Accounting in

Organisations and Society

Module 3 – Financial accounting
Topic 1: An introduction to financial accounting

Topic Notes

Topic 1: An introduction to financial accounting

By Craig Deegan

RMIT University
Financial accounting
Topic 1: An introduction to financial accounting
 Accounting in Organisations and Society

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March 2017

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Table of Contents
Learning Objectives ................................................................................................................ 1
What is financial accounting? ................................................................................................. 2
The why/who/what/how?......................................................................................................... 2
What is the objective of financial accounting? ........................................................................ 3
Some basic principles of, and key terms used in, financial accounting .................................. 4
Sources of regulation for financial accounting ........................................................................ 5
The conceptual framework for financial reporting ................................................................... 6
The elements of financial accounting...................................................................................... 7
The AASB Conceptual Framework’s definitions ..................................................................... 7
Assets ................................................................................................................................. 7
Ways to clarify assets ......................................................................................................... 8
Liabilities ............................................................................................................................. 9
Ways to clarify liabilities .................................................................................................... 10
Owners equity ................................................................................................................... 11
Income .............................................................................................................................. 12
Expense ............................................................................................................................ 12
The accounting equation....................................................................................................... 14
Application of the accounting equation ................................................................................. 15
Use of the accounting equation reflect the transactions ....................................................... 17
Expanding the accounting equation to include accounting for changes in equity ................. 19
Application of the expanded accounting equation ................................................................ 21
Resulting financial statements ................................................................................................ 1
Example .................................................................................................................................. 4
References.............................................................................................................................. 9

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Learning Objectives
By the end of this topic you will be able to:
• Explain what is financial accounting and its objective;
• Recognise the sources of regulation for financial accounting;
• Recognise the underlying assumptions of accounting information;
• Recognise the existence of the Conceptual Framework for accounting;
• Identify the elements of financial statements;
• Explain the role of the accounting equation in double entry book-keeping;
• Understand the impact of business transactions on the accounting equation;
• Summarise transaction analysis in a worksheet;

Suggested Reading
Business transactions, 2014 in Birt, J., Chalmers, K., Maloney, S., Brooks,
A., Oliver, J., Accounting: Business Reporting for Decision Making, 5th ed.,
John Wiley & Son, Australia, p116-150.
Australian Accounting Standards Board, 2016, Framework for preparation
and presentation of financial statements, viewed on 22 March 2017
<http://www.aasb.gov.au/admin/file/content105/c9/Framework_07-
04_COMPjun14_07-14.pdf >

Australian Accounting Standards Board, 2015, Presentation of Financial

Statements, AASB 101, p1-14, viewed on 22 March 2017
<http://www.aasb.gov.au/admin/file/content105/c9/AASB101_07-15.pdf>

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What is financial accounting?

• The practice of financial accounting relates to the preparation and presentation of
financial information for a variety of users so as to enable them to make decisions about
where they shall allocate their resources.
• Financial accounting information is used by people who are external to an organisation
(as well as by people who are internal).
• For external reporting purposes, it generates information that is historical in nature. That
is, it provides the results for a past time period – for example, the profits or losses for the
preceding year (the income statement); the cash flows for the preceding year (the
statement of cash flows); and the assets, liabilities and owners equity as at a recently
past date (the balance sheet).
• Being historical in nature means that the reports will provide an indication of
how management has used the funds (stewardship function). Past results
might also provide an indication of future performance.
• Financial accounting is heavily regulated with respect to the procedures to be used to
generate general purpose financial statements.
• Contrast this to budgeting or CVP calculations, which are used for
management of resources.
• By regulating financial reporting, this helps ensure that current financial
reports are comparable with the organisation’s previous financial statements
as well as with those of other organisations.
• The financial statements generated by financial accounting include the balance sheet
(also known as a statement of financial position), income statement, the statement of
cash flows, and the statement of changes in equity. Financial statements are also
accompanied by many pages of supporting notes (for large companies these can take up
well over 100 pages).

The why/who/what/how?
Returning to our general ‘accountability model’:
• Why produce financial accounting information?
The most obvious answer here is that an extensive amount of regulation requires it
(general purpose financial statements). Nevertheless even without regulation, investors
and other stakeholders with a financial interest in the organisation would demand it.
Investors (owners) would demand it to allow them to assess how well their funds are
being used in terms of their investment aims (which might be high capital growth and
receipt of dividends). It is also important for managers. Hence, in the absence of
regulation we would still expect it. The financial statements represent a communication
tool that aims to assist users with their decision making.
• Who are the stakeholders to whom the disclosures will be directed?
The primary audience of financial accounting information would be investors, creditors,
and managers. Many other stakeholders would also have an interest in the financial
position and performance and cash flows of an organisation (for example, employees so

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as to consider whether an organisation can pay higher wages, or customers - is the

organisation earning large profits which might justify calls for price decreases).
• What types of disclosures?
The types of disclosures required are heavily regulated. For example, by accounting
standards, stock exchange requirements, and corporations law requirements.
• How will the disclosure be made
The format of the disclosures and the medium for disclosure will tend to be regulated (for
general purpose financial statements).

What is the objective of financial accounting?

Financial accounting often leads to the generation of what are known as either special
purpose financial statements or general-purpose financial statements
• Special purpose financial statements (SPFSs) are financial statements designed to
meet the needs of a specific group, or to satisfy a specific purpose. For example, a bank
might demand a particular financial statement from a lender. SPFSs do not need to
comply with accounting standards.
• General purpose financial statements (GPFRs) are financial statements (which would
include, for example, a balance sheet, income statement, statement of cash flows, and
statement of changes in equity) that comply with accounting standards which are
intended to meet the information needs common to users of financial information, who
are unable to command the preparation of statements tailored to suit their own specific
information needs. For example, the financial statements prepared by large companies
listed on securities exchanges would be GPFSs. GPFSs comply with accounting
standards.
According to a document referred to as the Conceptual Framework for Financial Reporting
• The objective of general purpose financial reporting is to provide financial information
about the reporting entity that is useful to existing and potential investors, lenders and
other creditors in making decisions about providing resources to the entity.
• To satisfy this objective the Conceptual Framework identifies a number of qualitative
characteristics that financial information should possess. These include:
• Relevance
(Capable of influencing the decisions of users. Would include considerations of
‘materiality’)

• Faithful representation
(Ideally information should be complete, neutral and free from error).
• To be useful information, it needs to be both relevant and faithfully represented.
There can be some trade-offs.

• Comparability
• Entity uses same accounting principles each year
• Different entities use the same accounting principles

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• Some variation in methods is allowed under the standards, but the method used
must be disclosed

• Verifiability
Information provided can be sourced back to a transaction or event.

• Timeliness
If collection of information spans too long a period, it is no longer relevant.

• Understandability
Issues of ‘understandability’ need judgements to be made of the capabilities of
financial statement users.

Some basic principles of, and key terms used

in, financial accounting
• Entity concept
• The accountant is only to recognise transactions and events, which affect the
financial performance or position of the organisation. The organisation is separate
from the owners and other entities.

• Accounting period
• Whilst the life of an organisation might be considered to be indefinite, the accountant
nevertheless determines the financial performance of the entity for smaller periods –
for example, for 6 or 12 months. This can create a variety of potentially dysfunctional
effects as will be discussed elsewhere in this course.

• Monetary unit assumption

• The practice of financial accounting typically only recognises transactions or events if
a related monetary value can be assigned to them. This also creates some
dysfunctional effects that we will consider elsewhere in this course.

• Going concern
• Unless there is evidence to the contrary, the financial accountant assumes that the
organisation (the accounting entity) will continue operating into the foreseeable future.
This has various implications for how various assets, liabilities, income and expenses
are measured.
• If it is considered that the going concern assumption is not appropriate (for example,
it is not able to pay its debts as and when they fall due), then financial statements
have to be prepared on another basis – for example, on the basis of liquidation
values.

• Accrual basis of accounting

• Financial accounting is general done on an ‘accruals basis’. This means, for example,
that income is recognised when it is earned (which is not necessarily when the
related cash is actually received), and expenses are recognised as the expense is

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incurred (which is not necessarily the same time as when the related cash payment
is made). Accrual accounting can be contrasted with accounting, which is undertaken
on a ‘cash basis’.

• Conservatism
• This generally accepted concept assumes that financial accountants shall not
overstate the value of assets and shall not understate the value of liabilities.

Reflection
Do you think short-term creditors, long-term creditors and shareholders
mainly interested in the same characteristics of an entity? Why?

Sources of regulation for financial accounting

• Because governments have traditionally embraced a view that organisations must
demonstrate a high level of accountability in relation to their financial performance and
financial position – particularly large corporations – then minimum levels of disclosures
have been legislated.
• That is, particularly for large companies, they can’t simply disclose what they would
prefer to disclose
• Contrast this with disclosures about social and environmental performance which are
relatively unregulated
• For smaller organisations which typically have less separation between ownership
and management there tends to be less regulation (perception that the risks for
owners is lower)
• In Australia, the major source of company regulation is the Corporations Act, which is
enforced through the Australian Securities and Investments Commission.
• The Corporations Act has many requirements in relation to corporate reporting including
the need for company directors to ensure that the company complies with the relevant
accounting standards.
• Within Australia, accounting standards are released by the Australian Accounting
Standards Board.
• Whilst we will not be studying the accounting standards in this course you should go
to the website of the AASB to see the vast number of accounting standards on issue.
Many of the accounting standards released by the AASB were initially developed by
the International Accounting Standards Board, which is located in London.
Globally, many countries now use the accounting standards – known as
International Financial Reporting Standards (IFRS) – issued by the IASB
• The Australian Securities Exchange (ASX) also has various disclosure requirements
for companies listed on the ASX.

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• The Australian Taxation Office also has various reporting requirements for companies
(and other organisations and individuals).

The conceptual framework for financial

reporting
• We have already briefly referred to the Conceptual Framework. It sets out the concepts
that underlie the preparation and presentation of financial statements.
• We will not be covering this in great depth in this course as it will be covered in other
accounting courses that follow.
• The Conceptual Framework in use within Australia was developed by the IASB and it
provides us with the underlying framework for general purpose financial reporting.
• It is a ‘frame of reference’ when the IASB (and AASB) develops accounting standards
and other reporting guidance.
• It is also a useful reference for account preparers and auditors when there is no
accounting standard that addresses a particular issue
• Also useful to financial statement users when trying to understand and interpret
the financial reports they are reviewing
• Whilst there are many accounting standards, there is not an accounting standard
for every type of transaction and event
• A central goal in establishing a conceptual framework is to establish consensus on
issues such as:
• The scope and objective of financial reporting
• The qualitative characteristics that financial information should possess
• What the elements of financial reporting are, including consensus on the
characteristics and recognition criteria for assets, liabilities, income, expenses, and
equity

Reflection
What is a conceptual framework? And what purpose does it serve?

YouTube Video
Introduction to conceptual framework:
https://www.youtube.com/channel/UCnso1qlYVv4yb_dwwgyCEOA

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The elements of financial accounting

According to the Conceptual Framework, there are five ‘elements’ of financial reporting,
these being
• Assets
• Liabilities
• Equity
• Income
• Expenses

Discussion
Before we examine the accountants’ definitions let us consider how we
might define assets, liabilities, owners’ equity, income and expenses.
Do we think that a resource used by, and necessary to, an organisation
would be the same as an ‘asset’ as defined by the accountant?
– For example, clean water that might be freely available from a
nearby river might be necessary to our production process.
• Would the water be a resource of the organisation?
• Would it be an ‘asset’?
• Shouldn’t they be the same? If not, why not?

The AASB Conceptual Framework’s definitions

Assets
• According to the Conceptual Framework for the Preparation and presentation of
financial statements paragraph 49 (a) (AASB 2016, p.11), an asset is defined as follows:
• An asset is 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.

• There are three separate components to this definitions

1. resource controlled by the entity
2. result of past events
3. future economic benefits are expected to flow
• Let us consider each component separately, note that an asset does not necessarily
have to be ‘owned’ – it needs to be ‘controlled’ (meaning that leased assets are often
shown as ‘assets’). Further, the definition does not require the asset to be a ‘physical
asset’.

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Reflection
Whether and why the following items are (or are not) assets:
• Cash
• Building
• Machinery
• Inventory
• Debtors (accounts receivable)
• Shares held in another organisation
• Employees
• Underwater ground water supply which flows under the
organisation and from which water is drawn

Discussion
Consider the implications the asset definition has for the recognition of
various social and environmental ‘costs’ created by an organisation.
Answer the following questions:
1. The organisation uses a river to transport its goods to market –
would the river be an ‘asset’?
2. An organisation owns some housing near a mine, but the mine
has been abandoned and there is no demand for such buildings?
Are the houses an asset?
3. The managing director is very valuable to the organisation. Is she
an asset?

Ways to clarify assets

1. Current and non-current asset
• According to paragraph 66 of AASB 101 Presentation of Financial Statements (AASB
2015, p.16):
An entity shall classify an asset as current when:
a. it expects to realise the asset, or intends to sell or consume it, in its
normal operating cycle;
b. it holds the asset primarily for the purpose of trading;
c. it expects to realise the asset within twelve months after the
reporting period; or
d. The asset is cash or a cash equivalent (as defined in AASB 107)
unless the asset is restricted from being exchanged or used to settle
a liability for at least twelve months after the reporting period.
An entity shall classify all other assets as non-current.

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• According to paragraph 67 of AASB 101 Presentation of Financial Statements, ‘This

Standard uses the term ‘non-current’ to include tangible, intangible and financial assets
of a long-term nature. It does not prohibit the use of alternative descriptions as long as
the meaning is clear’ (AASB 2015, p.16).
2. Tangible and Intangible Assets
• Tangible Assets: Those assets that have a physical substance (e.g. plant and
machinery, motor vehicles).

• Intangible Assets: Assets which, while providing expected future benefits, have no
physical substance (e.g. copyrights, patents).
3. Property, plant and equipment: Property, plant and equipment are tangible items that:
(a) are held for use in the production of, or supply of, goods or services, for rental to
others, or for administrative purposes; and (b) are expected to be used during more than
one period (AASB 116).
4. Contra accounts: A contra asset account is an account with its balance is to be the
opposite of the normal balance found in an asset account. For example, an asset such
as a building will be shown as a non-current asset and a contra account for depreciation
will be subtracted from its value.

Discussion
Why do we use the different classifications of assets?
For example, even in the absence of regulation, why might we want to:
1. Difference between current and non-current assets?
2. Separate tangible assets from intangible assets?

Liabilities
• Within the Conceptual Framework for the Preparation and presentation of financial
statements paragraph 49(b) (AASB 2016, p.11), liabilities are defined as follows:
• A liability is 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.
• There are three separate components to this definition
1. Present obligation of the entity
2. Arising from past events,
3. An outflow from the entity of resources embodying economic benefits
• Let us consider each component separately. Note the emphasis on ‘present’ obligation
and the requirement that the outflows are ‘economic benefits’.

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Reflection
Whether and why the following items are (or are not) liabilities:
• Bank overdraft
• Loan from bank
• Rent payable
• Wages payable
• Creditors (accounts payable)
• Obligation to clean up contaminated land

Discussion
1. The organisation has guaranteed the debts of another
organisation. Would this create a liability?
2. The organisation has spilled tons of oil into the sea. Would this
create a liability?
3. The organisation has employed some people, but has not yet paid
them. Would this create a liability?

Ways to clarify liabilities

1. Current and non-current liabilities (The classification rules are similar to current
assets)
• According to paragraph 69 of AASB 101 Presentation of Financial statements
(AASB 2015, p.17) :
An entity shall classify a liability as current when:
a. It expects to settle the liability in its normal operating cycle;
b. It holds the liability in its normal operating cycle;
c. the liability is due to be settled within twelve months after the end
of the reporting period; or
d. it does not have an unconditional right to defer settlement of the
liability for at least twelve months after the reporting period.
An entity shall classify all other liabilities as non-current.
2. Provisions: An estimated liability for which there is greater uncertainty regarding the
amount or timing of the amount than for a normal liability.
3. Contingent liabilities: A potential liability that might arise in the event of a particular
event occurring. It will become a liability contingent on that event happening.
– Do contingent liabilities get disclosed within the balance sheet?

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Discussion
Why do we use the different classifications of liabilities?
For example, even in the absence of regulation, why might we want to:
1. Differentiate between current and non-current liabilities
2. Separately disclose ‘provisions’
3. Provide information about contingent liabilities in the notes to the
financial statements

Note:
The definitions of assets and liabilities are fundamental because the definitions of equity,
income and expenses flow directly from them.

Owners equity
• According to Conceptual Framework for Preparation and presentation of financial
statements paragraph 49(c) (AASB 2015, p.12) equity is defined as follows:
• Equity is the residual interest in the assets of the entity after deducting
all its liabilities.
• It can sometimes be described as net worth, that is, total value of asset less total value of
liabilities.
• We can see that the definition of equity therefore is directly dependent on the definition of
assets and liabilities.
• Types of equity accounts
• Contributions
• Retained earnings
• Reserves
• Distributions/Drawings

Reflection
If an organisation has assets measured at $10m and liabilities measured
at $3m then what is its ‘equity’?

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Income
• Within the Conceptual Framework for the Preparation and presentation of financial
statements paragraph 70(a) (AASB 2016,p.17) income is defined as follows:
Income is 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.
• There are therefore two essential characteristics of income, these being:
1. An increase in assets or a reduction in liabilities; and
2. An increase in equity, other than as a result of a contribution from owners

Reflection
Whether and why the following items would be considered to be income
(or not):
• Contribution of cash by the owner.
• Sale of inventory to a customer for $1,000 and the customer will
pay in two weeks.
• Sale of inventory to a customer for $1,000 cash.
• Loan of $10,000 from the bank
• Interest from bank on cash deposits

Expense
• Within the Conceptual Framework for for the Preparation and presentation of financial
statements paragraph 70(b) (AASB 2016, p.17), expenses are defined as follows ( it is
similar to the principles for income):
• Expenses are 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.
• There are therefore two essential characteristics of expenses, these being:
1. An decrease in assets or an increase in liabilities; and
2. An decrease in equity, other than as a result of a withdrawal from owners such as
dividends.

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Reflection
Whether and why the following items would be considered to be
expenses (or not):
• Distribution of cash to the owner.
• Purchase of inventory from a supplier.
• Repayment of a loan of $10,000 from the bank.
• Interest paid to the bank on a bank loan.
• Payment of wages.
• Theft of inventory.
• Spillage of tonnes of oil into the river that flows past the
organisation’s factory.
• Emissions of hundreds of tonnes of CO2 into the atmosphere from
the factory.

Discussion
Why the following items impact equity:
• Capital contributions.
• Capital withdrawals.
• Income.
• Expenses.

Summary of key definitions and places of disclosure

Element Definition Reported within:

Asset A resource controlled by the entity as a result of The balance sheet

past events and from which future economic (also known as the
benefits are expected to flow to the entity. statement of financial
position)

Liability A present obligation of the entity arising from The balance sheet
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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Element Definition Reported within:

Equity The residual interest in the assets of the entity The balance sheet
after deducting all its liabilities (will be increased
by contributions and income, and reduced by
drawings/dividends and expenses)

Income Increases in economic benefits during the The income statement

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.

Expense decreases in economic benefits during the The income statement

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

Once we have defined elements of accounting we then need to:

• Determine when to recognise them
• Determine how to measure them
• Determine how to present and disclose them

The accounting equation

• We can start by considering a simple representation of the accounting equation, this
being:
Asset (A) = Liability (L) + Owners’ Equity (OE)

• Let’s consider this equation. What it is telling us is that when an organisation has assets,
certain parties – either owners, or external creditors - will have a claim against those
assets
• The total of assets will balance the total of liabilities AND owners’ equity

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• This will be reflected within the balance sheet.

For example, let’s assume that an organisation commences operations by having the owner
contributing $500,000 in cash
A = L + OE
500,000 = 0 + 500,000
At this point, the owner has a claim on all the assets of the organisation (the accounting
entity).
The organisation then acquires a factory for $1m by way of a bank loan. The equation now
becomes:
A = L + OE
1,500,000 = 1,000,000 + 500,000

Application of the accounting equation

Illustration 1:
On January 2017, Mikey Gout resigned from his current job as a marketing manager of a
multinational company. And has commenced his own wholesale Clothes business (sole
trader). The following records are the activities he has recorded during January. But he
found these records didn’t tell him the business’s financial position and performance.
Knowing you are doing accounting, he approaches you for help.
First, please analyse each of the following transaction using the basic accounting equation
• On 1 January 2017 Mikey Gout commenced a business by contributing cash of $50,000
and a motor vehicle worth $30,000 [The business now has cash(asset) of $50,000, a
vehicle (asset) worth $30,000 and equity (residual interest of assets less liabilities) of
$80,000]
• On 4 January 2017 the business acquired a warehouse at a cost of $400,000 by way of
a bank loan [The business now has another asset (Warehouse) valued at 400,000 and a
new liability (Bank Loan) of $400,000. There is no change to equity]
• On 5 January 2017 Mikey noticed one of his Chinese suppliers has been put on the
“name and shame” list (it is a list of the biggest polluters in China) by the Ministry of
Environmental Protection of China. Local TV and newspapers have disseminated the list,
and most of the international TV and newspapers have broadcasted this news. [We are
currently looking at financial accounting which does not require disclosures of this nature.
Nevertheless the organisation is still accountable to its stakeholders for the actions of its
suppliers].
• On 8 January the business acquired some inventory (stock), on credit, for $50,000
payable in 20 days’ time [The business now has another asset (inventory) valued at
$50,000 and a new liability (accounts payable) of $50,000. There is no change to equity].

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• On 10 January Mikey promises the local community he is going to create at least 2

positions to local young graduates. [We are currently looking at financial accounting,
which does not require disclosures of this nature. Nevertheless the organisation is still
accountable to its stakeholders, the local community, for its actions in society].
• On 15 January the business sold half of the inventory to customers, on credit terms, for
$60,000. The amount is to be paid by the customers within 14 days. [There are four parts
to this transaction to consider: The business now has decreased its inventory (asset) by
$25,000 and acquired another asset (A/C Receivable) of $60,000 and made a profit of
$35,000 (increase in owners’ equity). We will deal with the treatment Income and
Expenses in the next section].
• On 18 January Mikey Gout signs a contract to recruit a very experienced supply-chain
manager who’s responsible for maintaining a healthy relationship with the suppliers. [We
are currently looking at financial accounting, which does not require disclosures of this
nature. Nevertheless the organisation is still accountable to its stakeholders, for its
actions].
• On 21 January the business paid wages of $1,000 [The business has reduced its cash
(asset) by $1,000 as well as reducing its profit (owners’ equity) by $1,000].
• On 28 January received amount due from debtors [The business has received cash of
60,000 which increases cash (asset) by $60,000 and as the A/C Receivables (debtors)
have paid their debt this asset is decreased by $60,000].
• On 29 January paid amount owing to creditors [The business has reduced its cash (asset)
by $50,000 and decreased its liability (A/C Payable) by $50,000].
• On 30 January, Mikey Gout withdrew $2000 for private purposes [The cash (asset) has
decreased by $2,000 as the owner, has received a distribution of $2,000 which reduces
the value of the owners equity in the business].

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Use of the accounting equation reflect the

transactions
Date Assets = Liabilities + Owners equity

1 January Increase cash by No effect Owner’s claim

50,000 and increase increase by
Moter Vehicle $80,000
increase by $30,000
New total $80,000
New total $80,000

4 January Increase Building by Bank’s claim No change

$400,000 increase by
$400,000 Total $80,000
New total $480,000
New total $400,000

5 January No change No change No change

8 January Increase Inventory Increase of No change

by $50,000 Accounts payable by
$50,000 Total $80,000
New total $530,000
New total $450,000

10 January No change No change No change

15 January Increase Accounts No change Increase Profit by

receivable by $35,000
$60,000 Total $450,000
Total $115,000
Decrease Inventory
by $25,000

New Total $565,000

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Financial accounting
Topic 1: An introduction to financial accounting
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 Accounting in Organisations and Society

18 January No change No change No change

21 January Decrease Cash by No change Decrease Profit by

$1,000 $1,000
Total $450,000
New total $564,000 New total $114,000

28 January Increase Cash by No change No change

$60,000
Total $450,000 Total $114,000
Decrease Accounts
receivable by
$60,000

Total of $564,000

29 January Decrease Cash by Decrease Accounts No change

$50,000 payable by $50,000
Total $114,000
New total of New total of
$514,000 $400,000

30 January Decrease Cash by No change Decrease Equity by

$2,000 $2,000
Total $400,000
New Total $512,000 New total $112,000

Therefore, from the preceding analysis we can see:

Assets = Liabilities + Owners’

equity

512,000 = 400,000 + 112,000

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Financial accounting
Topic 1: An introduction to financial accounting
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 Accounting in Organisations and Society

The double entry effect of transactions

What we can see from the preceding analysis is that if a particular asset is affected – say
increased - then there needs to be a corresponding decrease in another asset, or a
corresponding increase in either a liability or an equity account.
Otherwise the equation will not balance!

Reflection
If a particular liability increases, what other effects could there be?

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Financial accounting
Topic 1: An introduction to financial accounting
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 Accounting in Organisations and Society

Expanding the accounting equation to include

accounting for changes in equity
• Our original equation was:
A = L + OE
• Owners’ equity will be influence by profits – which is the difference between income and
expenses (I-E) – as well as by contributions from owners, and distributions made to
owners
• That is changes in owners’ equity equals:
(profits) + C-D (Contributions less Distributions)
Which is also the same as:
(I – E) + C – D
• Substituting this equation into the original accounting equation (above) gives us:
A = L + [(I – E) + C – D]
• Rearranging this equation (adding E and D to both sides) gives us our new equation:
A+E+D=L+I+C
• We can say that the left hand side is the application of funds, and the right hand side is
the source of the funds.
• Whilst not covered in this course, financial accountants depict any increase in the left
hand side above – that is, A, E and D – as debit entries, whereas any increase in the
right side - L + I + C - as credit entries. Conversely any decrease in the left side is a
credit, and any decrease in the right hand side is a debit.
• However, in this course we won’t introduce how to use debits and
credits. For students pursuing an accounting specialisation, you will be
able to learn this in your future courses.

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Financial accounting
Topic 1: An introduction to financial accounting
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 Accounting in Organisations and Society

Application of the expanded accounting

equation
Use the same transactions as before, we will show you how to use the expanded accounting
equation.

Use of the expanded accounting equation

Date A + E + D = L + I + C

1/1 80 80

4/1 400 400

5/1 No Change

8/1 50 50

10/1 No Change

15/1 60 25 60

(25)

18/1 No Change

21/1 (1) 1

28/1 60

(60)

29/1 (50) (50)

30/1 (2) 2

512 + 26 + 2 = 400 + 60 + 80

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Financial accounting
Topic 1: An introduction to financial accounting
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 Accounting in Organisations and Society

Need information about the individual ‘accounts’

• From the preceding slide we know what the aggregated totals for A, E, D, L, I and C, are,
but this would be of limited use.
• We need to set up separate accounts for each item of information we would like to
know about.
• For example, we might have a separate account for each of the assets cash
at bank, motor vehicle, warehouse, inventory, accounts receivable
• An organisation would typically have a ‘chart of accounts’ which identifies the various
accounts being used

Use the same transactions as before, we will show you how to analysis of changes in
individual accounts

Date Cash Inv. A/R MV Ware COG Wag Draw A/P Bank Sale Cont
hous S es ings loan s ributi
e on

1/1 50 30 80

4/1 400 400

5/1 No Change

8/1 50 50

10/1 No Change

15/1 (25) 60 25 60

18/1 No Change

21/1 (1) 1

28/1 60 (60)

29/1 (50) (50)

30/1 (2) 2

57 25 - 30 400 25 1 2 - 400 60 80

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Topic 1: An introduction to financial accounting
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 Accounting in Organisations and Society

Resulting financial statements

• Following the preceding transactions let’s now compile some financial statements.

Balance Sheet

A simple balance sheet as at January 31, 2017

Current assets
Cash at bank 57,000
Inventory 25,000
Non-current assets
Motor vehicle 30,000
Warehouse 400,000
Total assets 512,000
Non-current liabilities
Bank loan 400,000
Total Liabilities 400,000
Net assets 112,000
Owners’ equity
Retained earnings* 32,000
Contributions 80,000
112,000

• Profits that are left in the business and not distributed are called “Retained Earnings” In
this case it is the $34,000 profit less the $2,000 drawings”
Note: Owners equity = Assets – Liabilities

Reflection
Analysis of the balance sheet
1. What does the balance sheet tell us about the organisation?
2. Does it tell us about all the ‘assets’ or resources of the
organisation?

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Income Statement

A simple income statement for the month ending 31/1/17

Income
Sales revenue 60,000
Expenses
Cost of goods sold (25,000)
Wages (1,000)
Profit 34,000

Reflection
Analysis of the income statement
1. What does the income statement tell us about the organisation?
2. Does it tell us about all the ‘income’ and ‘expenses’ generated by
the organisation?

Cash Flow Statement

A simple statement of cash flows for the month ending 31/1/17

Cash flows from operations

From customers 60,000
Payment of suppliers (50,000)
Payments to employees (1,000) 9,000
Cash flows from financing operations
Capital contribution from owner 50,000
Drawing by owner (2,000) 48,000
Net increase in cash 57,000
Opening cash 0
Closing cash 57,000

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Topic 1: An introduction to financial accounting
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Reflection
Analysis of the statement of cash flow
1. What does the statement of cash flow tell us about the
organisation?
2. Why is the profit for the period ($34,000) different to the net cash
flow for the period ($57,000)?

Statement of Changes in Equity

A simple statement of changes in equity for the month ending 31/1/17

Capital Retained earnings Total equity

contribution

Balance at 1/1/17 0 0 0

Capital contributed 80,000 80,000

Drawings (2,000) (2,000)

Income for month 34,000 34,000

Balance 31/1/17 78,000 34,000 112,000

Reflection
Analysis of the statement of changes in equity
What does the statement of cash flow tell us about the organisation?
1. What does the statement of changes in equity tell us about the
organisation?
2. Because the total owners’ equity assets minus liabilities does this
mean that this is the amount the owner would get it the business
was sold?

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Financial accounting
Topic 1: An introduction to financial accounting
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 Accounting in Organisations and Society

Example
Illustration 2:
This example is an illustration of a series of transactions, details of increases and decreases
in individual accounts, and financial statements.
On October 1, 2017, your friend Tom commenced his own business -Tom Printing Services.
During the month, Tom recorded the following activities:
• October 1, to commence the business, he contribute $5,000 cash and 20 old printers
which are worth $4,000;
• October 2, he borrowed $40,000 from a bank, to be repaid in 4 years;
• October 6, he purchased stationeries, $2000 each on credit;
• October 15, he paid insurance of $3,000;
• October 18, he used his personal credit card to purchase a mobile phone worth $1000
for personal use;
• October 21, he received cash payment of $9,000 for his printing services;
• October 27, he paid $2,000, owing to creditors;
• October 28, he paid office rent of $2,000;
• October 30, he withdrew $1,000 from his business to purchase a computer for personal
use.
At the end of October, Tom started to worry about his business’ financial status. He found
his records did not tell him how his business was performing. Knowing that you are studying
accounting in RMIT, Tom came to you for help.

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Financial accounting
Topic 1: An introduction to financial accounting
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 Accounting in Organisations and Society

Use the basic accounting equation to record the business transactions

Date Assets = Liabilities + Owner’s equity

1 Oct Increase Cash by No change Owner's claim

$5,000 and increase by $9,000
Equipment by
New total $9,000
$4,000
New total $9,000

2 Oct Cash increase cash Bank’s claim No change

by $40,000 increase by $40,000
Total $9,000
New total $49,000 New total $40,000

6 Oct Office suppliers Suppliers’ claim No change

increase by $2,000 increase by $2,000
Total $9,000
New total $51,000 New total $42,000

15 Oct Cash decrease by No change Expense increase,

$3,000 which leads to
Total $42,000
equity decrease by
New Total $48,000
$3,000
Total $6,000

21 Oct Cash increase by No change Income increase,

$9,000 which leads to
Total $42,000
equity increase of
Total of $57,000
$9000
Total $15,000

27 Oct Cash decrease by Suppliers’ claim No change

$2,000 decrease by $2,000
Total $15,000
New Total $55,000 New Total $40,000

28 Oct Cash decrease by No change Expense increase,

$2,000 which leads to
Total of $40,000
equity decrease by
New total of $53,000
$2,000
Total $13,000

30 Oct Cash decrease by No change Owner’s claim

$1,000 decrease by $1,000
Total $40,000
New Total $52,000 New total $12,000

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Therefore, from the preceding analysis we can see:

Assets = Liabilities + Owners’

equity

52,000 = 40,000 + 12,000

Use the transactions as before, the below table shows you how to analysis of changes
in individual accounts

Date Cash Printer Office Insurance Rent Drawings A/P Bank Sales Contribution
supplies loan

1/10 5 4 9

2/10 40 40

6/10 2 2

15/10 (3) 3

21/10 9 9

27/10 (2) (2)

28/10 (2) 2

30/10 (1) 1

46 4 2 3 2 1 0 40 9 9

• Following the preceding transactions let’s now compile some financial statements

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Topic 1: An introduction to financial accounting
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 Accounting in Organisations and Society

Balance Sheet

A simple balance sheet as at 31 October, 2017

Current assets
Cash at bank 46,000
Office supplies 2,000
Non-current assets
Printers 4,000
Total assets 52,000
Non-current liabilities
Bank loan 40,000
Total Liabilities 40,000
Net assets 12,000
Owners’ equity
Retained earnings 4,000
Contributions 9,000
Drawings (1,000)
12,000

Note: Owners equity = Assets – Liabilities

Income Statement

A simple income statement for the month ending 31/10/17

Income
Sales revenue 9,000
Expenses
Insurance (3,000)
Rent (2,000)

Profit 4,000

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Cash Flow Statement

A simple statement of cash flows for the month ending 31/10/17

Cash flows from operations

From customers 9,000
Payment of suppliers (2,000)
Payments to others (5,000) 2,000
Cash flows from financing operations
Capital contribution from owner 5,000
Loan 40,000
Drawing by owner (1,000) 44,000
Net increase in cash 46,000
Opening cash 0
Closing cash 46,000

Statement of Changes in Equity

A simple statement of changes in equity for the month ending 31/10/17

Capital Retained earnings Total equity

contribution

Balance at 1/1/17 0 0 0

Capital contributed 9,000 9,000

Drawings (1,000) (1,000)

Profit 4,000 4,000

Balance 31/1/17 8,000 4,000 12,000

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Example
Example of a large listed company’s financial statements.

Westfarmers 2016 annual report

https://www.wesfarmers.com.au/docs/default-source/reports/2016-annual-
report.pdf?sfvrsn=4

Income statement p.86

Statement of comprehensive income p.87
Balance sheet p.88
Cash flow statement p.89
Statement of changes in equity p.90
Notes to the financial statements: 91-131

References

References
Accounting College, 2016, Introduction to conceptual framework, 14 Oct,
viewed on 18 March 2017
<https://www.youtube.com/channel/UCnso1qlYVv4yb_dwwgyCEOA>

Australian Accounting Standards Board, 2015, Conceptual Framework for

Financial Reporting, AASB Exposure draft, viewed on 22 March 2017
<http://www.aasb.gov.au/admin/file/content105/c9/ACCED264_06-
15.pdf>

Australian Accounting Standards Board, 2016, Framework for preparation

and presentation of financial statements, viewed on 22 March 2017
<http://www.aasb.gov.au/admin/file/content105/c9/Framework_07-
04_COMPjun14_07-14.pdf >

Australian Accounting Standards Board, 2015, Presentation of Financial

Statements, AASB 101, viewed on 22 March 2017
<http://www.aasb.gov.au/admin/file/content105/c9/AASB101_07-15.pdf>

Birt, J., Chalmers, K., Maloney, S., Brooks, A., Oliver, J., 2014,
Accounting: Business Reporting for Decision Making, 5th ed., John Wiley
& Son, Australia.

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Wesfarmers 2016 annual report, 2016, viewed on 18 March 2017

<https://www.wesfarmers.com.au/docs/default-source/reports/2016-
annual-report.pdf?sfvrsn=4>

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