Principles of Accounting

Chapter 1: Basic Accounting Concepts

What is Accounting?

Essential characteristics of accounting are:

• the identification, measurement, and communication of
financial information about
• economic entities to

• interested parties.
Who uses accounting data?
Internal Users
Management Tax
Authorities

Human Investors
Resources
There are two broad
groups of users of
financial information: Labor
Finance internal users and Unions
external users.
Marketing Creditors
Customers
External
Users
How is financial information communicated?
Economic Entity Financial Statements Additional Information

Financial Statement of Financial President’s letter

Information Position Prospectuses
Income Statement or Reports filed with
Identify Statement of governmental agencies
Comprehensive Income
and News releases
Statement of Cash Flows
Measure Forecasts
and Statement of Changes in
Equity Environmental impact
Communicate statements
Notes to the statements
Etc.
Reporting Framework

All the concepts, principles, conventions, laws, rules and regulations

that are used to prepare and present financial statements are known
as Generally Accepted Accounting Principles or GAAP.
The main sources of GAAP in a jurisdiction are:
• Company Law; and
• Accounting standards
GAAP varies from country to country, because each country has its
own legal and regulatory system. For example, there is Pakistan
GAAP, US GAAP etc.
Reporting Framework

Accounting standards
The accountancy profession has developed a large number of
regulations and codes of practice that professional accountants are
required to use when preparing financial statements. These
regulations are accounting standards.
Many countries and companies whose shares are traded on the
world’s stock markets have adopted International Financial
Reporting Standards or IFRS.
These are issued by the International Accounting Standards Board
(IASB).
Reporting Framework

Which framework do we follow in Pakistan?

A Conceptual Framework

A conceptual framework is a system of concepts and principles that

underpin the preparation of financial statements. These concepts and
principles should be consistent with one another.
It is a conceptual framework on which all IFRSs are based and hence
determines how financial statements are prepared and the information
they contain.
The Conceptual Framework is not an accounting standard in itself.
A Conceptual Framework

The International Accounting Standards Committee (the predecessor

of the IASB) issued a conceptual framework document in 1989. This
was called the Framework for the Preparation and Presentation of
Financial Statements and was adopted by the IASB.
The IASB has published a new document called ”The conceptual
framework for financial reporting” which includes new chapters and
those retained from the original framework.
A Conceptual Framework

The Conceptual Framework is currently as follows.

Chapter 1: The objective of general purpose financial reporting
Chapter 2: The reporting entity (to be issued)
Chapter 3: Qualitative characteristics of useful financial information
Chapter 4: Remaining text of the 1989 Framework:
• Underlying assumption
• The elements of financial statements
• Recognition of the elements of financial statements
• Measurement of the elements of financial statements
• Concepts of capital and capital maintenance
 ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic entity 1. Measurement 1. Cost
2. Going concern 2. Revenue recognition
Third level
3. Monetary unit 3. Expense recognition
The "how"—
4. Periodicity 4. Full disclosure implementation
5. Accrual

QUALITATIVE
CHARACTERISTICS ELEMENTS
1. Fundamental 1. Assets
qualities 2. Liabilities Second level
2. Enhancing qualities 3. Equity Bridge between
4. Income
levels 1 and 3
5. Expenses
ILLUSTRATION
Conceptual Framework for
Financial Reporting OBJECTIVE
Provide information about
the reporting
entity that is useful
to present and potential First level
equity investors, The "why"—purpose
lenders, and other of accounting
creditors in their
capacity as capital
providers.
Qualitative Characteristics of Financial Information

The Conceptual Framework states that qualitative characteristics are

the attributes that make the information provided in financial
statements useful to users.
Fundamental qualitative characteristics are
• relevance and
• faithful representation.
Enhancing qualitative characteristics are
• comparability,
• verifiability,
• timeliness and
• understandability.
Qualitative Characteristics of Financial Information

Relevance
Information is relevant if it can be used for predictive and/or
confirmatory purposes.
The relevance of information is affected by its materiality.

Faithful Representation
To be a faithful representation information must be complete, neutral
and free from error.
The Elements of Financial Statements

Five elements of financial statements are:

1. Assets
2. Liabilities
3. Equity
4. Income
5. Expenses
The Elements of Financial Statements

Assets
An asset is defined 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.
The Elements of Financial Statements

Liabilities
A liability is defined as:
• a present obligation of an entity
• arising from past events
• the settlement of which is expected to result in an outflow of
resources that embody economic benefits.
The Elements of Financial Statements

Equity
Equity is the residual interest in an entity after the value of all its
liabilities has been deducted from the value of all its assets. It is a
‘balance sheet value’ of the entity’s net assets. It does not represent in
any way the market value of the equity.
Equity may be sub-classified in the statement of financial position, into
share capital, retained profits and other reserves that represent capital
maintenance adjustments.
The Elements of Financial Statements

Income
Income is defined 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.
The Elements of Financial Statements

Expenses
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.
The Basic Accounting Equation

= + Equity
Assets Liabilities
The Expanded Accounting Equation

+ Owner’s
Assets
=
Liabilities Capital - + Revenue - Expenses
Drawings
Effect of Business Transactions on the Accounting Equation

What is a transaction?
A business transaction is an activity or event that can be measured
in terms of money and which affects the financial position or operations
of the business entity.
Effect of Business Transactions on the Accounting Equation

A company must
analyze each event
to find out if it
affects the
components of the
accounting
equation. If it does,
the company will
record the
transaction.
Each transaction
has a dual effect
on the accounting
equation.
Recognition

Identifying and Recording Transactions and Other Events

An item should be recognized in the financial statements if it
• meets the definition of an element,
• is probable that any future economic benefit associated with the
item will flow to or from the entity, and
• has a cost or value that can be measured reliably.
Transactions Analysis

Transaction (1). Investment By Owner.

Ray Neal decides to open a computer programming service which he
names Softbyte. On September 1, 2010, he invests $15,000 cash in
the business. The effect of this transaction on the basic equation is:
Transactions Analysis

Transaction (2). Purchase of Equipment for Cash.

Softbyte purchases computer equipment for $7,000 cash.
Transactions Analysis

Transaction (3). Purchase of Supplies on Credit.

Softbyte purchases for $1,600 from Acme Supply Company computer
paper and other supplies expected to last several months.
Transactions Analysis

Transaction (4). Services Provided for Cash.

Softbyte receives $1,200 cash from customers for programming
services it has provided.
Transactions Analysis

Transaction (5). Purchase of Advertising on Credit.

Softbyte receives a bill for $250 from the Daily News for advertising but
postpones payment until a later date.
Transactions Analysis

Transaction (6). Services Provided for Cash and Credit.

Softbyte provides $3,500 of programming services for customers. The
company receives cash of $1,500 from customers, and it bills the
balance of $2,000 on account.
Transactions Analysis

Transaction (7). Payment of Expenses.

Softbyte pays the following Expenses in cash for September: store rent
$600, salaries of employees $900, and utilities $200.
Transactions Analysis

Transaction (8). Payment of Accounts Payable.

Softbyte pays its $250 Daily News bill in cash.
Transactions Analysis

Transaction (9). Receipt of Cash on Account.

Softbyte receives $600 in cash from customers who had been billed for
services [in Transaction (6)].
Transactions Analysis

Transaction (10). Withdrawal of Cash by Owner.

Ray Neal withdraws $1,300 in cash from the business for his personal
use.
Transactions Analysis

Summary of Transactions