Accounting – Session 1

TOPICS

Financial accounting
 Accounting terminology
 Main financial statements
 Accounting ratios
Management accounting
 Costs: type and behavior
 Main costing systems
 Contribution analysis
 Short-term decision making

What is ACCOUNTING?
 Accounting is the language of business (a company aims to make a profit/has a
societal goal)
 Definition #2: Accounting = The provision of information to managers and
owners so that they can make business decision
 It is about recording, preparing and interpreting business transactions
 It answers key questions, such as: how much profit have we made?

Types of Accounting
 Distinction between Financial Accounting and Management Accounting

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 FINANCIAL ACCOUNTING
 It provides financial information about the financial performance of a
business
 It is required by law
 It is backward-looking
 Its main purpose is the preparation of the major financial statements (3)
 Aimed at external users (shareholders, banks, interest groups)

MANAGEMENT ACCOUNTING
 It provides detailed information about the performance of the internal
activities
 It is backward-looking and forward-looking
 It is NOT required by law
 It is focused on cost accounting and decision making
 Its main purpose is to assist the managers in operating the business
 Aimed at internal users

Internal users External users

- Management - Shareholders and analyst advisors
- Employees - Lenders
Main users
- Suppliers
- Customers
- Government and tax authorities
- Public

Everywhere the same?

Accounting rules and principles – may differ among countries:
- International Accounting Standard Board (IASB) publishes International
Financial Reporting Standards (IFRS)
- Non-listed companies (they don’t have to conform to this, they can use their
own rules)

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 1) Accounting context - factors:
 History
 Country
 Organizational (structure + nature of the business)
 Technological
2) Types of accountancy
 Auditing = checking that the financial statements, prepared by managers, give
a true and fair view of the accounts
 Bookkeeping = entering monetary transactions into the books of account
 Financial Accounting = preparation and interpretation of the financial accounts
 Financial Management = managing the sources of finance of an organization
 Insolvency
 Management Accounting = internal accounting of an organization
 Fraud Detection
 Taxation
 Management Consultancy
3) Types of accountant
 Professionally Qualified Accountants (6 institutions in UK)
o Chartered Accountant (3 institutes operate in the UK)
 Second-Tier Bodies
4) Limitations of Accounting – its historic nature and its failure to measure non-
financial transactions
5) Language of accounting
Income = the revenue earned by a business (not equal to cash received!)
Expenses = the costs incurred in running a business (not equal to cash paid!)
Assets = items owned (or leased) by the business which will bring economic benefits
Liabilities = amounts the business owes to a third party (trucks, equipment, buildings,
inventory)
Equity (Capital) = the assets less its liabilities to third parties = the owner’s interest in
business
Income – Expenses = PROFIT Assets – Liabilities = EQUITY

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 ANNUAL REPORT

 It is composed by:
 Financial statements
 Additional financial and non-financial information
 Main purpose: evaluation of the performance of the business
 Frequency, purpose and users may differ
 Sensitive information is NOT disclosed (strategic reasons)
 Available in:
 Company website (Investor Relations)
 EDGAR SEC (US listed companies)

Main financial statements:

 Income statement
 Statement of financial position = BALANCE SHEET
 Statement of cash flows = CASH FLOW STATEMENT

INCOME STATEMENT (profit and loss account) = income - expenses

- Shows revenue earned and expenses incurred over a period of time
- The difference leads to net income (profit) or net loss

STATEMENT OF FINANCIAL POSITION = assets – liabilities

- Shows assets, liabilities, and equity at a certain point in time

STATEMENT OF CASH FLOWS = cash inflows – cash outflows

- Shows cash received and paid over a period of time

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Exercise #1

***current assets = short-term assets

non-current assets – e.g. property, plant and equipment

The Accounting Equation

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Exercise #2

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 Accounting principles

A. Accounting conventions
 Entity = a business has a distinct and separate identity from its owners
 Monetary measurement = only items which can be measured in financial
terms are included in the accounts (e.g. pollution NOT, but a fine on pollution YES)
 Historical cost = the amount recorded in the accounts will be based on the
original amount paid for a good or service
 Periodicity = statements are prepared for a set period of time

B. Accounting Assumptions or Concepts

 Going concern = assumption that the business will continue into the
foreseeable future; important for assets valuation
 Accruals (or matching concept) = incomes and expenses are recognized
when they are accrued (i.e., earned or incurred) rather than when the money is received
or paid
o Expenses are incurred for the purpose of producing revenue
o Concept of offsetting expenses against revenues

Exercise #3

 Consistency = similar items will be treated similarly from year to year.

Same accounting policies

 Prudence = income and profits should be only recorded when they are
certain and provisions or liabilities should be recorded as soon as they are recognized

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 Mini-case

Chapter 3 (book) – Double-entry bookkeeping

Definition: A way of systematically recording the financial transactions of a

company so that each transaction is recorded twice.

Step 1: Assets = Liabilities

Step 2: Assets = Liabilities + Equity (distinct type of liability)
Step 3: Assets = Liabilities + Equity + Profit
Step 4: Assets = Liabilities + Equity (+Income – Expenses)
Step 5: Assets + Expenses = Liabilities + Equity + Income

Assets and expenses => debit entries (left-hand side)

Income, liabilities, equity => credit entries (right-hand side)

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 Basic rules of double-entry bookkeeping
1. For every transaction, there must be a debit and a credit entry.
2. These debit and credit entries are equal and opposite.
3. In the cash book all account paid in are recorded on the debt side, whereas
all amounts paid out are recorded on the credit side.

Four major types of items 1. Assets 2. Liabilities and equity 3. Income 4. Expenses

1. Assets
- Essentially items owned or leased by a business which will bring economic
benefits. Two main sorts of tangible assets (i.e., assets with a physical existence):
I. Non-current assets – can be divided into intangible assets such as patents
(goodwill) and tangible assets: property, plant and equipment. These are infrastructure
assets NOT USED in the day-to-day trading!!! They are assets in use usually over a long
period of time.
i. Motor vehicles
ii. Land and buildings
iii. Fixtures and fittings
iv. Plant and machinery
II. Current assets – used in the day-to-day trading
i. Inventory (Stock)
ii. Trade receivables (Debtors)
iii. Cash

2. Liabilities – divided into:

I. Short-term and long-term third party liabilities
II. Capital = equity which is a liability owed by the business to the owner
(increased by profits, reduced by losses)

Short-term: (i) Trade payables (creditors) (ii) Bank overdraft (iii) Proposed taxation
(companies only)
Long-term: (i) Bank loan repayable after several years (ii) Mortgage loan

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 3. Income – day-to-day revenue earned by the business (e.g. sales)
4. Expenses – day-to-day costs of running a business (e.g. rent and rates, electricity,
wages)

Chapter 4 (book) – Main financial statements:

Income Statement (Profit and Loss Account)

Definition: The statement detailing the income less the expenses of an

organization over a period of time, giving profit.
Overview of Income Statement
Revenue (for credit or cash)
Less
Cost of Sales (expense of directly providing R)
Equals
Gross Profit (R – CoS)
Add
Other Income (activities other than trading)
Less
Other expenses (costs incurred in meeting R)
Equals
Net Profit (left over after cost of sales and
expenses have been deducted from R)

***Revenue – reduced by sales returns (faulty, damaged goods)

***Main Cost of Sales = purchases (purchases returns; carriage inwards; inventory)
***Gross profit = essentially an organization’s profit from trading
***Other income = interest from money in a bank/building society (interest received);
dividends received from an investment or profit in sale of a particular item of plant,
property and equipment.

DEPRECIATION = non-cash payment!

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Main factors which complicate profit:
- The accruals/matching concept
- Estimation
- Changing prices
- The wearing out of assets

Impairment = an asset will have lost more value than is accounted for via depreciation.
Capital expenditure = a payment to purchase an asset with a continuing use in the
business such as an item of property, plant and equipment
Revenue expenditure = a payment for a current year’s good or services such as
purchases for resale or telephone expenses.

Chapter 6 (book) – Preparing financial statements

Main financial statements:

In the income statement:
profit = income – expenses paid
In the statement of financial position:
closing equity + drawings – opening equity = profit

Assets + Expenses = Liabilities + Equity + Income

=> TRIAL BALANCE
Assets – (Liabilities + Equity) = Income – Expenses
Statement of financial position Income Statement

4 steps:
1. Determine the Cost of sales => opening stock + purchases – closing inventory
(adjust purchases for purchases returns)
2. Sales – Cost of sales = Gross Profit (adjust sales for sales return)
3. List and total all expenses
4. Determine net profit

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 In relation to the steps!
1. All the property, plant and equipment (i.e., tangible non-current assets) are added
together.
2. Total assets (current + non-current) are determined next => total assets
3. Total liabilities are determined
4. Net assets = total assets – total liabilities
5. Closing equity = Opening equity + net profit

Five adjustments to TRIAL BALANCE

A. Inventories (Stock) – To maintain the double-entry, the asset of inventory is

entered twice:
1. First, in the trading part of the income statement
2. Second, in the current assets section of the statement of financial position

B. Accruals – appear in the final accounts in two places:

1. First, the amount owing is included in the income statement under expenses
2. Second, a matching amount us included under current liabilities in the
statement of financial position

C. Prepayments – must be deducted. The amount paid in advance is treated as an

asset which will be used up at a future date.

D. Depreciation:
1. First, a proportion of the original cost is allocated as an expense in the income
statement
2. Second, an equivalent amount is deducted from the property, plant and
equipment in the statement of financial position

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 E. Bad and doubtful debts – some may not be collected, while some other will
almost certainly not be collected
 Bad debts = recorded as an expense in the income statement and written
off trade receivables in the statement of financial position
 Provision for the impairment of receivables = set up by a business for
those debts it is dubious about collecting. It is always deducted from trade receivables in
the statement of financial position. BUT only increases/decreases in the provisions are
entered in the income statement! (an increase – as an expense; a decrease – as an
income)

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