Introduction to Financial Accounting

Chapter 1
1.a – Financial Accounting
 Accounting is the process of
o identifying,
o measuring,
o recording, and
o communicating economic information to assist users to make informed economic decisions.
 Financial accounting measures an organisation's performance over time, its position (status) at a point in
time and does so in whatever currency is judged relevant to the organisation.

Financial performance is the generation of new resources from day-to-day operations over a period of time.

Financial position is the organisation's set of financial resources and obligations at a point in time.

Financial statements are the reports describing financial performance and financial position (e.g. the balance sheet and the
income statement).

Notes are part of the statements, adding explanations to the numbers.

1.b – Who Uses Financial Accounting Information?

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1.c –
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1.d –
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1.e –
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1.f – Demands on the quality of financial accounting information

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1.g – Financial statement assumptions

 Accrual basis - financial reports are prepared on the accrual basis of accounting; that is,
o the effects of transactions and other events are re-cognised as they occur, regardless of whether
cash is received or paid at that time.
o The use of accrual accounting provides a better basis for assessing an entity's past and future
performance than information only related to cash receipts and cash payments during a period.
 Going concern - financial statements are prepared on the premise that the organisation will continue
operations as a going concern in the foreseeable future.
o If this is not the case, it is necessary to report the liquidation values of an organisation's assets,
 (i.e. what the assets could be sold for.)
o Consider the following example.
 Assume last year your university completely remodelled your classrooms with new
carpet, tiered seating and new inbuilt projection equipment. Under historical cost. the
cost of all those renovations would be recorded as an asset and then depreciated over
the life of the asset.
 If the costs were $10 million and depreciation in year 1 was $1 million, the book value
(cost - accumulated depreciation) would be $9 million. This is the amount that would
appear on the balance sheet.
 However, if the government closed your university - that is, it is no longer a going
concern - the assets would need to be recorded at liquidation value. Basically, they
would be recorded at what they could be sold for. Note that there is not much of a
second-hand market for tiered seating to fit a certain size of room, or carpet that has
been cut to fit that room. Liquidation value in this case would likely be a lot less than
historical book value.
 Accounting entity - under this concept, the accounting entity is separate and distinguishable from its
owners.
o For example, the accounting entity of a sole trader is differentiated from the financial affairs of
the owner. Similarly, a company is a separate entity from its shareholders.
o If either the sole trader or a shareholder of a company goes out and buys a new set of golf clubs.
it may affect his or her personal finances but does not affect the accounting entity.
o Accounting entities do not necessarily correspond to legal entities.
o For example, as noted above, the personal financial affairs of the sole trader can be separated
from the finances of the business, although there is no legal distinction. This concept puts a
boundary on the transactions that are to be recorded for any particular accounting entity. It also
allows the owner to evaluate the performance of the business.
 Accounting period - the life of a business needs to be divided into discrete periods to evaluate
performance for that period.
o Dividing the life of an organisation into equal periods to determine profit or loss for that period is
known as the accounting period concept.
o The time periods are arbitrary, but most organisations report at least annually, with large
companies preparing half - yearly and quarterly financial statements for outside purposes (in
some countries) and at least monthly (sometimes more frequently) financial statements for
management purposes.
 Monetary - accounting transactions need to be measured in a common denominator, which in Australia
is, not surprisingly, the Australian dollar.
o This allows comparisons across periods and across different companies.
o Transactions that cannot be reasonably assigned a dollar value are not included in the accounts.
This concept also assumes that the value of the monetary unit is constant over time, which
ignores inflation.
 Historical cost - under the historical cost concept, assets are initially re-corded at cost.
o many assets, such as inventory, will still be recorded at cost in the balance sheet in subsequent
periods although their value has increased. Some other assets - such as property, plant and
equipment - can be revalued periodically. Thus, in reading a balance sheet it is important to note
at what valuation the assets are being recorded.
1.h – Is accounting really important?

Chapter 2

Chapter 3
3.1 – Transaction Analysis
 Recall the accounting equation is:
o Assets=Liabilities+ Shareholde r ' s Equtiy
o After each transaction, the total assets must always equal the total liabilities and
shareholders' equity. This equality remains regardless of the type of transaction.

Transactions for LRM Ltd for March 2019

1. Shareholders invested $200 000 cash in the business. The effect of this transaction is to
increase cash (an asset) and increase share capital (a shareholders' equity account).
2. Land and buildings were purchased for $300 000, which is financed by a loan from the
seller repayable in five years. For this transaction, land and buildings (an asset) is increased.
This is financed through a loan, so loan (a liability account) is also increased. Note that this
transaction does not affect shareholders' equity. The shareholders do not have any more or
less equity in the company, as assets and liabilities increased by the same amount. Note that
after these first two transactions the accounting equation is still in balance, as will be the
case after every transaction.
3. Inventory worth $50 000 was bought on credit. Inventory is purchased for $50 000, with an
agreement to pay the suppliers at a later date (often 30 days after the date of sale). Again,
both an asset and a liability are increased. In this case inventory (asset) and accounts payable
(liability).
4. Equipment worth $90 000 was purchased by paying $20 000 cash and signing an
agreement to pay the remainder in 90 days. This involves the purchase of equipment
(increase in an asset), which is financed by both paying out cash (an asset) and incurring a
liability, which in this case is notes payable. Notes payable differs from accounts payable
because the liability is evidenced by a promissory note or b ill of exchange. Notes payable
increased by $70 000. Therefore there will be an overall increase in assets of $70 000
(equipment increase of $90 000 and a cash decrease of $20 000) with liabilities increasing
too by $70 000.
5. Damaged inventory that was purchased on credit at a cost of $5000 was returned to the
supplier. This reverses part of transaction 3. The damaged inventory is returned to the
supplier, thus decreasing inventory (an asset). As less money is now owed to the suppliers,
accounts payable (a liability) is also reduced.
6. Paid $30 000 on accounts payable. This results in the liability (accounts payable) being
reduced by a payment that reduces an asset (cash).
 7. Purchased $10 000 inventory using cash. All of the above six transactions have affected
both sides of the equation. However, this transaction affects only the asset side. It results in
one asset (inventory) increasing and another asset (cash) decreasing and therefore no overall
change to assets. Again, after all transactions have been recorded, the accounting equation

balances.

3.2 – Transaction Analysis Extended

Let us expand upon the accounting equation:

Assets=Liabilities+ Shareholde r ' s Equity

By breaking down the components of Shareholder’s Equity we get:
Assets=Liabilities+ Share Capital+ Retained Profits
Once again, breaking down the definition of RP
Assets=Liabilities+ Share Capital+Opening RP+ Net Profit−Dividends
And again, breaking down the meaning of Net Profit
Assests=Liabilities+ SC+ Opening RP + Revenue−Expenses−Dividends

Consider the following Example:

Example 3.2
Cash sales of $30 000 were made. The cost of the goods that were sold amounted to $12 000. This transaction has
two effects: one to re-cognise revenue and increase assets; the other to recognise an expense and decrease assets. A
cash sale of $30 000 was made. This increases a revenue account (sales revenue) and increases an asset (cash). We
are also told that cost of goods sold, often abbreviated as COGS, amounted to $12 000. Cost of goods sold is what
the company pays to acquire the goods that customers buy. It is not the same as sales revenue, but is rather an
expense the company incurs to earn sales revenue. In this case the expense (COGS) increases by $12 000 and
inventory (an asset) decreases by $12 000; that is, the goods when purchased were added to inventory, and now
that they are sold, inventory is decreased.

3.3 – Recording transactions: double-entry bookkeeping



Chapter 4 – Record Keeping

4.1 – The importance of good records
 Complete and accurate records are important: they provide the observations and the history of the
organisation. Without knowing what has happened, investors and managers cannot make plans, evaluate
alternatives properly or learn from past actions.
  In today's complex business environment especially since organisations have be-come very large - the
number of events (or transactions, as we will call them) is much too great for anyone to keep track of
without keeping accurate re-cords (written or, these days, mostly on computer).
 Re-cords provide the basis for extrapolations into the future, the information for evaluating and rewarding
performance, and a basis for internal control over the existence and quality of an organisation's assets.
Record keeping, however, does cost money; therefore, records should be worth their cost.
 How complex and sophisticated to make one's re-cords is a business decision, much like decisions such
as how to price or market one's product.

4.2 – Financial accounting's transactional filter

4.3 – Accounting’s 'books' and records

The Accounting Cycle
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Step 1: Source documents
Accounting record-keeping depends upon sets of documents to show that transactions have occurred.
Such documents are kept so that the accounting records can be checked and verified to correct errors.
They also permit auditing and can be used if there is a dispute or to support income tax claims and other
legal actions. The transactions themselves reflect various events in operating a business.

Step 2: Prepare journal entries

Based on source documents, accounting transactions are recorded by preparing journal entries. Because
this is when the business event is first recorded by the accounting system, these basic transactional records
are often called books of original entry.
Consider the following transactions:

 A consulting company provides services to a client on 1 February and sends it an invoice (source
document) for $10 000.
 The company buys a motor vehicle for $30 000 on 3 February, paying $12 000 cash and owing $18
000 to be paid in two years.
These would be recorded as follows:

Step 3: Post to ledgers

Consider a situation where, during the month, thousands of journal entries were written, of which 20 per
cent included either a debit or credit to the cash account. If you were asked the balance of the cash
account at the end of the month, how would you find out?
One option is to get the opening balance, add on all debit entries affecting cash and deduct all credit
entries affecting cash.
But doing this is time-consuming, and it would be preferable to have a source that will give you the
balance of the account at any point in time. Such a source is a ledger.
Ledgers are books (or computer records) that have a separate page or account code for each individual
account referred to in the chart of accounts.
Each area or page contains a summary of all the transactions relating to that particular account and,
therefore, posted to it.
Here is an example of the 'cash at bank' ledger account for a company:

Each ledger account is really just a convenient summary of the entries affecting it. In turn, the balance
sheet is a summary of all the account balances.
The general ledger is the complete set of all the accounts (assets, liabilities, equity accounts, revenues and
expenses) that lie behind the financial statements.
For demonstration and analysis purposes, accountants and accounting instructors often use a simplified
version of a ledger account called a T-account, which includes only the debits and credits columns of the
account, without calculating the balance after every entry. A T-account version of the above cash account

example would look like this:

AN EXAMPLE ON LEDGERS
Let's start with a very simple example where the company has only two opening balances:

Step 4: Prepare a trial balance

A trial balance is a list of all the accounts and the balances of each of the accounts.
The aim is that the sum of the debit balances equals the sum of the credit balances.
Because the general ledger contains all the accounts, all of which came from balanced journal entries, it
must balance (sum of debit-balance accounts equalling sum of credit-balance accounts) and it leads to a
balanced balance sheet.
Because errors might have been made, a standard bookkeeping procedure is to check that the ledger does
balance by adding up al l the debit and all the credit account balances and making sure the two totals are
equal. There is always a little uncertainty that this will work, so the calculation is called a trial balance.
An example of a trial balance is shown in Exhibit 4.1.

Step 5: Prepare adjusting journal entries and post to ledgers

At the end of each accounting period, it is necessary to adjust the revenue and expense accounts (and the
related asset and liability accounts) to reflect expenses incurred but not yet paid, revenues earned but not
yet received, cash received from customers before the work being done, and the using up of assets, which
creates an expense (such as depreciation). It is al l about splitting an expense or revenue item across two
different accounting periods. For example, an insurance payment could be made in March 2019 covering
1 April 2019 to 30 March 2020. At 30 June 2019, accounts have to be adjusted to reflect that 25 per cent
of the payment is a 2019 expense and 75 per cent is a 2020 expense. Assuming that the payment for
insurance (say, $200 000) was put to an asset account in March (i.e. DR prepayments $200 000, CR cash
$200 000), at 30 June it is necessary to reduce the asset (prepayments) to reflect that part of the asset is
used up. Therefore:
Step 6: Prepare an adjusted trial balance
After all the adjusting entries have been made and posted to the ledger accounts, then another trial balance
called an adjusted trial balance can be prepared. Follow the same process as described previously in step
4.

Step 7: Prepare closing journal entries and post to ledgers

Closing entries formally transfer the balances of the revenue and expense accounts to a profit and loss (P
& L) summary, then to retained profits.
This step will occur at the end of the accounting period. Closing entries reset the revenue and expense
account balances to zero to begin recording these items for the next accounting period. Closing entries are
simple to prepare. The steps are outlined below:

 Revenue accounts have credit balances and are closed (reduced to zero) with debits to the revenue
accounts and a credit to the P & L summary account.
 Expense accounts have debit balances and are closed (reduced to zero), with credits to the expense
accounts and debits to the P & L summary account.
 The P & L summary account, which is simply a holding account, is then closed off to retained profits.
o If the P & L summary has a credit balance after closing off the revenues and expenses (i.e. a
profit has been made), the entry is debit P & L summary and credit retained profits.
o If the account has a debit balance (i.e. a loss has been made), the entry is a credit to P & L
summary and a debit to retained profits.
Step 8: Prepare a post-closing trial balance
A post-closing trial balance can now be prepared as follows:

Note that there are no revenue and expense accounts in the above post-closing trial balance as these
accounts have been closed off in the previous step. If there is a revenue or expense account listed, a
closing entry may have been missed; this should be resolved before preparing the financial statements.
 Step 9: Prepare the financial statements
The items in the P & L summary account can be used as a basis for preparing the income statement, and
the items in the post-closing trial balance can be used to prepare the balance sheet. These statements are
shown in Exhibit 4.2.

4.4 – An illustrative example

Chapter 5 – Accrual Accounting Adjustments

5.1 – Conceptual foundation of accrual accounting
Accrual accounting is based on the idea that events, estimates and judgements that are important to the
measurement of financial performance and position should be recognised by entries in the accounts (and therefore
reflected in the financial statements). This is regardless of whether or not they are yet to be, or already have been,
realised by cash received or paid out.
Revenues are inflows of economic resources from customers, earned through providing goods or services. You
might say that companies are in business to earn revenues. • Expenses are outflows of economic resources to
employees, suppliers, taxation authorities and others, resulting from business activities, to generate revenue and
serve customers. You m ight say that incurring expenses is the cost of earning revenues. • Net profit is the d
ifference between revenues and expenses over a period of time, such as a month, a quarter or a year. You might say
that net profit is the measure of success in generating more revenues than it costs to do so. Note some features of
these cornerstones: • Revenues and expenses refer to inflows and outflows of economic resources. These flows
may be represented by the kinds of events recognised by the transactional record-keeping system described in
Chapter 4, but they may also involve other phenomena such as those d iscussed in section 5.2. In particular, they
may involve phenomena that arise before or after cash changes hands, as wel l as at the point of the cash flow. •
Net profit is dependent on how revenues and expenses are measured. Accountants don't (or shouldn't) choose the
profit number first, then force revenues and expenses to result in that number, but instead measure revenues and
expenses as best they can, then let net profit be whatever the difference is between properly measured revenues and
expenses.