FAC1502/103/3/2021

Tutorial letter 103/3/2021

Financial Accounting Concepts, Principles
and Procedures

FAC1502
Semester 1 and 2

Department of Financial Accounting

IMPORTANT INFORMATION:
This tutorial letter contains the replacement study units for study units 1 to 3 of the
study guide for FAC1502.
 FAC1502/103

CONTENTS

Page

1. INTRODUCTION .......................................................................................... 3
2. STUDY UNITS 1 TO 3 IN THE STUDY GUIDE FOR FAC1502 ................ 4

2
 FAC1502/103

1. INTRODUCTION
Dear Student,

This tutorial letter contains the following:

• the replacement study units for study units 1 to 3 in the study guide.

There is no prescribed text book for FAC1502 anymore. All references in the study guide to the
prescribed text book must be ignored and only the study guide needs to be studied.

LECTURERS AND CONTACT DETAILS

Please use only the following e-mail address for electronic communication with the lecturers:
FAC1502@unisa.ac.za

Please use telephone number (012) 429 4245 for all telephonic communication with the lecturers.
This telephone number is assigned to FAC1502 and linked to all the module‘s lecturers‘ telephone
numbers.

Lecturers Office
Mr V Booi Simon Radipere building 02-12
Ms MS du Rand Simon Radipere building 02-07
Ms L Govender Simon Radipere building 02-09
Mr S Mqadi Simon Radipere building 02-06

PLEASE NOTE:

Lecturers are available for telephone enquiries from 08:00 to 16:00 on weekdays.

Kind regards

FAC1502 LECTURERS

3
 FAC1502/103

2. STUDY UNITS 1 TO 3 IN THE STUDY GUIDE FOR FAC1502

TOPIC A

THE BASIC CONCEPTS, PRINCIPLES

AND OBJECTIVES OF ACCOUNTING

Learning outcome

The learner should be able to describe, calculate and record the financial performance and
financial position of a sole proprietor, by using the basic accounting equation and the
double-entry system to record the various types of transactions.

4
 FAC1502/103

CONTENTS

Study unit Page

THE BASIC CONCEPTS, PRINCIPLES AND OBJECTIVES
OF ACCOUNTING 6
THE FINANCIAL POSITION 24
THE FINANCIAL PERFORMANCE (RESULT) 34
4 THE RECORDING OF TRANSACTIONS (see study guide, page 22)

5
 FAC1502/103
STUDY UNIT

1
The basic concepts, principles and objectives
of accounting
Learning outcome

You are able to explain what is meant by the nature of accounting theory, principles,
accounting policy, practice and procedures.

Contents
Page
Key concepts 7

Introduction 7

What is accounting? 8

Definition 8

The nature of accounting 9

1.2.3 The purpose of accounting 9

1.2.4 The accounting process 10

Why study accounting 10

Developments in accounting 11

The function of accounting 12

1.6 Universal accounting denominator 13

1.7 The entity concept 13

1.8 Users of financial information 13
1.9 The fields of accounting 14

1.9.1 Financial accounting 14

1.9.2 Management accounting 14

1.10 The objective of general purpose financial reporting 15

1.11 Accounting principles 16
1.12 Accounting policy 16
1.13 Disclosure of accounting policy 16
1.14 International Financial Reporting Standards (IFRSs) 16

6
 FAC1502/103

1.15 Accounting standards and statements 17

1.15.1 Introduction 17
1.15.2 The Conceptual Framework for Financial Reporting 2010 17
1.15.2.1 The objective of financial statements 17
1.15.2.2 Underlying assumption 17
1.15.2.3 The qualitative characteristics of financial statements 17
1.15.2.4 Financial statements and the reporting entity 19
1.15.2.5 The elements of financial statements 19
1.15.2.6 Recognition and measurement of the elements of
financial statements 20
1.16 Exercise and solution 22

Self-assessment 23

1 KEY CONCEPTS
● financial information
● decision making
● nature of accounting
● unit of measurement
● forms of ownership
● fields of accounting
● accounting principles
● international financial reporting standards
● accounting statements
● accounting policy
● going concern
● qualitative characteristics
● elements of financial statements

BEFORE CONTINUING, READ TUTORIAL LETTER 101 UP TO THE FIRST ASSIGN-

MENT.

1.1 Introduction
In this module, we introduce you to the concepts, principles and procedures of accounting. The
first two study units are included mainly to give you some background knowledge. At first, the
information may appear to be rather confusing, but if you follow the study guide step by step,
working through all the examples and exercises in this study guide, the methods and procedures
will become clear. To master this subject, you must get as much practise as you can – so start
early in the semester.

Over the centuries, accounting developed in conjunction with and as part of the economic
system and it performs an extremely useful and important function in society.

Through the ages, records were always kept by hand, but nowadays computers are being used
increasingly. Whichever method is used, the basic principles remain unchanged, since all
activities in a business are still expressed in terms of money and are recorded. However, it is
necessary to know the procedures used in a manual system in order to understand how a
computerised accounting system works.

7
 FAC1502/103

GOLDEN RULE
Accounting CAN NOT be studied by merely reading/memorising. You need to practise,
practise and practise again!

1.2 What is accounting?

1.2.1 Definition
Accounting can be defined as the orderly and systematic recording of the monetary values of
financial transactions of an individual or business enterprise and the reporting of the results
thereof by way of the preparation and presentation of financial statements (par 1.15.2.3) to
enable the users (par 1.8) to make decisions.

Accounting is therefore a process consisting of the following three activities:

● identifying those events that are evidence of economic activity (transactions) relevant to the
particular business or entity
● recording the monetary value of the economic events (transactions) in order to provide a
permanent history of the financial activities of a business. Recording involves keeping a
chronological diary of measured events in an orderly and systematic manner and classifying
and summarising economic events
● communicating the recorded information to interested users. This information is commu-
nicated through the preparation and distribution of accounting reports, the most common of
which are known as financial statements.

GOLDEN RULE
Accounting records transactions in order to provide useful information for decision making.

The objectives of accounting are therefore to enable the users of financial information to
ascertain readily what the financial results and financial position of the entity is. With this
statement we mean:

a) Did the entity trade at a profit or loss?

b) What was the income of the entity and what were the expenses incurred in producing that
income?
c) How much does the entity owe to other entities?
d) How much do customers owe to the entity?
e) What is the nature and amount (in value) of the various kinds of property and other assets
the entity possesses?
f) What is the amount of the entity’s capital (equity)? (Study Guide: FAC1501, page 3, par
1.3)

It is, however, important to distinguish between the concepts accounting and bookkeeping which
are often erroneously regarded as synonymous. (Study Guide: PRAC01W, page 5 par 1.2)

Bookkeeping
Bookkeeping is concerned with the daily recording of business transactions from source
documents in such a way that entities or individuals can determine their exact financial position.
It is thus confined mainly to the recording of financial transactions. If this definition is compared
to the one of accounting given above, it becomes apparent that accounting includes
bookkeeping, but bookkeeping does not include accounting.

In brief accounting includes bookkeeping, but if we talk about bookkeeping we include only those
aspects of accounting that can be classified as bookkeeping (basically the first two of the
abovementioned activities). (Study Guide: PRAC01W, page 5, par 1.2)

8
 FAC1502/103
1.2.2 The nature of accounting
Accounting is a specialised means of communication which is used to convey a specialised
message about an entity’s finances. The recipient of this specialised message (the user of
financial information) must understand it otherwise the information that is conveyed has no
value.

Accounting uses words and figures to convey financial information to the users of such
information. As you progress with your study of accounting you will become familiar with the
meaning of these words and figures, which are also known as the concepts, principles and
procedures of accounting. This knowledge will ultimately help you understand the message
contained in financial statements.

Each and every person who is involved in an entity uses financial information to a greater or
lesser degree. Each of us also needs to know something about accounting to manage our
personal financial affairs. Financial resources are limited or scarce, and if we are going to spend
them we must plan properly. Knowledge of accounting is therefore also useful in this area.

Accounting is therefore a ‘‘language’’ used to convey financial information to interested

parties.

1.2.3 The purpose of accounting

Accounting is a provider of financial information to users. This is illustrated in diagram 1.1.

Diagram 1.1: The supply of information by accounting

Financial __ Accounting __ Reports __ User decisions

information system
| |
Financial Investing
statements Approving
Special report Loans
Tax returns Assessing taxes
Regulatory reports Negotiating labour
Managerial reports contracts
Establishing budgets

Accounting is a specialised medium for communicating financial information. It is essential in

the business world that useful financial information is truly and fairly presented. Users of the
information expect it to be accurate and comprehensive and accounting has been developed to
satisfy this specific requirement.

The aim of accounting is to provide quantitative information which is primarily financial in nature.
It provides answers to questions such as:

• can the entity generate enough income to exist?

• what are the expenses in relation to sales?
• are too little or too much inventory being kept?
• should the entity expands its operations?
• is the pricing policy correct?

The information needed for answering questions like these, is contained in the accounting
reports.

9
 FAC1502/103
1.2.4 The accounting process
Financial accounting functions as an information system: far-reaching decisions are taken on
the basis of the results reported in financial statements and business transactions have to be
measured, classified, summarised and recorded continuously. We call these actions the
financial accounting cycle. This cycle is demonstrated in the following diagram.

Diagram 1.2: The financial accounting cycle

TRANSACTION
DATA
↓
INPUT record on
↓
SOURCE
DOCUMENTS
↓
prepare
↓
SUBSIDIARY
JOURNALS → → → → →
↓ ↓
post to Update
↓ ↓
PROCESSING GENERAL SUBSIDIARY
LEDGER LEDGERS
↓
extract
↓
TRIAL
BALANCE
↓
prepare
↓
OUTPUT FINANCIAL ANALYSIS DESICION
→ AND → MAKING BY
STATEMENTS INTERPRETATION MANAGEMENT

Financial accounting is the systematic recording of the financial transactions of an entity in such
a manner that any information required by the entity is readily available. The systematic
recording of the financial information is called a financial accounting cycle, which consists of the
elements listed in diagram 1.2.

The processing stage entails the recording of transactions and this process is known as
bookkeeping. The ultimate goal of the input stage and the processing stage is to prepare
financial statements. (Study Guide: FAC1501, page 3, par 1.4)

1.3 Why study accounting

Accounting is the study of methods, which enables the orderly and systematic recording of all
proceedings or activities in an entity. Such proceedings or activities are called transactions. The
monetary value of these transactions is recorded in the accounting records of an entity. The aim
of which is to enable the businessperson or owner of an entity to ascertain the financial position
and financial results of the entity at all times.

10
 FAC1502/103
The advantages to be gained from studying accounting can be described as follows:

To the individual:

• It enables him/her to understand business terms and concepts, and to apply them.
• It promotes logical thought processes.
• It teaches him/her to pan and systematize his own finance.
• It teaches him/her to work accurately.
• It develops his/her sense of responsibility.
• It teaches him/her the value of money.

To the entity:

• It communicates financial information to the users of such financial information.

• It enables an entity to keep an accurate record of its daily business activities.
• It enables an entity to determine whether it made a profit or suffered a loss.
• It enables an entity to calculate the total value of its assets and liabilities.
• It enables an entity to function effectively and efficiently. (Study Guide: PRAC01W, page 11,
par 1.11)

1.4 Developments in Accounting

Ordinary people, entities and other organisations, for example schools, churches, hospitals and
clubs are constantly engaged in economic activities like working, trading and providing services.
Largely, these economic activities are based on transactions between interested parties. For
example, if you buy bread from your local baker you are engaged in a business transaction. The
baker has something that you need and you are willing to pay him/her money (the price of the
bread) in order for you to get the product (bread). The baker, in order to bake and sell bread,
must also enter into transactions. He/she must buy flour and other ingredients to bake the bread.
Some of these transactions can be conducted in cash, while others may be on credit, i.e. the
payment in cash is made sometime in the future.

In accounting, we refer to a business as an entity. The average size entity can enter into a large
volume of transactions in a single day. The owner of an entity cannot keep all the transactions
in his/her head and must write them down in order to keep a record of them. The owner or
somebody appointed by the owner who has the necessary knowledge, must capture the
essential data of a transaction on a business document. The data on these documents is then
captured by the process known as bookkeeping into specific accounting records used especially
for this purpose.

Accounting is relevant to individuals (you) as well as to entities, which need to keep record of
and control over their business transactions. The main concern of accounting is the record
keeping and reporting of financial transactions. This must be done in such a way that
management of an entity can rely on the accuracy of the accounting data when making financial
decisions that concern the financial affairs of an entity.

The ever-changing economic and social circumstances have influenced the historical
development of accounting. Clay tabloids from Babylonia and records reserved from Greek and
Roman civilisations are proof the financial records were kept in order to record details of
transactions and the financial relationship between parties.

Through the centuries trading activities increased, which brought about stronger competition
and resulted in lower profits for the traders. In order to stay successful, traders had to improve
their methods of recording financial information so as to enable them to make better business
decisions so that they could maximize their profits.

Before 1494 there was no systematic or uniform accounting method. Modern accounting had its
origin in Italy during the Renaissance when Lucas Pacioli, an Italian mathematician, published
his well-known work entitled Summa de Arithmetica Geometria et Proportionalita in 1494 in
Venice. It contained the first description of the principle of double entry on which modern
accounting is based.

11
 FAC1502/103
Originally accounting records were kept by hand, but today computers are increasingly being
used due to their ability to process a very large number of transactions very quickly. Whichever
method is used, the basic principles remain unchanged, since all activities in an entity are still
expressed in terms of money and are as such recorded. However, it is important to know and
understand the procedures used in a manual system in order to understand the operations of a
computerized accounting system. It is not possible to develop computerized accounting systems
without having expert accounting knowledge. (Study Guide: PRA01W, page 4, par 1.1)
It would be problematic if each entity kept individualized records of its transactions as this would
make it difficult to compare the performance of an entity with those of other similar entities. To
prevent this from happening, the accounting profession has standardized the way in which
entities are required to keep record of their transactions.
To improve uniformity the South African Statements of Generally Accepted Accounting Practice
(SA GAAP) was introduced. In 1995 these statements was fully harmonized by South Africa with
the International Financial Reporting Standards (IFRSs). SA GAAP is now identical to IFRSs.
Financial reporting standards, in terms of the Companies Act 71 of 2008 (Companies Act, 2008),
allows entities that meets the scope requirements of the conceptual framework for small and
medium-sized entities to use IFRS for Small and Medium-sized entities (IFRS for SMEs). It is
only a scaled down version of the complete IFRSs.
In South Africa the recording and reporting of financial information are governed by international
financial reporting standards as set by the Financial Reporting Standards Council (FRSC) in
South Africa. The purpose of these financial accounting standards will to a great extent ensure
that the same type of transaction is recorded by different entities in more or less the same way.
This will eventually ensure that the financial statements of different entities conduction of the
same type of business are comparable and that an entity’s financial statements will also be
comparable to those prepared in previous years.

1.5 The function of accounting

Accounting can be defined as the orderly and systematic identification and recording of the
monetary values of financial transactions of and individual or business entity, and the reporting
of the results of these transactions by way of the preparation and presentation of financial
statements to enable the users to use the information obtained in these financial statements as
a basis for decision making. Accounting is a specialised method used to communicate financial
information about an entity and its activities to those persons or entities that have an interest in
the activities of the entity.

Accounting is a process that involves three activities, namely:

• Identification – selecting those events that are evidence of economic activity (transactions)
relevant to the particular entity.
• Recording the monetary value of the economic events (transactions) so as to provide a
permanent history of the financial activities of the entity. Recording consists of keeping a
chronological diary of measured events in an orderly and systematic manner. Recording also
implies that economic events are also classified and summarized.
• The third activity encompasses the communication of the recorded information to interested
users. The information is communicated through the preparation and distribution of
accounting reports, the common of which are known as financial statements, that consist of:
A statement of financial position;
A statement of profit or loss and other comprehensive income;
A statement of changes in equity;
A statement of cash flow;
Notes, comprising of a summary of significant accounting policies and other explanatory
notes.
An entity does not necessarily refer to business entities. It can also refer to an educational
institution, a religious institution or a private household. (Study Guide: FAC1501, page 2, par
1.2).

12
 FAC1502/103
1.6 Universal accounting denominator
The common unit of measurement in accounting is money and in the Republic of South Africa,
the currency is known as the rand. All an entity’s transactions are converted into monetary values
before being processed. Using money as the common denominator, however, gives rise to two
important limitations:

● Not all events can be expressed in monetary terms.

● The value of money is unstable and is influenced by many economic factors such as inflation.

1.7 The entity concept

Basically all business activities can be narrowed down to two types of business activities,
namely:

Service entities

These types of entities render services (sell their skills and knowledge) for a fee. Examples are
firms rendering services like transport and storage, repairs by electricians, plumbers and
carpenters or personal services by hairdressers, bookkeepers, accountants, estate agents,
medical doctors, dentists, lawyers and photographers.

Trading entities

These types of entities specialises in the buying and selling of merchandise. Examples are
florists, ladies and gent’s outfitters, butchers, grocers, cafes, hardware stores and general
merchants.

It is, however, important to note that some business entities render not only a service but also
sell merchandise, that is they are also traders. An example of such an entity is a hairdressing
salon which renders a service but may also sell hair care products. Usually the product
compliments the service.

The business is seen as an entity completely separate from its owner(s). The following forms of
business exits.

Forms of ownership
The form of a business ownership refers to the way in which a business is owned and
managed – how the original funds for starting the business were raised and how the profits,
losses and risks in the business are divided.

In South Africa, there are the following forms of ownership, namely:

● sole traders
● partnerships
● close corporations
● profit companies like a State-owned company (SOC Ltd), Private company ((Pty) Ltd),
Personal liability company (Inc) and Public company (Ltd).
● non-profit companies (NPC) for public benefit or for an object relating to social or cultural
activities. (Koppeschaar et al, 2018:4)

1.8 Users of financial information

Financial statements are prepared and presented at least once a year and are directed towards
the common information needs of a wide range of users who analyse the information for various
decision-making purposes.

The following categories of users, and their need for accounting information, have been
identified:

13
 FAC1502/103
User Information needs
Clients/customers to assess the ability of the entity to continue as a
going concern.
Employees to assess the ability of their employer to provide
stable employment and remuneration.
Government and its agencies to regulate activities of the enterprise, compile
statistics and determine resource allocation and
tax policies.
Investors to assess the risk and return on an investment in
the enterprise.
Lenders to assess the ability of the enterprise to pay
interest on a loan and to repay loans.
Suppliers and other trade creditors to assess the ability of the enterprise to pay
amounts owing.
Management planning, that is determining future actions to be
taken;
or
exercising control, that is evaluating the current
situation and taking corrective steps.
The public require information such as the contribution of the
particular entity to the economy, the creation of
work opportunities, paying taxes, and making
charitable contributions.

Although employees are considered to be part of the organisation, they do not have the same,
unlimited access to the accounting records of the entity. (Study Guide: FAC1501, page 5, par
1.7)

Information are needed by users of financial statements on whether the reporting entity has
made efficient and effective use of the resources provided to the entity through the respective
equity and/or debt investments. This is known as the stewardship concept. In recent times this
notion manifest itself in concepts such as corporate governance and accountability.

1.9 The fields of accounting

Users of financial information can be subdivided into the following two categories:

● internal users – for example, management and employees

● external users – for example, investors, creditors and government

Two fields of accounting have developed as a result of this distinction between the users of the
information. Financial accounting is concerned with the provision of financial information to
mainly external parties, while management accounting is concerned with the provision of
financial information to people within the entity.

1.9.1 Financial accounting

This field of accounting is concerned with the measuring and recording of transactions for an
entity and the periodic preparation of various reports from such records in the form of financial
statements. The report provide useful information for managers, owners, creditors, financial
institutions, governmental agencies and the public concerning an entity as a whole. These
reports contain information regarding the financial position of an entity as a whole. These reports
are called financial statements and it contain information regarding the financial position of an
entity and the result of its activities. Financial accounting is governed by international financial
reporting standards (IFRS), which consists of external standards which must be adhered to.
These standards ensure the comparability of financial statements between entities.

1.9.2 Management accounting

Management accounting employs historical and estimated data which management uses in
conducting and evaluating current operations, and in planning future operations. In other words,
it provides specific information about specific aspects of an entity’s activities. The accountant,
14
 FAC1502/103
in preparing management reports, incorporates information that will be useful in helping
managers to make relevant decisions concerning an entity. Without this financial information, it
would be difficult for management to manage effectively.

Financial and management factors within an entity are both components of the same information
system. In practice, these two aspects of accounting often overlap. For example, information
needed for future planning by management will be extracted from the historical data contained
in financial accounting reports.

In this course, we concern ourselves with financial accounting. When we refer to accounting,
we mean financial accounting. (Study Guide: PRAC01W, page 10, par 1.9)

GOLDEN RULE

Financial statements must reveal a fair presentation of the financial position, the financial
performance and the cash flow of an entity.

1.10 The objective of general purpose financial reporting

The objective of general purpose financial reporting is to provide information about the financial
position, financial performance and changes in the financial position of an entity that is useful to
a wide range of users in making economic decisions relating to providing resources to the entity.

Users’ decisions involve decisions about: (IFRS Conceptual Framework Project Summary.
2018, p 5)

buying, selling or holding providing or settling loans voting, or otherwise

equity or debt instruments and other forms of credit influencing management’s
actions

To make these decisions, users assess: (IFRS Conceptual Framework Project Summary. 2018,
p 5)

prospects for future net cash inflows to the management’s stewardship of the entity’s
entity economic resources

To make both these assessments, users need information about both: (IFRS Conceptual
Framework Project Summary. 2018, p 5)

• the entity’s economic resources, claims against the entity and changes in those resources
and claims
• how efficiently and effectively management has discharged its responsibilities to use the
entity’s economic resources

The information is usually provided in the following components of financial statements:

• Statement of financial position as at the end of a financial period

The economic resources of an entity and the claims against these resources as well as the
liquidity and the solvency of an entity are recorded at a specific date in the statement of
financial position (Assets – Liability + Equity). The information on liquidity and solvency is
necessary to determine whether an entity will be able to meet its commitments when they
become due.

• Statement of profit or loss and other comprehensive income for the period
Information on the financial performance (Income – Expenses) of an entity during a specified
period is provided in the statement of profit or loss and other comprehensive income. The
financial performance of an entity should be reflected by the concept of accrual accounting.
In accordance with this basis, the effects of transactions are recognised when they occur and
not as cash is received or paid) and they are recorded in the accounting periods and reported
in the financial statements of the periods to which they relate.
15
 FAC1502/103

• Statement of changes in equity for the period

Information about changes in the structure of the entity’s equity as well as capital transactions
and other distributions made to owners are provided in the statement of changes in equity
for the period.

• Statement of cash flows for the period

Information is provided on the changes in the financial position of an entity in order to assess
the entity’s investing, financing and operating activities and the way in which the entity
acquires and distributes cash and cash equivalents. Information can also be gathered on the
entity’s ability to generate cash and cash equivalents and the needs to utilise cash flows

• Notes to the financial statements for the period

Necessary additional information and accounting policies applied is provided for a better
understanding of the financial statements.

1.11 Accounting principles

In this study unit we turn our attention to the theory of accounting. You may well ask: ‘‘Why?
Accounting is supposed to be a practical subject’’. This is true, but no subject that is logically
structured can exist without a theoretical foundation.

The techniques used in the practice of accounting are based on conceptual and theoretical
ideas. These techniques are generally known as accounting principles.

1.12 Accounting policy

Situations often occur in our everyday lives that are repetitive (ie they are always the same),
but they would each have a different outcome if we were to act differently each time. If we do
not have some kind of guideline on how we should act in such cases, our actions would
probably be inconsistent. Our friends would think we were unreliable. If we lay down a guideline
so that we always act the same way in a particular situation, we can say that we are determining
a policy for our actions, which will result in our actions being consistent.
We encounter precisely the same situation in accounting. Transactions of a repetitive nature
frequently occur, and the requirement of consistency means that an entity has to establish an
accounting policy to determine exactly how such transactions should be treated. Accounting
policy is thus a set of decisions about how the entity will handle the same type of transaction in
order to achieve a consistent result.

1.13 Disclosure of accounting policy

Since an accounting policy represents an entity’s decisions about situations which it could deal
with in various ways, it has to disclose its accounting policy in its financial statements. For
example, an entity has to indicate what basis it has used to deal with the depreciation of
property, plant and equipment.

1.14 International Financial Reporting Standards (IFRSs)

This is the next important concept that you will encounter in your accounting studies. For the
sake of conciseness, we will refer to this as IFRS.

If everyone were to develop his or her own language and grammatical rules, communication
would break down. We therefore have generally applicable language and grammar rules.

Accounting, as a specialised medium of communication, has precisely the same problem. If

each entity were to prepare financial reports according to its own accounting rules and its
interpretation of accounting theory and principles, chaos would result in the world of economics
and business.

16
 FAC1502/103

1.15 Accounting standards and statements

1.15.1 Introduction
The objective of creating accounting standards for particular issues (eg for the treatment of
taxation in financial statements) is to limit the variety of available accounting practices, but
without striving for strict uniformity or creating a set of rigid rules for all circumstances. The
ultimate aim of accounting standards is to encourage widespread use of particular standards in
financial reporting and to eliminate undesirable alternatives.

1.15.2 The Conceptual Framework for Financial Reporting 2010

Bear in mind that the conceptual framework is not a standard. It is a conceptual framework ‘‘...
which sets out the objectives and concepts which underlie the preparation and presentation of
financial statements ...’’.

1.15.2.1 The objective of financial statements

See paragraph 1.10 on page 16.

1.15.2.2 Underlying assumption

According to the conceptual framework, there is one underlying assumption for financial
statements.

This is the going concern concept.

The financial statements are normally prepared on the assumption that an entity is a going
concern and will continue to operate for the foreseeable future. (Study Guide: ACB151Z, page
12, paragraph 1.2.3)

1.15.2.3 The qualitative characteristics of useful financial information

For information to be useful it must both be relevant and provide a faithful representation of what
it purports to represent. Relevance and faithful representation are the fundamental qualitative
characteristics of useful financial information, and the guiding concepts that are applied
throughout the revised Conceptual Framework.
The fundamental qualitative characteristics are:
(1) Relevance
To be useful, information must be relevant to the decision-making needs of users about the
asset or liability and any related income and expense. Information has the quality of
relevance when it influences the economic decisions of users by helping them evaluate
past, present or future events or confirming, or correcting, their past evaluations. Therefore,
relevant information has one or both of the characteristics of predictive value or confirmatory
value.
Materiality plays an important role when evaluating the relevance of information. Information
is considered to be material if its omission or misstatement could influence the decisions of
users based on this information.

(2) Faithful representation

All items that have an influence on the financial position and/or financial performance of an
entity must be reported in an appropriate manner in the financial statements. Information
must faithfully represent the substance of what it purports to represent. According to the
Conceptual Framework the following three characteristics would ensure faithful
representation:

• Completeness;
• Neutrality (without bias); and
• Free from error.
17
 FAC1502/103

A faithful representation is affected by level of measurement uncertainty.

For information to be useful, it must be both relevant and faithful represented.

Further enhancements to the qualitative characteristics of financial information are:

(1) Comparability
Users must be able to compare the financial statements of an entity through time in order
to identify trends in its financial position and financial performance. This quality therefore
attempts to introduce a common language into the presentation of financial statements so
that users can compare information about an entity for different periods, or with information
of other similar entities.
Comparability in the accounting treatment should be consistent for:
• The same items over time;
• The same items in the same period; and
• Similar items of different but similar entities over time and in the same period.

(2) Verifiability

This characteristic of financial information enables users to confirm that the information
presented does in fact faithfully present the events or transactions it is supposed to present.
There are two ways in which information can be verified, namely:

• Direct verification whereby the cash balance can be verified by counting the cash.
• Indirect verification whereby the closing balance on inventories can be confirmed by
physically counting the quantities and recalculating the cost value by using the same
valuation method used by the reporting entity.

(3) Timeliness

Recent and reliable information increases the usefulness of the financial statements.
Usually older information is less useful and may only be useful to identify and assess certain
trends.

(4) Understandability

An essential quality of the information provided in financial statements is that it is readily

understandable to the average user. The Conceptual Framework comments on this,
indicating (par.25) that users are assumed to have:
• a reasonable knowledge of business and economic activities; and
• a willingness to study the information with reasonable diligence.

The Conceptual Framework adds that information of a complex nature should not be
excluded from the financial statements (where relevant to users’ decision-making) merely
because it may be too difficult for certain users to understand. However, the provision of
information should be included only if the benefits are considered to outweigh the costs of
providing the information.

Previously it was said that the aim of financial statements is to report on the financial position,
changes in the financial position and the financial performance of an entity. We use three
different financial statements to do just that.

• The statement of financial position is used to report on the financial position of a business
entity;
• The statement of cash flows reports on the change in financial position; and
• The statement of profit or loss and other comprehensive income reports on financial
performance. Each of these statements consists of different elements. It is important to
learn these elements as quick as possible. (Study Guide: ACB151Z, page 13, paragraph
1.2.4)

18
 FAC1502/103
1.15.2.4 Financial statements and the reporting entity

A reporting entity is:

• an entity that is required, or chooses, to prepare financial statements
• not necessarily a legal entity – could be a portion of an entity or comprise more
than one entity (IFRS Conceptual Framework Project Summary. 2018, p 7)

Financial statements are:

a particular form of financial reports that provide information about the reporting
entity’s assets, liabilities, equity, income and expenses (IFRS Conceptual Framework
Project Summary. 2018, p 7)

1.15.2.5 The elements of financial statements

GOLDEN RULE

The following are elements of financial statements:

Elements that measure the financial position (assets = equity + liabilities):
assets
equity
liabilities

● Elements that measure profitability (profit or loss = increase or decrease in equity):

(4) income
(5) expenses
The elements of different financial statements

• The statement of financial position

The statement of financial position reports on the financial position of an entity. At the end
of the financial period it summarises all the assets, liabilities and equity accounts of the
entity. The Conceptual Framework (par 49) defines these elements as follows:

Assets

These are present economic resources controlled by the entity as a result of past events. An
economic resource is a right that has the potential to produce economic benefits
You will further on in this study guide learn that assets can be further classified into two
categories, namely current assets and non-current assets.

Equity

This is the residual interest in the assets of the entity after deducting all its liabilities.
Equity is also described as the part of the entity that belongs to the owners of the entity,
which could be one person (sole trader), two to twenty partners (partnership), one to ten
members (close corporation) and numerous shareholders (companies). The changes that
occur in respect of equity in a financial period will be disclosed on the statement of changes
in equity.

19
 FAC1502/103
Liabilities

These are present obligations of the entity to transfer economic resources as a result of past
events.
An obligation is a duty or responsibility that the entity has no practical ability to avoid.
Similar to assets, liabilities can also be classified into two categories, namely current liabilities
and non-current liabilities.

• The statement of profit or loss and other comprehensive income

The statement of profit or loss and other comprehensive income reports on the financial
performance of an entity. At the end of the financial year all income and expense accounts
are closed off to the statement of profit or loss and other comprehensive income. The
Conceptual Framework (par 70) defines these elements as follows:

Income

Income is increases in assets, or decreases in liabilities that result in an increase in equity,

other than those relating to contributions from holders of equity claims.
Income accounts include amongst others, sales, rental income, commission income and
credit losses recovered.

Expenses

Expenses are decreases in assets, or increases in liabilities, that result in decreases in

equity, other than those relating to distributions to holders of equity claims.
Expense accounts include amongst others cost of sales, water and electricity, salaries and
wages, interest expenses, stationery, credit losses, depreciation and other operating
expenses.
Once able to define the different elements of the financial statements, it is necessary to know
when to recognise these items in the financial statements. (Study Guide: ACB151Z page 14,
paragraph 1.2.5)

1.15.2.6 Recognition and measurement of the elements of financial statements

Recognition is the process of incorporating in the statement of financial position or statement of

profit or loss and other comprehensive income an item that meets the definition of an element
and satisfies the criteria for recognition.

An item that meets the definition of an element should be recognised in the statement of financial
position or statement of profit or loss and other comprehensive income if:

• It is probable that any future economic benefit associated with the item will flow to or from
the entity.
• The item has a cost or value that can be measured with reliability. (Study Guide: ACB151Z,
page 15, paragraph 1.2.6)

The following measurement bases are identified in paragraph 4.55 of the Conceptual
Conceptual Framework:

Historical cost measurement bases (IFRS Conceptual Framework Project Summary. 2018,
p 12)

• historical cost provides information derived, at least in part, from the price of the
transaction or other event that gave rise to the item being measured

• historical cost of assets is reduced if they become impaired and historical cost of liabilities
is increased if they become onerous

• one way to apply a historical cost measurement basis to financial assets and financial
liabilities is to measure them at amortised cost (cost after subtracting depreciation)
20
 FAC1502/103

Historical cost measures are entry values and provide monetary information about assets,
liabilities and related income and expenses, using information derived, at least in part, from the
price of the transaction or other event that gave rise to them. Transaction costs are taken into
account if they are incurred in the transaction or other event giving rise to the asset or liability
(Descriptive Accounting IFRS Focus. 2018. Paragraph 2.7.1.1, P 19):

The historical cost of an asset is updated over time to depict, if applicable:

• The consumption of part or all of the economic resources that constitutes the asset
(depreciation);
• Payments received that extinguish part or all of the assets;
• The effect of events that cause part or all of the historical cost of the asset to be no longer
recoverable (impairment); and
• Accrual of interest to reflect any financing component of the asset.

The historical cost of a liability is updated over time to depict, if applicable:

• Fulfilment of part or all of the liability;
• The effect of events that increase the value of the obligation to transfer the economic
resources needed to fulfil the liability to such an extent that the liability becomes onerous (it
is onerous if the historical cost is no longer sufficient to depict the obligation to fulfil the
liability); and
• Accrual of interest to reflect any financing component of the liability.
For financial assets and financial liabilities, a way to apply the historical cost basis, is to measure
the items at amortised cost. The amortised cost of a financial asset or financial liability is updated
over time to depict subsequent changes.

Current value measurement bases (IFRS Conceptual Framework Project Summary. 2018,
p 12)

Assets should be recorded at the amount paid, or the fair value of the consideration given, to
acquire the assets at the time of their acquisition. Liabilities should be recorded at the amount
of proceeds received in exchange for the obligation, or in some circumstances (for example,
income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the
liability in the normal course of business (Conceptual Framework, paragraph 4.55(a)).

• current value provides information updated to reflect conditions at the measurement date
• current value measurement bases include:

Fair value
• the price that would be received to sell an asset, or paid to transfer a liability, in an orderly
transaction between market participants at the measurement date
• reflects market participants’ current expectations about the amount, timing and
uncertainty of future cash flows

Assets are carried at the present discounted value of the future net cash inflows the item is
expected to generate in the normal course of business. Liabilities are carried at the present
discounted value of the future net cash outflows that are expected to be required to settle the
liabilities in the normal course of business (Conceptual Framework, paragraph 4.55(d)).

A basis that is not mentioned in the Conceptual Framework is the fair value basis although it is
a basis frequently referred to in IFRS. Fair value is defined in IFRS as “the price that would be
received to sell an asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date” (IFRS 13, Fair Value Measurement).

Currently, the most commonly adopted method is the historic cost method that is sometimes
used in combination with other methods such as fair value.

21
 FAC1502/103
Value in use (for assets) fulfilment value (for liabilities)

reflects entity-specific current expectations about the amount, timing and uncertainty of
future cash flows. It is therefore the present value of the cash flows, or other economic
benefits that an entity expects to derive from the use of an asset and from its ultimate
disposal. An exit value.

Assets are carried at the amount of cash or cash equivalent that could currently be obtained by
selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is
the undiscounted amounts of cash or cash equivalent expected to be paid to satisfy the liabilities
in the normal course of business (Conceptual Framework, paragraph 4.55(c)).

Current cost

reflects the current amount that would be:

• paid to acquire an equivalent asset

• received to take on an equivalent liability

Assets are carried at the amount of cash or cash equivalent that would have to be paid if the
same or an equivalent asset was acquired currently. An entry value. Liabilities are carried at the
undiscounted amount of cash or cash equivalent that would be required to settle the obligation
currently (Conceptual Framework, paragraph 4.55(b)).

Assets are carried at the amount of cash or cash equivalent that could currently be obtained by
selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is
the undiscounted amounts of cash or cash equivalent expected to be paid to satisfy the liabilities
in the normal course of business (Conceptual Framework, paragraph 4.55(c)).

1.16 Exercise and solution

We end this study unit with a few revision questions. It is in your own interest to try to answer
these by referring to the study unit.

Exercise

(1) Discuss the nature of accounting.

(2) What is the common unit of measurement in accounting?
(3) Name the four main forms of ownership.
(4) Discuss the different users of financial information.
(5) Differentiate between financial accounting and management accounting.
(6) Name the qualitative characteristics of financial information.
(7) Define the concept of accounting policy.
(8) What is meant by disclosure of accounting policy?
(9) Describe the concept of international financial reporting standards.
(10) Discuss the underlying assumption of financial statements.
(11) Name the fundamental qualitative characteristics of financial statements.
(12) Name the elements of financial statements.

22
 FAC1502/103

(1) Refer to paragraph 1.2.2.

(2) The common unit of measurement in accounting is money.
(3) Sole trader
Partnership
Close Corporation
Company
(4) See section 1.8.
(5) See section 1.9.
(6) See section 1.15.2.3 in this tutorial letter.
(7) See section 1.12 in this tutorial letter.
(8) See section 1.13 in this tutorial letter.
(9) See section 1.14 in this tutorial letter.
(10) See section 1.15.2.2 in this tutorial letter.
(11) Relevance
Faithful representation
(12) Assets
Liabilities
Equity
Income
Expenses

SELF-ASSESSMENT

Now that you have studied this study unit, can you:

● describe the importance of financial information as a basis for decision making?

● discuss the different users of financial information and their needs?
● state the different forms of ownership?
● discuss the nature of accounting?
● explain the difference between financial and management accounting?
● name the qualitative characteristics of financial statements?
● explain what is meant by the accounting policy?
● explain what is meant by the disclosure of the accounting policy?
● explain what is meant by the international financial reporting standards?
● explain what is meant by the accounting standards and statements?

23
 FAC1502/103
STUDY UNIT

2
The financial position

Learning outcome
Students should be able to describe what the primary purpose of accounting is and what is
understood by the double entry system. They should also be able to calculate the financial
position of an entity and the elements of the basic accounting equation.

Contents Page

Key concepts 24

2.1 Introduction 25

2.2 Accounting entity 25

2.3 The financial period 25

2.4 Financial position 25

2.5 The elements of financial statements 25

2.5.1 Assets 26
2.5.2 Liabilities 27
2.5.3 Equity 28
2.6 The basic accounting equation (BAE) 28

2.7 The double-entry system 29

2.8 Revision exercises and solutions 32
2.8.1 Revision exercise 1 32

2.8.2 Revision exercise 2 32

Self-assessment.1 33

KEY CONCEPTS
● Accounting entity
● Accounting equation
● Financial position
● Assets
● Liabilities
● Equity
● Double-entry
● Net worth

24
 FAC1502/103
2.1 Introduction
The primary purpose of accounting (paragraph 1.2.3) is to give information (paragraph 1.2.4)
on the financial position (paragraph 4.7) and the financial result (paragraph 4.15.1) of an entity.
This study unit deals with the key elements of the financial position (paragraph 1.15.2.5).

2.2 Accounting entity

Every entity for which separate financial records are kept is an accounting entity (paragraph 1.7).
It is extremely important to see the business as a separate entity from its owners because
transactions entered into by the entity have to be dealt with from the point of view of the entity
whose accounting records are being done.

2.3 The financial period

The financial statements of any business entity, regardless of whether it operates as a company,
close corporation, partnership or sole trader, consist of at least the following:

The statement of financial position, which provides information about the financial position of the
business at the end of that specified period (any period of monthly, every 3 monthes, every
six months or every 12 months). The heading of the statement of financial position identifies
the data at which it is reporting, for example:

XYZ Traders
Statement of financial position as at 30 September 20.2

If the financial period is one year the period will be from 1 October 20.1 until 30 September 20.2
and the statement of financial position will be as at the last day of the financial year. Therefore,
the statement of financial position reports on the assets, liabilities and equity of the entity only
for one day. (Study Guide: ASK131-U, page 28, paragraph 3.2.7)

2.4 Financial position

The financial position of the entity is described in terms of assets, liabilities and equity at a given
time. They are reflected in a statement of financial position, which is essentially an accounting
report on the financial position of an entity. The statement of financial position communicates
relevant financial information to the owners, creditors and other interested parties.
A simplified example of a statement of financial position according to the basic accounting
equation is as follows:
BUSINESS TRADERS
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20.9
R
ASSETS
Tools and equipment 88 800
Bank 8 200
97 000

EQUITY AND LIABILITIES

Capital 40 000
Creditor/Trade payables 7 000
Long-term loan 50 000
97 000

COMMENT
This statement of financial position (balance sheet) is in a basic form. Later we will deal with
statements of financial position (balance sheets) in more detail.

25
 FAC1502/103
2.5 The elements of financial statements
Every entity implements a financial accounting system according to the minimum financial
accounting standards and practices when it draws up financial statements that are used in
making economic decisions. Financial statements (paragraph 1.15.2.4) will reflect the financial
effects of transactions by grouping them into broad classes according to their economic
characteristics namely assets, equity, liabilities, income and expenses, Assets, equity, liabilities,
income and expenses are called the elements of financial statements.

The elements directly related to the measurement of financial position at a given time in the
statement of financial position are assets, liabilities and equity.

2.5.1 Assets
Let’s have a look at the difference between non-current assets and current assets (Study Guide:
FAC1501. 2014: 24).

ASSETS

Assets are present economic resources

controlled (used) by the entity, as a result of past
events (assets was bought).

CURRENT ASSETS NON-CURRENT ASSETS

An asset shall be classified as current when it
satisfies any of the following criteria (IAS 1.66):
• It is expected to be converted into money
(realised), or is intended for sale or
consumption in the entity’s normal
operating cycle.
• It is held primarily for the purpose of being
traded.
• It is expected to be converted into money
(realised) within twelve months of the
statement of financial position date.
• It is cash or cash equivalent unless it is
restricted from being exchanged or used to
settle a liability for at least 12 months after
the end of the reporting period.
Examples of current assets are:
• Trading inventories
• Consumable stores on hand
• Debtors/Trade receivables
• Accrued income
• Prepaid expenses
• Bank (favourable balance)
• Cash float
• Petty cash
All other assets (thus being assets that are
not classified as current assets will be
classified as non-current). (IAS 1.60)
Non-current assets include tangible,
intangible and financial assets of a long-term
nature. (In this module we will only concern
ourselves with tangible non-current assets.)
It is not the intention of the entity to sell non-
current assets, but to use these assets over
the long-term in its business operations to
earn an income.
Non-current asset are those assets with a
useful life of longer than one year.
Examples of non-current assets are:
• Land
• Buildings
• Vehicles
• Furniture
• Equipment
• Machinery

An asset is recognised as an element of the financial statements when:

• It is probable that economic benefits will flow to the entity; and
• the cost or valuation of the asset can be measured reliably. (Koppeschaar et al, 2017:21)

The following examples of how assets may be employed are given in paragraph 4.10 of the
26
 FAC1502/103
Conceptual Framework, assets may be:
• Used singly or in combination with other assets in the production of goods or services to be
sold by the entity;
• Exchanged for other assets;
• Used to settle a liability; or
• Distributed to the owners of the entity.

2.5.2 Liabilities
Let’s have a look at the difference between current and non-current liabilities (Study Guide:
FAC1501. 2014: 25).

LIABILITIES

Liabilities are present obligations (debts) of the entity

to transfer economic resources (payments) as a result
of past events (borrowing or purchasing).

CURRENT LIABILITIES NON-CURRENT LIABILITIES

A liability shall be classified as current when it All other liabilities (thus being liabiliteis that
satisfies any of the following criteria (IAS 1.69): are not classified as current liabilities will be
classified as non-current). (IAS 1.69)
• It is expected to be settled in the entity’s Are long-term debts, and have to be settled
normal operating cycle (usually one year). after one year of the statement of financial
position date.
• It is held primarily for the purpose of being
traded.
• It is expected to be settled within twelve .
months after the statement of financial
position date.
• The entity does not have an unconditional
right to defer settlement of the liability for at
least twelve months after the end of the
reporting period.
Examples of current liabilities are: Examples of non-current liabilities are:
• Creditors/Trade payables • Long-term loans
• Bank overdrafts • Mortgage
• Current portion of long-term borrowings • Debentures
• Short-term borrowings
• Accrued expenses
• Income received in advance

A liability is recognised when:

• It is probable that economic benefits will flow from the entity when an obligation is settled;
and
• The amount of the benefit to be given up can be measured reliably. (IAS 37, Provisions,
Contingent Liabilities and Contingent Assets)

The settlement of obligations can take place in a number of ways, for instance through:

• The payment of cash;

• The transfer of other assets;
• The provision of services;
• The replacement of one obligation with another; or
• The conversion of an obligation into equity. (Conceptual Framework, paragraph 4.16)
27
 FAC1502/103
2.5.3 Equity
The difference between the value of assets owned by an entity and the liabilities it has incurred
represents net asset value. If we express this as an equation, then
ASSETS - LIABILITIES = NET ASSET VALUE
The net asset value represents the portion by which the assets exceed the liabilities. Net asset
value is therefore also called EQUITY.
According to these principles the correct statement of financial position for Business Traders is
as follows:
BUSINESS TRADERS
STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20.9
R
ASSETS
Non-current assets
Tools and equipment 88 800
Current assets
Bank 8 200
97 000
EQUITY AND LIABILITIES
Equity
Capital 40 000
Non-current liability
Long-term loan 50 000
Current liability
Creditor/Trade payables 7 000
97 000

2.6 The basic accounting equation (BAE)

The logical method of recording transactions by way of the accounting equation is used to
process transaction data. Transactions may:

• affect assets and/or equity and/or liabilities.

• generate income or give rise to expenditure

The accounting equation states that:

ASSETS = EQUITY + LIABILTIES

A = E + L

OR

EQUITY = ASSETS - LIABILTIES

E = A - L

The equity equals all the assets in the entity less all the claims against those assets
(liabilities).

The accounting equation is a mathematical equation that should always balance. The financial
position of an entity is indicated by this equation.

For the accounting equation to always balance it requires the involvement of two accounts for
each transaction. The accounting equation is, therefore, based on the double-entry accounting
system.

Basic requirements for the accounting equation

A minimum of two accounts must be used for each transaction.
The equation must remain in balance after each transaction. In other words the debit

28
 FAC1502/103
side (A) is equal to the credit side (E + L)

Consider the following example of transactions that affect assets and/or equity and/or liabilities:

Before the entity starts to do business, the accounting equation will look like this:

Debit side = Credit side

A = E + L
Possessions the entity owns = Amounts owed to the + Amounts owed to third
owner of the entity parties
What the entity owns = What the entity owes
0 = 0

Note that the recording of transactions is done from the point of view of the business
entity independent from its owner.

Every entity for which separate financial records are kept is a financial accounting entity. It is
extremely important to see the entity as separate from its owner: transactions entered into by
the entity have to be dealt with from the point of view of the entity whose books are being done.
(Study Guide: FAC1501, page13, paragraph 2.7)

Why do we say that the accounting equation is a fact, and not a rule? To answer this question
you need to know what each concept in the equation means:

• Assets are basically all the resources controlled by the entity (whether they are owned by the
entity or not).
• Liabilities are the debts of the entity (all the money owed to third parties).
• Equity refers to the wealth of the owner(s) (from the business only). It is an indication of how
much of the asset base actually belongs to the owner(s).

An easy way to remember the accounting equation is to ask yourself:

“What would the owner have left for himself if he closed his business today, sold all the assets,
and paid back all the liabilities?” Remember, not all assets controlled by the entity are owned
by the entity. If the business entity bought a vehicle on credit, for example, it does not belong to
the entity until the final instalment is paid. Until then, the vehicle actually belongs to the financier,
and will be accompanied by a liability (debt) in the accounting records of the entity. If the owner
thus decides to close the business, the money owed on this vehicle would still be due. In simple
language, the accounting equation thus states a fact.

The equity (wealth) equals all the valuables (assets) in the business less all the claims
against those assets (liabilities)

Before you will be able to use the accounting equation it is very important that you learn about
the double-entry principle that drives the accounting process. (Study Guide: ACB151Z, page 18,
paragraph 2)

2.7 The double-entry system

Bookkeeping is the part of financial accounting that is concerned with the recording of
transactions. The transactions are recorded in an account.

An account consists of a left-hand side and a right-hand side and is presented in a “T”
format. The left-hand side is referred to as the debit side and the right-hand side is
referred to as the credit side. The name of the “T” account is written across the centre
at the beginning of each account.

This can be illustrated as follows:

Dr (debit side) …… Account (credit side) Cr

Left-hand side (LHS) Right-hand side (RHS)

29
 FAC1502/103
For each asset, liability, equity, expense and income there will be a “T” account in the accounting
records of the entity. All these “T” accounts together are called the general ledger.

The double-entry principle provides a logical method of recording transactions. In using the
double-entry system the monetary (money value) of each transaction must be entered on the
debit side of one ledger account as well as on the credit side of another ledger account. The
entry in one ledger account refers to the corresponding entry in the other ledger account.

As the entries in the two ledger accounts have been entered on opposite sides, the use of the
double entry system allows for cross references. Each transaction is entered in two separate
accounts on opposite sides, and it is therefore possible to check and control the arithmetical and
accounting accuracy of the work. If each transaction is recorded so that the debit and credit
entries are equal, the same sum of all the debits to the account must equal the sum of all the
credits. This can be explained by way of the accounting equation. (Study Guide: FAC1501, page
12, paragraph 2.6)

The double-entry system is based on the fact that every transaction affects two or
more items in the BAE. In principle it means that each transaction must be recorded in
such a way that the equation remains in balance. The dual effect which each transaction
has on the elements of the BAE is the fundamental principle on which all entries in an
accounting system are based.

When the double-entry principle is applied the following rules need to be followed:

Dr (debit side) Assets (credit side) Cr

+ -

Dr (debit side) Equity, Liabilities (credit side) Cr

- +

The above can be summarised as follows:

• Assets increase on the (left) debit side and decrease on the (right) credit side of the T-
account.
• Equity and liabilities increase on the (right) credit side and decrease on the (left) debit side
of the T-account.

For you as a learner in accounting the reality is that the double-entry rules are not one of those
concepts that you can try to understand – you have to learn them! (Study Guide: ACB151Z,
page 19, paragraph 2.3)

The statement of financial position, example on page 32, paragraph 4.7, in the study guide.

Exercise 1

The assets of Maxi Services amount to R30 000 and its liabilities (creditors) to R5 000.
Calculate the equity.

We use the BAE. The amounts which are given are substituted for the appropriate
symbol and the unknown symbol is calculated.

A = E + L
This basic accounting equation will be adjusted to be able to calculate the equity:
E = A - L (Creditors/Trade payables)
R30 000 - R5 000
R25 000

30
 FAC1502/103

Exercise 2

T Tom is the owner of Zebra Services which offers a carpet cleaning service. On
30 November 20.1 Zebra Services owns equipment amounting to R100 000. Clients owe
R40 000 for services rendered and Zebra Services owes R20 000 to a supplier for parts
purchased. Zebra Services also has R10 000 in cash in the bank.

Show the BAE for Zebra Services and determine the equity.

Step 1: Identify the assets

Equipment = R100 000
Trade receivables = R 40 000
Bank = R 10 000

Step 2: Identify the liabilities

Trade payables = R20 000
Substitute these amounts into the equation:

A = E + L
This basic accounting equation will be adjusted to be able to calculate the equity:
E = A - L
Equity Equipment + Trade receivables + Bank Trade payables
R(100 000 + 40 000 +10 000) - R20 000
R130 000

Zebra Service’s financial position can also be presented in the form of a statement of
financial position (previously known as balance sheet) as follows:

ZEBRA SERVICES
STATEMENT OF FINANCIAL POSITION AS AT 30 NOVEMBER 20.1
R
ASSETS
Equipment 100 000
Trade receivables 40 000
Bank 10 000

150 000

EQUITY AND LIABILITIES

Equity 130 000
Trade payables 20 000

150 000

31
 FAC1502/103

2.8 Revision exercises and solutions

2.8.1 Revision exercise 1
(1) Define the concept of an accounting entity.
(2) Describe the financial position of an entity in terms of the BAE.
(3) Explain the nature (paragraph 1.15.2.5.2) of

(a) assets
(b) equity
(c) liabilities

(4) Name two sources of financing.

(5) What is meant by the double-entry system?

Solution: Revision exercise 1

(1) An accounting entity is any entity for which separate financial records are kept.

(2) ASSETS = EQUITY + LIABILITIES

(3) (a) Assets are the possessions of the entity.

(b) Equity is the interest which the owner has in the business and which the entity
therefore owes to him.
(c) Liabilities are creditors’ interests or interests of parties other than the owners).
Liabilities are therefore the debts of the entity.

(4) The owner

Trade payables

(5) In principle it means that every transaction has a dual effect on the elements of the BAE
and that after every transaction the BAE must remain in balance.

2.8.2 Revision exercise 2

Calculate the missing figures using the BAE.
R
(1) Bank = 4 000
Vehicles = 5 000
Equipment = 7 000
Capital = ?

(2) Capital = 150 000

Loan = 50 000
Bank = ?
Machinery = 190 000

(3) Bank = 5 000

Trade receivables = 15 000
Buildings = 100 000
Furniture = 40 000
Trade payables = 50 000
Capital = ?

32
 FAC1502/103

(4) Capital = 60 000

Loan = 10 000
Trade payables = 6 000
Assets = ?

Solution: Revision exercise 2

(1) A = E + L
This basic accounting equation will be adjusted to be able to calculate the equity:
E = A - L
Capital Bank + Vehicles + Equipment
R(4 000 + 5 000 + 7 000) - R0
R16 000

(2) A = E + L
Machinery + Bank Capital Loan
R190 000 + Bank = R150 000 + R50 000
Bank = R10 000*
* R190 000 – R(150 000 + R50 000)

(3) A = E + L
This basic accounting equation will be adjusted to be able to calculate the equity:
E = A - L
Capital Bank + Trade receivables + Trade payables
Buildings + Furniture
R(5 000 + 15 000 + 100 000 R50 000
+ 40 000) -

R160 000 - R50 000

R110 000
(4) A = E + L
Assets Capital Loan + Trade Payables
R60 000 + R(10 000 + 6 000)
R76 000

SELF-ASSESSMENT

Now that you have studied this study unit, can you:

● describe the primary purpose of accounting?

● describe an entity?
● describe the financial position of the entity?
● describe the double-entry system?
● calculate the elements of the basic accounting equation?

33
 FAC1502/103
STUDY UNIT

3
The financial performance ( result)

Learning outcome

Students should be able to apply the concepts of income and expenditure to determine the
gross and net profits (or losses) and the effect thereof on equity.

Contents Page

Key concepts 34

Introduction 35

The financial performance (result) 35

Income 35

Expenditure 37

Influence of profit or loss on equity 38

Statement of profit or loss and other comprehensive income (income statement)

(financial performance) 39

Statement of changes in equity 39

Accounting policies and explanatory notes 39

Revision exercises and solutions 40

Revision exercise 1 40

Revision exercise 2 40

Self-assessment 41

KEY CONCEPTS
Financial result
Profit/loss
Income
Expenditure

34
 FAC1502/103
3.1 Introduction
In paragraph 2.3 we discussed the first component of the primary goal of accounting, which is
to determine the financial position of an entity as it is reflected in the statement of financial
position. In this study unit we discuss the second component of this primary goal, namely the
financial performance of the entity, and indicate how it is reflected in the form of a statement
of profit or loss and other comprehensive income.

3.2 The financial performance ( result)

The financial result of an entity is measured in terms of the profit or loss which the entity has
made over a specific period, which is referred to as the financial period and which is normally
a year. An entity makes a profit when the income it has earned is more than the expenditure it
has incurred in generating or producing that income. The difference between the income and
expenditure is known as the profit or loss. Profit is the owner’s reward for the capital he or she
has invested and the entrepreneurial spirit he or she has shown. It therefore increases the
equity.
The statement of profit or loss and other comprehensive income provides information about the
results of the operating activities of the business during a specified period, i.e. its performance.
The heading of the statement of profit or loss and other comprehensive income identifies the
period on which it is reporting, for example:

XYZ Traders
Statement of profit or loss and other comprehensive income for the year ended
30 September 20.2

The statement of profit or loss and other comprehensive income reports the income and
expenses, including gains and losses of the entity.

3.3 Income
Profit or loss is frequently used as a measure of performance. The elements directly related to
the measurement of financial performance for a period in the statement of profit or loss and other
comprehensive income are income and expenses (Study Guide: FAC1501. 2014: 34-35).

Income less expenses = profit/loss for the year

The objective of every entity is to earn as large an income as possible.

Income is the income earned by the entity through its normal everyday business
activities for the financial accounting period (normally a year), for example sales, rent
income, interest income and credit losses recovered.

Expenses are the running expenses of the entity for the financial accounting period
(normally a year) necessary to earn the income, for example purchases, rent expenses,
telephone expenses, water and electricity, salaries and wages.

35
 FAC1502/103

INCOME

Profit/income is increases in assets or decreases

in liabilities, that result in increases in equity,
other than those relating to contributions from
holders of equity claims.

REVENUE PROFIT/GAINS

Revenue earned from the entity’s normal Gains are increases in economic benefits,
activities (daily operating activities), for which do not arise from the normal activities
example: of the entity, for example:
• Fees earned • Profit on sale of non-current asset
• sales
• Interest income
• Rental income
• Commission income
• Credit losses recovered

When the double-entry principle is applied the following rules need to be followed:

Dr (debit side) Equity, Liabilities & Income (credit side) Cr

- +

• Income increase on the (right) credit side and decrease on the (left) debit side of the T-
account because income increase the profit for the year.

Income is recognised when:

• An increase in economic benefits through an increase in assets or a decrease in liabilities has

arisen for the entity, and
• It can be measured reliably. (Koppeschaar et al, 2017:21)

Income is therfore recognised simultaneously with the increase in assets or a decrease of a

liability. In practice, it is normally required that revenue should be earned before it is recognised.

36
 FAC1502/103
3.4 Expenditure
Expenditure is incurred to earn income (Study Guide: FAC1501. 2014: 36).

EXPENSES

Losses/expenses are decreases in assets, or

increases in liabilities, that result in decreases in
equity, other than those relating to contributions
to holders of equity claims.

REVENUE PROFIT/GAINS

Expenses are incurred in the normal course of Losses are decreases in economic benefits,
the entity’s activities. They arise from the which do not arise from the normal activities
generation of income, for example: of the entity, for example:
• Cost of sales • Loss on sale of non-current asset
• Wages and salaries
• Interest expenses
• Rental expenses
• Advertising
• Credit losses
• Insurance
• Repairs and maintenance
• Telephone expenses
• Water and electricity
• Postage
• Rates and taxes
• Stationery
• Consumables
• Packing materials
• Bank charges
• Depreciation
• Administrative expenses

When the double-entry principle is applied the following rules need to be followed:

Dr (debit side) Expenses (credit side) Cr

+ -

The above can be summarised as follows:

• Expense increase on the (left) debit side and decrease on the (right) credit side of the T-
account because expenses decrease the profit for the year.

Expenses are regarded as:

• The decline in economic benefits resulting from a decrease in an asset, or the increase of a
liability,
• That can be measured reliably. (Koppeschaar et al: 2017:22)

Expenses are therefore recognised simultaneously with the increase of a liability or the decrease
of an existing asset.

37
 FAC1502/103
3.5 Influence of profit or loss on equity
Equity refers to the wealth of the owner. Literally speaking, one can say that if the owner of a
business had to close down the entity at a particular date, sold all the valuables (assets) in the
entity and paid all the liabilities, the amount left would constitute the equity. There are two
methods through which equity can be calculated. The first method is by means of the accounting
equation. The second method is by means of income and expenses.
Income (profit) increases and expenditure (losses) decreases the owner’s interest.

Equity can be calculated by the following two methods:

• Method A – By using the accounting equation

Equity = Assets – Liabilities
• Method B – By using equity accounts
Dr (debit side) Capital (credit side) Cr
- +

BUSINESS TRADERS
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20.9
R
Capital (Opening balance) xx xxx
Plus: Additional capital contributions during the year xx xxx
Plus: Total comprehensive income for the year xx xxx
Less: Drawings (xx xxx)
Capital (closing balance) xx xxx

Exercise

The financial position (BAE) of T Payn, an attorney, on 28 February 20.0 is as follows:

Assets = E+ L
R50 000 R30 000 R20 000

For the year ended 28 February 20.1 he had the following income and expenditure:

R
Services rendered 180 000
Salaries 100 000
Administrative costs 20 000
Insurance expenses 10 000

Calculate T Payn’s equity on 28 February 20.1.

We use the equation which we discussed in paragraph 2.4 and 4.3:

Profit = Income – Expenditure
= Services rendered – (Salaries + administrative cost +
insurance expenses)
= R180 000 – R(100 000 + 20 000 + 10 000)
= R180 000 - R130 000
= R50 000
E = R30 000 + R50 000
= R80 000

38
 FAC1502/103
COMMENTS

● Capital plus profit together form the equity of the owner. See the above exercise —
R(30 000 + 50 000) = R80 000.
● Profit is income minus expenditure.

3.6 Statement of profit or loss and other comprehensive

income (financial performance)
The financial performance is measured in the statement of profit or loss and other
comprehensive income of an entity (previously known as the income statement).

According to these principles the correct statement of profit or loss and other comprehensive
income for Business Traders is as follows:

BUSINESS TRADERS
STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE
YEAR ENDED 31 DECEMBER 20.9
Notes R
Services rendered xx xxx
Other income x xxx
Rental income x xxx

xx xxx
Distribution, administrative and other expenses (x xxx)
Telephone expenses x xxx
Salaries x xxx

Profit for the year xx xxx

Other comprehensive income for the year * -
Total comprehensive income for the year xx xxx

* Other comprehensive income for the year falls outside the scope of the FAC1502 syllabus.

See an example of the statement of profit or loss and other comprehensive income on page 44,
paragraph 4.15.1 of the study guide.

3.7 Statement of changes in equity

The purpose of the statement of changes in equity (see example at Method B discussed under
paragraph 3.5) is to reconcile the equity at the beginning of the financial period with the equity
at the end of the financial period. The balance of the equity at the end of the financial period is
then shown in the statement of financial position.
See an example of the statement of changes in equity on page 45 paragraph 4.15.2 of the study
guide.

3.8 Accounting policies and explanatory notes

Additional information on items appearing in the financial statements is given in the notes to the
financial statements. See an example of notes to the financial statements on page 47, paragraph
4.15.4 of the study guide.

39
 FAC1502/103

3.9 Revision exercises and solutions

3.9.1 Revision exercise 1
(1) How is the financial performance (result) calculated in accounting terms? Which financial
report reflects the financial performance?
(2) Give three examples of income.

(3) Give three examples of expenditure.

(4) How is profit/loss determined for a financial period?
(5) Does a loss increase or decrease the equity of the owner?

Solution: Revision exercise 1

(1) Income minus expenditure. The statement of profit or loss and other comprehensive
income reflects the financial performance.
(2) Refer to paragraph 3.3.
(3) Refer to paragraph 3.4.
(4) Expenditure is subtracted from income. Refer to paragraph 3.2.
(5) A loss decreases equity.

3.9.2 Revision exercise 2

On 28 February 20.2 Alpha Services showed the following income and expenditure for the
financial year.
R

Services rendered 850 000

Salaries 520 000
Wages 50 000
Telephone expenses 4 000
Stationery 2 000
Interest income 1 000
Insurance 12 000

Calculate the net profit/loss of Alpha Services on 28 February 20.2.

Solution: Revision exercise 2

Income = Services rendered + Interest income
= R(850 000 + 1 000)
= R851 000
Expenditure = Salaries + Wages + Telephone expenses+ Stationery + Insurance
= R(520 000 + 50 000 + 4 000 + 2 000 + 12 000)
= R588 000
Profit = Income - Expenditure
= R851 000 - R588 000
= R263 000

40
 FAC1502/103

SELF-ASSESSMENT

Now that you have studied this study unit, can you:

● describe the concept income?

● describe the concept expenditure?
● calculate the profit (or loss)?
● calculate the effect of profit/loss on equity?

4 REFERENCES
Board of International Financial Reporting Standards. March 2018. Conceptual Framework for Financial
Reporting. IAS.
Koppeschaar et al. 2017. Introducution to IFRS. South Africa: LexisNexis (Pty) Ltd.
Koppeschaar et al. 2018. Descriptive Accounting IFRS focus, 21st edition. South Africa: LexisNexis (Pty)
Ltd.
Study guide ACB151Z. 2008. Accounting for Bankers 1 (adopted to the new Conceptual Framework).
Study guide ASK131U. 2008. Accounting skills (adopted to the new Conceptual Framework).
Study guide FAC1501. 2014. Introductory Financial Accounting (adopted to the new Conceptual
Framework).
Study guide PRAC01W. Certificate Course in Practical Bookkeeping (adopted to the new Conceptual
Framework).

©
UNISA 2019

STUDY UNITS 4 TO 17

Please ignore any references to the prescribed text book and only study the contents of the study guide,
Tutorial letter 102/3/2020 and this Tutorial letter 103/3/2020.

41