Introduction to Financial Accounting

KnS Institute of Business Studies

By Saad Abu Bakar

Introduction to Financial Accounting

What is Accounting?
Quite simply, accounting is a language: a language that provides information about the financial position of an organization. When you study accounting you are essentially learning this specialized language. By learning this language you can communicate and understand the financial operations of any and all types of organizations. Accounting is defined as: Its an Art of Recording Classifying Summarizing

financial information in a significant manner and in terms of money transactions and events which are, in part at least, of a financial character, and interpreting results thereof. This definition brings out the following attributes of accounting: 1. Events and transactions of a financial nature are recorded. Events of a non-financial nature, say the passing of control from one person to another, cannot be recorded. 2. The record must be in such a way as to be able to portray the significance of all the transactions and events individually and collectively, class by class and as a whole. This involve both analysis and summarisation 3. Result of Accounting must also help its user to understand the meaning of financial statements that is placed before him.

Users of Financial Statements

It is easy to assume that the only users of accounting information are shareholders - since it is a requirement of company law that shareholders must receive periodic accounting statements. However, in reality there are many users of accounts. The table below summarises the main user groups and provides examples of their areas of interest in accounts:

User
Investors

Interest in / Use of Accounting Information

Investors are concerned about risk and return in relation to their investments. They require information to decide whether they should continue to invest in a business. They also need to be able to assess whether a business will be able to pay dividends, and to measure the performance of the business' management overall. The key accounting information for an investor is therefore: - Information about growth - sales, volumes - Profitability (profit margins, overall level of profit) - Investment (amounts invested, assets owned) - Business value (share price) - Comparative information of competitors

From the desk of Saad Abu Bakar

Page 1

Introduction to Financial Accounting

Lenders
Banks and loan stockholders who lend money to a business require information that helps them determined whether loans and interest will be paid when due. The key accounting information for lenders is therefore: - Cash flow - Security of assets against which the lending may be secured - Investment requirements in the business

Creditors

Suppliers and trade creditors require information that helps them understand and assess the short-term liquidity of a business. Is the business able to pay short-term debt when it falls due? Creditors will, therefore, be looking for information on: - Cash flow - Management of working capital - Payment policy

Debtors

Customers and trade debtors require information about the ability of the business to survive and prosper. As customers of the company's products, they have a long-term interest in the company's range of products and services. They may even be dependent on the business for certain products or services. Customer will be particularly interested in: - Sales growth - New product development - Investment in the business (e.g. production capacity) Employees (and organisations that represent them - e.g. trade unions) require information about the stability and continuing profitability of the business. They are crucially interested in information about employment prospects and the maintenance of pension funding and retirement benefits. They are also likely to interested in the pay and benefits obtained by senior management!. Employees will, therefore look for information on: - Revenue and profit growth - Levels of investment in the business - Overall employment data (numbers employed, wage and salary costs) - Status and valuation of company pension schemes / levels of company pension contribution There are many government agencies and departments that are interested in accounting information. For example, the Inland Revenue needs information on business profitability in order to levy and collect Corporation Tax. Customs & Excise need accounting information to verify Value Added Tax ("VAT") returns; local government need similar information to levy local taxes and rates. Various regulatory agencies (e.g. the Competition Commission and the Environment Agency) need information to support decisions about takeovers and grants, for example. Investment analysts are an important user group - specifically for companies quoted on a stock exchange. They require very detailed financial and other information in order to analyse the competitive performance of a business and its sector. Much of this is provided by the detailed accounting disclosures that are required by authorities such the London Stock Exchange. However, additional accounting information is usually provided to analysts via informal company briefings and interviews. Interest groups, formed by various groups of individuals who have a specific interest in the activities and performance of businesses, will also require accounting information.

Employees

Government

Analysts

Public at large

From the desk of Saad Abu Bakar

Page 2

Introduction to Financial Accounting

Fundamental Accounting Equation

Assets = Liabilities + Capital
Where, Assets refers to economic resources controlled by an entity Liabilities refers to the an obligation that legally binds an individual or company to settle a debt Capital refers money invested in a business to generate income or the owners share in the assets of the entity and it is always equal to what is left out of assets after paying off outsiders.

Accounting Concepts
Going Concern Concept
Financial statements are prepared assuming that the company is a going concern which means that the company intends to continue its business and is able to do so. The status of going concern is important because if the company is a going concern it has to follow the generally accepted accounting standards. The auditors of the company determine whether the company is a going concern of not at the date of financial statements.

Examples
1. An oil and gas firm operating in Nigeria is stopped by the Nigerian court from carrying out operations in Nigeria that firm is not a going concern in Nigeria, because it has to shut down. 2. A bank is in serious financial troubles and the government is not willing to bail it out. The Board of Directors has passed a resolution to liquidate the business. The bank is not a going concern. 3. A merchandising company has a current ratio below 0.5. A creditor Rs.1,000,000 demanded payment which the company could not make. The creditor requested the court to liquidate the business and recover his debts and the court grants the order. The company is no longer a going concern. 4. A nationalized refinery is in cash flows problems but the government of the country provided a guarantee to the refinery to help it out with all payments, the refinery is a going concern despite poor financial position.

From the desk of Saad Abu Bakar

Page 3

Introduction to Financial Accounting

Business Entity Concept
In accounting we treat a business or an organization and its owners as two separately identifiable parties. This concept is called business entity concept. Businesses are organized either as a proprietorship, a partnership or a company. They differ on the level of control the ultimate owners exercise on the business, but in all forms the personal transactions of the owners are not mixed up with the businesses'.

Examples
1. A CA has 3 rooms in a house he has rented for Rs.3,000 per month. He has setup a single-member accounting practice and uses one room for the purpose. Under the business entity concept, only 1/3rd of the rent or Rs.1,000 should be charged to business, because the other 2 rooms or Rs.2,000 worth of rent is expended for personal purposes. 2. The CPA received Rs.900 bill for utilities. He paid the whole amount using his business account. Rs.600 is to be considered a withdrawal because only Rs.300 (1/3rd) related to business and the other Rs.600 was for domestic purpose. 3. Each public accounting business is required to pay Rs.100 to a local association of CPAs each month. He pays that amount from a personal bank account. The amount shall be considered additional capital.

Monetary Unit Assumption

Accounting is the language of business and numbers are its letters. Through accounting we can communicate only those accounting transactions and other events which can be expressed in monetary units. This is called monetary unit assumption. Accounting focuses on the financial aspects of the business and that too for matters which can be expressed in terms of currencies. One aspect of the monetary unit assumption is that currencies lose their purchasing power over time due to inflation, but in accounting we assume that the currency units are stable in value. This is alternatively called stable dollar assumption. 1. The company's property, plant and equipment on 2009 balance sheet amounted to Rs.2 billion. During 2010 inflation was 10%. The monetary unit and stable dollar assumption prohibits any adjustment to current or prior period figures to account for the inflation. 2. The BP oil spill in Gulf of Mexico was a natural disaster but accounting only reports the financial impact in the form of claims paid, damages paid, cleanup costs, etc. This is due to the limitation imposed by the monetary unit assumption.

From the desk of Saad Abu Bakar

Page 4

Introduction to Financial Accounting

Dual Aspect concept
Each transaction has two aspects. That can be explained through fundamental Accounting equation: Assets = Liabilities + Capital If a business has acquired an asset, it must have resulted in one of the following: a. Some other asset has been given up b. The obligation to pay for it has arisen; or, rather, c. The owner/proprietor has contributed money for the acquisition of the asset The reverse is also true.

From the desk of Saad Abu Bakar

Page 5