ADVANCED ACCOUNTING (Class Notes-1) Assts. Prof.

Özgür Teraman, PhD

This course is also of benefit to those managers in business, government or industry

whose work involves them in dealing with accounting information.

MBA students are often puzzled why they are required to take a course in accounting,
and even more so when they have to take a demanding examination at the end of it.

The fact is that these days, no matter what your job, you need to have some knowledge
of accounting matters. The main reason for this is that for different specialists to talk
to each other they have to speak in a language that everyone understands.

In business that language is money and that happens to be the accountants’ language.

The use of a common language enables all the various activities that take place within
a business to be translated into monetary terms and for all reports to be prepared on
the same basis. So if you need to know what is going on in other departments you will
find it much easier if you speak the language of accounting.

Why accounting is important

You might be graduated from perhaps business, engineering, languages, law,

management or one of the sciences. And then you find to your horror that you have to
do some accounting. Why?

You probably have an idea that accounting has something to do with balance sheets
and profits and tax and thing like that but you are certainly not sure what that has to
do with the subject you’re studying.
 Accounting is basically about collecting information and letting people who need it have
it, like shareholders and managers.

• If you were a manager would you really be quite happy to accept all that the
accountants gave you?

• Would you know what it meant, how reliable it was and what you were supposed
to do with it?

The point we are making is that accountants provide a service for other people.

Most accountants are probably highly qualified, experienced and good at their job, but
as accountants they should not take the decisions.

That is the manager’s job – it could be your job and you will know much more about
your business than any accountant.

There is no doubt that you will be able to make even better decisions:

(a) if you have some knowledge and some understanding of the nature of accounting
information; and

(b) what it can and what it cannot do in helping you plan and control your business.
Accounting is a service provided for those who need information about an
entity’s financial performance, its assets and its liabilities.

• Service.

• Information.

• Entity.

• Financial performance.

• Assets.

• Liabilities.

• It relates to only one entity.

• It has to be quantifiable.

• It must be converted into monetary terms.

• It relates to period of time.

Managers are often surprised when they realize that accounting information is
restricted in such ways.

This gives rise to what is sometimes called the expectations gap.

This was especially so in the early 2000s when there was a great many accounting
scandals. The best known one in recent times involved an American company called
Enron.
 THE MAIN BRANCHES OF ACCOUNTING

Financial accounting

Classification and recording of the monetary transactions of an entity in accordance

with established concepts, principles, accounting standards and legal requirements
and their presentation, by means of income statements, balance sheets and cash flow
statements, during and at the end of an accounting period.

‘Concepts, principles, accounting standards and legal requirements’

 Income statements (or profit and loss accounts), balance sheets and cash flow
statements are known collectively as the financial statements.

Book-keeping

Recording of monetary transactions, appropriately classified, in the financial records

of an entity.

Management accounting

The application of the principles of accounting and financial management to create,

protect, preserve and increase value for the stakeholders of for-profit and not-for-profit
enterprises in the public and private sectors.

Cost book-keeping

The recording of monetary transactions, appropriately classified, in the financial

records of an entity in order to ascertain the cost of a specified thing or activity.

Auditing

Systematic examination of the activities and status of an entity, based primarily on

investigation and analysis of its systems, controls and records.
 1 External auditors.

External auditors formally report to the owners on whether the financial accounts
represent what is called ‘a true and fair view’ of the entity’s affairs.

2 Internal auditors.

Internal auditors perform routine tasks and undertake some detailed checking of the
entity’s accounting procedures.

Taxation

Taxation is a highly complex and technical branch of accounting.

Accountants who are involved in tax work are responsible for calculating the amount
of tax payable both by business entities and by individuals.

All legal means of minimizing the amount of tax that might be demanded by the
government. This is known as tax avoidance.

The non-declaration of sources of income on which tax might be payable is known as

tax evasion.

Financial management

Financial managers are responsible for setting financial objectives, making plans
based on those objectives, obtaining the finance needed to achieve the plans and
generally safeguarding all the financial resources of the entity.
Bankruptcy and liquidation

Bankruptcy is a formal legal procedure. The term is applied to individuals when

their financial affairs are so serious that they have to be given some form of legal
protection from their creditors.

The term liquidation is usually applied to a company when it gets into serious
financial difficulties and its affairs have to be ‘wound up’, i.e. arrangements made for
it to go out of existence in an orderly fashion.

The accounting equation

The system that accountants use to record financial data is known as double-entry
bookkeeping.

Assets
Liabilities
Capital

There is a close relationship between assets, capital and liabilities. It is frequently

presented in the form of what is called the ‘accounting equation’

Assets = liabilities + capital

Assume that you have decided to go into business. You do so by transferring £2000 in
cash from your own private bank account.

The business now has £2000 invested in it. This is its capital but it also has £2000 in
cash. The cash is an asset. So the £2000 asset equals the £2000 of capital. Or in
equation form:

The equation captures the twofold effect of the transaction: the assets of the
business have been increased by the capital contributed by the owner.

You decide to transfer £1500 of the cash to a business bank account. The effect on
the equation is:

You borrow £500 in cash from one of your friends to help finance the business. The
assets will be increased by an inflow of £500 in cash, but £500 will be owed to your
friend. The £500 owed is a liability and your friend has become a creditor of the
business. The business has total assets of £2500 (£1500 at the bank and £1000 in
cash). Its capital is £2000 and it has a liability of £500. The equation then reads:
 If £800 of goods were then purchased in cash for subsequent resale to the entity’s
customers, the equation would read:

The vital point to remember about the accounting equation is:

If an adjustment is made to one side of the equation, you must make an identical
adjustment either to the other side of the equation or to the same side.

Double-entry book-keeping

Transaction must be recorded twice. A change to the accounting system is called an

entry and so we talk about making entries in the accounts.

Accounts used to be kept in various bound books referred to as ledgers and all the
ledgers used in a particular accounting system are known collectively as the books of
account.
 debit: meaning to receive, or value received.

credit: meaning to give, or value given.

Entering transactions in accounts

When entering a transaction in an account always make sure that you:

Debit the account which receives

And
Credit the account which gives

Examples of some common ledger account entries

Entry 1 The proprietor contributes some cash to the business.

Debit: Cash Account Credit: Capital Account

Entry 2 Some cash in the till is paid into the business bank account.

Debit: Bank Account Credit: Cash Account

Entry 3 A van is purchased for use in the business; it is paid for by cheque.

Debit: Motor Vehciles (Van Account) Credit: Bank Account

Entry 4 Some goods are purchased for cash.

Debit: Inventory (Purchases Account) Credit: Cash Account

Entry 5 Some goods are purchased on credit terms from Fred.

Debit: Inventory (Purchases Account) Credit: (A/P)Fred’s Account

Entry 6 Some goods are sold for cash.

Debit: Cash Account Credit: Sales Account

Entry 7 Some goods are sold on credit terms to Sarah.

Debit: A/R (Sarah’s Account) Credit: Sales Account

A ledger account example

Joe Simple: a sole trader

The following information relates to Joe Simple, who started a new business on 1 January
2012:

1 1.1.12 Joe started the business with £5000 in cash.

2 3.1.12 He paid £3000 of the cash into a business bank account.

3 5.1.12 Joe bought a van for £2000 paying by cheque.

4 7.1.12 He bought some goods, paying £1000 in cash.

5 9.1.12 Joe sold some of the goods, receiving £1500 in cash. Required: Enter the above
transactions in Joe’s ledger accounts.
Balancing the accounts

Balancing an account requires the book-keeper to add up all the respective debit
and credit entries, take one total away from the other, and arrive at the net balance.

In order to keep a control on the management of the business, it is advisable to balance

the accounts at reasonably short intervals.

The frequency will depend on the nature and the size of the entity but once a month is
probably sufficient for most entities.

The trial balance

It has three main purposes:

1 to check that all of the transactions for a particular period have been entered
correctly in the ledger system;

2 to confirm that the balance on each account is correct; and

3 to assist in the preparation of the profit and loss account and the balance sheet.
1.1 Edward commenced business with £10,000 in cash.
3.1 He paid £8000 of the cash into a business bank account.

6.1 He bought a van on credit from Perkin’s garage for £3000.

9.1 Edward rented shop premises for £1000 per quarter; he paid for the first quarter
immediately by cheque.

12.1 He bought goods on credit from Roy Limited for £4000.

15.1 He paid shop expenses amounting to £1500 by cheque.

18.1 Edward sold goods on credit to Scott and Company for £3000.

21.1 He settled Perkin’s account by cheque.

24.1 Edward received a cheque from Scott and Company for £2000; this cheque was
paid immediately into the bank.

27.1 Edward sent a cheque to Roy Limited for £500.

31.1 Goods costing £3000 were purchased from Roy Limited on credit.

31.1 Cash sales for the month amounted to £2000.

Preparing basic financial statements

1 Double-check

2 Go through the TB line by line,

3 Insert the ‘R’ balances

4 Transfer the ‘C’ balances

5 Calculate the gross profit (or loss) in the trading account,

6 Calculate the net profit (or net loss)

7 Separate all the capital income balances

Year end adjustments

Stock (Inventory)

All the purchases that have been made during the year will have been sold by the end of
it and so there will almost certainly be some goods still left in the stores.
In accounting terminology, purchases still on hand at the period end are referred to as
stock (the Americans use the term inventory).

The cost of goods sold is made up of three elements: opening stock, purchases and
closing stock.

Expressed as a formula:

Cost of goods sold = (opening stock + purchases) – closing stock

By making an adjustment for opening and closing stock, the trading account should now
appear as
Depreciation

Expenditure that covers more than one accounting period is known as capital
expenditure.

Expenditure on fixed assets is necessary in order to help provide a general service to

the business. The benefit received from the purchase of fixed assets must extend beyond
at least one accounting period.

The annual depreciation charge is calculated as follows:

The reducing balance method of calculating depreciation results in a much higher
charge in the early life of the asset than does straight depreciation.

Either the straight-line method or the reducing balance method it is necessary to work out
(a) how long the asset is likely to last;
(b) what it can be sold for, and
(c) its useful life.
The depreciation charge for the year is charged to the profit and loss account as an
expense. The balance sheet would include the following details for each group of fixed
assets:
1 the historic cost (or revalued amount),
2 the accumulated depreciation;
3 the net book value (NBV).
In other words, line 1 minus line 2 = line 3.
 ACCRUALS AND PREPAYMENTS

Accruals

An accrual is an amount owing for a service provided during a particular accounting

period but still unpaid for at the end of it.

The accrual will be included in the amount charged to the profit and loss account for the
period as part of the cost of the service provided.

The formula is:

(amounts paid during the year + closing accruals) – opening accruals

The closing accruals will be shown on the balance sheet as part of the current liabilities.

Prepayments

A prepayment is an amount paid in cash during an accounting period for a service that will
be provided in a subsequent period.

For example, assume a company’s year end is 31 December.

It buys a van halfway through 2011 and licences it for 12 months, so half of the fee paid
will relate to 2011 and half to 2012.

Prepayments made during the year will be deducted from the amount charged to the profit
and loss account.
The formula is:

(amount paid during the year + opening prepayments) – closing prepayments

The closing prepayments will be shown in the balance sheet as part of the current assets.

Bad and doubtful debts

If the goods are not eventually paid for, we will have overestimated the profit for that
earlier period.

There is a technique whereby we can build in an allowance for any possible bad debts.

How to account for bad debts?

How to allow for the possibility that some debts may be doubtful?

Bad debts

Bad debt must be written off to the profit and loss account as an expense.

On the balance sheet trade debtors will be showed after deducting any bad debts that
have been written off.
Provisions for bad and doubtful debts

We can allow for the possibility that some debts may become bad by setting up a
provision for bad and doubtful debts and debiting an annual charge to a special
account.

The estimate will normally be based on the experience that the entity has had in dealing
with specific bad debts.

The provision is usually expressed as a percentage of the outstanding trade debtors.