE SHEET AS AT (DATE)
Cost $ Non-current assets 1 Buildings Plant and equipment X X ____ X ____ Depreciation $ (X) (X) ____ (X) ____ X X X X ____ X ____ X ____ X X (X) ____ X ____ X X X X X X ____ X ____ X ____ Total $ X X ____ X

Current assets 2 Inventory Trade receivables Prepayments Cash

Total assets Capital 3 Balance brought forward Profit for the year 4 Drawings 5 Retained profit for the year Balance carried forward Non-current liabilities6 Bank loans Current liabilities7 Trade payables Short-term borrowings Bank overdraft Accruals

Total equity and liabilities

Notes 1 These are assets intended for continuing use in the business, year on year, ie not for resale. Examples might include an office building, an item of production machinery or a delivery truck. These are assets acquired for conversion into cash in the ordinary course of business. Conventionally, these are listed in a particular order: less liquid assets first and more liquid assets later.

Chapter 1

Introduction to accounting

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Funds provided to the business by the proprietor. Net result of trading operations for the period as shown in the income statement. Amounts withdrawn from the business by the proprietor during the period. Funds provided to the business by people other than the proprietor, repayable after more than one year after the balance sheet date. Amounts owed by the business, payable within one year of the balance sheet date.

Note. Non-current assets in the balance sheet are normally valued at their original cost less an amount called depreciation. The idea behind this is that in each accounting period a proportion of the assets cost is consumed or used up until eventually the whole of its cost is written off. From then on, the value of that asset in the balance sheet is zero. Expenditure on acquiring non-current assets is referred to as capital expenditure. It is useful to distinguish this from revenue expenditure, which is expenditure on items of inventory or expenses such as electricity or rental costs. INCOME STATEMENT FOR THE YEAR ENDED (DATE)
$ Sales revenue 1 Opening inventory Add: Purchases Less: Closing inventory Cost of sales 2 Gross profit3 Sundry income 4 5 Less: Expenses Net profit X X ____ X (X) ____ (X) ____ X X (X) ____ X ____ $ X

Notes 1 2 Income which is derived from the main trading activities of the organisation, ie the value of goods or services sold to customers during the year. This represents the cost of goods which were actually sold. It is calculated by taking the cost of goods available for sale during the period (ie opening inventory and purchases), and deducting the cost of the goods unsold at the end of the period (closing inventory). Gross profit - this is the profit made on the trading activities of the business. When expressed as a percentage of sales it highlights the amount of profit for each $1 of sales. The greater this percentage is, the greater is the underlying profitability of the business. Income other than that derived from the main trading operation of the business (eg rent received from renting out part of the business premises, or interest received). Costs incurred incidental to the direct cost of goods sold (eg wages, rent, rates).

4 5

It is common to distinguish between two different sections in the income statement. The trading account, being the top part of the statement shown above, ending with the figure of gross profit. The rest of the statement, beginning with gross profit and then showing the deduction of expenses to arrive at net profit.

3.5

Example

The following information is available for David Pedleys business for the year ended 31 December 20X8. He started his business on 1 January 20X8.
Trade payables (at year-end) Trade receivables (at year-end) Purchases (in the year) Sales (in the year) Motor van (at cost; ignore depreciation) Drawings (in the year) Insurance (for the year) General expenses (for the year) Rent and rates (for the year) Salaries (for the year) Inventory (at year-end) Sales returns (in the year) Cash at bank (at year-end) Cash in hand (at year-end) Capital introduced (during the year) $ 6,400 5,060 16,100 28,400 1,700 5,100 174 1,596 2,130 4,162 2,050 200 2,628 50 4,100

Required Prepare an income statement for the year ended 31 December 20X8 and a balance sheet at that date. 3.6 Step 1 Draft a blank income statement and balance sheet for the following reasons. To familiarise yourself with the format To prompt you in answering the question To develop a good exam technique Solution

INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20X8

$ Sales revenue Less: Sales returns $

________

Opening inventory Purchases Closing inventory Cost of sales Gross profit

________ ________ ________

Chapter 1

Introduction to accounting

Salaries Rent and rates Insurance General expenses ________ __________ Net profit ________

BALANCE SHEET AT 31 DECEMBER 20X8

$ Non-current assets Motor van Current assets Inventory Trade receivables Cash at bank Cash in hand Total assets ______ Capital account Capital introduced Profit for the year Drawings Retained profit for the year Current liabilities Trade payables ________ Total equity and liabilities ________ $

______ ______

________

Step 2 Start with the income statement. Work down the proforma pulling out the figures you need from the information given and ticking them off as you use them. First on the proforma is sales revenue
$ Sales revenue $ 28,400

Tick sales on your list of information, as follows

$ Sales 28,400

Next on the proforma is sales returns, opening inventory and purchases.

$ Sales revenue Less: Sales returns 16,100 $ 28,400 (200) ______ Purchases

Tick sales returns and purchases on your list, as follows.

$ Purchases Sales returns 16,100 200

Note that David Pedley commenced business on 1 January 20X8 with no opening inventory. Continue with this process until the income statement is complete.
$ Sales revenue Less: Sales returns $ 28,400 (200) ______ 28,200 Opening inventory Purchases Less: Closing inventory Cost of sales Gross profit Salaries Rent and rates Insurance General expenses 16,100 (2,050) _______ (14,050) _______ 14,150 4,162 2,130 174 1,596 ______ (8,062) ______ Net profit 6,088 ______

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Chapter 1

Introduction to accounting

Step 3 Repeat this process for the balance sheet, slotting figures into the proforma and ticking off your list of figures. Once the balance sheet proforma is complete you should have ticked off all the figures on your list. The last figure to input in the balance sheet is the net profit for the year from the bottom of the income statement.
BALANCE SHEET AT 31 DECEMBER 20X8 $ Non-current assets Motor van Current assets Inventory Trade receivables Cash at bank Cash in hand $ 1,700 2,050 5,060 2,628 50 ______ 9,788 ______ 11,488 ______ 4,100 6,088 (5,100) _______ 988 ______ 5,088 6,400 ______ 11,488 ______

Total assets Capital account Capital introduced Profit for the year (per income statement) Less: Drawings Retained profit for the year Balance carried forward Current liabilities Trade payables Total equity and liabilities

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4.1

The regulatory system

Introduction

The contents and presentation of financial statements that must be presented to a companys shareholders are influenced by the following regulations: Local statutory rules in force in the country in which the business is registered. Regulations of various types issued by the accounting profession.

As far as this syllabus is concerned, you do not have to know any local rules in force in a particular country. This syllabus is based on the International Accounting Standards (IASs) issued by the International Accounting Standards Committee (IASC). The IASC was set up in 1973 with the objective of achieving harmonisation of financial reporting practices worldwide. Over the years the importance of the IASC has grown, to such a point that the organisation restructured itself with effect from April 2001. Future accounting standards will now be issued by the International Accounting Standards Board (IASB), supervised by the IASC Foundation, a not-for-profit corporation incorporated in the USA. Until 2001, the accounting standards issued by the IASC were called International Accounting Standards. The IASB has announced that in future its standards will be called International 11

Financial Reporting Standards (IFRSs). At the time of writing this book, no IFRSs have yet been issued, so that it is only IASs that you have to be familiar with. The IASs that are examinable for this Paper are listed at the front of this book. The IASBs role is to issue high quality accounting standards. Neither the IASB nor the IASC Foundation have any enforcement mechanism to require entities to use IASs. It is up to individual countries to decide on which accounting standards should be used for financial statements prepared in their jurisdiction. Economically developed countries tend to issue their own domestic accounting standards for use in that country; for example in the US the Financial Accounting Standards Board (FASB) issues standards for use in the US. While the FASB may consider the contents of IASs when drawing up its own standards, in themselves IASs have no direct application in such a jurisdiction. Other countries may decide to adopt IASs wholesale, saving the expense of developing their own domestic accounting standards. 4.2 The procedure for developing an IFRS

The IASBs new procedure for developing IFRSs is similar to the IASCs old procedures for developing IASs. The IASBs new procedure is intended to be as follows: (a) (b) (c) (d) The IASB identifies a topic and establishes an Advisory Committee to give advice on the issues arising in the project. The IASB may issue Discussion Documents for public comment. Following the review of public comments, the IASB publishes an Exposure Draft for public comment. This ED is a draft of the full IFRS to be issued. Following the review of further public comments, if approved by at least eight of the Boards fourteen members, the IASB will issue a final document as an IFRS. Benchmark and allowed alternative treatments

4.3

Some IASs contain a choice of permitted accounting treatments for certain transactions or events. One treatment will usually be designated the benchmark treatment, which is the tacitly preferred treatment. The other treatment(s) will be allowed alternative treatments, that are permitted by the IAS but not preferred. The IASB has committed itself to try and reduce the number of permitted choices in its accounting standards in order to improve the comparability between financial statements prepared in accordance with IASs. 4.4 Generally Accepted Accounting Practice (GAAP)

GAAP encompasses the whole set of accounting practices in force in a particular country or jurisdiction. For example, in the USA, financial statements could be said to comply with US GAAP. GAAP includes local statute, stock exchange requirements, relevant accounting standards, common practices not the subject of a standard, etc. Since GAAP is an allencompassing term, it is probably best to avoid referring to International GAAP since such a concept cannot exist. IASs lay down accounting standards to be followed, but there is no international statute that must be complied with. It is therefore advisable to refer to financial statements as complying with International Accounting Standards rather than as complying with International GAAP. The term International Accounting Standards is taken to include existing IASs as well as future IFRSs when they start to be issued.

Summary

Accounting is the recording and presenting of monetary information. There is a distinction between financial accounting and management accounting. A sole trader is a separate accounting entity but not a separate legal entity.

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Chapter 1

Introduction to accounting

Shareholders have limited liability in terms of the debts of the company they invest in. Information must exhibit certain key characteristics if it is to be useful. The main financial statements are the income statement (showing the revenue and expenses for the period) and the balance sheet (prepared at the end of the period). Accounting has a regulatory framework which gives guidance on the preparation and presentation of the financial statements. The IASC has issued a series of IASs. In future the IASB will continue to issue further international standards, now to be called IFRSs.

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