Accounting Fundamentals In Society ACCY111

Lecture 2
Dr Sanja Pupovac
Chapter 2 and Chapter 10

1. Financial statements for decision making

2. The accounting equation

3. Underlying assumptions of financial statements

4. Conceptual framework and qualitative characteristics of financial

statements
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In week 1:
• Accounting is an information system

– Designed to communicate financial information

– To interested users
– For making economic decisions

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BASIC FINANCIAL STATEMENTS
• Financial statements are the outcome of the accounting process :

1. Identification – transactions
2. Measurement – quantification in monetary terms
3. Recording – classification/summarisation (posting to journals/ledgers)
4. Communication – accounting reports and analysis and interpretation

• Are the primary information source for users

• Are useful for many decisions

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 TYPES OF BUSINESS ENTITIES
2. Partnership:
• Owned by two or more partners
• Simple to set up
• Separate accounting entity, not separate legal entity

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 TYPES OF BUSINESS ENTITIES
1. Single proprietorship or sole trader:
– Owned by one person, e.g Hawaii Surfboards
– Simple to set up
– Common form of business structure
– Separate accounting entity, not separate legal entity

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 TYPES OF BUSINESS ENTITIES
3. Company or corporation:
– Owned by shareholders
– Separate accounting entity
– Separate legal entity
– Limited liability (Protection for owners)

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Definition of elements in financial statements

• The Conceptual Framework provides definitions of important elements underlying

general purpose financial reports, namely:
– assets
– liabilities
– equity
– income
– expenses

See Chapter 10.

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 BALANCE SHEET

• Also known as the Statement of Financial Position:

– Reports financial position of an entity at a specific point in time.
– Shows assets, liabilities and equity of the entity.
– Represents the accounting equation:
Assets = Liabilities + Equity
•Alternative formats:
– account format
– narrative format.

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 THE ACCOUNTING EQUATION
(re-arranged)

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 BALANCE SHEET
Definitions of elements

• Assets in the current Conceptual Framework:

– An asset is defined in the current Conceptual Framework as ‘a resource

controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity’.

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 BALANCE SHEET
Definitions of elements

Current assets (short term assets)

•Assets expected to be converted to cash or used in the business within the year

•Listed in order of liquidity

•Examples:
–Cash
–Accounts Receivable
–Inventory
–Prepaid expenses
–Supplies
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 BALANCE SHEET
Non – current assets

– Long term assets

– Assets expected to be realised for longer than one year
– Property, plant, and equipment
– Motor Vehicle
– Land
– Buildings
– Machinery and equipment
– Furniture and fixtures

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 BALANCE SHEET
Definitions of elements

• Liabilities in the current Conceptual Framework:

– A present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources
embodying economic benefits.

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 BALANCE SHEET
Definitions of elements

Current liabilities (short term liabilities)

– Debts expected to be paid in one year
– Accounts payable
– Wages payable
– Short term loans payable
– Interest payable
– Taxes payable

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 BALANCE SHEET
Definitions of elements

Non – current liabilities (long term liabilities)

– Debts expected to be paid after one year
• Mortgage payable
• Long-term loans
• Long-term notes payable
• Deferred income taxes

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 BALANCE SHEET
Definitions of elements

• Equity in the current Conceptual Framework:

– The Conceptual Framework defines equity as ‘the residual interest in the
assets of the entity after deducting all its liabilities’.

• Also called Capital or Accumulated Surplus/Funds

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Recognition of elements
• Recognition means the process of incorporating in the statement of financial
position/balance sheet or income statement an item that meets the definition
of an element.

• It involves the inclusion of dollar amounts in the entity’s accounting system.

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Let’s Practice!

• See week 2 lecture problem

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 INCOME STATEMENT
• Also known as Profit or Loss Statement

• Reports financial performance over a specific time period (e.g.

month, year, etc.)

• Shows income and expenses:

• Income > Expenses = Profit
• Income < Expenses = Loss

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Definition of elements
• Income in the current Conceptual Framework:
– The Conceptual Framework defines income as:
• Increases in economic benefits during the accounting period in the
form of inflows or enhancements of assets or decreases of liabilities
that result in increases in equity, other than those relating to
contributions from equity participants.

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Definition of elements
• Expenses in the current Conceptual Framework:
– The definition of expenses in the Conceptual Framework is as follows:
• Decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in
decreases in equity, other than those relating to distributions to equity
participants.

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 STATEMENT OF CHANGES IN EQUITY
• Used to see the changes in capital for the year
• Explains the changes in equity during the period

Opening capital + profit (or subtract loss) – drawings

=
Closing Capital

• Linking statement between the Income Statement and the Balance Sheet

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Financial statements relationship:

• Financial statements relationship:

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Let’s Practice!

• See week 2 lecture problem

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EFFECTS OF TRANSACTIONS ON THE ACCOUNTING
EQUATION and FINANCIAL STATEMENTS

Assets = Liabilities + Equity

• The accounting equation always balances

• Transactions result in changes in assets, liabilities and owners equity
• Elements of the accounting equation change with each transaction, but equality
of accounting equation remains unchanged

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 EXAMPLE:
Hawaii Surfboards

1. Joe Surfer deposits $53 000 in a business bank account:

Assets = Liabilities + Equity

Cash at J. Surfer, Capital

Bank
(1) $53 000 = $53 000

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 EXAMPLE:
Hawaii Surfboards

2. Joe Surfer purchased in cash surfboards for $32000 and paddle boards for $6000:

Assets = Liabilities + Equity

Cash at Bank Paddle Boards Surfboards J. Surfer,
Capital
(1) $53 000 = $53 000
(2) -38 000 + 6 000 + 32 000
15 000 + 6 000 + 32 000 = $53 000

$53 000 = $53 000

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 EXAMPLE:
Hawaii Surfboards
3. Joe Surfer purchased surfing supplies for $2500 on credit:

Assets = Liabilities + Equity

Cash at Bank Paddle Boards Surfboards Surfing Accounts J. Surfer, Capital

Supplies Payable

(1) $53 000 = $53 000

(2) -38 000 + 6 000 + 32 000

15 000 + 6 000 + 32 000 = $53 000

(3) + 2 500 = + 2 500

15 000 + 6 000 + 32 000 + 2 500 = + 2 500 $53 000

$55 500 = $55 500

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 KEY POINTS FROM EXAMPLE
• Every transaction affects at least two components of the equation
• This gives rise to the term:

Double-Entry Accounting

• After each transaction is recorded the accounting equation must remain

balanced

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 UNDERLYING ASSUMPTIONS OF FINANCIAL STATEMENTS

• Accounting Entity Assumption

– Identify clearly the boundaries of the entity being accounted for
– Personal transactions of the owner must remain separate from the transactions of the
entity
• Accrual Basis Assumption
– Accounting is an “event” driven process
– The effects of transactions are recognised when they occur, not when the cash is
received/paid
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 UNDERLYING ASSUMPTIONS OF FINANCIAL STATEMENTS

• Going Concern Assumption

– Unless we have evidence to the contrary, we assume an entity will continue
to operate in the future

• Period Assumption
– The life of the entity can be “broken up” into equal time intervals
– Profit is determined for particular periods of time in order to be comparable

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Qualitative characteristics of financial information

• The IASB’s Conceptual Framework asserts that there are six main qualitative
characteristics that financial information should have in order to be the subject
matter of general purpose financial reports.
– relevance
– faithful representation
– comparability
– verifiability
– timeliness and understandability.
See Chapter 10.

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Qualitative characteristics of financial information

• Fundamental characteristics:
– Relevance:
• Financial information must have a quality that makes a difference in a
decision of an economic nature made by users.
– Faithful representation:
• For a complete faithful representation, information must be complete,
neutral and free from material error.

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Qualitative characteristics of financial information

• Enhancing qualitative characteristics:

– Comparability:
• Comparability is the qualitative characteristic that enables users to identify and
understand similarities in, and differences among, items.

– Verifiability:
• It means that different knowledgeable and independent observers could reach
consensus, although not necessarily complete agreement, that a particular piece
of information is a faithful representation of the economic phenomena.

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Qualitative characteristics of financial information

• Enhancing qualitative characteristics:

– Timeliness:
• Timeliness simply means having information available to decision makers
in time to be capable of influencing their decisions.
– Understandability:
• Expect a reasonable knowledge of business and economic activity and
financial accounting

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Next Week…..

Chapter 3: Recording Transactions.

 “I learned that courage was not the absence of fear, but the triumph over it. The brave
man is not he who does not feel afraid, but he who conquers that fear.” Nelson Mandela

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Closer Title