FAQ Basic Accounting Concepts

Basic accounting concepts – Q&A Peter Baskerville

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Published in Australia by Nowmaster PO Box 960 Spring Hill Queensland, 4000 www.nowmaster.com ©Peter Baskerville 2013 ISBN 978-0-9922949-0-8 The moral rights of the author have been asserted. First published 2013 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior permission in writing of Nowmaster Pty. Ltd. Enquiries concerning reproduction outside the scope of the above should be sent to Nowmaster Pty Ltd. at the address above.

BASIC ACCOUNTING CONCEPTS – Q&A About the book and the author.........................................................................................vi Introduction to accounting................................................................................................. 1 What is accounting?.................................................................................................. 1 What is the difference between accounting and accountancy?.................................2 Where did accounting start?.....................................................................................4 What was accounting like before double-entry bookkeeping?...................................5 What is the difference between financial accounting and management accounting? .................................................................................................................................. 6 What is the purpose of accounting?..........................................................................9 Role of accountants and bookkeepers..............................................................................11 Why do we need accounting?..................................................................................11 What is the difference between a bookkeeper and an accountant?........................12 Why do we need accountants?................................................................................14 Accounting concepts and conventions.............................................................................18 What are the accounting concepts and conventions?.............................................18 What is the accounting entity assumption?.............................................................20 What is the going concern concept in accounting?.................................................22 What is the revenue recognition principle?.............................................................23 What is the matching principle in accounting?........................................................26 What is the time period assumption in accounting?................................................30 Types of account group classifications.............................................................................33 The five account groups..........................................................................................33 What are assets in accounting?...............................................................................33 Assets and the accounting equation.......................................................................33 What are liabilities in accounting?...........................................................................37 What is owner’s equity in accounting?....................................................................41

Basic accounting concepts—Q&A

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What is revenue in accounting?..............................................................................43 What is the difference between revenue and income?............................................45 What are expenses in accounting?..........................................................................48 What are expense classifications and functions in accounting?..............................50 What is the accounting difference between an expense and an investment?.........52 What is the difference between capitalisation and expensing?...............................53 What is the difference between a cost and an expense in accounting?..................54 What are overheads in accounting?........................................................................56 Double-entry bookkeeping with debits and credits..........................................................59 What is the double-entry bookkeeping system?......................................................59 Why is double-entry bookkeeping such a big deal?.................................................61 How is the accounting equation formed?................................................................62 What are debits and credits in the bookkeeping system?.......................................64 How do you apply debits and credits in bookkeeping?............................................66 How do you make sense of debits and credits in accounting?.................................68 How can I better understand debit and credit?.......................................................75 The accounting process................................................................................................... 77 What is the accounting cycle?.................................................................................77 What are the steps in the accounting process?.......................................................79 What are source documents in accounting?............................................................80 What is the Chart of Accounts in accounting?.........................................................83 What are journals in accounting?............................................................................85 What is a ledger account in accounting?.................................................................87 What are subsidiary ledgers in accounting?............................................................88 What is posting in accounting?...............................................................................91 What is the general ledger in accounting?..............................................................93 What is a trial balance in accounting?.....................................................................94 What is an audit trail in accounting?.......................................................................96 What are end-of-period adjustments in accounting?...............................................98

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Accounting methods: cash vs accrual............................................................................101 What is cash accounting?......................................................................................101 What is accrual accounting?..................................................................................103 What are the advantages and disadvantages of Cash VS Accrual accounting?.....105 If there were no tax benefits, would there be any advantages for accrualaccounting?...............................................................................................107 Financial transactions and special accounts...................................................................109 What are accruals in accounting?..........................................................................109 What are prepaid expenses in accounting?...........................................................111 What is a contra account in accounting?...............................................................113 What is amortisation in accounting?.....................................................................115 What is Cost of Goods Sold?..................................................................................118 What are bad debts in accounting?.......................................................................119 What are doubtful debts in accounting?................................................................122 What is the difference between bad debts and doubtful debts in accounting?......124 What is a 10-column worksheet in accounting?....................................................126 Financial statements and standards...............................................................................129 How is IFRS different from GAAP?..........................................................................129 Who are the stakeholders of a business?..............................................................129 What are financial statements in accounting?.......................................................131 How do you read and understand a Balance Sheet?.............................................133 How do you read and understand the Income Statement?....................................137 What is the financial ratio analysis?......................................................................139 List of accounting terms and abbreviations....................................................................142 Glossary of Accounting Terms........................................................................................151


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ABOUT THE BOOK AND THE AUTHOR This e-book is a guide and reference resource for students of accounting (and its subsidiary, bookkeeping). In simple language, it explains the basic accounting concepts and why they are important in the process and application of accounting/bookkeeping. Basically, the mechanics of accounting is little more than adding and subtracting figures, and sometimes applying a percentage. So, it is not usually the maths of accounting that students find difficult to grasp. Rather, it is the WHY of accounting. This book compiles answers provided by Peter Baskerville to questions about the WHY of basic accounting. It is designed as a learning resource that users can ‘dip in and out of’ as they seek answers to specific questions, rather than as a book to be read sequentially from cover to cover. As a result, there is some necessary repetition to ensure answers to all questions are contained and comprehensive. Peter has taught bookkeeping and accounting for many years at a technical college, and has first-hand experience in helping students to understand basic accounting concepts. Peter explains the background and first principles that underpin each concept. The answers are grouped and ordered according to the standard learning process in accounting, but their focus is on the WHY: why accounting and bookkeeping operate as they do.

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INTRODUCTION TO ACCOUNTING WHAT IS ACCOUNTING? Accounting is a financial recording and reporting system (see Figure 1). Accounting identifies and classifies financial transactions; it then summarises these financial transactions into financial reports. Financial reports communicate relevant financial information to interested persons called stakeholders. This information allows stakeholders to decide how to best use the economic resources of the accounting entity (that is, the business or enterprise).

Identify and classify financial transaction s

Summarise transaction s in financial reports

Send financial reports to stakeholder s

Stakeholde rs decide how to use economic resources of accounting entity

Figure 1 The accounting system DEFINITION OF ACCOUNTING Here is a simple definition: Accounting is a system that provides numeric information about the finances of an accounting entity. Here is another definition: Accounting is the systematic recording, reporting and analysis of the financial transactions of a business. Yet another definition is as follows: Accounting is a tool for recording, reporting and evaluating—in monetary terms—the transactions, events and situations that impact on an enterprise. The American Accounting Association defines accounting as: the process of identifying, measuring and communicating information to permit judgment and decision by users of accounts.


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An even simpler definition is this: accounting is the language of business.

KeyFACTS   

Accounting is a system that operates for as long as the accounting entity exists. Accounting is interested only in the financial or monetary transactions of the accounting entity. The first phase of accounting is to identify, collect, measure, classify and record financial transactions; a second phase is to calculate, summarise, report and evaluate financial



information. The intent of accounting is to communicate the financial information of the accounting entity to



decision makers. Accounting deals with maintaining and storing financial results.

Accounting is not an end in itself. It is not, like art in a museum, to be displayed as a ‘beautiful set of numbers’ (even if you hear businesspeople speaking this way). Accounting is primarily a means to an end. This means that accounting is a process. Accounting provides the most relevant and reliable financial information possible so that the real work of an accounting entity (for example, a business) can be done. The real work is to make the best possible decisions about how to use the economic resources of the entity.

SUMMARY—DEFINITION OF ACCOUNTING Based on the above definitions and conclusions, accounting can be divided into two broad elements: 1.

Accounting is an information process that identifies, classifies and summaries the

2.

financial events and transactions that impact on a business. Accounting is a reporting system that communicates relevant financial information to interested person (stakeholders). This information allows stakeholders to assess performance, make decisions about and/or control the economic resources of a financial entity.

WHAT IS THE DIFFERENCE BETWEEN ACCOUNTING AND ACCOUNTANCY? Accounting is the action or process of keeping financial accounts. Accountancy describes the duties of an accountant, the person whose job is to keep, inspect and interpret financial accounts. In relation to business, accountancy is, in effect, the total of all actions taken by a business to: 

to record financial transactions 2




to produce reports that allow stakeholders (such as managers, investors, funders, owners) of the business to make informed decisions about the financial resources under their control.

The main reasons why a business has a vital interest in accountancy are listed in Figure 2.


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Government compliance: Tax laws require a business to report to the government on its revenue and income. Accountancy provides a process to meet this requirement. Funding: Banks, investors and finance institutions require reports on the financial performance and position of a business before they invest in, or loan funds to, that business. Accountancy provides these reports in the form of an Income Statement and a Balance Sheet. Financial performance: A prime function of management is to ensure that the business will endure. Accountancy provides a reporting mechanism (by way of an Income Statement) that details a business’s revenue, expenses and resulting profit. Managers can use this statement to make informed decisions to ensure the sustainability of the business. Budgeting and control: Financial information provided by the accountancy system allows managers to prepare budgets that become a benchmark for performance and a means of controlling the finances under their control.

Comparison: Accountancy, because it is universally applied using accounting standards, Figure 2 Main reasons why a business is interested allows businesses to be in accountancy compared. This comparison

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WHERE DID ACCOUNTING START? The accounting system we use today had its beginning in systems used by merchants in Venice over 500 years ago. HISTORY OF ACCOUNTING Generally, historians agree that the Renaissance period began in what we now call Italy during the late 1200s AD. The Renaissance was well established by about 1450. It saw a huge increase in trade with some merchants becoming very wealthy. Some merchants lent money even to kings. This rapid increase in trade and wealth led to the development of early banking systems. The city–state of Venice went even further, developing an accounting system to record complex financial dealings. Most accountants today regard the Franciscan friar and mathematician Luca Pacioli (1446–1517) as the ‘father of accounting’. Pacioli did not claim to have invented the accounting system as such, but he did present the system in a way that others could easily understand. Da Vinci, a colleague of Pacioli, helped Pacioli to illustrate his second most important manuscript, De divina proportione [Of divine proportions]. Da Vinci mentions Pacioli many times in his notes. FIRST ACCOUNTING TEXTBOOK Pacioli’s most important manuscript was the five-section book called (translated into English) The collected knowledge of arithmetic, geometry, proportion and proportionality. The book was published in 1494, about the same time that Columbus was said to have discovered America. This book by Pacioli was one of the earliest books printed on the Gutenberg press. This is how is all started for Pacioli. Guidobaldoda Montefeltro (1472–1508), the wealthy Duke of Urbino, asked Pacioli to help him to manage his financial affairs. Pacioli did so, and was the first person to codify and publish the Venetian accounting system. This accounting system is explained in one section (made up of 36 short chapters) of Pacioli’s five-section book (see above). For the next century, The collected knowledge of arithmetic, geometry, proportion and proportionality was the only accounting textbook available. Most of the principles, processes and concepts described in this book have been adopted by accountants right up to today. These principles, processes and concepts include the:    

accounting cycle use of journals and ledgers duality of financial transactions (that is, debits equalling credits, or ‘doubleentry bookkeeping’) formation of account groups: Assets (including Receivables and Inventories), Liabilities, Owner’s equity, Income/Revenue, and Expenses

 

year-end closing entries the trial balance, which Pacioli believed should be used to prove a balanced ledger.

The system Pacioli described in his book has become known as the ‘double-entry accounting’ system. WHAT WAS ACCOUNTING LIKE BEFORE DOUBLE-ENTRY BOOKKEEPING? Before Pacioli codified the double-entry bookkeeping system, accounting systems of a sort did exist in some societies. These systems are today described as ‘primitive accounting’. Some of these primitive accounting systems date back more than 7,000 years to the time of ancient Babylon, Assyria and Sumeria. Over time, these primitive accounting systems led to the invention of more sophisticated numerical systems and the accounting principles in use today. In fact, it has been difficult for comparative philologists (people who study language) to identify exactly where numbering (and hence accounting) systems started and where they then separated into uniquely different fields. EARLY METHODS OF COUNTING The use of counting systems goes back to the dawn of intelligence among human beings. Ancient peoples in different parts of the world developed their own counting systems. Many used their fingers and toes to help them to count. Hence, the bases of many of these early counting systems were 5, 10 or 20. For example, the ancient Mexicans used 20 as their number base. The Peruvians, who used knotted strings called quipus, had a decimal system (based on 10) as did the early Greeks. The Chinese, Tibetans and Hottentots used the concepts of ears and hands, respectively, to denote 2 and the forebears of the Brazilians generally counted by the joints of the fingers, and consequently counted in lots of 3. Further developments in numbering systems, and hence accounting, included the use of: • Pebbles and twigs: Apart from using body parts to help them count, some people began using pebbles and twigs, where each item represented an animal or item of economic value. • Bullae and tokens: The bullae were round or cylindrical-shaped clay objects, either hollow or solid. They were used over 3,000 years ago to help keep track of shipped goods, or to calculate inventory. The variety of differently shaped tokens inserted inside the hollow bullae (or described in script on the outside surface of solid bullae) represented the items being accounted for. • Clay tablets: Over time, the use of tokens and bullae evolved into depicting symbols on clay surfaces. At first, sellers would imprint their tokens onto wet clay tablets as a form of recorded accounting. But not all tokens transferred 6


their imprint clearly onto wet clay. So, in time, some merchants began drawing the token symbols on the clay tablets. This drawing of token symbols became the first documented accounting system in history. • Abacus: The abacus was invented in ancient China. Its use later spread throughout the world. The abacus consists of a wooden frame with wires threaded through strings of beads. Adding, subtracting, multiplying or dividing calculations were carried out by sliding the beads in certain ways across the wires. Merchants could not only perform complex calculations on their abacus this way, but also keep the results of these calculations on their abacus as a record of financial transactions. WHAT IS THE DIFFERENCE BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING? Financial accounting prepares a limited number of prescribed financial reports in accordance with statutory standards and the needs of external stakeholders. Financial accounting summarises the consequences of past decisions on the performance of the business as a whole. Management accounting prepares an unlimited number of financial reports in accordance with business requirements and the needs of management. Management accounting analyses the performance of units within the business by comparing results with pre-set budgets. Management accounting thus assists management in its future planning and control functions. WHY DO WE HAVE TWO TYPES OF ACCOUNTING? Business managers need accounting information to help them make sound decisions about the organisation. Investors look for business profits in the hope of dividends. Creditors and lenders watch an organisation’s ability to meet its financial obligations. Governmental agencies need information to ensure that the correct tax is collected and to regulate business activities. Brokers and business analysts use financial information to form an opinion on investment recommendations. Employees chose successful companies that enhance their career prospects, and they often have bonuses or share options that are tied to enterprise performance. These examples are but a small sample of the sorts of people who are interested in the financial information of an organisation (that is, the organisation’s stakeholders). For simplicity in reporting, accountants group these stakeholders into two main user groups, as shown in Figure 3.

External users (not directly involved in daily activities of the organisation)

Internal users (directly involved in daily activities of the organisation)

• • • • • •

government agencies lenders and investors (owners) creditors suppliers and customers trade associations society at large

• Board of Directors • Chief Executive Officer /Chief Financial Officer • entrepreneurs • vice-presidents • employees • line managers (for example, business unit managers, plant and store managers)

Figure 3 Two main user groups of accounting information In general, accounting information and financial reports designed for external users are prepared in accordance with Financial Accounting Standards. Managerial accounting, on the other hand, provides accounting information to internal users according to their specific needs. While the reporting styles for each branch of accounting are vastly different, the underlying objective is the same—to satisfy the information needs of the user. FINANCIAL ACCOUNTING Financial accounting focuses on producing a limited set of specific prescribed financial statements in accordance with generally accepted accounting principles (GAAP). The central outputs from financial accounting are audited financial statements. These financial statements include the Balance Sheet and Income Statement, which provide a ‘scorecard’ by which the overall past performance of a business can be judged by outsiders. This branch of accounting targets those external stakeholders with an interest in the reporting enterprise, but who are not involved in the day-to-day operations of the business. The reports produced by this branch of accounting are used for so many different purposes that it is often called ‘general-purpose accounting’. In addition to the financial statements, external stakeholders also have access to financial reporting via press releases. These press releases are sent directly to investors and creditors or via the open communications of the internet.

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The emphasis in financial accounting is on summaries of financial consequences of past activities and decisions. So, only summarised data is prepared which covers the entire organisation. The data prepared must be objective, precise and verifiable (usually by an outside auditor). This style of reporting must follow the generally accepted accounting principles set by peak accounting bodies in conjunction with government agencies. The numbers used in financial accounting are historical in nature. While the figures in financial statements seem to be fixed and not able to be changed, they are actually based on estimates, judgments and assumptions. This is why financial statements usually include ‘Notes to the Accounts’. These notes (from management) explain and help users to interpret the numerical information. A more specialised area of financial accounting is tax accounting. MANAGEMENT ACCOUNTING Management accounting deals with information that is not made public; the information is used for internal decision making only. These reports are far more detailed than those for financial accounting; they can cover performances and activities by departments, products, customers and employees. Management accounting is an accounting system that helps management to achieve the goals and objectives of the organisation. The emphasis is on the measurement, analysis, communication and control of financial and non-financial information. Management accounting is primarily interested in helping the organisation’s department heads, division managers and supervisors to make better decisions about the daily operations of the business—in particular, those relating to planning and control decisions. The essential data is conveyed in a wide variety of reports specifically targeted at those who direct and control the organisation. These reports help to promote more efficient and effective planning; they also help to organise resources, direct personnel and motivate staff, as well as being useful ‘tools’ in performance evaluation and operations control. Unlike financial accounting, there are no external rules for management accounting. The emphasis in management accounting is on making decisions that affect the future. Results are compared with budgets, activity-based costing, financial planning or industry benchmarks. Reports are delivered frequently and in a timely way to meet the needs of management. Most reports are analytical, and emphasise variations in the key indicators that monitor the financial performance of the business unit. A more specialised area of management accounting is cost accounting.

Table 1 Main differences between financial and management accounting Area of difference

Financial

Management accounting

accounting Number of financial reports

Limited number— specifically Balance Sheet and Income Statement

Unlimited number—set by needs of management

Rules governing preparation of financial reports

Government-backed accounting standards (that is, GAAP)

No rules

Financial reports

Generally required

Not required

Financial reports primarily prepared for ...

External stakeholders not involved in day-today operations of the entity

Internal stakeholders involved in day-today operations of the entity

Are financial reports made public?

Yes

No

Financial information in reports contains ...

Organisational summaries

Detailed performances and activities of the organisation’s business units, products, customers or employees

Financial information in reports emphasises ...

Objectivity, preciseness and is verifiable

Analytical aspects that identify variations in key performance indicators

Financial reports assist stakeholders with ...

Evaluation, assessment and investment decisions

Planning, resource allocation and control decisions

Frequency of financial report preparation

Typically half-yearly and annually according to statutory requirements

Typically daily, weekly, monthly according to needs of management

Financial performance is compared with ...

Prior periods

Pre-set budgets and industry benchmarks

Emphasis of financial performance

Historical, being a consequence of past activities and decisions

Analytical, in making future decisions

A specialised area is …

Tax accounting

Cost accounting

WHAT IS THE PURPOSE OF ACCOUNTING? The purpose of accounting is to provide financial information about economic entities (for example, businesses) in the form of financial statements and other 10


reports. Financial statements allow internal and external stakeholders to evaluate the performance of the business and its management. This evaluation permits stakeholders to make informed judgments and decisions about the entity and their engagement with the entity. FINANCIAL STATEMENTS Each stakeholder is interested in gaining knowledge about the financial position and performance of the enterprise or business. Financial statements provide this information and help stakeholders make economic decisions in relation to their involvement with the enterprise. The accounting information system is designed to produce financial statements that fulfil the key purposes and objectives of accounting (see Table 2).

Table 2 Key purposes and objectives of accounting To provide a management information system (MIS) that …

 





To enable organisations to comply with the statutory requirements of governments and other institutions (e.g. stock exchanges)

•

Systematically records business transactions created from business activities (the record-keeping function) Communicates to managers and other stakeholders financial information that identifies the profitability, viability and financial position of the business Assists managers to make decisions and to control activities that protect the property of the business from unjustified and unwarranted use Enables management to plan short- and long-term business activities by analysing historical financial information to predict future outcomes communicated via budgets and strategic plans Compliance relates to providing financial information as a basis for taxation, corporate regulations, industrial relations and environmental assessment

Financial statements prepared for external stakeholders give insights into the following: • accountability of the managers: (that is, ask the following question: Have the finances of the business been appropriately used to benefit the business rather than the personal interests of the managers?) • capital position of the business: (that is, the amount of money distributed to the owners and the amount of capital remaining to settle the debts of the business (loan funds, creditors)) • valuation of an business’s equity: (that is, to provide enough information for others to assess the value of an business from their perspective)

• financial strength: (that is, the business’s ability to pays its current bills as they become due, the debt to equity ratio and interest cover) • financial sustainability: (that is, its profitability, its return on investment or return on assets employed, the efficiency of the asset use by management).

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ROLE OF ACCOUNTANTS AND BOOKKEEPERS WHY DO WE NEED ACCOUNTING? Do you know what would happen if the accounting function were removed from the business and the economic system? • A government would not have access to tax income from business. Taxes could, of course, still be raised in other ways, but they would be unlikely to be enough to provide the standard of community services we enjoy today. It is unlikely, too, that other tax methods would be as equitable (that is, with an entity’s ability to pay based on a percentage of profits). History records what has often happened in societies where taxes imposed on the people are not equitable. • Investors would be ‘flying blind’ and would thus be likely to withhold vital capital needed for businesses to survive and grow. Banks, investors and finance institutions require verifiable and accurate reports on a business’s financial performance and position before they can trust it, invest in it or provide it with loan funds. Accountancy provides these reports in the form of an Income Statement and a Balance Sheet and makes transparent the financial performance and position of a business and its management decisions. No accounting = no investment/trust = no capitalist economy

• Business owners and managers could not track their current financial performance in an accurate and timely way. A key function of business management is to ensure that the business will endure. Accountancy provides a reporting mechanism by way of an Income Statement that details the revenue, expenses and resulting profit that managers can use to make informed decisions to ensure the sustainability of the business. No accounting = ill-informed decisions = poor use of resources and the failure of the business to survive

• Banks as the core component of the global financial system could not facilitate the means of economic exchange. Trade between entities would therefore eventually cease. Businesses would not offer credit, turning the efficiency of our current financial system back to the ‘dark ages’ of barter and localised subsistence living. • Business and economic planners would have ‘no instruments with which to fly’. Financial information provided by the accountancy system allows managers to prepare budgets that become instruments, gauges and benchmarks of performance and a means of controlling the finances under their control. No accounting = no ability to plan = end of economic growth and development

• Comparisons that promote productivity and improved performance—and that are the key drivers in maximising the use of the world’s limited resources—would disappear. Accountancy, because it is applied using international accounting standards, provides a means of comparing businesses. This comparison provides benchmarks by which under- or over-performance of a business can be judged relative to an industry average, previous periods or against the entire business world. Furthermore, the three key reports produced by the accounting system provide answers to the fundamental questions that go to the heart of a business’s ability to survive (see Figure 4).

Is the business currently profitable? Does it continue to have the capacity to endure? Which way is the profit trending?

• Answered by comparing last month's operating profit with that for the previous month • Displayed on the Profit and Loss Statements created by the accounting system

Can the business pay its bills as they fall due? Can the business remain solvent into the near future and avoid bankrupcy?

• Answered by the cash flow forecast produced by analysing the Profit and Loss Statement and changes to the Balance Sheet created by the accounting system

What is the financial strength of the business? What is its net worth and how much value has the business created for the owners?

• Answered by the value of the owner’s equity section of the Balance Sheet

Figure 4 How the accounting system answers fundamental questions about business viability WHAT IS THE DIFFERENCE BETWEEN A BOOKKEEPER AND AN ACCOUNTANT? Bookkeeping is a task-oriented function that routinely and systematically records an organisation’s day-to-day financial transactions. Accounting is more results-oriented than bookkeeping. Accounting is involved more with interpreting and using financial information than in preparing it. 14


BOOKKEEPERS Bookkeeping is generally the tedious, clerical and exacting role in the accounting system. Today bookkeepers use computer and accounting software to do much of this work. The bookkeeper function is performed primarily by skilled clerical personnel who may or may not have any formal accounting training. They will, however, have a basic knowledge of the ‘double- entry system’, which ensures that financial transactions are recorded correctly. Bookkeepers are required to classify transactions into the correct ledger accounts as previously determined by the accountant and business owner. A final check in the bookkeeping process is called a ‘trial balance’. This summary ensures that financial transactions have been correctly recorded. At this point, the bookkeeper usually hands the system over to the accountant who performs the second element of the accounting function: analysis and reporting. ACCOUNTANTS Quite often the terms bookkeeper and accountant are used interchangeably. Certainly, they both play a role in the accounting process. However, they each perform quite different functions. Let’s revisit a definition of accounting to help us understand these differences: Accounting consists of two key elements:

 

an information process that identifies, classifies and summarises the financial events that take place within an organisation a reporting system that communicates relevant financial information to interested persons, which allows them to assess performance, make decisions and/or control the economic resources in the organisation.

As a rule, bookkeepers do only the first element described above. Accountants, who are trained and able to do both, generally do the second element. This is because accountants are uniquely specialised professionals whose time would be poorly invested in tasks that a computer—together with accounting software and a competent bookkeeper—could easily perform. So, accountants deal with the big picture. They set up the overall structure and design for both the financial information capture and the appropriate financial reporting functions.

KeyFACTS •

Accountants are responsible for reporting to governments and statutory requirements. These

•

reports include the Statement of Financial Performance and the Statement of Financial Position. Accountants also prepare reports and advise business managers in developing their businesss. This advice may relate to: –

resolution of complex financial reporting issues

– – – –

cash flow and profit forecasting auditing to check the accuracy of information tax planning and lawful tax minimisation redesigning business accounting systems to ensure maximum efficiency.

Generally, accountants need to be highly qualified with a university degree plus membership of a peak accounting body that is maintained by the accountant’s continuous professional development. WHY DO WE NEED ACCOUNTANTS? People might seek the services of an accountant for many different reasons; these reasons may include: 

to seek the advice of someone who is appropriately qualified in trying to understand and interpret the 70,000 or so pages of taxation law and then apply it to a business. Many people in business do not have the time or expertise to so that and are happy to pay for an accountant’s professional services to ensure that: – the business complies with the law and avoids penalties, legal costs and potential criminal charges – the business and related transactions are structured in a tax-effective way to ensure that tax is not overpaid. This might happen simply by getting the timing of payments and the signing of agreements in the wrong order. – business personnel spend their time doing what they do best, which is building the business, not being involved in something where they have no specialised expertise 



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to help businesses fully understand the financial performance and position of their business on a continual basis. Qualified accountants have significant experience in business and can help set up a specialised chart of accounts and a management information system that helps to identify under-performing aspects of the business. Their networks give them access to industry benchmarks which they can use to identify these areas of under-performance. to enhance credibility when applying for bank loans and when seeking investment partners. Accountants give such external parties confidence, particularly if the accountant has prepared the financial statements according to GAAP and gives assurances to that fact. Accountants can also ‘talk the language’ that financiers and investors speak. If the accountant is not at the negotiation table, there is a chance a business will not effectively communicate its message and that its access to funds therefore is limited.


Of course, an accountant is not needed anymore to ‘keep the books’ of a business. Modern computerised accounting systems allow many businesses to do their own bookkeeping. The vast majority of accountants are happy with this development because they can now spend so much more of their time giving clients the value-added advice and analysis that are really needed.

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or many business owners and managers, the accountant is always their first appointed and primary ongoing adviser in business. Most owners and managers will report that they have always saved more money from their accountant’s advice than they have ever paid for their service. What advice do you have for someone who is interested in working in the accounting field but not sure where to get started?

C

ase study: Wray Rives, qualified accountant

Wray Rives is a qualified accountant and an active Quora participant. He may well wish to add to what is said below if contacted on Quora. This is what he says about becoming an accountant … ‘I studied accountancy at university as part of a degree in business and quickly saw its value in contributing to the success of my entrepreneurial dreams. I don’t have the temperament to be an accountant but I did see the value of financial/accounting skills for entrepreneurs in regard to financial modelling in business plans, structuring corporate/accounting entities, keeping your own books with computerised bookkeeping, understanding financial statements, adopting managerial accounting in regard to cash flow budgets, accessing finance options and conducting valuation analysis. See my answer on this at: Which specialty within accounting is more beneficial to a career in entrepreneurship—Tax or Audit? So, I didn't work directly in a recognised accountancy field but I have embraced accountancy skills in all my entrepreneurial endeavours and in my advisory roles. If you are interested in working in any of the specialised accounting fields, you must begin with an understanding of accounting/finance theory via a formal education. If you wish to eventually become a qualified accountant (rather than just acquire the accounting skills as I have) you will need to firstly complete an accounting or business or finance degree at a university and then complete additional specialised accounting studies as required by the professional accounting association that you may be required to join.

Check with the peak accounting body in your country in regard to their membership requirements before choosing your formal education pathway.’

SPECIALISED FIELDS OF ACCOUNTING • Bookkeeping: This sub-set of accounting could be performed by a paraprofessional who has completed formal vocational education (diploma or certificate level) at a college. Generally, a person does not need to have completed a degree or belong to one of the peak accounting bodies to work in bookkeeping. It would be necessary, though, to apply your formal education to implanting and maintaining leading industry computerised accounting packages. • Financial accounting jobs: People in these roles primarily prepare financial reports for shareholders, government agencies/departments, stock exchanges and corporate regulators; they must be a member of one of the peak accounting bodies. In Australia, these bodies are represented as CAs (Charted Accountants) and CPAs (Certified Practicing Accountants). This field requires current and complete knowledge of tax law and accounting standards, provided through membership of a selected peak professional accounting body. Auditing is a specialised role in financial accounting that also requires membership of a peak accounting body. • Management accounting: This field of accounting is primarily interested in helping the organisation’s department heads, division managers and supervisors make better decisions about the day-to-day operations of the business and, in particular, those relating to planning and control decisions. The emphasis is on making decisions that affect the future, with results being compared with budgets, activity-based costing, financial planning or with industry benchmarks. These analytical reports emphasise variances in the key indicators that monitor the financial performance of the business unit. Experience counts significantly in getting jobs in this field but entry generally requires, as a minimum, a degree in accountancy/finance. TYPES OF ACCOUNTING CAREER JOBS So you are an accountant! Where might you seek a career in accounting?

Table 3 Opportunities for a career in accounting Location

Employer role

Career benefits

Requirements

Public accounting firms

Responsible for providing accounting services to individuals, businesses and government. The ‘big 4’ in this area are: PricewaterhouseCoop

Useful way to start an accounting career. Provides foundation knowledge before moving into more specialised areas.

Candidates with a degree in accounting/finance

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Firms will generally assist employees in qualifying for peak body membership.

ers, Deloitte and Touché, KPMG, and Ernst & Young. Government

Responsible for preparing budgets, tracking costs and analysing government initiatives.

Working at any level of government, prospects for advancement are generally good, due to the size of the organisation. The slow-paced, noninnovative, bureaucratic environment and politicised decision making are ‘downsides’.

Preferred candidates generally have 5+ years of ‘big 4’ industry experience.

Corporations (of all sizes)

Responsible for preparing (or helping to prepare) financial statements, for tracking costs, for handling tax returns and for working on major transactions.

The work is more dynamic than government work, and career prospects are good.

Preferred candidates will generally have industry experience and have membership of a peak body.

Independent

Responsible, as a selfemployed accountant for creating one’s own business.

Benefits flow from good customer contact, independence and good financial returns; disadvantages when business is not so good.

Clients will often choose an accountant who is a member of a peak body when perusing independent service providers.

Entrepreneurship

Opts to pursue own entrepreneurial dreams, using accounting/finance skills only to build and manage a business outside of accounting. practice

Prospects for becoming a valuable founding member of any business startup team.

Formal qualifications and peak body membership are a distinct advantage but not critical.

SUMMARY—BEING AN ACCOUNTANT If you wish to work in any field of accountancy, start with a formal education. This should preferable be an accounting/finance degree at a university.

ACCOUNTING CONCEPTS AND CONVENTIONS WHAT ARE THE ACCOUNTING CONCEPTS AND CONVENTIONS? Accounting is based on generally accepted accounting principles (GAAP). These principles summarise the assumptions, practices, principles and concepts that provide the basis for measuring financial values and for reporting on the results of business activities. Accounting concepts and conventions guide accountants when reporting on the financial performance and position of a business. Accounting principles and assumptions greatly influence the reported financial position and performance of a business. WHY IS THERE A NEED FOR ACCOUNTING PRINCIPLES AND CONVENTIONS? Accounting deals almost exclusively with numbers. Yet it is not purely a science of objective measurement or assessment. Accounting also involves a degree of subjective judgement because values are involved, and anyone in business will tell you that value is definitely ‘in the eye of the beholder’. What one businessperson holds to be important, or values, another one won’t. Either way, in order for the stakeholders of a business to make sound decisions, they need financial information that—as accurately as possible—reflects the ‘true and fair view’ of the financial performance and position of the business. TOWARDS A ‘TRUE AND FAIR VIEW’ The concepts and conventions that accountants have adopted to guide the preparation of financial statements for a business help to support them in taking a ‘true and fair view’ approach. These concepts and conventions are sometimes called assumptions or principles. Whatever we call them, or however they are grouped, it is important that these concepts and conventions be appropriately applied by those responsible for preparing the financial statements of a business. The concepts and conventions that need to be applied in this regard are listed in Figure 5. These key concepts explained in more detail in the text that follows. Accounti ng entity assumpt ion

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Going concern concept

Monetary measure ment assumpti on

Time period conventi on


Historic al cost convent ion

Matchin g (or accruals ) principl e

Realisat ion of income conventi on

Full disclosu re concept

Material ity principl e

Prudence (or conservat ism) principle

Consiste ncy conventi on

Dual aspect concept

Objectiv ity concept

Substan ce over form principl e

Figure 5 Accounting concepts and conventions

• Accounting entity assumption: The accounting entity assumption states that the business is an entity (perceived to have its own existence) that is separate from its owner. Therefore business records should be separated and kept distinct from the personal records of the business owner(s). – This is also known as the economic entity concept or the separate business entity principle. • Going concern concept: Accountants assume, unless there is evidence to the contrary, that a company is not going broke and will continue to operate for an indefinite period of time or at least into the foreseeable future. This assumption allows businesses to spread (amortise) the cost of a fixed asset over its expected useful life. • Monetary measurement assumption: Accountants do not account for items unless they can be quantified in monetary terms (that is, money was exchanged to acquire the item or a market exists that would be prepared to exchange money for it). A business may have other valuable resources (like workforce skills, business morale, market leadership, brand recognition, quality of management) but these do not get recorded in the financial statements because they cannot be quantified in monetary terms. • Time period convention: This convention allows for the performance evaluation of a going concern business to be broken up into specific period of time such as a month, a quarter or a year. – This is also known as the accounting period convention. – This short time period of assessment allows internal and external users to adjust their strategy for the business. Also, using the time period assumption, the accountant and other users can compare like to like financial results over a similar period of time. • Historical cost convention: This convention requires that the assets of a business be recorded in the ledger accounts at the price paid to acquire them. No account is taken of the changing values of these assets in the marketplace. • Matching principle or Accruals principle: This principle holds that expenses should be ‘matched’ against revenues that they enabled, and should be recorded in the same period in which the revenue is earned. This approach is supported by the accrual accounting method. To do this, accountants need to prepare accruals at the end of each reporting period to take account of expenses incurred but for which there is no source document. These are part of the end-of-period adjustments.

• Realisation of income convention (revenue recognition): With this convention, accountants recognise financial transactions (and any profits arising from them) at the point of sale or at the transfer of legal ownership. This may be different from the point when cash actually changes hands. • Full disclosure concept: The full disclosure concept requires that financial statements provide sufficient information to help users of the information to make knowledgeable and informed decisions about the business. • Materiality principle: Accountants only record events significant enough to justify the usefulness of the information. Only items deemed significant for a given size of operation are recorded. Otherwise the accounts will be burdened down with minute details. • Prudence/Conservatism principle: The rule is to recognise revenue only when it is reasonably certain of happening and recognise expenses as soon as they are incurred (whether paid or not). Accounting in this manner ensures that financial statements do not overstate the business’s financial position. As a rule, accounting chooses to err on the side of caution and to protect investors from acting on inflated or overly positive results. • Consistency convention: According to this convention, transaction classification and valuation methods should remain unchanged from one period to the next. This allows for more meaningful comparisons of financial performance between periods by the stakeholders. • Dual aspect concept: The dual aspect concept is based on the accounting equation: Assets = Liabilities + Owners Equity

All transactions recorded in the accounts must keep this equation in balance. To do this, financial transactions are allocated both a debit side and a credit side of equal amounts. • Objectivity concept: The objectivity concept states that transactions must be recorded on the basis of objective evidence. This means that accounting records will initiate from a source document to ensure that the information recorded is based on fact and not on personal opinion. • Substance over form principle: In accounting, real substance takes precedent over legal form. This means that accountants consider the economic or accounting point of view rather than just the legal point of view when recording transactions. This helps to explain the difference between a legal entity and an accounting entity. WHAT IS THE ACCOUNTING ENTITY ASSUMPTION? It is important to understand the principle of keeping the personal financial affairs of the business owners separate from the businesses they operate. Applying the accounting entity assumption helps produce meaningful and relevant financial reports for decision makers. LEGAL ENTITY

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An entity is something that is perceived, known or inferred to have its own separate existence. For example, the law recognises people as legal entities because they have their own separate existence. Under the law, this status allows people to sue other legal entities and to also be sued by them. The law in most countries of the world also recognises some non-persons or nonliving things as legal entities. Registered companies are a good example: while they are non-persons and non-living, they are recognised legal entities. These non-person legal entities have the same rights and obligations under the law as an individual person. However, not all non-person activities are recognised as legal entities. For example, a sole trader’s business (for example, a plumbing business) or a local social club (for example, a Darts Club) are not recognised as legal entities. This is because under the law they are not perceived to be separate and distinct from the owners or they have not been registered as a separate legal structure. ACCOUNTING ENTITY Accounting takes the concept of entity one step further than the law. In accounting, every business (including sole traders) becomes its own accounting entity. So, while the law does not recognise the sole trading business as a separate legal entity distinct from its owner/s, accounting does recognize the sole trader’s business as a separate accounting entity. The accounting system records the financial affairs of each accounting entity separately, as shown in Figure 6. Financial transactions are separated between:  

the business owner’s financial affairs the financial affairs of the sole trading firm, which the owner may operate.

Under the accounting entity assumption, a business entity, regardless of its legal status, is treated as being separate and distinct from the owners or managers of that business.

The owner of the firm • shown in the accounting system as one 'accounting entity'

The firm itself • shown in the accounting system as a separate and distinct 'accounting entity'

Figure 6 How the accounting system records the financial affairs of each ‘accounting entity’ PURPOSE OF THE ACCOUNTING ENTITY ASSUMPTION One of the key reasons for creating separate accounting entities is to enable the accounting system to provide more useful and relevant financial reports to assist decision making in relation to each specific ‘accounting entity’. For example, if the owner’s financial affairs are separated from the financial affairs of the business, decision makers like financiers and managers can clearly assess the business' s financial performance, position and sustainability. WHAT IS THE GOING CONCERN CONCEPT IN ACCOUNTING? One fundamental concept of the GAAP is the going concern concept. (The term concern here means a business or enterprise. It started being used to mean a business or enterprise in the early 1900s.) The going concern concept reflects the desire of stakeholders for realistic financial statements that accurately reflect the financial performance of a business over short and consecutive time periods. The going concern concept directs accountants to prepare financial statements on the assumption that the business is not about to go broke or be liquidated (that is, where the business closes and sells all assets for whatever price it can get). The opposite view to the going concern concept is that the business will cease trading shortly and that all the assets will be sold off within the current year.

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A

ccountants adopt the going concern concept so they can prepare realistic financial reports. Otherwise, accountants would have to write off all assets in the current period including long-term assets that still have an economic benefit for future periods. So, unless there is significant evidence to the contrary, accountants base their valuations and their reporting of financial data on the assumption that the business will remain in existence for an indefinite period. 

An indefinite period means the foreseeable future or long enough for the business to meet its objectives and to fulfil its commitments. It is important to note that the going concern concept does not imply or guarantee that the business is profitable or that it will remain so for the foreseeable future.

In other words, the going concern concept assumes that when a business buys assets such as land, equipment and buildings, it does so with the intent that these assets will produce income over a number of years. The business does not purchase these assets with the intention to close operations soon after purchase and then resell them. For example, let’s assume that a business recently purchased equipment costing $5,000, which had 5 years of productive/useful life. Under the going concern concept, the accountant would write off only 1 year’s value $1,000 (1/5th) this year, leaving $4,000 to be treated as a fixed asset with future economic value for the business. IMPLICATIONS OF THE GOING CONCERN CONCEPT The going concern concept has significant implications for the valuation of assets and the liabilities of a business. By applying the going concern concept, accountants are able to value and include long-term assets in a Statement of Financial Position (Balance Sheet). If the going concern assumption was not applied, the accountant would need to write these assets off as costs within the year of purchase. Applying the going concern concept also allows accountants to properly allocate transactions that overlap 2 or more consecutive years. As well, by applying the concept of a going concern, accountants can record assets at historical costs. Recording assets at historical cost means the accountant does not need to constantly assess the liquidated value of business assets when preparing the financial statements.

For example, partly completed manufactured goods like work in progress would have little value in a liquidation. However, under the going concern concept, work-in-process assets are recorded at their current costs, which would be significantly greater than the liquidated value. GOING CONCERN IN COMPANY LAW Another aspect of going concern affects the directors of companies. This is a slightly different concept to the going concern concept in accounting. Corporation laws generally require directors of companies to declare that their business continues to be a going concern. In this context, it means that the directors believe that the business they manage is able to pay its bills as they become due. These directors are required to disclose to the shareholders in the Notes to the Financial Statements if there are any factors that may put in doubt the company’s status as a going concern. WHAT IS THE REVENUE RECOGNITION PRINCIPLE? The revenue recognition principle is a set of guidelines that helps accountants to identify when a revenue event has taken place and how to appropriately record cash exchanges before, during and after the revenue event. The revenue recognition principle also helps to determine the accounting period in which the revenue is to be recorded. BACKGROUND TO THE REVENUE RECOGNITION PRINCIPLE The primary purpose of accounting is to provide the necessary information for sound economic decision making to take place. A key piece of that information is the calculation of net income (that is, revenues less expenses). The growth and size of the net income informs decision makers about the sustainability, financial strength and growth capacity of the business. Growth can be determined only by comparing net income results over a series of accounting periods made up of similar durations (that is, monthly, quarterly or yearly).

I

dentifying when revenue can be legitimately recorded into the books of the business, and the accounting period that it should be recorded against, are important considerations for accountants and decision makers alike. The revenue recognition principle guides accountants on how the revenue timing issues should be managed and treated in the financial statements. (Note: The

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term recognition means the moment when a financial transaction should be recorded in the bookkeeping system of a business.) The rule underpinning the revenue recognition principle is that revenue should be recorded in the books of a business only when:  

payment is assured (realisable) and measurable revenue has been actually earned (final delivery and completion of work).

These rules must be adhered to before an event can be recorded as revenue in the bookkeeping system of a business. Figure 7 summaries these principles.

Revenues are realised when measurable cash or claims to cash (Accounts Receivable) are received in exchange for goods or services.

Revenues are earned when such goods are transferred and services have been provided (that is, when the revenue generation process has been substantially completed or as soon as the customer has a legal right of ownership over the goods).

Revenues are considered realisable when the assets received in such an exchange are readily convertible to cash or have a clear claim to cash.

Figure 7 Accounting rules for treatment of revenue THE ISSUE WITH REVENUE RECOGNITION IN ACCOUNTING Let’s look at the following situation to try and understand what the revenue recognition principle sets out to solve.

C

ase study: revenue recognition principle and Blake’s Furniture Store

Blake's Furniture Store issues a purchase order for 20 timber chairs @ $125 each in December and includes a check for $500 as a deposit. According to the agreement, the chairs are to be delivered in January with the remaining $2,000 to be paid in February.

This financial event takes place over three monthly accounting periods: December, January and February. So, the question is ... ‘In what month should the revenue be recorded (recognised) and how much should be recorded?’ The answer to this question is determined by the bookkeeping method being used by the business, and then applying the revenue recognition principle There are two bookkeeping methods: the cash accounting method and the accrual accounting method. Large corporations and for-profit companies must use the accrual accounting method while small businesses and associations can choose one or the other. Using the cash accounting method to determine when revenue should be recognised is relatively easy because under the cash accounting method revenue is recognised (recorded) when the cash from the customer is actually received(that is, revenue recorded in the books of the business is $500 in December and $2,000 in February). The accrual accounting method records the revenue in the month that it was earned, without regard to when cash is actually received. Under the accrual accounting method, revenue is earned when either the goods are delivered or the service has been performed/completed (revenue recorded in the books of the business is $2,500 in January). (Note: The deposit in December is initially treated as a liability because the deposit money remains owing to the customer until the legal transfer of ownership of the chairs takes place in January with the delivery of the good.)

TYPES OF TRANSACTION INVOLVING REVENUE The revenue recognition principle impacts on the four primary ways that a business can earn revenue. These are illustrated in Figure 8.

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Providing services: These revenues are recognised when the service is completed. It is common practice to use the date on the invoice to determine the revenue recognition (recording) date.

Selling inventory: These revenues are recognised at the date of the sale but commonly interpreted as the date of delivery. The date is taken from the invoice or cash receipt.

Earning Granting permission torevenue use

Selling an asset other than

recognised at the agreed/negotiated time intervals or as the assets are actually used.

inventory: These could be fixed assets that are disposed of during the conduct of a business and revenues are recognised when the sale takes place or when the invoice has been sent.

business assets (e.g. interest for borrowed/invested money, rent for use of fixed assets of business, and royalties for use of intangible assets like patents): These revenues are

Figure 8 Four primary ways that a business can earn revenue

SUMMARY—REVENUE RECOGNITION PRINCIPLE 

Revenues are realised when measurable cash or claims to cash (Accounts Receivable) are received in exchange for goods or services. Revenues are considered realisable when the assets received in such an exchange are readily



convertible to cash, or have a clear claim to cash. Revenues are earned when goods are transferred and services have been provided (that is, when the revenue generation process has been substantially completed, or as soon as the customer has a legal right of ownership over the goods).

WHAT IS THE MATCHING PRINCIPLE IN ACCOUNTING? The matching principle is a fundamental accounting concept in the measurement of net income. The matching principle directs those preparing financial statements to ensure that revenues and all their associated expenses are recorded in the same accounting period. This is done to ensure that a net income is not distorted by time differences in billing and cash exchanges. The matching principle is the basis on which the accrual accounting method of bookkeeping is built. BACKGROUND TO THE MATCHING PRINCIPLE

One key purpose of accounting is to provide the information needed for sound economic decision making. Sound economic decisions can be made only if a business is able to measure and report accurately on its profitability. Profitability for a business directly determines the sustainability, financial strength and growth capacity of the business. Profitability is calculated as the amount remaining after revenue has been offset by all the expenses incurred in earning that revenue.

S

o, it is vitally important that business decision makers identify all the revenues earned for an accounting period and that these revenues are offset by all the associated expenses incurred in earning that revenue. This requirement led to the development of the matching principle. The matching principle helps avoid the possibility of mis-stating the net income for a given period. The choice of bookkeeping method impacts significantly on the matching principle. There are two methods of bookkeeping allowable under tax laws and accounting standards: the cash accounting method and the accrual accounting method. THE MATCHING PRINCIPLE AND CASH ACCOUNTING The cash accounting method does not apply the matching principle. This is because the cash accounting method is designed as a simpler bookkeeping system for use by small sole proprietor businesses or small associations primarily for tax purposes. The cash accounting method delays recording revenue and expenses until the cash actually exchanges (that is, the cash is received or paid). Under the cash accounting method, no regard is taken to the period in which the revenue was earned or the expense legally incurred. THE MATCHING PRINCIPLE AND ACCRUAL ACCOUNTING On the other hand, the accrual accounting method does adhere to the matching principle. The accrual accounting method also recognises revenue (revenue recognition principle) as soon as a product has been sold or a service has been performed, regardless of when the money is actually received by the business.

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Unlike the cash accounting method, the accrual accounting method eliminates the timing mismatches that can occur when expenses paid and revenue received happen in different accounting periods. WHEN DOES THE MATCHING PRINCIPLE BECOME AN ISSUE? The matching principle becomes an issue when accountants wish to report on the financial performance of a business for a specific period. This specific period in accounting is created under the accounting period convention. The accounting period convention incorporates the desire by decision makers to receive regular and comparable updates on the performance of their business on a per month, per quarter or on an annual basis (that is, for tax purposes). The matching principle ensures that the financial reports for these short accounting periods accurately measure the net income. APPLYING THE MATCHING PRINCIPLE So, to apply the matching principle appropriately, an accountant would need to:   

choose an accounting period apply the accrual accounting method of bookkeeping simultaneously adhere to the revenue recognition principle.

Businesses that adopt these principles are able to more accurately evaluate their actual profitability and financial performance for specific periods of time by eliminating the disparities in the accounting entry timings.

ase study: Build Rite and the matching and revenue recognition principle C

The following case study presents examples of the matching principle and the revenue recognition principle under the two bookkeeping methods:

 

cash accounting method, or cash basis accrual accounting method, or accrual basis.

Table 4 Comparison between cash accounting and accrual accounting methods

Method A business is paid $1,000 in January for ABC consulting work completed and invoiced in December.

Cash accounting method Records $1,000 as Consultancy revenue in January.

Accrual accounting method Records $1,000 as Consultancy revenue in December.

A business pays a printing bill of $500 in February for printing used in December for ABC consultancy work.

Records $500 as printing expense in February.

Records $500 as printing expense in December.

The impact on net income reporting using the cash method is: •

no impact on December net income with these transactions. Profitability is understated for the month. net income for January increased by the cash revenue received of $1,000. Profitability is overstated for the month. net income for February decreased by the paid expense of $500. Profitability is understated for the month. matching principle and revenue recognition principle are not applied.

• • •

The impact on net income reporting using the accrual method is: •

net income for December increased by $500 (that is, $1,000 revenue less $500 expense) no impact on net income for January or February with these transactions net income for all months accurately stated matching principle and revenue recognition principle are applied.

• • •

IMPACT OF THE MATCHING PRINCIPLE ON FINANCIAL TRANSACTIONS Before producing the financial statements for a business, accountants need to scrutinise the transactions and source documents to ensure that all revenue has been identified under the revenue recognition principle and that all associated expenses incurred have been identified, matched and recorded. Invariably, this scrutiny identifies end-of-period adjustments that need to be made to the ledger accounts. These adjustments are needed to ensure that the ledger accounts comply with the matching principle and to produce meaningful reports that accurately describe the financial performance and position of the business. These end-of-period adjustments create transactions known as accruals. There are four types of accruals that create transactions in the end-of-period process in order to comply with the matching principle. These four types of accrual are described in Table 5.

Table 5 Four types of accruals Type of revenue

Description

Accrued revenue

Adding transactions for revenue that has not yet been invoiced

A staged monthly invoice for partially completed work $1,000 in a six (6) month contract worth $6,000

Accrued expense

Adding transactions for expenses that have

The electricity used in the current reporting period that has not yet been

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Example

not yet been recognised

billed by the supplier.

Deferred revenue

Transferring to future periods income transactions that, while recorded in the current period, actually belong to future periods. These amounts become liabilities of the business because the business has not yet performed the work and so has no claim to the customer payment.

$1,000 cash received by the business as a deposit for work that has not yet been commenced

Deferred expense

Transferring to future periods expense transactions that, while recorded in the current period, actually belong to future periods. These amounts become assets of the business because the value of the expense has not yet been used up or utilised.

Transferring the remaining time covered under a 12- month insurance payment

Note: A special type of accrued expense is depreciation. Depreciation expense apportions the cost of a fixed asset over its useful life. The useful life of a fixed asset will cover a number of accounting periods.

SUMMARY—MATCHING PRINCIPLE IN ACCOUNTING In summary, the matching principle in accounting:  is used by accountants to calculate net income  is vital for providing decision makers with the accurate financial performance of a 

business reports the revenues and the associated expenses incurred in earning that revenue



in the same accounting period accounts for revenue and expenses when they happen regardless of the cash

 

exchange timings (that is, when cash is received or paid) is the basis on which the accrual accounting method of bookkeeping is built does not apply for the cash accounting method of bookkeeping



is closely aligned with the revenue recognition principle and the accounting period



convention leads to additional accrual transactions being created from the end-of-period adjustments that need to be made to the accounts of the business before the



financial statements are distributed eliminates the disparities that can occur in entry timings in the books of the business.

WHAT IS THE TIME PERIOD ASSUMPTION IN ACCOUNTING? The time period assumption is also known as the periodicity assumption or accounting period assumption. The time period assumption allows accountants to subdivide the entire economic life of a business into specified time intervals. It is assumed that accounting can manage the varying time-period impacts of financial transactions, and so produce financial statements that accurately reflect the financial performance of business in a specific time period. BACKGROUND TO THE TIME PERIOD ASSUMPTION IN ACCOUNTING As businesses have grown and become more complex over the last few centuries, so did the growing need for, and importance of, accounting. The need for the accounting function to provide regular financial information about a business’s performance grew as:    

professional managers took over from owners–operators in managing large businesses business owners (shareholders) became more detached from the day -to-day operations of the business more complex business structures were created governments increased their legislative requirements of business (for example, through tax and corporate law).

TIME PERIOD ASSUMPTION The primary purpose of accounting is to provide the necessary information for sound economic decision making. In the fast-changing world of business, decision makers need this information to be provided in a timely manner. What a ‘timely manner’ means, however, may vary according to business needs. Figure 9 outlines some possible timeframe scenarios.

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Daily Daily sales sales report report for for aa salesperson salesperson

Weekly Weekly gross gross profit profit report report for for aa business business unit unit manager manager

Quarterly Quarterly and and half-yearly half-yearly Profit Profit and and Loss Loss Statement, Statement, Balance Balance Sheet Sheet and and Statement of Cash Statement of Cash Flows Flows reports reports for for shareholders shareholders

Monthly Monthly profit profit and and loss report for loss report for aa company company CEO CEO

Yearly Yearly tax tax and and annual company annual company reports reports for for government government agencies agencies and and statutory statutory authorities authorities

Figure 9 Examples of timeframes for the reporting of financial information So, while a business may be expected to exist for a long period of time, stakeholders in the business need reports on business activities and financial performance to be provided in shorter time periods. Stakeholders also require that these reports be regular and sequential. This is so that performance with prior like periods can be compared, and so that business strategies can be changed in regard to any identified trends. This enables decisions makers to makes changes to business strategies in a timely fashion to take account of any identified trends, whether they be positive trends to be exploited or negative trends to be mitigated. In responding to this information need of stakeholders, accountants assume that the entire economic life of a business can be subdivided into stakeholderspecified time periods. In making the time period assumption, accountants also assume that it is possible to prepare financial statements that will accurately reflect the financial performance of a business for the specified time period.

I

n fact, the going concern assumption, the accrual accounting method, endof-period adjustments, accruals, the revenue recognition principle and the matching principle have all developed from this push by stakeholders to accurately reflect the entity’s financial

performance for shorter specified time periods. THE ACCOUNTING PERIOD A term deriving from the time period assumption is the accounting period. The accounting period is the period of time over which net income/profits are calculated and reported. The common accounting periods are months and quarters for internal stakeholders and years for external stakeholders, either fiscal (July–June) or calendar (January–December). The time period covered by the statements (accounting period) will be shown in the header area of the Income Statement, the Statement of Cash Flows, and the Statement of Stockholders’ Equity (that is, the Income Statement for the month ended 31 March 20xx or the Statement of Stockholders’ Equity for the year ended 31 December 20xx).

SUMMARY—TIME PERIOD ASSUMPTION IN ACCOUNTING The time period assumption:  grew from the need to provide regular reports on financial performance to both 

internal and external stakeholders allows accountants to subdivide the entire economic life of a business into specified time intervals. This is vital in providing decision makers with accurate financial



performance of a business. assumes that time periods can be set by stakeholders according to their needs (for



example, monthly for managers and yearly for government tax departments) allows for performance comparisons to be made with like for like periods to



identify any trends (opportunities to exploit, or threats to mitigate) is identified as the accounting period and is stated in the header of the Income



Statement, the Statement of Cash Flows and the Statement of Stockholders’ Equity is closely related to the going concern concept, the accrual accounting method, balance-day adjustments, accruals, and the revenue recognition principle in regard to accurately reflecting the financial performance of businesses for these specified time periods.

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TYPES OF ACCOUNT GROUP CLASSIFICATIONS THE FIVE ACCOUNT GROUPS The five account groups have been a part of the accounting system for the past 500 years. Every financial transaction can be categorised by accounts belonging to these groups. The five account groups are shown in Figure 10.

Assets - items of economic value over which the firm has legal control (for example, land, cash, equipment)

Liabilities - monies owed by the firm to external entities (for example, trade creditors, loan providers, government agencies)

Revenue - monies paid by others for goods and services provided by the firm (for example, merchandise sales, professional fees earned)

Owner's equity monies owed by the firm to internal entities (for example, investors, owners)

Expenses - assets that were consumed and the cost of services used in earning the revenue (for example, rent, cost of goods sold, wages)

Figure 10 The five account groups WHAT ARE ASSETS IN ACCOUNTING? Assets are those items of financial value that the business will use to make profits for the owners. The formal definition of an asset as described by the International Accounting Standards Board is as follows: An asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. It is important to understand that, in an accounting sense, an asset is not the same as ownership. While the business has control over its assets, the business is not the ultimate owner of their inherent monetary value. ASSETS AND THE ACCOUNTING EQUATION

Assets are one of the three elements in the accounting equation; the other two, as mentioned earlier, are liabilities and owner’s equity. The accounting equation, as mentioned earlier, states: Assets = Liability + Owners Equity

Assets

Accounting equation

Liabilities

Owner’s equity

Figure 11 The three elements in the accounting equation What the account equation means for a business is this: 

If the business ceases trading and sells its assets, the money from that sale would be used to first pay out the obligations of the business (liabilities), with the remaining money going to the owners (owner’s equity).

ACCOUNTING ENTITY ASSUMPTION AND THE ACCOUNTING EQUATION To help to clarify this important point—namely, the relationship of assets to a business— let us first revisit the accounting entity assumption. Previously, we saw that a business is set up to make profits for the owners. We also saw that when operating under the accounting entity assumption, the business is treated in accounting as separate and distinct from the owner/s of the business. When the business is first formed, it owns nothing in its own right and it owes nothing to anyone. Once the business receives initial funds (capital) from the owners and other lenders (liabilities), it is able to use those funds to purchase

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items of economic value that the business can use to produce profits for the owners. These items are known in accounting as the assets of the business.

S

o assets in accounting are anything that a business legally controls that has both inherent monetary or exchange value and is capable of producing future profits for the business. The business will uses both the equity funds (owner’s equity) and the debt funds (liabilities) to purchase assets. Figure 12 lists some typical assets.

Equipment

Inventory

Cash reserves

Figure 12 Some typical assets So, from the business perspective, the value of the assets the business controls must be equal to the combined value of the equity funds (owner’s equity) and the debt funds (liabilities). The relationship between assets, liabilities and owner’s equity is known as the accounting equation. TYPES OF ASSETS IN ACCOUNTING Assets are categorised in different ways.

KeyFACTS •

Assets can be tangible and intangible.

• •

Tangible assets can be touched or handled (for example, land, buildings, equipment, vehicles). Intangible assets cannot be touched (for example, patents, trademarks, copyrights, franchises, goodwill, web sites). But intangible assets still have a monetary value and a business can control

•

them. Assets can be represented on the Statement of Financial Position (or Balance Sheet) as current assets or non-current (fixed) assets.

CURRENT ASSETS Current assets are cash and other assets expected to be converted to cash, sold or consumed either within 1 year or in the operating cycle (whichever is longer). These asset values continually change in the normal course of business activity. There are five major sub-groups detailed in the Figure 13.

Cash and cash equivalents

Accounts receivables

Short-term investments

Sub-groups of current assets

Pre-paid expenses

Inventory

Notes 1. Cash and cash equivalents include currency, petty cash, bank deposit accounts and negotiable instruments (for example, money orders, cheque, bank drafts).

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2. Short-term investments include securities bought and held for sale in the near future to generate income on short-term price differences (trading securities). 3. Accounts receivables is money owed to the business by its customers who purchased goods and/or services on account. 4. Inventory is merchandise held to sell to customers. Also includes work in progress for a manufacturing business. 5. Pre-paid expenses are expenses paid in advance. They still have asset value as the value has not yet been exhausted or used.

Figure 13 Sub-groups of current assets NON-CURRENT/FIXED ASSETS Non-current or fixed assets have value beyond the next 12 months and do not constantly change in value as current assets do. They are classified as noncurrent or fixed assets as long as they remain for use within the business and are not items that are purchased with the intent to sell.

KeyFACTS •

Fixed asset accounts may include land, buildings, furniture, fixtures, equipment, vehicles,

•

computers, furniture and appliances. Long-term investments are investments that are held for many years and are not intended to be

•

disposed of in the near future (that is, bonds, common stock, or long-term notes). Intangible assets are items of economic value that are not physical in nature (that is, patents, goodwill and trademarks).

OTHER ASPECTS OF ASSETS IN ACCOUNTING Assets are recorded in the Statement of Financial Position (Balance Sheet) as monetary values. This statement is the detailed description of the accounting equation and so also lists the liabilities and the owner’s equity. Fixed assets are written off against profits over the asset’s expected life. This is done by depreciating a proportional amount of the asset value each accounting period. The accumulated depreciation since the asset was purchased is displayed as a negative amount alongside the asset in the Statement of Financial Position (Balance Sheet). WHAT ARE LIABILITIES IN ACCOUNTING? Liabilities are the financial obligations and debts of an entity arising from past transactions and occurring during the course of business operations. These financial obligations are paid by the accounting entity to external parties over time via the transfer of economic benefits including money, goods or services. The external parties of an accounting entity include banks, other financial institutions, creditors and government agencies.

Liabilities include credit card debt, overdrafts, accounts payable, term loans and mortgages. DEFINITION OF LIABILITIES IN ACCOUNTING The Australian Accounting Research Foundation defines liabilities as follows: the future sacrifice of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions and other past events. Liabilities are the monies that a business is obliged to repay to others. Some characteristics of liabilities are detailed in Figure 14.

Liabilities Liabilities are are funds funds provided provided to to a a business business mostly mostly by by non non owners owners..

Liabilities Liabilities are are also also known as the known as the debts debts of of a a business. business.

Liability Liability funders funders are are not not entitled entitled to to the the profits profits of of a a business. business.

Liability Liability funders funders are are sometimes sometimes entitled entitled to to interest interest on on the the unpaid debt. unpaid debt.

The The business business uses uses liability liability funders funders to to purchase purchase assets. assets.

Liability Liability funders funders have have certain certain claims claims over the assets over the assets of of the the business. business.

Liabilities Liabilities are are typically: typically: 1. 1. loans loans owing owing to to financial institutions financial institutions 2. 2. money money owing owing to to suppliers suppliers (creditors) (creditors) 3. 3. payments payments owning owning to to governments governments (taxes) (taxes)

Figure 14 Some features of liabilities and liability funders (also known as debt funders) When the assets of a business are liquidated, the debts are paid first. The equity funders are entitled to what money is left over.

KeyFACTS •

A business uses liabilities (debt funds) to purchase assets.

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•

Liability funders (debt funders) are not entitled to the profits of the business, are sometimes entitled to interest on the unpaid debt, and have certain claims over the assets of the business.

ACCOUNTING ENTITY ASSUMPTION AND LIABILITIES To understand liabilities, let us first revisit the accounting entity assumption. The accounting entity assumption states that, in accounting, a business must be treated as a distinct entity. The business, as a distinct entity, will record its financial transactions in a separate book of accounts to that of the owners of the business. By applying the accounting entity assumption, the business is able to give accurate reports on its own financial position and performance. The accounting entity assumption also determines the perspective that the business will take when recording financial transactions. A business is created to make profits for the owners of that business. When the business is first created, it owns nothing in its own right and it owes nothing to anyone. It is an empty shell. However, from this point on, the business will view every financial transaction from its own perspective. It will not record transactions from the owner’ s perspective. The funding of a business is illustrated in Figure 15, and explained further in the text that follows.

Step 3: Step 2:

Step 1: investm ent of funds by business owners, called owner's equity

Business then receives funds from non-owners, called liabilities

Business uses owner's equity (equity funds) and liabilities (debt funds) to purchase assets

Figure 15 The funding of a business STEP 1—INVESTMENT BY BUSINESS OWNERS (OWNER’S EQUITY) The first transaction a business records into its books of account is the initial investment of funds by the owners of the business. These investment funds— provided to the business by the owners—are called owner’s equity (or equity funds).

Owner’s equity funds remain in the business until the business ceases to trade. The business views these funds as belonging to the owners but the business is not obliged to repay them. Owner’s equity funds are investment funds. Investment funds entitle the owners to all the profits that the business makes. STEP 2—FUNDS RECEIVED FROM NON-OWNERS (LIABILITIES) Soon after the business is created it also receives funds provided by non-owners. Banks and suppliers are typical non-owners who provide funds to the business. Funds provided to the business by non-owners are called liabilities. The business acknowledges that these funds belong to the non- owners and understands that the business is obliged to repay them. Liability funds are known as debt funds. Debt funds do not entitle the fund providers to any profits that the business makes. However, sometimes debt fund providers will receive an interest payment for the funds provided. STEP 3—USE OF EQUITY AND DEBT FUNDS TO PURCHASE ASSETS The business uses both the equity funds (owner’s equity) and the debt funds (liabilities) to purchase assets. Assets, as we saw earlier, are those items of financial value that the business will use to make profits for the owners. Typically assets include equipment, inventory and cash reserves. So, from the business perspective, the value of the assets the business controls must be equal to the combined value of the equity funds (owner’s equity) and the debt funds (liabilities). The relationship between these three elements— assets, liabilities and owner’s equity— is, as stated earlier, known as the accounting equation. TYPES OF LIABILITIES IN ACCOUNTING There are three main types of liabilities in accounting:   

current liabilities non-current liabilities (sometimes known as long-term liabilities) contingent liabilities.

CURRENT LIABILITIES Current liabilities are short-term financial obligations. Short term in this context is defined as obligations that are required to be paid off within one year. Current liabilities are recorded in the Statement of Financial Position (Balance Sheet). Typical current liabilities include:    

expenses due but not yet paid (wages, taxes, and interest payments) accounts payable to suppliers short-term notes revenues collected in advance.

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NON-CURRENT LIABILITIES Non-current liabilities are long-term financial obligations. Long-term liabilities are not required to be paid off within 1 year. Long-term liabilities often involve large sums of money that allowed the business to open or expand or to purchase a significant asset. Non-current liabilities are recorded in the Statement of Financial Position (Balance Sheet). These debts will typically take the business a long time to repay. Typical long-term liabilities include:   

mortgages over property a bank term loan lease obligations for vehicles or equipment.

CONTINGENT LIABILITIES Contingent liabilities are type of liability that typically affects large public companies. A contingent liability is a non-measurable liability that a company has for an adverse event, transaction or incident that has already taken place. Contingent liabilities are reported in the Notes to the Accounts. Contingent liabilities are not usually recorded in the Statement of Financial Position (Balance Sheet) of the business. Typical contingent liabilities could be:   

a lawsuit taken against a company an environmental clean-up responsibility new regulations or penalties that could impact on the company.

WHAT IS OWNER’S EQUITY IN ACCOUNTING? Owner’s equity is one of the three elements in the accounting equation; the other two, discussed earlier, are assets and liabilities. ACCOUNTING ENTITY ASSUMPTION AND OWNER’S EQUITY To understand owner’s equity, let us first revisit the accounting entity assumption. The accounting entity assumption states that, in accounting, a business must be treated as a distinct entity. The business, as a distinct entity, will record its financial transactions in a separate book of accounts to that of the owners of the business. By applying the accounting entity assumption, the business is able to give accurate reports on its own financial position and performance. The accounting entity assumption also determines the perspective that the business will take when recording financial transactions. Earlier, we saw that a business is created to make profits for the owners of that business. The business owns nothing in its own right when it is first created and it owes nothing to anyone. However, from this point on, the business will view every financial transaction from its own perspective. It will not record transactions from the owner’s perspective.

FUNDS PROVIDED BY THE OWNERS OF A BUSINESS The first transaction a business records into its books of account is the initial investment of funds by the owners of the business. These investment funds, provided to the business by the owners, are called owner’s equity. Owner’s equity funds remain in the business until the business ceases to trade. The business views these funds as belonging to the owners but the business is not obliged to repay them. Owner’s equity funds are investment funds. Investment funds entitle the owners to all the profits that the business makes. Owner’s equity funds are also known as equity funds. FUNDS PROVIDED BY NON-OWNERS OF A BUSINESS Soon after the business is created it also receives funds that are provided by non-owners. Banks and suppliers are typical non-owners who provide funds to the business. Funds provided to the business by non-owners are called liabilities. The business will then use both the equity funds (owner’s equity) and the debt funds (liabilities) to purchase assets. Assets are those items of financial value that the business will use to make profits for the owners. Typically, assets include equipment, inventory and cash reserves. So, from the business perspective, the value of the assets the business controls must be equal to the combined value of the equity funds (owner’s equity) and the debt funds (liabilities). The relationship between assets, liabilities and owner’s equity is known as the accounting equation. DEFINITION OF OWNER’S EQUITY IN ACCOUNTING Owner’s equity represents the resources invested by the owners in the business. It is often known as the ‘residual’ claim over the assets because the claim of the debt funders (liabilities) must be satisfied before the claim of the owners. Owner’s equity has also been defined as follows: Owner’s equity is an accounting term used to describe the net investment of owners or stockholders in a business. Under the accounting equation, equity also represents the result of assets less liabilities. Owner’s equity: • • • •

represents investment funds that the business is not required to repay equals Assets less Liabilities is also called net assets, or just ‘equity’, or the book value of the company is the funds provided to a business by its owners.

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When the assets of a business are liquidated, the debts are paid first. The equity funders (owners) are entitled to what money is left over.

Owner’s equity increased by: 1. additional investments by owners 2. current earnings (profits of the business) 3. previous period's profits not being distributed to owners (retained earnings)

Owner’s equity decreased by: 1. equity withdrawals in the form of: - drawings by sole proprietors - dividends by shareholders of companies - losses from the business operations

Figure 16 Financial impacts on owner’s equity

SUMMARY—OWNER’S EQUITY     

Owner’s equity represents investment funds that the business in not required to repay. Under the accounting equation: Owner’s equity = Assets less Liabilities. Owner’s equity is also called net assets, or simply ‘equity’, or the book value of the business. Owner’s equity is funds provided to a business by its owner/s. When the assets of a business are liquidated, the debts are paid first. Equity funders are entitled to what money is left over.

WHAT IS REVENUE IN ACCOUNTING? Revenues or revenue in business is the gross income received by an entity from its normal business activities before any expenses have been deducted. Income may be received as cash (or cash equivalent). Income is typically generated from the sale of goods or the rendering of services for a particular period of time. BACKGROUND TO REVENUE IN ACCOUNTING The purpose of business is to earn a profit from the sale of products (revenue). These products may be tangible in nature (that is, goods) or intangible (that is, services). Profit is the money left over after deducting from the gross sales of these products, the cost of the activities required to generate those sales (expenses).

KeyFACTS 

A business generates revenue when it exchanges its goods or services with customers in return for money or other assets.



A business incurs expenses by exchanging its assets for the goods and service activities needed to generate that revenue.



A business makes a profit if its revenues exceed its expenses. However, if the costs of generating the revenue (expensed assets and service activities) are greater than the revenue received, the business makes a loss. (Note: Sometimes a business receives assets (cash) from lenders (loans provided to the business) or from its owners (capital investment). This receipt of assets is not revenue. Only those assets received from customers or clients in exchange for goods or services are treated as revenue in accounting.)

Over the 500 years or so of applied accounting, the terminology of the word revenue has evolved, being given labels such as ‘turnover’, ‘top line’, ‘sales’, ‘gross receipts’, ‘fees earned’ or even ‘income’. Unfortunately, the term income also has a meaning in some circumstances of profit (that is, after expenses have been deducted) and this can be confusing for some. Revenue is referred to as the ‘top line’ because that’s where revenue is reported on the Income Statement (Statement of Financial Performance). Net income or net profit on the other hand is referred to as the ‘bottom line’ because it is reported in the last line of this same statement. Non-profit organisations may refer to revenue as gross receipts. Revenue in the double-entry bookkeeping system is one of the five account groups where financial transactions can be recorded. The other four are Assets, Liabilities, Owner’s equity, and Expenses. Revenue accounts are created in the General Ledger to record the various ways that the entity earns revenue. TYPES OF REVENUE IN ACCOUNTING Business revenue is gross income generated from the normal/ordinary activities of a business entity (whatever its type). This revenue may come from: • sale of goods: For businesses such as manufacturers, wholesalers and retailers, most revenue is generated from the sale of goods. • provision of services: Service businesses (for example, accounting firms, doctors, hairdressers) generate most of their revenue from providing (rendering) services. • loan of fees and investment: Financial services businesses, such as car rentals and banks, receive most of their revenue from fees and interest generated by lending assets to other organisations or individuals, or from royalties earned for the use of intellectual property. Investment firms may receive revenue from dividends paid to them by other companies based on their shareholdings.

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• Other: Non-profit organisations generate revenue that includes donations from individuals and corporations, support from governments, income from fundraising activities or membership dues. Other income in the for-profit sector could be the profit made on the sale of assets. es ris A fr o m c tiv a s e ho d ra n u b fe rma g s l rn tie fE o g tiv c a x e fp v d ra n s gg e u n r- -ly s a ic p ty a tic u s e g n v e E a tu n v ly E io c a re tu w o fl n e h ts a fb o c s ly in u d n u t s a e x p e s n e x s r s n e a to th in eb in e s u s s a tM u o c a rtn p uc o e ib in u o rla e p g t a rlio t mo e d rIs ta e n me m ry ta e u rm s te s in s d in

Figure 17 Main features of revenue NET REVENUE AND OTHER REVENUE Revenue is the gross sales/fees earned. Net revenue is the gross revenue minus any product returns, allowances and any discounts for the early payment of invoices. (Note: Revenue should not include tax collected by the business in relation to a value-adding tax. This cash received should not be recorded as revenue but rather as a liability because it is monies owed to the government.) While revenue is the gross income received from the normal operations of a business, other revenue (that is, non-operating revenue) is revenue received from the non-core operations of a business. This could be:  

profit on the sale of equipment used by the business to generate sales interest income earned from keeping a checking account with a bank.

Other revenue/income is usually separated and reported at the bottom of the Income Statement. This is because it may otherwise distort the view about the sustainable financial performance of the business, which should be based on its normal operations. REVENUE RECOGNITION IN CASH ACCOUNTING AND ACCRUAL ACCOUNTING

One further complication with the concept of revenue is that revenue reported for a particular period will depend on the accounting method a business has adopted. This complication is dealt with under the revenue recognition principle where generally accepted accounting principles or International Financial Reporting Standards determine what is to be reported as revenue in a given period. Each of the accounting methods (cash accounting and accrual accounting) uses a different approach to measure revenue. 



Accrual accounting records (recognises) revenue as soon as the legal obligation to pay has been transferred to the customer, regardless of when the cash is exchanged. Cash accounting delays the recording (recognising) of the revenue until the cash payment is received by the customer.

WHAT IS THE DIFFERENCE BETWEEN REVENUE AND INCOME? Revenue is the gross sales or cash receipts received by a business from its customers in the ordinary course of business that involves selling goods or providing services. Revenue is also known as turnover, sales, or fees earned. 

Revenue is the first line detailed on an Income Statement.

Income is the increase in economic benefit available to the business owners from the net result of the revenues less the expenses incurred in earning that revenue for a previous period. Income is also known as net profit or earnings. 

Income is the last line detailed on an Income Statement, which is why it is also called the ‘bottom line’.

BACKGROUND TO THE REVENUE AND INCOME Over the past 500 years of accounting, many terms have developed around the concept of income. These terms are often used interchangeably in everyday life without consequence. However, some of these terms in accounting describe different aspects of the profitability of a business. Adding to the confusion for accounting students is the fact that some accounting teachers, textbooks and even some accountants themselves may use these words interchangeably in general conversation. The important thing to understand is that there are two distinct accounting concepts here that need to be understood, and named in a consistent manner. REVENUE VERSUS INCOME

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Generally, the terms turnover, sales and revenue mean the same thing. These terms refer to the sale of goods or the provision of services that arise from the core activity of the business. 

This item (revenue) appears as the first line on an Income Statement.

On the other hand, income (or net income), earnings and profit (or net profit) generally mean the same thing. These terms refer to the net increase in economic benefit made available to the business after expenses have been deducted from the revenue/turnover/sales in a given accounting period. 

This item appears as the last entry on the Income Statement, which is why income is often referred to as the ‘bottom line’.

Gains are special revenue items that do not arise from the core activity of the business (for example, gains from the disposal of a fixed asset or gains from movements in the exchange rates involving international transactions).

I

ncome then encompasses both revenue and gains and is the increase in the owner’s equity arising from the activities of the business (that is, revenues less the costs involved in generating that revenue). It should be noted that income does not include increases in equity that are contributed by owners. In accounting practice, income is always used in the context of net income and is the same as net profit.) DEFINITIONS OF REVENUE, GAINS, GROSS PROFIT, NET PROFIT AND INCOME IN ACCOUNTING Definitions and explanation of some key terms associated with revenue and income are detailed in Table 6.

Table 6 Revenue and income—definitions and explanations Term

Definition

Explanation

Revenue

The gross increase in cash, receivables and other assets that arise in the ordinary course business

Revenue could include:      

sales of goods by a retailer (merchandise sales) tuition fees by educational institutions accounting fees by an accounting firms (rendering of services) lease income by a property developer interest earned by banks dividends received by investment firms.

Revenues result from activities that define the reason

for the existence of the business—the sale of goods or provision of services for which the customers pays. Gains

Represent other items considered as income but that do not arise in the ordinary course of business

Gains may be sales from the disposal of resources other than products. This includes:   

gain on the sale of investments gain on the sale of property, plant and equipment gains on the sale of intangible assets.

They may also be foreign exchange gains (that is, gains resulting from foreign currency exchange transactions and translations). The key difference between revenue and gains is that revenues are earned from the regular activities of the business (its primary reason for existence) and gains are earned from a peripheral (non-core) activity of the business. Income

The increase in economic benefit for the owners of a business that arises during an accounting period

The economic benefit may result in an increase in assets (cash/receivables) or a decrease in liabilities (payables, loans) but always with a corresponding increase in owner’s equity.

Gross profit

The profit before indirect costs like overheads have been deducted

Gross profit is the amount left over from the revenue after the direct costs of making a product or providing a service have been deducted.

Net profit

The amount left over after deducting indirect costs from gross profit

Indirect costs include such expenses as depreciation, distribution, selling and administrative costs, taxation, and interest payments.

Income in accounting means the amount left over after revenue has been reduced by the expenses incurred in earning that revenue (that is, the cost of doing business). Income is the same as net profit.

WHAT ARE EXPENSES IN ACCOUNTING? An expense in accounting is the money spent or cost incurred in an entity’s efforts to generate revenue. Expenses represent the cost of doing business where doing business is the sum total of the activities directed towards making a profit. BACKGROUND TO EXPENSES IN ACCOUNTING It is important to firstly be quite clear about the difference between a cost and an expense. This is because, as explained below, these elements have different meanings in accounting. 52


 

A cost is a monetary measure of the resources that have been sacrificed to acquire an asset. An expense is that part of the cost that has expired and been used up by activities directed at generating revenue.

While all expenses are costs, not all costs are expenses.

KeyFACTS Expenses can take the form of:   

cash payments (such as wages and salaries, rent, advertising) an expired portion of an asset (for example, calculated depreciation/amortisation) a reduction in revenue (such as bad debts).

Expenses are summarised and included in the Income Statement as deductions from the revenue. Revenue minus expenses calculates the net profit for the business for a given period. (Note: Cash payments do not always mean that an expense has occurred. For example, a business might pay $10,000 to the bank to reduce its bank loan. This payment will reduce the cash holding of the business but it is not an expense. It is rather a reduction in the amount of the loan and liability the business has to the bank.) In double-entry bookkeeping, expenses are one of the five key account groups by which financial transactions can be categorised. The other four account groups are assets, liabilities, owner’s equity and revenue. Expenses, under the double-entry bookkeeping system debit/credit rules, are recorded as:  

a debit to the specific expense account a corresponding credit entry as either a decrease in an asset (exhausting something of economic value, usually cash) or an increase in a liability (creating an obligation to pay for goods or services used in the generation of revenue, usually accounts payable).

(Note: The purchase of such things as vehicles, equipment or buildings is not an expense. These purchases are known as capital expenditure items and are treated initially as an asset to be expensed over its useful life—that is, by depreciation/amortisation.) EXPENSES IN CASH AND ACCRUAL ACCOUNTING

Expenses are recorded in the ‘books of a business’ according to the method/basis of accounting chosen by the business: cash accounting or accrual accounting (also called cash basis and accrual basis, respectively). 



Under accrual accounting: The expense will be recorded in the accounting system at the point when a legal obligation has been created. This is usually at the date of goods shipped/received or the date that the service was performed. Under cash accounting: The recording of the expense is delayed until the cash payment is made (for example, an electricity bill for the month of April but paid in May will be recorded as an electricity expense in April under accrual accounting but recorded as an electricity expense in May under cash accounting).

ACCRUAL ACCOUNTING AND THE MATCHING PRINCIPLE Accrual accounting is built on the matching principle in accounting. The matching principle tries to accurately report the profits for each accounting period. This requires matching the revenue for a given period directly with the expenses incurred in earning that revenue in the same period. For example, under accrual accounting, sales commission expense will appear on the Income Statement in the same period that the related sales are reported, regardless of when the commission is actually paid. EXPENSES AND TAX LAW Tax law can also influence the type and amount of expenses that can be claimed as a deduction when determining the income tax payable for a business. For example, while legal expenses may be paid by a business, not all legal expenses are deductible expenses under tax law. There are many other examples of business-related expenses that may not qualify under tax law as deductible expenses. Accountants and tax agents usually have the job of sifting through the business expenses to remove the expenses that cannot be claimed, before lodging a tax return or report. Each country sets its own tax laws. However, there are some common elements when deciding the question: Which expenses qualify as a tax deduction? Common elements include the fact that the expenses must be: • • • •

part of the ordinary course of doing business necessary for the development of the business paid or incurred during the taxable year not paid before the start of a business or in creating it (these would be treated as capital expenditure costs)

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• be a trade or business activity that is continuous, regular and one where profit is the primary motive. WHAT ARE EXPENSE CLASSIFICATIONS AND FUNCTIONS IN ACCOUNTING? By applying expense classifications and functions to financial reports, the decision maker can identify: 

the real, primary and underlining profitability of the business  functional areas where expenses are either within or outside of predetermined norms or targets for the business. BACKGROUND TO EXPENSES IN ACCOUNTING The purpose of accounting, as explained earlier, is to provide meaningful financial information that can be used to make decisions about the management and performance of a business. Two financial statements provide this key financial information: the Income Statement (Statement of Financial Performance) and the Balance Sheet (Statement of Financial Position). 



The Balance Sheet provides details about the financial strength or net worth of the business by presenting the assets, liabilities and owner’s equity at a point in time. The Income Statement provides details about the sustainability or profitability of the business by presenting the revenue and expenses for a past accounting period.

EXPENSES BY CLASSIFICATION AND FUNCTION Expenses are divided into two main classifications: operating and non-operating. Operating expenses are associated with the main activity of the business (primary activities) while expenses associated with a peripheral activity of a business are classified as non-operating (secondary activities). For example, interest expense for the majority of businesses is regarded as a non-operating expense because it involves the finance function of the business, rather than the primary activities of buying/producing and selling. Non-operating expenses may also be recorded as other expenses. Expenses can be further sub-classified according to their function; that is, reporting expenses according to the activity for which the expenses were incurred. Each business will group their expenses by the functions that are the most relevant to them. Some businesses may group Employee expenses, Vehicle expenses or Occupancy expenses depending on their significance to the business.

Generic classifications for all businesses may include those listed in Table 7.

Table 7 Generic expense classifications Type of expense

Description

OPERATING EXPENSES Cost of goods sold (or Cost of sales expense)

This represents expenses that can be directly linked to the goods produced and sold by a business (that is, raw materials in manufacturing, product purchases in retail, and charge-out staff expenses in professional practices).

Selling

This represents expenses required to sell the products (for example, salaries of salespeople, commissions and travel expenses, advertising, shipping).

General administrative

This represents expenses required to manage the business (salaries of officers / executives, legal and professional fees, utilities, insurance, office rents, office supplies).

Depreciation/amortisation

This represents the expense that records the loss in value over time of fixed/intangible assets. 

For example, a vehicle purchased for $50,000 with 5 years of useful life will create a depreciation expense of $10,000 each year for 5 years until it is written off—using the straight line method of depreciation. The same treatment would be applied when amortising an intangible asset like a patent.

NON-OPERATING EXPENSES Financing

This represents the costs of borrowing funds from various financiers (for example, interest expenses).

Extraordinary item

This represents other expenses or losses that are not part of the ordinary business operations (for example, foreign exchange loss, loss on sale of an asset).

Income tax

This represents the tax payable to tax authorities in the current reporting period.

EXPENSES AND THE CHART OF ACCOUNTS 56


A Chart of Accounts sets out all the ledger accounts into which financial transactions will be recorded. A Chart of Accounts generally includes the five main account groups (shaded yellow in Figure 18 below) and are allocated the number of the group. Three additional groups (and their respective numbers 5, 7 and 8, and shaded green in Figure 18) are added to help provide meaningful financial information for decision makers.

1

ASSETS

2

LIABILITIES

3

OWNER'S EQUITY

4

REVENUE

5

COST OF GOODS SOLD

6

EXPENSES

7

NON-OPERATING REVENUE

8

NON-OPERATING EXPENSES

Figure 18 Components in the Chart of Accounts WHAT IS THE ACCOUNTING DIFFERENCE BETWEEN AN EXPENSE AND AN INVESTMENT? An expense is that economic portion of an asset that has been used up within the accounting period. An investment is that portion of an asset that continues to have future economic value at the point of reporting. C

ase study: expenses and investments A small business spent $10,000 on merchandise items at the start of the year, made quite a few sales, and had $5,000 left at the end of the year.

The financial report at the end of the year would show $5,000 ‘expensed’ as cost of goods sold and a $5,000 ‘investment’ remaining as an Asset. So, while $10,000 was paid out by the business in total, only $5,000 of it was expensed in accounting terms (used up in the generation of sales) in that year. A total of $5,000 continues to have future economic value (an asset). Only the $5,000 expensed portion of the money spent on merchandise items is subtracted from the revenue to calculate the profit.

Another answer to the question about differences between expenses and investments might be as follows:  

with an expense, the monetary value outlay is used up in generating revenue with an investment, revenue is still generated but the value of the initial monetary outlay remains.

Terminology is a difficult area of accounting, with many similar but significantly different terms being used interchangeably. Blame the medieval Italian roots for this, as well as the 500 or so years that accounting has had to accumulate all sorts of variant English terms to describe the same or similar events. So, another way you might describe the same outlay of money being treated differently in accounting would be to compare an expense payment with an asset purchase (that is, an outlay of $3,000 for shop rent is recorded in the accounting system as an expense but an outlay of $3,000 for a computer is recorded in the accounting system as an asset purchase or investment). WHAT IS THE DIFFERENCE BETWEEN CAPITALISATION AND EXPENSING? In accounting, when you capitalise an asset, you are reporting that it still has economic value that will benefit future periods. It is therefore reported on the Balance Sheet. However, if you expense an asset, you are reporting that its economic value has been used up in the creation of revenue in the current period. It is therefore reported on the Income Statement of the business.

c

ase study: capitalising and expensing

Let’s take the case of a business purchase of a $60,000 boat to illustrate the difference between capitalisation and expensing. An accountant would normally capitalise the entire asset value of the boat when it is first purchased but then expense a portion of the boat’s value each year based on the useful economic life of the boat. For instance, if the boat was expected to benefit the business (earn revenue) for say 10 years before it needed to be replaced, the accountant would expense $6,000 of the boat’s value each year ($60,000/10 years).

58


Accounting for the loss in value (expensing) of the boat reduces the capitalised value of the boat as reported in the Balance Sheet as it equally reduces the profits reported in the Income Statement each year by the same amount. After 10 years the capital value is reduced to $0 because the entire value of the boat has been expensed and it has no economic value left to benefit future periods. This expense in accounting is called Depreciation. For instance, if the boat was expected to benefit the business (earn revenue) for say 10 years before it needed to be replaced, the accountant would expense $6,000 of the boat’s value each year ($60,000/10 years).

The greatest implication in the choice between capitalising and expensing is on the profit reported each period. Choosing to capitalise an asset rather than to expense it ensures higher profits, which, in turn, leads to higher taxes and a higher business value. Choosing expensing over capitalisation for an asset would produce the opposite result. While accounting standards are set by governments to guide accountants when making this choice, this is an area where some ‘creative accounting’ takes place depending on the needs of the business at the time (that is, to lower taxes payable, then expense the asset; or to increase business value when securing loans or investments, to then capitalise the asset). WHAT IS THE DIFFERENCE BETWEEN A COST AND AN EXPENSE IN ACCOUNTING? The terms cost and expense are commonly used in the fields of business, economics and accounting. In some fields, they can be used interchangeably without issue. In accounting, however, the terms have quite different meanings. Basically:  

sacrificing resources (money) to acquire products is called a cost using up the value of those products to generate revenue for a business is called an expense.

Y

ou could say that expenses are costs that have expired while costs are potential future expenses that have not yet expired.

BACKGROUND TO EXPENSE AND COSTS IN ACCOUNTING Accounting as a system of recording and reporting on financial information has been operating for over 500 years. During that time, the meaning of many words used in English has also evolved. Students of accounting today must not only deal with the fact that many terms describe the same accounting function but also that words with similar meanings in everyday usage have quite different

meanings in accounting. The difference in meanings between cost and expense is one terminology issue that students of accounting must be clear about. What further complicates understanding the difference in meaning between cost and expense is that accounting teachers and authors often follow established language traditions and may use the words interchangeably. Adding to this mix is the term expenditure, which is also frequently substituted for both the terms cost and expense. We will see further in this outline that the meaning of the term expenditure most closely equates to that for cost, and that expense is actually a subset of both. Another entity that influences the meaning of the terms cost and expense is government tax laws and their interpretations. Tax law generally allows businesses to claim deductions for expenses incurred in carrying on the business. However, there is no definitive list of what a business can and cannot claim as an expense, and not all expenditures/costs paid by a business are considered claimable expenses under tax law. A registered accountant is usually required to guide businesses through the process that calculates the expenses a business can claim as a deduction against income. These registered accountings may also seek to define expenses in terms of claimable deductions under tax laws. DEFINITION OF COSTS AND EXPENSE IN ACCOUNTING A summary from one set of definitions provided by the Australian Accounting and Standards Board explains that:  

cost is the amount of cash or cash equivalents paid to acquire an asset expenses are the decreases in economic benefits during the accounting period ... that result in decreases in equity.

In other words, cost is a sacrifice of resources. For example, when we buy something, we cease to have the ability to use that resource to buy something else. A printing business may purchase for cash $1,000 worth of photocopy paper for this month with the intent of using it to generate revenue. So the printer has sacrificed $1,000 of cash resources, which are now not available to them, for other uses. The photocopy paper has ‘cost’ the printing business $1,000 but it has also acquired an economic benefit to the same value.

Expenses are those costs used up in generating revenue for the same accounting period. For example, if the printing business used only $800 worth of the photocopy paper in generating revenue for the month, it would, for accounting purposes, need to record $800 as an expense for the month, with the remaining $200 being recorded as an asset because it has future economic value. It could be said that the economic benefit of the photocopy paper stock has decreased as has the potential 60


profit (equity) due to the printer. (This is because expenses reduced the revenue, which reduced the profit for the owners: Revenue less Expenses = Profit.)

So while a cost is the calculation of the monetary value of the resources sacrificed to acquire an asset, an expense is the calculation of the monetary value of the costs that were actually used up in generating revenue. Being able to separate the meaning of expenses and costs is a key component of the matching principle in accounting.

C

ase study: cost and expense in John Smith Accountants

The business John Smith Accountants takes out a 12-month insurance cover for $12,000 at the beginning of the current month. The cost of insurance was $12,000. At the end of the first month, the company has used up 1/12thof the insurance cover but still has the economic benefit of 11/12th of the insurance cover. So, in accounting terms, at the end of the first month, the business will record an expense of $1,000 but will record the remaining cost of the insurance as an asset of $11,000. So the cost of insurance consisted of unexpired and expired portions, with the expired portion being the expense. So while cost is defined as the monetary value of the utility (or benefit), expense is defined as the monetary value of the utility that has already expired in business activities, provided those activities are directed towards generating income. This means that a cost when utilised becomes an expense. So, the $1,000 mentioned above would appear as Insurance Expense in John Smith Accountants’ Income Statement (Statement of Financial Performance) and the $11,000 would appear as Prepaid Expense in the Current Asset section of the Balance Sheet (Statement of Financial Position). The used, utilised or expired portion of the insurance cost was expensed while the unused or unexpired cost of the insurance is recorded as an asset because it has future economic value.

CONFUSION WITH THE TERMS COST AND EXPENSE IN ACCOUNTING As mentioned previously, significant confusion surrounds the use and meaning of the terms cost and expense. This is because not only do some accountants, teachers and authors use the terms interchangeably, but also so does the accounting system itself. Let’s consider the 500-year-old and embedded accounting phrase cost of goods sold. Is the term cost here consistent with the definitions we have given above. Unfortunately, no. This is because cost of goods sold is an expense.

Unfortunately, we cannot prevent words used in common language changing in meaning over time, even if the terms used in accounting do not. Other cost terms that are really expenses include:      

finance costs (expenses applicable to financing companies which offers loans and deposit services) cost of services (expenses relating to the costs of services that are direct costs attributable to the revenue gained from providing services) direct costs (expenses that can be linked directly to a good/service being sold) indirect costs (expenses that cannot be linked directly to a good/service being sold) fixed costs (expenses that do not change in relation to any changes in business activity) variable costs (expenses that change proportionally in relation to any changes in business activity).

WHAT ARE OVERHEADS IN ACCOUNTING? Overheads in accounting are important when trying to calculate product costs in the manufacture of goods or the provision of services. Overheads are those expenses that do not relate directly to a specific product and so must be shared equitably between all products produced by the business. Typical examples of overheads in accounting include rent, insurance and utilities. Overheads in accounting may also be known as indirect costs, fixed expenses or burden cost. BACKGROUND TO OVERHEADS IN ACCOUNTING The concept of overheads is used in both the manufacturing and distribution/sale of a product. In manufacturing, cost accountants use overheads to establish the actual cost of a product. In selling, cost accountants use overheads to establish the gross profit achieved and to calculate the contribution to overheads achieved from the sale of products. As explained in the matching principle, accountants try to match revenue with the expenses incurred in earning that revenue for a given period. Cost accountants try to do the same for a given product when calculating the actual cost of the product. Some expenses can be easily linked to a product like the raw materials that were used in the product’s production. Other expenses like overheads cannot be easily matched with the production or sale of a particular product because— like rent, insurance and utilities—they relate to all products produced or sold. Expenses that can be directly matched with a particular product would include the raw materials, direct labour and specific expenses (like freight) used in the production/sale of the product. There is no accounting standard that clearly identifies what expenses should be classified as overheads because overheads 62


vary from industry to industry. Most businesses separate their overheads from their total expenses in order to help business decision makers in areas such as:    

cost valuation of finished goods and work-in-progress pricing budgeting the analysis of financial performance or profitability of products and cost centres.

The Income Statement is an example of overheads being separated from the total costs. For example, the direct costs (cost of goods sold) are subtracted from the sales to calculate the gross profit. Overheads (indirect costs) are then subtracted from the gross profit to calculate the net profit. Gross profit is an important key performance indicator for most businesses when monitoring and setting their selling prices. Identifying and allocating overheads is an important aspect of a cost accountant’s work. Overheads are often seen as a ‘bad’ expense because they do not directly relate to the production/sale of the business products. Still, a certain amount of overheads are needed to run a business effectively. Businesses will generally, however, want to separate out the overheads and monitor them carefully. The concepts of cost and expense are often used interchangeably in this area of accounting. TYPES OF OVERHEAD Overheads are a special type of expense. In accounting, expenses are all the resources consumed in pursuit of revenue. While direct expenses (materials, labour) relate specifically to the products being produced and sold, overheads (indirect expenses) are those expenses that relate generally to all products being sold and do not naturally link to a specific product. Typical types of overhead are detailed in Figure 19.

Administration/ Administration/ office office salaries salaries

Stationery Stationery and and office office expenses expenses

Accounting/ Accounting/ audit audit fees fees

Brand Brand advertising advertising and and some some selling selling expenses expenses (e.g. (e.g. travel, travel, accommodation) accommodation)

Depreciation Depreciation of of fixed fixed assets assets

Insurance Insurance

Interest Interest of of loans loans

Legal Legal fees fees

Rent Rent

T axes Taxes

Figure 19 Typical types of overhead

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Utilities Utilities costs costs

DOUBLE-ENTRY BOOKKEEPING WITH DEBITS AND CREDITS WHAT IS THE DOUBLE-ENTRY BOOKKEEPING SYSTEM? The double-entry bookkeeping system is a set of rules for recording an entity’s financial transactions. It ensures that a balance is constantly maintained between the value of the entity’s assets and the claims over those assets by the entity’s owners, funders and creditors. To achieve this, a debit entry and a credit entry (of equal value) must to be made for every financial transaction. Hence the double entry. HISTORY OF THE DOUBLE-ENTRY BOOKKEEPING SYSTEM The concept of double-entry bookkeeping dates back more than 500 years. As described earlier in this e-book, Franciscan friar and mathematician Luca Pacioli (1446–1517) was the first (in 1494) to publish details of a Venetian accounting system that included double-entry bookkeeping as its core feature. The doubleentry bookkeeping system is still followed by accountants today. ACCOUNTING PRINCIPLES AND PROCESSES DETAILED IN PACIOLI’S BOOK The key accounting principles and processes detailed in Pacioli’s book are listed in Figure 20 and explained in more detail in the text that follows.

A y fg o s U jT D le d n c a iv F p u r t Y b

Figure 20 Key accounting principles and processes detailed in Pacioli’s book Accounting cycle: This is the complete accounting process of recording and reporting on financial transactions. It starts with the financial transaction being recorded and ends with the summarising and reporting of all the financial transactions in the financial statements of the business. Use of journals and ledgers: These are two separate processes in the accounting cycle.  Journals (that is, Cash Receipts Journal) record financial transactions as they happen, in a date and time order.  Ledgers (that is, the General Ledger) then classifies and groups these transactions into their relevant account type (for example, Sales account). Debits and credits: Debits and credits are the essence of the double-entry bookkeeping system. What it means is this: every financial transaction has two sides when recorded in the accounting system. One side has a debit value and the other a credit value. The value of debit side must always equal the value of the credit side. For example, when $200 of inventory is purchased for cash, the Purchases account records $200 on the debit side and the Cash account records $200 on the credit side of the transaction. Five account groups: There are only five account groups into which financial transactions are classified and recorded. (These were explained in some detail in a previous section of this e-book.) These account groups are listed in Figure 21.

Assets

Liabiliti es

Owner' s equity

Revenu e

Expens es

Assets are items of value such as equipment. Revenue comprises payments received from Liabilities are monies owned to non-owners suchcustomers or business activities such as merchandise as bank loans. sales and interest from bank deposits. Owner’s equity are monies owed to owners such Expenses are costs incurred in generating the revenue as the initial capital invested. such as electricity.

Figure 21 The five account groups 66


Year-end closing entries: These are the adjusting financial entries that need to be calculated at the end of an accounting period and included in the financial statement of the period in review. These transactions ensure that the financial statements accurately reflect the performance and position of the business (for example, at the close of every financial year when the income tax needs to be calculated). Trial balance: This is an internal check conducted on data entries in the General Ledger to ensure that the accounting process was accurately completed (that is, that a debit value and an equal credit value were recorded for every transaction). This accuracy is confirmed when all the ledger accounts of the business are listed and the total of the accounts with debit balances equals the total of the accounts with credit balances.

SUMMARY—DOUBLE-ENTRY BOOKKEEPING SYSTEM The key things to remember about the double-entry bookkeeping system are:  For every financial transaction recorded in the accounts of a business, there is a debit entry and a credit entry. Furthermore, the total of the entries on the debit side 

must always equal the total of the entries on the credit side. The double-entry bookkeeping system ensures that the accounting equation always remains in balance. That is, the total value of the assets of a business must always



equal the total combined values of the liabilities and the owner’s equity. Double-entry booking was first documented over 500 years ago, yet its principles



are still followed today. Double-entry bookkeeping provides a means of self-checking the accounting system records in the form of a trial balance.

WHY IS DOUBLE-ENTRY BOOKKEEPING SUCH A BIG DEAL? Well, for a start, double-entry bookkeeping is one of the few professional processing systems that is as relevant today as it was 500 years ago when first documented by Pacioli. The entire accounting profession and the financial reporting of the biggest companies on the planet today continue to apply Pacioli’s system. Some people say that the growth in business size and complexity in the world today could never have happened without the double-entry bookkeeping system. They argue that this is because the system informs managers continuously of their venture’s financial status and solvency. It thus helps to ensure the venture’s economic survival. As well, under this system, investors are offered the degree of transparency necessary to encourage continuing investment in the venture. Over the five centuries that it has been used, the double-entry bookkeeping system has proven to be the best way to accurately collate, classify and report on the vast number of financial transactions that take place in a venture. Accurate financial reports are produced because the double-entry bookkeeping

system emphasises the importance of accuracy in recording every single transaction (that is, for every transaction, the total of the debit amounts must equal the total of the credit amounts). This approach ensures that the accounting equation always remains in balance; that is: Assets = Liabilities + Owner’s equity.

Perhaps, though, double-entry bookkeeping has made an even more significant contribution to business (and the world of finance). For a start, it is a financial recording system that makes errors and fraud more difficult to be undetected. It also correctly represents the reality—that in a closed system (like finance, there are always two sides to every transaction. 



In other words, if an enterprise receives investment money, not only are the enterprise’s assets increased (cash) but also the enterprise has an obligation to investors (owner’s equity) of equal proportion. Likewise, the bank secures the purchase of property, the enterprise increases its assets (property) and liabilities (loan from the bank) in equal amounts: hence the double-entry system.

Some have humorously suggested that if double entry (writing it down twice) is good...then triple entry (writing it down three times) must be even better! Hopefully, the previous paragraph explains that double-entry bookkeeping is not just about writing something down twice, but rather recognising that when a financial transaction in a venture takes place, two quite different components of the venture’s financial status are affected (not just one). The double-entry bookkeeping allows all stakeholders in a venture to get an accurate picture of the financial performance (Profit and Loss Statement) and financial position (Balance Sheet) of the venture at any time. Such knowledge of a venture’s financial sustainability and strength allows stakeholders to make informed decisions about the efficient and effective allocation of scarce resources—the fundamentals of sound business practice. This helps, in turn, to ensure that businesses remain viable and that the most successful ventures attract the appropriate amount and quality of resources. Double-entry bookkeeping is such a big deal because, arguably, we may not have had the Industrial Revolution nor our current global shareholder-based corporations and stock exchanges without a financial system like it. The successful growth of corporations could not have been sustained over time without being underpinned by such a sound financial system. HOW IS THE ACCOUNTING EQUATION FORMED? The accounting equation is an integral part of the double-entry bookkeeping system. Understanding this will help you to understand one of the first principles on which accounting is based.

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THE BUSINESS AS A SEPARATE ENTITY A business is created to make money for the owners. In accounting, when a new business is formed, a separate accounting entity is created. From this point on, the financial recording and reporting are done so from the perspective of the new business. 

At this point, the new accounting entity owns nothing and it owes nothing.

This situation changes when funds are provided to the business by the owners in the form of capital investment. Other funds may also be supplied to the business by lenders (that is, bank loans) and/or creditors. Given access to these funds, the business—as a separate accounting entity— can then buy assets which will be used to make profits for the owners. These funds provided by the funders could be used/employed by the business to buy land, buildings, plant, equipment, merchandise inventory (goods to sell) or simply kept as cash reserves to provide the new entity with working capital (money to pay bills with). These items are categorised as the assets of the business. While the business has control over the assets, it actually ‘owns’ nothing for its own benefit. If all the assets were sold and business activities ceased, the liabilities (banks and creditors) would be paid out in full first. Whatever money was left over from the sale would be then given to the owners. This would leave the business in the same position as it started: owning nothing and owing nothing. THE FIRM AS A SEPARATE ACCOUNTING ENTITY Remember, a business has nothing when it is created. So, the value of the funds that the business uses/employs will be equal to the value of the funds provided to it. In this position, the business, as a separate accounting entity, now owes money to the funders (that is, owners, banks and creditors) but has been given control over (or ‘ownership’ of) assets that it has purchased. The total value of the assets then must be the same value as the funds provided to the business.

... the value of funds provided to the business

The values of funds the business uses equals ...

Figure 21 A financial balance of business funds DIFFERENT BUSINESS FUNDERS

Looking again at the business funders, there is a natural category break up, as shown in Table 8. The accounting system treats these funding providers differently: funds provided to the business by the owners in the first group is called owner’s equity and the funds provided by non-owners in the second group are called liabilities.

Table 8 Different business funders Type of funder

Business investment strategy

Owners

Owners invest long term in the business to secure unlimited profit potential and to control the business entity’s activities.

Non-owners (such as banks and creditors)

These shorter term funders are not provided with a profit share or control over the business. They will, however, have an agreement with the business to repay the monies owed to them in their capacity as debt funders of the business.

The formula known as the ‘accounting equation’ recognises the natural split in the type of funding provider, and that all the assets of a business are financed by the funders. WHAT ARE DEBITS AND CREDITS IN THE BOOKKEEPING SYSTEM? The terms debit and credit have many different meanings in our society. The meaning of the term debit in the bookkeeping system has no relationship with the term debt, which means ‘money that is owed to someone else’. Below, by way of example, are some examples of different meanings for the term credit. Note that all of these meanings are different from the meaning of the term credit used in the bookkeeping system:

The word credit

70

Recognition for past achievements: She already had several performances to her credit.


Grading a level of academic achievement: You received a credit on that exam paper.

Requirement to identify a source of information: You must credit the original author of that work.

Taking goods now and paying for them later: You can have these goods on credit.

Recognition for work: He gave her credit for trying.

Figure 22 Different (non-accountancy) meaning of the word credit The important thing is to understand the terms debit and credit, as used in the bookkeeping system:  

debit does not mean ‘– ’, ‘negative’ or ‘bad’ credit does not mean ‘+’, ‘positive’ or ‘good’.

The terms debit and credit are used in the bookkeeping system simply as a way to classify financial transactions. This method provides a way of recording the changing values in the financial accounts of a business caused by monetary transactions. It also properly captures, reflects and records the flow of economic resources from a source to a destination. At the same time, the debit and credit method of classification and recording keeps the accounting equation in balance for each new entry; that is: Assets = Liabilities + Owners Equity.

If you do not clearly understand the how the terms debit and credit are used in the bookkeeping system, you will find bookkeeping impossible to use and apply. 

To make it clear in accounting, Dr [for debit] and Cr [for credit] are used to show that we are using the meaning of these terms as used in the bookkeeping system.

ORIGIN OF THE TERMS DEBIT AND CREDIT IN THE BOOKKEEPING SYSTEM When Pacioli first recorded the double-entry bookkeeping system in 1494, he used the Latin terms credre and debere. The concept of negative numbers was not generally accepted in mathematics in Europe when he first codified the double-entry bookkeeping system. This may explain why he used debit and credit rather than + and –. Pacioli was so convinced of the duality of financial transactions that he declared that no bookkeeper should go to sleep at night unless the total of the debit equalled the total of the credit! In the 1500s, English translators described these Latin terms (credre and debere ) as credit and debit, respectively. From this, the convention has grown to

use Dr (for debit) and Cr (for credit) in the bookkeeping system. (There is no ‘r’ in the English word debit but there is an ‘r’ in the Latin term debere.) The Latin term credre means to entrust something; debere means to owe someone. For example, if Person (A) entrusts USD$100 to Person (B), Person (B) owes USD$100 to Person (A). This example illustrates that financial transactions always have two sides. Similarly, economic resources flow or transfer from a source to a destination. Pacioli used the terms credre and debere to describe this principle: that every financial transaction has two sides, with the source recorded as a Cr, or Credit, and the destination recorded as a Dr, or Debit. Traditional definitions of the concepts of debit and credit (in the bookkeeping system) are as follows:  

debit is one side of the entry in the bookkeeping system that is placed on the left side of a T account credit is the other side of the entry in the bookkeeping system (the other side of the financial transaction) that is placed on the right side of a T account.

While this is not a very informative definition of the terms, it is the one you are most likely to find in dictionaries. In essence, the debit and credit method used in double-entry bookkeeping captures and records the flow of economic resources in a financial transaction as economic resources transfer from a source (credit) to a destination (debit). The method also ensures that the accounting equation, which is the foundation stone on which the entire double entry bookkeeping system is built, remains in balance after each transaction is recorded.

SUMMARY—DEBIT AND CREDIT The key things to remember about the debit and credit are:  The terms debit and credit have many different meanings in English.  In the 500-year-old system of double-entry bookkeeping, the terms debit and credit are used to classify and record financial transactions. Their meaning comes from the Latin terms originally used for them: debere (which means to owe someone)— from which we get debit— and credre (which means to entrust something)—from 

which we get credit. The double-entry bookkeeping system ensures that the accounting equation always remains in balance—that is, the total value of the assets of a business (or other entity) must always equal the total combined values of the liabilities and the



owner’s equity. Every financial transaction has two sides: the source of the economic resource and the destination of the economic resource.

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

The source of an economic resource is recorded as a credit or Cr, and the



destination of the economic resource is recorded as a debit or Dr. The debit and credit method of classification and recording keeps the accounting equation in balance.

HOW DO YOU APPLY DEBITS AND CREDITS IN BOOKKEEPING? Debit and credit are the key elements of the double-entry bookkeeping system which records the transfer of economic resources from the source (credit) to the destination (debit). RECORDING PERSPECTIVE To record a financial transaction in a bookkeeping system for a business, you need to understand the perspective of the recording entity. Each business records financial transactions from the perspective of their own business. For example, when Business A purchases stock from Business B, Business A records an increase in Purchases and a decrease in Cash. Business B records the same financial transaction quite differently. From the perspective of Business B, there has been an increase in Sales and an increase in Cash. So, the first thing to determine when using the double-entry bookkeeping system is: from whose perspective are you recording this financial transaction? In whose books are you recording the financial transaction? The next step is to follow the process outlined in Table 9.

Table 9 Steps to determine the debit and credit sides of a financial transaction Step numb er

Description of action required

Example

1

Determine which ledger accounts are involved in the financial transaction. (There should be at least two.)

A business uses $100 cash to pay an electricity bill. This financial transaction would involve the (1) Cash account and the (2) Electricity account.

2

Identify to which account group the accounts belong. (Each account must belong to one of the five detailed in Table 15 below.)

Looking at Table 15, we see that the Cash account belongs to the Asset group and the Electricity account belongs to the Expenses group.

3

Identify the change in the accounts. Has it increased or decreased?

The Cash account has decreased by $100 and the Electricity account has increased by $100.

4

5

Now apply the logic of the (Dr/Debit) (Cr/Credit) in Table 17.

If an Asset decreases, you (Cr/Credit) it. If an Expense increases, you (Dr/Debit) it. The Cash account is an Asset so we (Cr/Credit) it; the Electricity account is an expense so we (Dr/Debit) it.

Make sure the (Dr/Debits) equal the (Cr/Credits).

The Cash account $100 (Cr/Credit) = the Electricity account (Dr/Debit).

ACCOUNT GROUPS There are only five account groups in the bookkeeping system. These groups are broken down into smaller sub-accounts.

Table 10 Account groups Account group

Description

Example

Assets

Items of economic value that the business legally controls

Cash, equipment, land, buildings

Liabilities

Monies owed by the business to non-owners (that is, bank loans, creditors)

Bank loans or creditors (suppliers who have yet to be paid for the goods and services they supplied to the business)

Owner’s equity

The value of the business owed to the owners (that is, initial capital, retained profits)

Includes the initial capital investment and the retained earnings. Calculated by subtracting the value of the liabilities from the value of the assets.

Revenue

Monies paid by customers for the goods, services and investment activities of the business

Merchandise sales, fees charged, interest on bank deposits

Expenses

The costs incurred in earning the revenue

Cost of sales, overheads such as electricity and rent, financial expenses

Table 11 Dr/Debit and Cr/Credit sides of a financial transaction recorded in the bookkeeping system When you INCREASE the $ amount in this account group, you ... it

When you DECREASE the $ amount in this account group, you ... it

Asset

(Dr /Debit)

(Cr/Credit)

Liability

(Cr /Credit)

(Dr/Debit)

Account group

74


Owner’s equity

(Cr/Credit)

(Dr/Debit)

Revenue

(Cr/Credit)

(Dr/Debit)

Expenses

(Dr/Debit)

(Cr/Credit)

RECORDING PERSPECTIVE REVISITED One (Cr/Credit) that worries many students is the one that appears on their statements from the bank. They have identified that the Cash at Bank account as an asset for their business. Now according to Table 11, when you increase an asset you (Dr/Debit) it. 

So then they ask: Why does my statement from the bank show a (Cr/Credit) balance when I have money in it and why are my deposits treated as a (Cr /Credits)?

The answer is a basic one of perspective. Remember, each business records financial transactions from its own perspective. Think about the deposited financial transaction from the bank’s perspective. How does the bank view the money that has just been deposited? Whose money is it? That’s right, it is yours! So the deposit is recorded from the bank’s perspective as a liability (money owed by the bank to you) because when money is deposited into a customer’s account, the bank’s liability increases. This is why (using Table 11) banks will (Cr/ Credit) a customer’s account when the customer deposits money into it and why a (Cr /Credit) balance on the bank statement represents an asset to the business. The bank and the business each record the same financial event— but from their own different perspectives. HOW DO YOU MAKE SENSE OF DEBITS AND CREDITS IN ACCOUNTING? CONFUSION ABOUT THE TERMS DEBITS AND CREDITS The different between debits and credits is possibly one of the most difficult concepts to understand in accounting. This is due in large part to the additional meanings that have been added to these terms from the ones that were first coined some 500 years ago in Venice. The Latin text that described the Venetian accounting system was translated into English in the 16th century. At that time, the Latin terms debere and credre were translated into the words debits and credits (respectively) in English. Now while debits and credits have a unique meaning in accounting, many other different meanings have been given to these words in the English language. It is these new meanings that cause the most confusion for students of accounting. For example, the term credit has more than 10 different meanings in English. Some of these are shown in Figure 24 below.

T To o ascribe ascribe an an achievement achievement to to someone someone

T To o obtain obtain goods goods and and services services before before paying paying for for them them

The The money money lent lent or or made available made available under under a a credit credit arrangement arrangement

Acknowledgement Acknowledgement of of a grade level in an a grade level in an examination examination

Source Source of of pride pride that that reflects reflects well well on on another another person person or or organisation organisation

Figure 23 Some different (non-accounting) meanings of the term credit in English The accounting meaning of the term credit should not be confused with any of the above meanings. Nor should the term debit be equated with the concept of debt. Furthermore, the terms debit and credit in accounting have no relationship with the concepts of good and bad, nor positive and negative.

T

he first step to making sense of debits and credits in accounting is to understand these terms only within their accounting meaning.

The definition of debits and credits as used in accounting is as follows: … [it is] a classification method that is used in accounting to record the financial transactions of a business. The debits and credits method records the flow of financial resources from a source (credit) to a destination (debit). Every accounting transaction in a business involves this flow of financial resources. The uniqueness of the debit and credit classification method is found in the fact that while various individual account values may change with each new transaction, the accounting equation that underpins the accounting system (as stated below) … 76


Assets = Liabilities + Equity

… always remains in balance. RELATIONSHIP BETWEEN THE ACCOUNTING EQUATION AND DEBITS AND CREDITS The accounting equation reflects the economic reality of a business. Let’s recall again why a business is created: it is created by owners to make a profit for the benefit of owners. When that business is formed by the owners, the accounting system sees the new business as a separate entity that is distinct from the owners. This means that the accounting system will record financial transactions from the point of view of the business entity not the owner.

KeyFACTS 

From an accounting point of view, when a new business is first formed by the owners, the new

 

business has zero assets. The only way a new business can get to control assets is if the assets are provided by others. Others ( in this case) may be external funders like banks who lend money to the business



(liabilities) or internal funders like owners who invest money in the business (owner’s equity). Because all the assets of a business have been supplied by ‘others’ (namely, through liabilities and



owner’s equity), these ‘others’ have an economic claim over that business. That claim is the equivalent of the value of the total assets that the business controls.

Hence, we have the founding principle underpinning the accounting equation: Assets = Liabilities + Equity

It was obvious to the medieval Venetian merchants that a system was needed to record the impact of the numerous financial transactions on a business without upsetting this underlying economic principle explained by the accounting equation. So—you guessed it —they came up with the concept of classifying individual transactions as debits and credits, although they referred to them using the Latin terms: credre and debere, respectively. This debit and credit classification method that the Venetians invented to record individual financial transactions ensured that the fundamental accounting equation, explained above, always remained in balance. The debit and credit classification method achieves this by applying the rules outlined in Figure 24.

Left side of the accounting equation Changes in value to accounts on the left side of the accounting equation (assets) will be a debit if the account values increase and a credit if the account values decrease.

Right side of the accounting equation Changes in value to accounts on the right side of the accounting equation (liabilities and owner’s equity) will be a credit if the account values increase and a debit if the account values decrease.

For each transaction ... For each transaction, the total of the debits must equal the total of the credits.

Figure 24 The debit and credit rules in accounting WHY IS REVENUE RECORDED AS A CREDIT IN ACCOUNTING? Revenue is treated as a credit in accounting because it is a sub-category of equity, and equity accounts in accounting are credited when they increase. BACKGROUND TO REVENUE IN ACCOUNTING The accounting equation is: Assets = Liabilities + Owners equity

Owner’s equity includes such accounts as Capital, Retained Earnings and Current Earnings (also known as Net Profit). Current Earnings in the equity accounts is the final result taken from the Income Statement and is calculated by the formula: Net Profit = Revenues – Expenses

According to the debit/credit rules below, increases in the equity accounts are credited. So because an increase in revenue will increase the Net Profit, it must 78


also increase the equity account called Current Earnings in the Balance Sheet. Because the double-entry bookkeeping system requires that increases in equity are credited, it follows that the revenue account must be credited when it increases as well. DEBIT AND CREDIT RULES Another way to look at it is to understand that whenever revenue is generated, assets are always affected. For example, if a business sells goods in exchange for cash, assets (Cash or Accounts Receivable) will increase. However, to maintain the basic accounting equation, either the liability or the equity accounts must increase by an equal amount. Now since no debt or liability to an external entity is created when we sell goods, it must be the equity account that increases. So, an increase in revenue must lead to an increase in equity. It needs to be noted that sometimes a business will receive assets from lenders (by way of loans) or from its owners (by way of capital investments). The receipt of such assets by the business is not treated as revenue but rather as:  assets with a corresponding liability in terms of loans, and  assets with a corresponding owner’s equity in terms of capital investments.

O

nly those assets received from customers or clients in exchange for goods or services represent revenue.

CONFUSION RELATING TO RECORDING REVENUE AS A CREDIT IN ACCOUNTING Many students of accounting are confused by treating revenue as a credit when recording transactions in the accounting system. This is typically because students associate debits as being good for business and credits as being bad for business. 

They perceive that receiving cash is good— and it is treated as a debit— so why isn’t making sales (revenue), which is also good for business, also treated as a credit?

To clarify, we need to look at these transactions from the point of view of the business. Remember all accounting transactions are recorded from the perspective of the business (that is, the business as a separate entity concept). In a way, the business looks at all transactions in a completely neutral way. 

There is no ‘good’ or ‘bad’ from the point of view of the business because, in reality, it ‘owns’ nothing and does not benefit from the profits generated.

The business, in accounting terms, is simply a vehicle whose primary goal is to make profits for the owners. Remember that it is the business owners (equity) and other parties (liabilities), together, that have a 100% claim over the assets of the business (that is, if all the assets of the business were sold, the liabilities would be repaid and the remaining money would go to the owners, leaving the business entity with what it started with—nothing). This is the underpinning concept behind the accounting equation: Assets = Liabilities + Owners equity

So, from the business perspective, revenue is considered potential profit. By recording revenue as a credit (increased equity), the business is acknowledging that the revenue potentially belongs to the owners. 

In other words, the revenue received by the business increases the claims of the owners over the assets.

In keeping the accounting equation in balance we will then increase assets (cash) with a debit entry and increase equity (revenue) with a credit entry. The revenue (credit entry) belonging to the owners of the business is reduced by (debit entry) the costs associated with the activities needed to earn that revenue (that is, expenses). THE FINANCE SYSTEM The final concept you need to fully understand to make sense of debits and credits in accounting is to understand how this classification method relates to the finance system. Finance is a closed system. This means, that money does not just appear in your bank account from time to time, nor does it just disappear into thin air.

I

n finance there is always a source and a destination of funds—you cannot have one without the other. In other words financial resources ‘flow’ from one place to another.

The debits and credits system completes this record of financial funds movement.  

The credit side of the transaction (or the credit entry) represents the withdrawal from the source. The debit side of the transaction (or the debit entry) represents a deposit in the transaction’s ultimate destination.

80


So, this classification system of debits and credits in accounting is very closely related to the economic concept of duality in financial transactions (that is, for every financial transaction, the debit entries must equal the credit entries. 

The reason for this is that in a closed system there must be a source and destination of an equal amount for each transaction.

Figure 25 Understanding debit or credit in accounting: the decision tree 82


While it is best to determine the debits and credits classification via the decision tree shown in Figure 25, as a general rule, the source of a transaction is credited and the destination is debited. HOW CAN I BETTER UNDERSTAND DEBIT AND CREDIT? It is the personal view of the author that fully understanding the debit and credit concept in accounting is near impossible when you are first confronted with it. Learning how to apply the debit and credit concept is far easier. You can be an outstanding bookkeeper or accounting student by just learning the application rules. The author of this e-book has taught accounting students for many years and ‘kept the books’ for his own businesses. But he says he never really understood the rationale behind the debit and credit concept in accounting. In his opinion, the dictionary definitions, as detailed below, do very little to help that understanding: • Debit: an entry in the left-hand column of an account (‘T’ account) or the lefthand side of the Balance Sheet • Credit: an entry in the right-hand side of an account (‘T’ account) or the righthand side of a Balance Sheet. Adding to the confusion, is the fact that the debit and credit concept and terminology was developed over 500 years ago, with the first accounting textbook being written in Latin. English as a language has morphed substantially over the past five centuries since the Venetian method of accounting was first translated. Many different meanings have been producing for the terms debit and credit besides the meanings intended in accounting. Is it any wonder that the debit and credit concept is a difficult one for students living in the 21st century to fully grasp! The following tips may help students trying to better understand the debit and credit concept.

1.

Do not link the meanings of the terms debit and credit in accounting with any other meanings of these words in everyday English.

2.

Debit and credit in accounting do NOT mean ‘plus and minus’, ‘good and bad’ or ‘increasing and decreasing’, respectively.

3.

The accounting terms debit and credit acknowledge and record the duality of financial transactions. In other words, finance is a closed system; money just doesn’t appear or disappear. For example, if money is received by a business, it must have been given by others and vice versa. (So, two entries of equal amounts are required to

record the transaction and the transaction’s effect on financial resources.)This means that credit = the source of funds and debit = the destination of funds

4.

Debit and credit are accounting concepts that capture in the books of a business the flow of economic resources from a source (credit) to a destination (debit). For example, take a situation where a bank provides funds to a business as a loan. The bank loan is the source of funds so it is recorded as a credit. The Bank account of the business is the destination of the funds so it is recorded as a debit.

5.

Applying this principle will help you identify the ‘credit = source’ and ‘debit = destination’ of every transaction. Debit and credit is a recording system that ensures that the accounting equation always remains in balance after each and every transaction; that is: Assets = Liabilities + Equity The Venetian merchants who developed this system 500 years ago decided that increases on the asset side would be called a debit and increases on the liabilities and owner’s equity side would be called a credit—with corresponding debit and credit entries for decreases. If every transaction is recorded with an equal amount for the debit and the credit, the accounting equation will always remain in balance. A balanced accounting equation allows business managers to accurately calculate and split the claims that all parties have over the assets of the business (liabilities = external parties such as banks and suppliers; owner’s equity = owners).

6. Debits and credits are always recorded from the perspective of the business.

This is why if the Cash at Bank account in the books of the business is a debit balance then the bank balance on the Bank Statement will be a credit balance. This is because while cash is an asset to the business (an item of value that the business owns), it is a liability for the bank (money owed to a customer).

84


THE ACCOUNTING PROCESS WHAT IS THE ACCOUNTING CYCLE? The accounting cycle is the sequence of accounting procedures that is repeated for each reporting period, where the closing balance of the previous period becomes the opening balance of the new period. ACCOUNTING CONCEPTS AND THE ACCOUNTING CYCLE When reporting on the financial performance and financial position of a business, accounting assumes that the business is a going concern—that it will continue to trade indefinitely. But stakeholders in the business (that is, people such as managers, owners and financiers) need information about the business in much shorter periods so that they can make informed decisions about their involvement with the business. Different stakeholders have different reporting needs, and different periods by which they need information. For this reason, accounting has developed another concept called the accounting period or time period. The accounting period concept allows for the financial reports of the business to be made available to stakeholders in shorter periods of time. The common accounting periods accountants use are:    

monthly quarterly half-yearly annually (yearly).

It is these shorter and continuing time periods of reporting that have created the accounting cycle.

KeyFACTS 

The accounting cycle is the series of accounting activities that occur within a specific accounting

 

period. This series of activities is repeated for each accounting period of time. The accounting period starts with account balances taken from the Statement of Financial Position (Balance Sheet) and ends with new balances on the same statement after all the transactions for the period have been properly accounted for—this makes up the accounting



cycle. The Statement of Financial Position (Balance Sheet) is the detailed summary of the accounting equation, where the recorded value of the assets of the business is equal to the combined totals of its liabilities and the equity (capital investment) of the owners.

THE BASIC ACCOUNTING CYCLE The basic accounting cycle consists of a number of elements, as detailed in Figure 27.

1: 1: Start Start

2: 2:

5. 5. End End

4. 4.

Statement Statement s s

Transactio Transactio ns ns

3. 3.

Adjustmen Adjustmen ts ts

Key

1.

The accounting cycle starts with the balances from the previous accounting period’s permanent ledger accounts (taken from the Statement of Financial Position (Balance Sheet)).

2.

This step records all financial transactions that occurred in the current period into the books or accounting system.

3.

This step sees adjustments made at the end of the current period (that is, to match the expenses with the revenues generated and make adjustments to inventory and accounts receivable).

4.

The financial statements produced include the Statement of Financial Performance (Income Statement or Profit and Loss Statement). The ‘bottom line’ or profit from this statement becomes the current earnings in the owner’s equity section of the Statement of Financial Position. (This is because the profits of the business belong to the owners of the business.)

5.

The current accounting period ends with the new balances for the permanent accounts detailed in the Statement of Financial Position (Balance Sheet). These closing balances for the current period now become the opening balances for next period’s accounting cycle.

86


Figure 27 Steps in the accounting cycle (continued) •Prepare the Financial Statements. The two main financial statements created are the Statement of Financial Performance (Income Statement) and the Statement of Financial Position (Balance Sheet). •Prepare an adjusted trial balance. As part of the 10-column worksheet, a trial balance will be prepared of the adjusted entries only. If these are in balance (debit entries = credit entries), a new adjusted trial balance is compiled as a basis for the financial statements.

Step 9 Step 8

Step 6

•Prepare a trial balance.**

Step 7

•Calculate and make adjusting entries in the journal..#

•Post the details from the journals to the general ledger where all the accounts are kept. Summary details are transferred (posted) from the journals to the general ledger. Ledgers are kept by account types (for example, Electricity, Cash, Accounts Payable).

•Record the transaction details into the appropriate journal.*

•Analyse and classify the transaction. Determine (i) the transaction amount in monetary terms (ii) the ledger accounts affected by the transaction and (iii) the account(s) to be debited and the account(s) to be credited. •Prepare the source documents for the transaction (that is, receipts, invoices and cheques).

•Identify that a financial transaction or event has occurred.

Step 5 Step 4 Step 3 Step 2 Step 1

There are a number of steps in the accounting process. Because these steps are repeated every accounting period they are also referred to as the accounting cycle. These steps are detailed in Figure 28. WHAT ARE THE STEPS IN THE ACCOUNTING PROCESS?

Figure 26 Elements of the accounting cycle

• Close the temporary accounts and transfer the balances to owner's equity.# #

Step 10 Step 11

• Prepare the after closing trial balance. The final trial balance is calculated after the closing entries from the temporary accounts are made. At this point, only the permanent accounts (Assets, lLabilities and Owner's equity) that make up the Statement of Financial Position appear in the after closing trial balance.

Step 12

• Reverse the accrued journal entries. The accruals recorded on the last day of the previous accounting period must be reversed on the first day of the new accounting period. This is done to avoid the possibility of double entries when the actual transaction (that had previously been accrued) occurs in the next period.

*

A journal records the debit and credit details of a transaction in a chronological (date and time) order. It also records the account name and the account number allocated by the Chart of Accounts. Common journals are: Cash Receipts Journal, Cash Payments (disbursement) Journal, Sales Journal, Purchased Journal and General Journal.

**

The trial balance lists and summarises all the General Ledger account balances to ensure that the total of the debit balances equals the total of the credit balances. The sum total is not meaningful. The important thing is that the totals of both columns (debits and credits) agree. A balanced trial balance ensures that there were no recording errors. However, it does not guarantee that the amounts are correct (that is, the right amounts may have been posted to the wrong accounts). Correct the discrepancies identified from trial balance if required.

#

Adjusting entries need to be made at the end of each accounting period to match the revenue earned in that period with the expenses incurred in earning it. These adjustments are called accruals and deferred items in accrual accounting. These entries are also journalised and posted to the General Ledger. The source document used to record adjusting entries is typically a 10-column worksheet.

## Temporary accounts are cleared by transferring the amounts in them to the Income Summary Account. This account is part of the retained earnings as reported in the owner’s equity section of the Statement of Financial Position. Temporary accounts are the revenue, expense, dividend, owner’s drawings accounts as well as other gains or losses made. These temporary accounts begin the next accounting period with a zero balance. (a) Steps with text shaded green are those steps taken (sequentially) at the start of the accounting period. (b) The step with text shaded blue is the step taken at the start of the next accounting period.

Figure 28 Steps in the accounting cycle (continued) WHAT ARE SOURCE DOCUMENTS IN ACCOUNTING?

88


Source documents is an accounting term; the term describes the original records that contain the details substantiating the financial transactions entered into the internal accounting system of a business. Typical source documents include sales invoices, cash receipts, cash register slips, credit notes and deposit slips. Source documents provide the documentary evidence of a business deal or accounting event. Source documents are a critical part of an audit trail that establishes the authenticity and tracking history of an accounting system’s financial records. BACKGROUND TO SOURCE DOCUMENTS IN ACCOUNTING All manufacturing systems are identified by their three key elements: inputs, processes and outputs. 

Outputs are the financial statements and reports produced for business decision makers.

In accounting:



Inputs are the data taken from source documents generated whenever financial transactions occur.



The process is known as the doubleentry bookkeeping system, which accurately captures and categorises inputs so that they can produce meaningful reports.

Inputs Proces s Outpu ts

Figure 28 Relationship between inputs, process and outputs in accounting

KeyFACTS Source documents:   

are the essential inputs that provide the details required by internal accounting systems assist in the internal control of the resources of the business ensure that there is documentary evidence to support the purchase or sale of items of value and



the receipt and payment of money provide the evidence or proof that a transaction has occurred, which makes it difficult for people



to misappropriate or steal cash or other resource items from the business are required by both company and tax auditors.

The details from the source document should be recorded in the appropriate accounting journal as soon as possible after the transaction has occurred. After recording the details, all source documents should be filed in a document system from which they can be readily retrieved at a later date if required. Government tax law requires that these source documents are kept for a number of years (typically from 3 to 7years depending on the country). In the event of an audit, these source documents should support the data recorded in the accounting journals and the General Ledger by providing an indisputable audit trail from source documents to journals to General Ledger to trial balance to financial statement. A source document should describe all the key aspects of the transaction such as: • • • • • •

names and addresses of the entity buying/selling the good/services date when the transaction occurred amount of the transaction amount of any taxes nature and purpose of the transaction (that is, a description) special terms and conditions of the transaction (that is, any discount, payment and delivery details) • authorised signature for payment or acceptance of goods/services. COMMON SOURCE DOCUMENTS Source documents are generally related to the particular activity as shown in Table 12 below.

Table 12 Common source documents for business activities Business activity

Source documents

Cash received by the business

Cash receipt (copy), cash register tapes, bank statement, bank deposit slip

Cash paid by the business

Cheque butt, ATM or EFTPOS receipt, bank statement, payroll records, cancelled cheque

Petty cash payments

Petty cash voucher, cash receipts

Business giving credit to customer

Business invoice (copy), business credit/debit note

Business receiving credit from a supplier

Supplier’s original invoice, supplier’s statement, supplier’s debit/credit note, credit card statement and receipts

Any activity not generating a document

Memorandum

The various source documents are described below: • Sales invoice: used to record the goods/services details and the amount owing to the business by a customer. The original goes to the customer with the copy held by the business. • Purchase invoice: used to record the goods/services details and the amount owing by the business to suppliers. The original is provided by the supplier to the business. • Credit note: used by a business/supplier to correct an overcharge in the invoice • Debit note: used by a business/supplier to correct an undercharge in the invoice • Petty cash voucher: used as evidence of cash payment to another party • Cheque butt/stub: used to record the amount paid on a particular numbered cheque to the payee • Cash receipt: used to acknowledge money received from customers and cash paid to suppliers • Bank statement: used as a summary of cash movements through the business bank account • Memorandum: used as a note explaining a transaction if no other documents exist • ATM receipt: used as evidence that money was taken from the business bank account via the ATM • EFTPOS receipt: used as evidence of a purchase from a supplier using the EFTPOS system. • Supplier’s statement: issued by suppliers in regard to invoices unpaid at a particular date • Cash register tape: automatically generated by the cash register and provides an unbroken sequence of cash transactions and events • Bank deposit slip/form: used to record the monies deposited in the bank. The original is provided to the bank with the copy retained by the business. • Credit card receipt: used to verify transactions on a credit card statement that relate to the business • Payroll record: used to verify payments made to employees in the form of salaries and wages and includes timesheets • Cancelled cheque: used as an internal control to ensure that all cheques can be accounted for.

SUMMARY—ACCOUNTING SOURCE DOCUMENTS

In summary, accounting source documents:  provide evidence of the transactions recorded in the accounting system in the event of an end-of-year financial audit



satisfy the requirements of the tax law in regard to proof of income and expenditure.

WHAT IS THE CHART OF ACCOUNTS IN ACCOUNTING? The Chart of Accounts is a structured list of all the accounts in the General Ledger. These accounts are created by businesses to record the details of their financial transactions in the accounting information system. The Chart of Accounts groups and indexes the accounts by name and identifying codes according to the structure of the financial reports (that is, Assets, Liabilities and Owner’s equity for the Balance Sheet, and Revenue and Expenses for the Income Statement). A Chart of Accounts with its structured identifying codes provides accounting staff with an efficient and effective tool when processing financial data in computerised accounting programs. BACKGROUND TO THE CHART OF ACCOUNTS IN ACCOUNTING Financial data is processed in the accounting information system in two stages, described below. FIRST STAGE The financial data is recorded in the journals in date and time order from the details found on the transaction source documents. This financial data is recorded in the journals according to the debit/credit principles of the doubleentry bookkeeping system. SECOND STAGE All the journalised financial data is then posted (transferred) to ledger accounts in the General Ledger according to its type (that is, all the sales data from the journals is posted to the Sales account and all the purchases details are transferred to the Purchases account). These accounts receive both debit and credit entries from the journals, creating a debit or credit balance at the end of an accounting period. These balances are then used to prepare the financial statements. One of the primary purposes of accounting is to provide financial information in a meaningful way so that decision makers can make informed decisions about financial matters. To provide the information required by the many internal and external stakeholders of the business, accountants will create hundreds of accounts that capture, summarise and report on every aspect of the business. It would be highly inefficient and ineffective if these accounts were not grouped and indexed in some logical order. This logical order forms the basis of a Chart of Accounts.

CHART OF ACCOUNTS STRUCTURE Given the diversity of businesses operating in today’s world, it would be impracticable to have one standard Chart of Accounts stipulated for use. So, each business must create and index accounts according to the information needs of its internal and external stakeholders. The widespread use of computers has also had an impact, with accounts given short identifying codes to make data entry more accurate and efficient. (It is easier and quicker to type 10001 for Cash at Bank than to type the full account descriptor.) These identifying codes form the basis of the accounting computer software used to prepare the required financial statements. Given that the account balances in the General Ledger form the basis of the two key financial statements, it makes sense to index them in the Chart of Accounts. So, the accounts are first grouped by Revenue and Expense (according to the reporting requirements of the Income Statement) and by Assets, Liabilities and Owner’s equity (according to the reporting requirements of the Balance Sheet). The most common method for allocating account codes to these groups is via a variation of the number sequence of the Dewey Decimal system that is typically used by libraries to classify their books and other resources. The great advantage of using this system is that it can be easily expanded without upsetting the structure of the accounting system. (That is, it easily allows new accounts to be added to the Chart of Accounts to more accurately reflect what the business does and/or regulatory reporting requirements.) Hence, the structure of a business’s Chart of Accounts will typically change a little over time to reflect these developments. Some businesses include in the code given to an account:    

the the the the

account group account sub-group relevant cost centre specific project or program.

So, the Chart of Accounts provides: • a logical index that makes it more efficient for data entry staff to find and enter the appropriate account against the details of the financial transactions being recorded in the journals • the necessary coding for computerised accounting packages to report appropriately on the accounts in the financial statements • an ordered structure to guide accountants when introducing new accounts into the General Ledger without upsetting the accuracy of the financial statements. WHAT ARE JOURNALS IN ACCOUNTING?

Journals in accounting were traditionally called the ‘day book’. This is due to the origins of the English word journal. The English word comes from the French word jour, which means day. It was also traditionally expected that journals would record all of the financial transactions that occurred on each particular day. Journals recorded transactions as they occurred (or as soon as possible afterwards) in date and time order. Journals became known as the ‘books of original entry’ because they were the point at which financial information entered the accounting information system. The financial information system manages the financial data as it is:    

entered into the journal transferred to the General Ledger summarised in the trial balance presented for stakeholders in the form of financial reports.

BACKGROUND TO JOURNALS IN ACCOUNTING When the Franciscan friar and mathematician Luca Pacioli (1446–1517) first published his book on the double-entry bookkeeping system in 1494, he outlined the key role that journals would play in this process. Today accountants continue to follow the concepts Pacioli outlined in recording financial transactions in the accounting information system (even if Pacioli used quill pens and parchment and today’s accountants use computer programs)! The key objectives in recording financial transactions in the journals include: • recording each entry with sufficient clarity and information to allow a person, without the aid of memory, to understand in the future the exact nature and purpose of the transactions • classifying each entry so an aggregate can be easily extracted at the end of each accounting period. TYPES OF JOURNAL The act of recording transactions in a journal is called journalising. While all entries could conceivably be entered into the accounting information system via the general journal alone, it would be a highly inefficient approach to journalising. So, due to the often huge volume of financial transactions that need to be recorded on a daily basis, accountants have, over time, developed a range of specific journals designed to record groups of transactions sharing common characteristics. This grouping of transactions facilitated the creation of the subsidiary ledger system. It also made the calculations and posting of the summarised journal information to the General Ledger far more accurate and efficient.

So, today, instead of a general journal supported by six specialised journals, we have seven buttons or tabs on the computer screen that capture all the information described below. The various journals that have been developed over the years are described in Table 13.

Table 13 Types of journals used in accounting Journal name

Description/purpose

Sales Journal

To record the sales made to credit account customers

Purchases Journal

To record the purchases from suppliers that are to be paid at a later date

Cash Receipts Journal

To primarily record cash sales, and payments by customers towards their credit account

Purchases Returns and Allowances Journal

To record returns made to suppliers and allowances given

General Journal

To record any transaction that did not fit appropriately into the other specialised journals (for example, a capital injection by the business owners)

At pre-determined intervals (monthly, quarterly or annually) the journals entries are summarised and the totals for each account are transferred (posted) to the General Ledger. JOURNAL ENTRIES IN ACCOUNTING Data entries relating to business transactions and recorded in the journals are called journal entries.

KeyFACTS 

Business transactions are those events that will change the value of the assets and/or liabilities

 

and/or owner’s equity of a business. Business transactions generate verifiable, tangible evidence in the form of source documents. These source documents (such as sales invoices, supplier invoices, cheque butts and deposit books) are the back-up documentation for the recording of the journal entry.

Journal entries are recorded in chronological order while applying the doubleentry bookkeeping system at all times and for each entry. Each journal entry will include debit and credit amounts and will identify the ledger accounts (from the Chart of Accounts) that the transaction has affected, as well as the date that the transaction was recorded. To assist reviewers of the entries (for example auditors), comments are also included to detail the source of the financial information being recorded and any relevant reasons for the entry (transaction). The initial journal entry is an

important component of the audit trail that stretches from the source document all the way to the Balance Sheet.

J

ournal entries should be recorded as the business event occurs, or as soon as possible after it. The facts and details are still fresh in the mind. If the recording is done very soon after the transaction occurs, relevant documents, conversations and calculations are still readily available to verify or correct an entry. WHAT IS A LEDGER ACCOUNT IN ACCOUNTING? A ledger account is a separate accounting record in the General Ledger that collects and stores the debit and credit details of a specific aspect of financial activity. All the debit and credit details in a ledger account come from the journals that initially recorded the details of financial transactions in a date and time order. The process of transferring the transaction details from the journals to the ledger accounts is known as posting. BACKGROUND TO LEDGER ACCOUNTS IN ACCOUNTING Businesses will typically have hundreds of ledger accounts. Businesses create and name ledger accounts according to the reporting needs of their stakeholders. These ledger accounts are coded and structured into five major groups according to the pre-determined Chart of Accounts: Revenue, Expenses, Assets, Liabilities and Owner’s Equity. The entire collection of ledger accounts is known as the General Ledger. The double-entry bookkeeping system has two major processing stages, described below. STAGE 1 Details of source documents (in a date and time order) are recorded in the journals according to the double-entry bookkeeping principles of debit and credit. Ledger account codes are recorded in Stage 1 to ensure efficient and accurate transfer (posting) of the transaction details from the journal to the ledger accounts. STAGE 2 All the debit and credit details from the journals are taken into ledger accounts and summarised into groups by financial activity type (account type). In a

computerised accounting system, this transfer of details is done automatically based on the account code entered in the journals. T ACCOUNTS AS LEDGER ACCOUNTS The best way to visualise a ledger account is as the letter T, where the account title and account code run along the top line (the horizontal part of the letter T), with a centred line (the vertical part of the letter T) separating debit entries on the left and credit entries on the right. Each ledger account created by a business will belong to one of the five account groups: Revenue, Expenses, Assets, Liabilities and Owner’s equity. A common use of T accounts is in preparing adjusting entries (accruals and deferrals).

Step 1 Financial transaction details recorded in journals where principles of double-entry bookkeeping applied via the debit and credit rules

Step 2 Ledger accounts receive information from the journals via process known as posting

Step 3 Debit details from journals recorded on left of the T account and credit details on the right

Step 4 By subtracting one side of the T account from the other, one can assess if a specific account has a current debit or credit balance*

* An account has a debit balance where the total of the debit amounts is greater than the total of the credit amounts. It has a credit balance where the total of the credit amounts is greater than the total of the debit amounts. Normally the Liabilities, Revenue and Owner’s equity ledger accounts have a credit balance and the Assets sand Expense ledger accounts have a debit balance.

Figure 29 From journals to ledgers In a computerised system, an additional column is created in the ledger accounts that keeps a running debit/credit balance based on the flow of transaction details being posted from the journals. The closing balances of the individual ledger accounts at the end of each accounting period will then become line entries on the financial statements, with the Revenue and Expense ledger accounts being reported on the Income Statement, and the Assets, Liabilities and Owner’s equity accounts being reported on the Balance Sheet.

WHAT ARE SUBSIDIARY LEDGERS IN ACCOUNTING? Subsidiary ledgers in accounting involve the grouping of individual accounts that share a common element. Individual accounts that share a common element include Suppliers, Customers, Inventory items and Fixed assets. These individual accounts collectively add up to the value of the corresponding control account reported as a total in the General Ledger. For example, the Accounts Payable account is the control account for the subsidiary ledger of Suppliers and known as the Creditors ledger. The Accounts Receivable account is the control account for the subsidiary ledger of Customers and known as the Debtors ledger. BACKGROUND TO SUBSIDIARY LEDGERS IN ACCOUNTING Accounting is defined, generally, as the process of recording financial transactions so that reports can be produced that give stakeholders an accurate view of the financial performance and position of the business. But accounting is also more than that. Accounting is also about the control of those finances and about managing the way in which financial transactions impact on the financial performance and position of the business. This control function of accounting also allows for the monitoring of the delegated responsibilities within the accounting process, which incorporates the accountability of persons and the tracking of financial assets and functions under their control. Considering the vast volume of financial transactions that take place every day in many businesses, it is perhaps no wonder that some financial functions over time have been separated from the core accounting process and are now handled by subsidiary departments. Two areas typically handled by subsidiary departments are the Accounts Receivable and the Accounts Payable functions.

ACCOUNTS RECEIVABLE

ACCOUNTS PAYABLE

Accounts receivables deals with the creation and management of debtor accounts that allows customers to purchase goods and services from the business on credit.

Accounts payables deals with the creation and management of creditor accounts that allows the business to purchase goods and services from suppliers on credit.

Figure 30 Accounts Receivable and Accounts Payable Creating the subsidiary systems in accounting helps businesses efficiently and effectively manage and monitor the status of individual supplier and customer

accounts. Recording all this information in just one account in the General Ledger would make managing these functions very difficult. So the accounting system sets up specialised journals and ledgers. These specialised journals and ledgers make it easy to manage the goods and services sold to individual customers on credit in the debtors subsidiary system and to manage the goods and services purchased from individual suppliers on credit in the creditors subsidiary system. 



The debtors subsidiary system includes a Sales journal and a Debtors ledger that is used to manage the sales on credit and the payments made by individual customers in relation to their account. The creditors subsidiary system includes a Purchases journal and a Creditors ledger that is used to manage the purchases on credit and the payments made by the business to the individual supplier accounts.

Businesses create subsidiary ledgers whenever they need to so as to monitor the individual components of a controlling General Ledger account. So in addition to the Accounts Receivable subsidiary ledger and the Accounts Payable subsidiary ledger, a business may create an Inventory subsidiary ledger (which has separate accounts for each product); and a Property, Plant and Equipment subsidiary ledger (which has separate accounts for each long-lived asset). Note: The concept of credit as it is used here is not to be confused with the specialised meaning of credit as used in the double-entry bookkeeping system. In this context here, credit means the ability of a customer or business to take possession of goods before paying for them. So, the business extends credit to customers (allowing them to take the goods now and pay for them later) and buys goods on credit (allowing the business to take possession of goods or services on the basis of agreed terms with the supplier, where the business will pay for them later). SUBSIDIARY LEDGERS AND THE GENERAL LEDGER The General Ledger is the primary set of accounts used by accountants to prepare the financial statements of a business. Where used, the subsidiary ledgers contain the breakdown of the individual details that support the totals reported in the General Ledger accounts. Accounts in the General Ledger that have subsidiary ledgers in support are known as control accounts. For example, the Accounts Receivable account in the General Ledger is the control account for the Debtors subsidiary ledger and the Accounts Payable subsidiary ledger account in the General Ledger is the control account for the Creditors subsidiary ledger.

It is imperative that the total of all the individual account balances in the subsidiary ledger is equal to the amount reported in the control account in the General Ledger. The process used to verify this balance is known as a subsidiary ledger reconciliation.

Discrepancies between the total of the subsidiary ledgers and the General Ledger control accounts can occur because every transaction that deals with sales/purchases on credit and cash received/paid on these accounts must be recorded in two places, namely:  

the appropriate individual customer/supplier in the subsidiary ledger the appropriate control account in the General Ledger.

Computerised accounting systems go some way to eliminating this potential discrepancy by automatically updating both the individual account in the subsidiary ledger and the control account in the General Ledger, with one correct recording of the transaction in the subsidiary journal.

SUMMARY—CREDITORS AND DEBTORS SUBSIDIARY LEDGERS In summary:  Financial reports are produced from the General Ledger not the subsidiary ledgers.  Subsidiary journals are set up to record transactions specifically related to the 

subsidiary ledgers (for example, the Sales journal and the Purchases journal). Apart from the general journal, all other journals need to post their details to both the individual accounts in the subsidiary ledgers and the control accounts in the General



Ledger. Customer payments processed through the Cash Receipts journal will need to be posted to the Debtors ledger, while cash sales and other cash received like owner’s capital



invested will be posted directly to the appropriate General Ledger account. Supplier payments made by the business and processed through the Cash Payments journal will need to be posted to the Creditors ledger, while cash purchases and other cash payments like loan repayments will be posted directly to the appropriate General



Ledger account. The subsidiary ledgers are not part of the main accounting process but are simply a listing of the individual accounts that explain and justify the total amount reported in



the relevant control account in the General Ledger. Systematically, the subsidiary ledgers must be reconciled with the control account balances in the General Ledger to ensure the accuracy of the financial information; that



is. –

the total of the individual customer account balances must equal the Accounts

–

Receivable amount reported in the General Ledger the total of the individual supplier account balances must equal the Account

Payable amount reported in the General Ledger. Computerised accounting systems have automated (reduced the process to one transaction) posting to both the subsidiary ledger and the General Ledger, provided the proper journal is used. This has eliminated many of the errors that occurred with the manual accounting system.

WHAT IS POSTING IN ACCOUNTING?

Posting in accounting refers to the process of transferring to the ledgers, the details of financial transactions originally recorded in the journals of a business. Posting is an important step in the double-entry bookkeeping system. Posting transfers the debit and credit aspects of a financial transaction (recorded chronologically in the journals) to the relevant accounts impacted by that transaction in the ledger. Postings take place between the general journal and the General Ledger as well as from the subsidiary journals to both the Subsidiary and the General ledgers. BACKGROUND TO POSTING IN ACCOUNTING Accounting is a specially designed recording system that details the financial events conducted by a business (or other financial entity). These financial events are called transactions in accounting. The specially designed recording system is known as the double-entry bookkeeping system. By following centuries-old accounting principles of double-entry bookkeeping, the accounting system is able to produce reports that constantly monitor and measure the financial sustainability and financial strength of the business (or financial entity). The financial sustainability of a business is reported in the Income Statement and the financial strength of a business is reported in the Balance Sheet. The accounting process begins with financial transactions that impact directly on the monetary value of either the assets, liabilities or equity of a business. These transactions are evidenced by source documents such as invoices, receipts, deposit slips, memos and check butts. The details of these source documents are entered into the journals of a business.

T

he process of entering the details of financial events into the accounting system is known as journalising the transactions.

The journals record the details of the transaction chronologically in date and time order. The accounting process then transfers the details contained in the journals to those accounts specifically affected by the transaction. That is, the transaction of paying an electricity bill would reduce the amount the business had in its Bank account and increase the Electricity Expense account. Collectively, all these accounts make up the General Ledger of the business. The accounts of the General Ledger are the building blocks that produce the financial reports of the business. The process of transferring the details of the financial transaction recorded in the journals into the relevant accounts in the General Ledger is called posting in accounting. In today’s computerised accounting world, posting to the General Ledger takes place automatically the moment that the transaction is correctly journalised and

saved. In a double-entry bookkeeping system, a transaction is correctly journalised when the debit values of the transaction equal the credit values. POSTING FROM SUBSIDIARY JOURNALS IN ACCOUNTING Under the manual accounting system, it became very messy to list in the financial reports all the customers who owed the business money and all the amounts owed by the business to its suppliers. To tidy up the financial reports, the accounting system grouped all the amounts owed by customers under the single General Ledger account called Accounts Receivable and all the money owed to suppliers in a single General Ledger account called Accounts Payable. To deal with this, the accounting system set up the subsidiary ledgers called the debtors ledger to keep all the individual account details of money owed by customers, and the creditors ledger to keep all the details of money owed to suppliers. Special subsidiary journals were also set up in the accounting system to record these special transactions.  

A Sales journal records those sales made to customers that have an account that allows them to pay for the goods and services at a later date. A Purchases journal records purchases made by the business of goods and services for which it has taken possession but not yet paid for.

These Sales and Purchases journals continue to be part of the computerised accounting systems. The details of transactions recorded in the Sales and Purchases journals still need to be posted to both the Accounts Receivable and Accounts Payable accounts in the General Ledger as well as to the individual customer and supplier accounts in the subsidiary ledger. This two-step process in the manual accounting system is now a one-step automated process in the computerised system. WHAT IS THE GENERAL LEDGER IN ACCOUNTING? The General Ledger is the central core of the accounting information system.

KeyFACTS 

The General Ledger is where all of the financial transactions of a business are categorised and



summarised into accounts. The accounts in the General Ledger group similar transactions into individual records producing



a continually updated credit/debit balance for each. The number and type of accounts that make up the General Ledger are determined by the Chart



of Accounts. The General Ledger contains a permanent history of all the financial transactions that have taken



place in the business since its first day of operation. The General Ledger is sometimes known as the nominal ledger and often abbreviated as GL.

BACKGROUND TO THE GENERAL LEDGER IN ACCOUNTING Until the 1980s, all ledgers were books that recorded the financial information of a business. Today, with the vast number of accounting software packages, ledgers have become digital databases of financial information. Under the double-entry bookkeeping system, financial transactions are initially captured by the journals applying the principles of debit/credit. Journals, as the original books of entry, record on a daily basis all the financial transactions of a business in a date and time order. However, journals do not provide information in one place about a specific account or aspect of the business. For example, to calculate the cash balance with only the journals as records, one would need to check all the journal entries in which cash was affected. Given the vast amount of transactions involved, this undertaking would be very difficult and prone to mistakes.

To streamline this process, accounting transfers these journalised transactions to the specific account in the General Ledger according to the account type (that is, Assets, Liabilities, Owner’s Equity, Revenue, and Expenses). The debit/credit aspects of each transaction recorded in the journals are maintained by the General Ledger accounts producing a current credit or debit balance. The General Ledger also provides the basis for the preparation of the financial reports.  

The Income Statement is prepared from the closing balances of the Revenue and Expense accounts. The Balance Sheet is prepared from the closing balances of the Assets, Liabilities and Owner’s equity accounts.

SUMMARY—THE GENERAL LEDGER 

All the financial transactions of a business (or financial entity) are categorised and



summarised into accounts in the General Ledger. The number and type of accounts that make up the General Ledger are determined



by the Chart of Accounts. The General Ledger contains a permanent history of all the financial transactions of



a business. With computerisation, General Ledgers have become digital databases of financial

 

information. Journals post (transfer) all data captured to the General Ledger. General Ledger accounts are grouped according to the account type (that is, Assets,



Liabilities, Owner’s equity, Revenue, and Expenses). The double-entry bookkeeping system first applied in the journals is maintained in



the General Ledger. The General Ledger provides the details required to prepare the financial statements.



The General Ledger is sometimes known as the nominal ledger and often



abbreviated as GL. The General Ledger makes it easy to track information and to quickly see account



balances. Transactions cannot be recorded directly into the ledger; they must be routed



through the journal. Transferring information from the journals to ledger accounts is called posting.

WHAT IS A TRIAL BALANCE IN ACCOUNTING? A trial balance in accounting is prepared to verify that the double-entry bookkeeping rules have been adhered to in recording the financial transaction during a particular period. This is done by totalling all the [Dr/Debit] balances in the General Ledger and ensuring that this total agrees with the total of all the [Cr/Credit] balances in the General Ledger. DEFINITION OF TRIAL BALANCE IN ACCOUNTING The accounting system is built on the concept of double-entry bookkeeping. The double-entry bookkeeping system requires that a minimum of two entries are made for each financial transaction that occurs in a business. The double-entry bookkeeping system also requires that:  

all financial transaction must have at least one [Dr/Debit] entry and one [Cr/Credit] entry and for each financial transaction the total of the [Dr/Debit] entries must equal the total of the [Cr/Credit] entries.

The trial balance, then, is a summary report that tests whether all the financial transactions entered into the accounting system over a specific period of time have followed the double-entry bookkeeping rules in regard to [Dr/Debit] and [Cr/Credit] entries.

I

f the double-entry bookkeeping rules have been followed correctly, the total of all the [Dr/Debit] account balances in the General Ledger will equal the total of all the [Cr/Credit] account balances in the General Ledger. PREPARATION OF A TRIAL BALANCE IN ACCOUNTING A trial balance can be prepared at any time but it is mostly prepared just before preparing the financial statements. (Note: While the financial statements are

prepared for both internal and external stakeholders, the trial balance is prepared for, and used by, only the internal accounting team.) The trial balance is simply a listing of all the accounts from the General Ledger with their balances. The balances of the accounts will be either a [Dr/Debit] or a [Cr/Credit] depending on their nature and financial activity. For example, Asset and Expense accounts will most likely have a [Dr/Debit] balance while Liabilities, Owner’s Equity and Revenue accounts will most likely have[Cr/Credit] balances.

The total of accounts with [Dr/Debit] balances should be the same at the total of accounts with [Cr/Credit] balances, provided that the double-entry bookkeeping system was correctly applied. So, in essence, the trial balance is prepared to confirm the accuracy of the postings to the General Ledger. In a manual accounting system, it is necessary to prepare a trial balance because of the many ways that the General Ledger could be out of balance (that is, where the total of the [Dr/Debits] do not equal the total of the [Cr/Credits]). Modern computerised accounting software systems enforce the double-entry bookkeeping requirements at the data-entry level making it impossible for either the General Ledger or the trial balance statement to be out of balance. PRESENTATION OF THE TRIAL BALANCE The trial balance statement consists of the header rows followed by a list of all the general ledger accounts. The current balances of these general ledger accounts are place in either the [Dr/Debit] or the [Cr/Credit] column. The [Dr/Debit] and the [Cr/Credit] columns are then totalled and compared. They should be the same.

SUMMARY—THE TRIAL BALANCE The trial balance:  tests to see if the double-entry bookkeeping rule has been correctly applied  is a list of all the accounts with balances in the general ledger  establishes that the total of all the accounts with a [Dr/Debit] balance is the same  

as the total of all the accounts with a [Cr/Credit] balance is prepared only for the internal accounting team is prepared and checked before preparing the financial statements.

WHAT IS AN AUDIT TRAIL IN ACCOUNTING? An audit trail is a process pathway built into a well-designed accounting system that allows amounts reported in the financial statements to be traced back to their original source.

KeyFACTS

 

An audit trail is a complete step-by-step history of every transaction in the accounting system. An audit trail comprises a chronological sequence of records and source documents that provide



the evidence an auditor needs to reconstruct previous steps in the accounting system. An audit trail facilitates defect analysis and so helps to verify the accuracy and reliability of financial reports.

BACKGROUND TO AN AUDIT TRIAL IN ACCOUNTING Financial statements are the end product of the bookkeeping/accounting system. These financial statements are used by stakeholders (that is, shareholders, managers, funders, suppliers and customers) to make financial decisions about the allocation and use of resources under their control. It is important to these stakeholders that the financial statements are accurate and can be relied upon when making their decisions about resource allocations. With this in mind, accountants map out a process that allows an independent auditor to trace the amounts reported on the financial statements back to the original source documents and transactions. This mapping process is known in accounting as ‘providing an audit trail’. Furthermore, with the separation of roles between business fund suppliers (shareholders) and business fund controllers (management) that have come about with the industrial age, shareholders need to verify the reports that management prepares about the use of shareholder funds. This requirement led to the rise of independent auditors who check the accuracy and reliability of the books of the business on behalf of the shareholders. The auditor follows the audit trail when carrying out this process, looking for evidence to validate each step in the accounting process. This includes checking the original source documents and transactions. PURPOSE OF AN AUDIT TRAIL IN ACCOUNTING The audit trail traces the transaction from the source documents that provide evidence of a financial event through to the eventual reporting of the impact on that transaction on the financial position of the business in the Balance Sheet. The audit itself starts at the end, with the financial statements (Balance Sheet and Income Statement). The account balances (from the General Ledger) in these reports are identified. These account balances are made up of journal entry summaries, which are, in turn, made up of individual transactions that can be matched with the source documents via receipt/invoice number. The fact that transactions can be chronologically sorted by date order and journal summaries by sequenced numbers helps make the audit trail robust.

T

he audit trail is a process that allows others to check the accuracy and reliability of the financial reports by tracing back the trail that the transaction took as it progressed through the accounting system —all the way back to the source document and financial event that caused the transaction to be recorded. This ability to check the accuracy and reliability of each transaction in the accounting systems has a number of benefits: • It helps to identify: – any attempts at fraud or misappropriation of funds – any attempts by management to misrepresent the financial performance or position of a business – incomplete or missing data, including any mathematical inaccuracies in period-end accounting records – weakness in the internal control system of assets implemented by management. • It provides evidence for tax authorities in regard to tax expense claims • It helps auditors to detect instances of inappropriate record-keeping behaviours or unlawful business practices. WHAT ARE END-OF-PERIOD ADJUSTMENTS IN ACCOUNTING? End-of-period-adjustments in accounting are journal entries made to the accounts of a business immediately before financial statements for a given accounting period are prepared and distributed. Financial statements are prepared at the end of each accounting period; these can be monthly for large corporations or annually for small to medium businesses. End-of-period adjustments ensure that these financial statements reflect the true financial position and performance of a business. They do this by allocating to the appropriate period the income earned and expenses incurred. End-of-period adjustments are also known as year-end-adjustments, adjustingjournal-entries and balance-day-adjustments. End-of-period-adjustments apply the matching principle of accounting which includes accruals, deferrals and asset value adjustments. BACKGROUND TO END- OF-PERIOD-ADJUSTMENTS IN ACCOUNTING The primary purpose of completing the balance-day-adjustments is to ensure that the financial statements accurately reflect the financial position and

performance of the business. Stakeholders in a business venture use the financial statements to make decisions, particularly about the best use of financial resources under their control. It is therefore very important that the financial statements presented to these stakeholders are accurate. End-of-period adjustments become necessary in accounting to two key areas: 1. to take account of the different time impacts of the accounting period and multi-period financial transactions (for example, a 12-month magazine subscription that benefits the business over 12 different monthly accounting periods) 2. to better reflect asset realities (for example, to adjust the inventory amount in the accounts to reflect the value of an actual stocktake done at the end-ofperiod). The mismatch between the accounting time periods for which stakeholders require financial information on the one hand and the real life, conduct and transaction times of a business on the other hand is one area requiring end-ofperiod adjustments. For example, some transactions, like an insurance payment, may cover several accounting periods. Not all transactions fit neatly within the monthly, quarterly, halfyearly or annual reporting periods that stakeholders require. Hence, end-of-period adjustments must be made to the accounts of a business so that only that part of the financial transaction that relates to the current period is included in the financial reports for the current period.

Apart from making end-of-period adjustments for the timing mismatches mentioned above, end-of-period adjustments must also be performed to appropriately adjust asset values. Before distributing financial statements to the stakeholders of the business, accountants and bookkeepers check to see that all the asset values in the accounts reflect their real value according to either the accounting standards, tax laws and/or organisational policies. Typical assets that need to be checked and adjusted when necessary include those detailed in Figure 31.

Merchandise inventory

To make adjustments to reflect the physical or

Fixed assets

To make allowances for their depreciation

Accounts Receivable

To write-off bad debts and provide for doubtful

Supplies or stores

To record adjustments to the supplies

stocktake valuation according

debts

stores values to the end-of-period stocktake

Figure 31 Assets typically requiring end-of-period adjustments END-OF-PERIOD ADJUSTMENTS AND ACCRUAL ACCOUNTING There are two methods accountants and bookkeepers use to record and report on the financial transactions of a business:  

cash accounting accrual accounting.

Under the cash accounting method, financial transactions are recorded in the accounts of a business only when the cash is actually exchanged. For example, revenue is recorded when the money is received and expenses are recorded only when the actual payment is made. Businesses using the accrual accounting method are required to record revenue when a legal obligation on the customer/client is created and record expenses when the business incurs a legal liability to pay—regardless of when the cash is actually exchanged. So by applying the accrual accounting method, the income earned in a given accounting period will accurately match the expenses incurred in earning that revenue. This is known in accounting as the matching principle. The matching principle ensures that the financial reports accurately reflect the financial performance and the financial position of the business for the given accounting period. The matching principle applied in accrual accounting requires that adjusting entries are made to the accounts to ensure that all the revenue earned in an accounting period, together with all the expenses incurred in earning that revenue, are recorded and reported in the same accounting period. END-OF-PERIOD ADJUSTMENTS—ACCRUALS AND DEFERRALS The two key end-of-period adjustments that need to be made under the matching principle are accruals and deferrals. ACCRUALS Accruals are end-of-period adjustments made under the matching principle that recognise (bring to account) those revenues that have been earned and those expenses that have accumulated in the current period but which have not yet been recorded in the books of the business.

DEFERRALS Deferrals are end-of-period adjustments made under the matching principle that transfer to future accounting periods those revenues and expenses recorded in the current period but which, in fact, belong to these future periods. The different types of end-of-period adjustments are detailed in Table 14.

Table 14 Different types of end-of-period adjustments Account type

End-of-period adjustment

Accrued revenue

Adding transactions for revenue that has not yet been invoiced 

Accrued expense

Adding transactions for expenses that have not yet been recognised 

Deferred revenue

for example, the electricity used in the current reporting period that has not yet been billed by the supplier. (Note: a special type of accrued expense is depreciation. Depreciation expense apportions the cost of a fixed asset over its useful life. The useful life of a fixed asset will cover a number of accounting periods.)

Transferring to future periods income transactions that, while recorded in the current period, actually belong to future periods. These amounts become liabilities of the business because the business has not yet performed the work and so has no claim to the customer payment. 

Deferred expense

for example, a staged monthly invoice for partially completed work of $1,000 in a 6-month contract worth $6,000

for example, $1,000 cash received by the business as a deposit for work that has not yet been commenced

Transferring to future periods expense transactions that, while recorded in the current period, actually belong to future periods. These amounts become assets of the business because the value of the expense has not yet been used up or utilised. 

for example, transferring the remaining time covered under a 12-month insurance payment

ACCOUNTING METHODS: CASH VS ACCRUAL WHAT IS CASH ACCOUNTING? Cash accounting is a method of bookkeeping that delays recording the revenues and expenses of a business until the cash is exchanged (that is, when cash is actually received or paid out). By contrast, the accrual accounting method records revenues at the point they are earned and records expenses when a legal obligation to pay is created. BACKGROUND TO CASH ACCOUNTING Cash accounting exists primarily to provide a cost- and time-effective method of recording and reporting on the financial events of predominantly small cashbased businesses. The majority of the users of financial information (stakeholders) would prefer that the financial events of a business were recorded and reported on using the accrual accounting method. The accrual accounting method is generally preferred because it adheres to the accounting concept of the matching principle and the revenue recognition principle. The cash accounting method does not. The matching principle ensures that the net income, for shorter accounting periods (say months), is accurately calculated by ensuring that the revenues earned in each period are matched with all the expenses incurred in earning that revenue. Still, stakeholders understand that the more complicated accrual accounting method is not always an appropriate or feasible standard to place on all businesses. This is particularly the case for small sole proprietor service-based businesses which have very little inventory, which collect cash on completion of the work, and which pay cash for the majority of their supplies. Cash accounting is the appropriate method for recording and reporting on the financial events of a business of this type because the additional costs of complying with the accrual accounting method would not be justified in regard to any benefits secured. Basically, the accrual accounting method serves the purpose of accounting far better than the cash accounting method because the accrual accounting method is acknowledged as providing a truer and fairer representation of the financial position and performance of the business. The purpose of accounting is to provide the information that is needed for sound economic decision making to take place. The information provided by the cash accounting method is not as reliable as the accrual accounting method for decision making because:

• there may be revenue earned by the business that has not yet been recorded (for example, unpaid sales invoices) • there may be expenses owed by the business that are not yet recorded because the bill has not yet been received or paid (for example, an electricity bill or rent for the past month) • there may be payments made by customers that should not yet be recorded as revenue (for example, deposits paid by customers for future work) • there may be purchases for inventory that have not yet been sold and remain in stock (under the cash accounting method, this amount would be expensed even though the inventory asset remained) • there may have been payments made by the business for some expenses that still have future economic benefit (for example, insurance paid for 12 months in advance). Every cash-based small business could experience any or all of the above situations, which would distort the net income results presented in their financial statements. Government tax departments and accounting standards accept this possible profit distortion for small cash-based business using the cash accounting system because the extra cost and time required to use the accrual accounting method cannot be commercially justified for them. Large businesses, however, that reach certain legislated sales thresholds (for example, $5 million per year of sales in the United Stated) are required by tax law to record financial transactions and prepare financial reports based on the more complicated accrual accounting method.

Table 15 Examples of the accrual and cash accounting methods Method

Cash accounting method

Accrual accounting method

A business is paid $1,000 in January for consulting work completed and invoiced in December.

Records $1,000 as Consultancy revenue in January

Records $1,000 as Consultancy revenue in December

A business pays an electricity bill of$500 in July for electricity used in June.

Records $500 as Electricity expense in July

Records $500 as Electricity expense in June

SUMMARY—CASH ACCOUNTING METHOD OF BOOKKEEPING The cash accounting method of bookkeeping:  is predominantly used by small sole-proprietor businesses and small associations  

that do not have inventory and have a limited number of debtors/creditors is a more cost- and time-effective method than the accrual accounting method is accepted as a method of bookkeeping by tax law and accounting standards, though NOT for larger corporations or for-profit public companies



does not adhere with the matching principle or the revenue recognition principle of



accounting is not a reliable measure of net income when calculated for shorter time periods like



months. is also known as the ‘cash basis’ when describing how the financial reports were prepared (that is: They were prepared using the cash basis).

WHAT IS ACCRUAL ACCOUNTING? Accrual accounting is a method of bookkeeping that records revenues and expenses as they are earned or incurred. By contrast, the cash accounting method delays the recording of revenues and expenses until the cash is actually exchanged (received or paid). BACKGROUND TO ACCRUAL ACCOUNTING Businesses come in all shapes and sizes. At one end of the scale for business size, are corporations large enough to employ teams of accountants and bookkeepers to process their financial transactions. Sole proprietors, on the other hand, cannot afford such expert service and are mostly forced to record their own financial transactions. Yet every business, regardless of its size, is required under tax law to prepare financial statements that calculate their net profit/income. Government realise that it would be grossly unfair to set the same reporting requirements for the sole proprietor as for the large publicly owned corporation. So, governments give small businesses a choice. Governments allow small businesses to record their financial transactions and prepare their financial reports for tax purposes using the simpler and less time-consuming cash accounting method. Large businesses that reach certain legislated sales thresholds (that is, $5 million per year in sales in the United States) do not have this choice. These large businesses are required by tax law to record financial transactions and prepare financial reports based on the more complicated accrual accounting method. This is because the accrual accounting method is regarded by accountants and government regulators as providing a truer representation of the financial position and performance of the business. (Note: It is common practice to substitute the term accrual basis when explaining how the financial reports using the accrual accounting method have been prepared.) ACCRUAL ACCOUNTING METHOD VS THE CASH ACCOUNTING METHOD The major difference between the accrual accounting method and the cash accounting method is the way in which revenue and expenses are recorded in the accounts of the business.

ACCRUAL ACCOUNTING METHOD

CASH ACCOUNTING METHOD Revenue and expenses are recorded ONLY when the cash is exchanges (that is, when revenue is received as cash

Revenue and expenses are recorded at the moment a legal obligation is created (for example, when goods are shipped or service delivery completed in the case of revenue, or when goods are received or service delivery is completed in the case of expenses).

Figure 32 Revenue and expenses: cash accounting method vs accrual accounting method

The accrual accounting method also properly applies the accounting concept of the matching principle; the cash accounting method does not. Applying the matching principle in accounting, requires accountants to record, in the same period, the revenue and all expenses incurred in earning that revenue. The matching principle ensures that profits (revenue less expenses) are accurately reported for each accounting period (that is, that revenue earned in one period is accurately matched against the expenses that correspond to that period), so a truer picture of net profit for each period is calculated. The accrual accounting method therefore requires end-of-period adjustments to be made to the business revenues and expenses while the cash accounting method does not. These end-of-period adjustments create transactions known as accruals. Over the longer term, both the accrual accounting method and the cash accounting method will produce similar total profit results. The key difference between the two methods occurs in the different profit outcomes reported over the shorter accounting periods (monthly, for example). These different approaches can still create significant variances in annual results as well. The cash accounting method will distort profit calculations significantly in the shorter accounting periods if the business sells/buys on credit and/or keeps an inventory of saleable products.

Table 16 Differences between the accrual and cash accounting methods Feature of accounting method



Purpose

To track the movement of cash

To more accurately report on the financial performance and position of a business

Used by

Small businesses

Public companies, businesses with Accounts Payables and Accounts

Receivable, companies that are required to do so by law Revenue recognition/recording

When cash is received

When economic exchange is complete or legal obligation created

Expense recognition/recording

When cash is paid sometimes relating to previous accounting periods

Under the matching principle, expenses must be recorded in the same period as the resulting revenue earned from the expense outlay.

Judgement

The movement of cash can be measured objectively.

The allocation of revenues and expenses to different periods is subjective.

Table 17 Examples of the accrual and cash accounting methods Method



A business is paid $1,000 in January for consulting work completed and invoiced in December.

Records $1,000 as Consultancy revenue in January

Records $1,000 as Consultancy revenue in December

A business pays an electricity bill of $500 in July for electricity used in June.

Records $500 as Electricity expense in July

Records $500 as Electricity expense in June

SUMMARY—ACCRUAL ACCOUNTING METHOD OF BOOKKEEPING The accrual accounting method of bookkeeping:  accounts for accounts for expenses when a legal obligation to pay is created 

regardless of when the bill is actually paid complies with the matching principle by ensuring that the revenues and all the accompanying expenses incurred in earning that revenue are recorded in the same



accounting period involves end-of-period adjustments to ensure that the revenue recognition principle

 

and the matching principle are appropriately applied to the financial statements accurately measures and reports on the net income of a business often referred to as the ‘accrual basis’ when describing how the financial statements



were prepared is an option for small businesses but is the ONLY bookkeeping method allowed under tax laws and accounting standards for large corporations and for-profit public companies



has various advantages and disadvantages relative to the cash accounting method.

WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF CASH VS ACCRUAL ACCOUNTING? Both the cash and accrual accounting methods of bookkeeping are accepted by tax law and accounting standards as appropriate ways to record and report on the financial events of a business. The advantages and disadvantages of each method are relevant only to small businesses which can choose between these methods. Large corporations and for-profit companies are required to report on their financial position and performance using ONLY the accrual accounting method. Each bookkeeping method has advantages and disadvantages. If a business has the option to choose, these advantages and disadvantages need to be weighed up carefully before deciding which one is best for the business. It will probably be necessary to seek the advice of an accountant in this regard. DEFINITIONS OF CASH ACCOUNTING AND ACCRUAL ACCOUNTING Cash accounting delays the recording of revenues and expenses until the time that the cash actually exchanges (that is, revenues are recorded when the cash is received, and expenses are recorded when the bills are actually paid). Furthermore, cash accounting does not attempt to match the revenues with the associated expenses incurred in earning that revenue and report them both within the same accounting period. Accrual accounting is a method of bookkeeping built on three key accounting principles or conventions: the accounting period convention, the revenue recognition principle and the matching principle. Accrual accounting sets out to accurately report net income for each accounting period regardless of its length (that is, monthly, quarterly or yearly). It achieves this objective by:  recognising revenue at the point it is earned (that is, delivery of goods or completion of service work) regardless of when the cash is exchanged Cashrevenues accounting Accrual accounting  recording those in the same period as the associated expenses incurred in earning those revenues. Expenses are recorded at the point that a • It is simpler to maintain. Data can • It gives a truer and fairer legal obligation to pay is created (that is, receipt of goods or completion of a be taken from minimal sources representation of the financial service from a supplier). •

•

•

•

(bank statements, check butts, position and performance of the deposit book). business. It is less time-consuming to prepare • It complies with both tax law and financial reports because accounting standard ADVANTAGES OF THE CASH ACCOUNTING AND minimal adjustment is needed requirements. • The financial reports have more ACCRUAL ACCOUNTING METHODS to cash records. It is easier to understand and credibility with financial operate for people with limited institutions and investors. • It is a reliable financial analysis and accounting knowledge and decision-making tool which can skills. Taxes are paid only after cash is make valid comparisons with received so it do not cause the prior periods and industry cash flow problems that the benchmarks. • It positions the business for future accrual accounting method can growth where the accrual create Finalised financial reports can be accounting system will prepared on demand without eventually need to be adopted.

Figure 33 Advantages of the cash accounting and accrual methods of accounting

DISADVANTAGES OF THE CASH ACCOUNTING AND ACCRUAL ACCOUNTING METHODS Cash accounting • Financial reports do not represent the true financial position and performance of the business. • This method does not comply with the accounting concept of the matching principle. • Financial institutions may not accept this accounting method when making loan applications. • It is an unreliable tool for financial analysis and decision-making. • Performance comparisons are difficult to make with prior period results and industry benchmarks.

Accrual accounting • More transactions are required to record the same number of financial events. • It is more complicated, with the need to calculate and manage the end-of-period adjustments. • If often requires the additional expense of an accountant to help prepare the financial statements. • There is a more stringent requirement to keep all source documents to help identify the timing and scope of revenues and expenses. • Financial reports take longer to prepare due to the income/expense adjustments

Figure 34 Disadvantages of the cash accounting and accrual methods of account

IF THERE WERE NO TAX BENEFITS, WOULD THERE BE ANY ADVANTAGES FOR ACCRUALACCOUNTING? The personal view of the author is that tax is not the driving force behind a decision to use accrual accounting. Simply put, the primary purpose of accounting is to provide accurate information on the financial position and financial performance of a business so that stakeholders can make informed decisions about the allocation of scarce economic resources under their control. Accrual basis accounting performs this role far better than cash basis accounting. •

•

– – – –

Accrual basis accounting is proper accounting in that it applies and adheres to all the concepts, conventions and standards deemed necessary by statutory/governing authorities to accurately report on the financial activities of a business. Cash basis accounting is a cost–benefit compromise allowed by governing authorities which accept that, in certain circumstances, the cost of fully complying with accounting standards (accrual basis accounting) far outweighs the benefits of producing accurate financial reports. Cash basis accounting is typically appropriate and allowed for: sole traders (for example, tradespeople) small businesses that do not extend credit to customers non-profit organisations whose primary focus is to report funds received and funds used rather than profits government departments where cash management rather than profit is the primary concern.

Generally any organisation that has many stakeholders, that engages in complicated financial operations and whose primary purpose is profit would benefit from accrual basis accounting. This is because stakeholders would be able to make better decisions about the allocation of scarce economic resources under their control. For the purpose of accuracy and accountability, publicly traded entities, in particular, are required by law to use accrual basis accounting. The concept of cash flow management, while absolutely vital to a business, is a separate issue to the decision about which accounting basis to use.  

Financial accounting is primarily concerned with preparing financial reports that accurately report on past financial activities. Management accounting focuses on interpreting the past financial reports to plan future financial activities.

While profit plans could be based easily on accrual basis reports, the cash flow budget would require the management accountant to analyse the cash implications of accrual basis reports in order to set sound cash flow predictions. While this does require extra work, the general consensus by stakeholders and governing authorities is that if the costs are not too prohibitive, accrual basis accounting is the preferred option when wanting accurate reports on the profit performance and financial strength of a business.

FINANCIAL TRANSACTIONS AND SPECIAL ACCOUNTS WHAT ARE ACCRUALS IN ACCOUNTING? Accruals in accounting are special journal entries made by accountants and bookkeepers at the end of each accounting period before the financial statements are prepared and distributed. Accruals are the practical application of the matching principle where income and expenses must be recorded in the accounting period where they are, respectively, earned and incurred. Accrual entries involve bringing to account revenue that has been earned but not yet invoiced and expenses that have been incurred but not yet billed. BACKGROUND TO ACCRUALS IN ACCOUNTING The key purpose of accounting is to provide stakeholders in a business with relevant, accurate and timely financial information so that the stakeholders can make sound decisions about the use of financial resources under their control. Accounting provides this financial information by way of the financial statements that give stakeholders a picture about the financial performance (Income Statement) and financial position (Balance Sheet) of the business. Business is a continuing and constantly changing entity. But stakeholders require financial information to be provided in pre-determined and comparable set time periods known as accounting periods. Typical accounting time periods are monthly, quarterly, half-yearly and annually. Also, relevant information for stakeholders can be provided only if the accounting system matches all the revenue earned in these time periods with all the expenses incurred in earning that revenue. This concept is known as the matching principle in accounting and it is designed to give a true picture of the profitability and sustainability of a business for any given period. The issue for accountants and bookkeepers is that while the stakeholders need the performance and position of the business to be reported in set accounting periods, either many transactions affect multiple periods or the cash exchange takes place outside of the current accounting period. In order to apply the matching principle properly in each accounting period, accountants and bookkeepers need to make a series of special journal entries at the end of each period so that the correct amount of income earned is reported and the correct amount of the expenses incurred is also reported in the same period. ACCRUALS IN ACCOUNTING Strictly speaking, accruals in accounting are those special journal entries made in the end-of-period-adjustments that deal specifically with income earned in the current period and expenses incurred in the current period that have not yet

OTHER END- OF-PERIOD ADJUSTMENTS

Figure 35 Types of accruals reate accruals for both electricity and payroll so the financial reports prepared for 30 June truly reflects the

tnightly payroll was 28 June. So 2 days of wages were incurred between 28 and 30 June but not yet record

Involves recording expenses incurred in the current period but has not yet recorded in the books of accou

ACCRUED EXPENSE

partial earning of income by creating an accrued revenue to ensure the financial reports reflect the true pi

t to build something. While the invoice may be raised at the end of the 3-month contract period, the reven

Involves recording revenue earned in the current period but not as yet recorded in the books of accou

ACCRUED REVENUE

been entered into the accounts of the business. Over time, the concept of accruals in everyday practice has come to mean processing all the end-of-period adjustments—that also includes deferrals and asset value adjustments. The two types of accruals are detailed in Figure 35.

Other end-of-period adjustments are often included in the accruals process and these are detailed in Table 18.

Table 18 Some end-of-period adjustments often included in the accruals process Item

Comment

Example

Deferred revenue

Involves transferring to future periods income transactions that, while recorded in the current period, belong to future periods. These amounts become liabilities of the business because the business has not yet performed the work and so has no claim to customer payment.

For example, $1,000 cash received by the business as a deposit for work that has not yet started.

Deferred expense

Involves transferring to future periods expense transactions that, while recorded in the current period, belong to future periods. These amounts become assets of the business because the value of the expense has not yet been used up or utilised.

For example, transferring the remaining time that is covered under a 12-month insurance payment.

Depreciation

This special end-of-period adjustment journal entry recognises in the books of a business the loss in value of fixed assets that occurred over the accounting period.

For example, the loss in value of a new motor vehicle after 1 year ‘on the road’.

Bad/doubtful debts

These special end-of-periodadjustments adjust the value of the Accounts Receivable and are designed to give an accurate picture of the money that can be expected from the debtors of the business.

For example: A debtor has not paid their account for over 120 days and it looks like they may go into receivership.

Inventory adjustment

This involves changing the book value of inventory to reflect the stocktake and valuation done at the end of the period.

For example: Writing off stock that has now become obsolete.

WHAT ARE PREPAID EXPENSES IN ACCOUNTING?

Prepaid expenses are payments made for goods or services in the current accounting period that will be used to generate revenue in a future

accounting period. A prepaid expense still has future economic benefit that can be used to achieve future business objectives. Prepaid expenses are typically recorded as a current asset on the Balance Sheet in the current reporting period. BACKGROUND TO PREPAID EXPENSES IN ACCOUNTING Many payments made by a business are for costs that have already been consumed. For example, electricity, wages, professional services, telephone and repairs are all examples of payments made for services after the business has obtained the benefit. These payments where the costs have already been used to generate income in the current accounting period are treated in accounting as expenses. There are, however, some payments that a business makes where the benefit will be obtained in a future accounting period. For example professional dues, insurance premiums, subscriptions to magazines and journals, leases and memberships are all examples of paying for services before the business receives the benefit. These payments, where the costs have not yet expired and still retain future economic benefit for the business, are treated in accounting as prepaid expenses. This payment is expected to provide economic benefits in one or more future accounting periods. We can see from the definition of an asset in accounting that prepaid expenses must be recorded as an asset. So, prepaid expenses will appear in the Balance Sheet representing retained value and a future economic benefit for the business. Prepaid expenses will not appear in the Income Statement as an expense because the costs incurred in obtaining the prepaid expenses have not yet been used to the benefit of the business. Prepaid expenses are usually treated as short-term or current assets because they will be typically consumed or utilised in less than a year after the end-of-period-adjustments. The primary reason that accountants create what are called Prepaid Expenses accounts is based on the accounting requirement to prepare reports that present a true and fair view on the finances of the business. This requirement comes from the need to apply the matching principle in accounting, which is underpinned by the accrual basis of preparing financial reports. Without the option of recognising some cost payments as prepaid expenses, the financial reports would not accurately reflect the financial performance and position of the business. c

ase study: prepaid expenses

An account is preparing the financial statements for a small business for the year ended 30 June 2011. The accountant notices that the small business owner paid a $1,200 insurance premium on 1 June 2011; she includes it in the books for the year as Insurance Expense: $1,200. After reviewing the insurance contract, the accountant notices that the insurance cover is for a 12-month period ending on 31 May 2012. Applying the matching principle and the accrual method of accounting, the accountant calculates that only 1/12th of the insurance costs has been used up by 30 June 2011 and that there is still 11 months of economic benefit remaining in the policy as at 30 June 2011. So, the accountant leaves $100 in the Insurance Expense account, which represents 1 month’s worth of insurance cover that has been used up or expensed by 30 June 2011. The accountant then transfers the remaining $1,100—representing future economic benefit that has not yet been used up or expensed—to a current asset account called Prepaid Expense or Prepaid Insurance. To have left the books of the business as they were presented to the accountant by the small business person would have understated the profits and the assets of the business for the financial year ended 30 June 2011. The use of the Prepaid Expenses account has helped ensure that the financial statements now represent a true and fair view of the financial performance and position of the business.

WHAT IS A CONTRA ACCOUNT IN ACCOUNTING? A contra account in accounting is any account that offsets another account. Contra accounts are a special category of negative transactions that are separated out from the main account and then summed collectively as an offset. A contra account is set up by accountants to specifically highlight negative amounts within the accounts of a business. Accountants do this because they believe that these amounts are material enough for stakeholders to be specifically informed about them. If these transactions were not treated as a contra account, important information relating to the business operations (for example, treating sales returns as an expense) may be hidden from view within larger number sets. Instead of reporting this category of transactions in their apparent natural class, contra transactions are matched with the key account to which they directly relate to as an offset. Examples of a contra account include:     

Accumulated Depreciation (offset Assets) Sales Returns (offset Revenue) Value-added Tax Paid (offset Liabilities) Owner’s Drawings (offset Owner’s Equity) Discounts Received (offset Expense).

BACKGROUND TO A CONTRA ACCOUNT IN ACCOUNTING A key purpose of accounting is to provide stakeholders with meaningful information about the performance and position of key elements of the business so that they can make informed decisions about the allocation of resources under their control. Sometimes, as already indicated above, this means highlighting a particular category of transaction that might otherwise be hidden within a much larger set of numbers. For example, the Sales account of a business typically has a very large volume because it represents the total inflow resulting from all the various activities of the business. On the other hand, sales returns by customers (that is, for example, for faulty goods) would typically represent only a very small percentage of the total sales. If these sales returns were simply dealt with as a sales reversal inside of the Sales account, it would have very little impact on the overall sales result. However, treating sales returns inside the Sales account would, in fact, hide a key performance indicator that is important to every business— that performance indicator is customer satisfaction. Separating out the sales returns in this example and treating it in its own category (negative sales) allows stakeholders to measure and monitor the degree and change in customer satisfaction over subsequent accounting periods. 

So instead of reporting net sales of $95,000, accountants will report gross sales of $100,000 and include ‘less sales returns of $5,000’.

Treating the reporting in this way gives stakeholders a more informed view of the financial performance of the business (that is, that there is a 95% customer satisfaction with the items sold by the business). This information would otherwise be hidden if not for this special offset account treatment. 

This offset or negative account (that is, sales returns in this example) is known in accounting as a contra account.

In terms of how the contra account is reported in the financial statements, here is how the above situation would be reported: Revenue Gross sales $100,000 Less sales returns $5,000 Net sales $95,000 EXAMPLES OF A CONTRA ACCOUNT IN ACCOUNTING There are five classifications of accounts in accounting:  

(Assets Liabilities

  

Owner’s Equity Revenue Expenses.

All five of these accounts can have contra accounts. If the Assets account (debit balance by nature) has a contra, then the contra account will have a credit balance. On the other hand, if a Liabilities account (credit balance by nature) has a contra account, the contra account will have a debit balance. The contra account is not an asset or liability in itself, but is, in fact, an account used to adjust the gross amount of the related Assets or Liabilities account. The key effect of a contra account is to reduce the value of the gross account it is offsetting. Generally, any account that is reported in the Income Statement or Balance Sheet that begins with ‘Less’ is a contra account. Some of these are described in Table 19.

Table 19 Examples of contra accounts Contra account

Offset

Explanation

Accumulated Depreciation

Offset/negative/contra Assets

Where the original/historical cost of the fixed asset is offset/reduced by the amount of the fixed asset that has been expensed to date

Value-added Tax Paid

Offset/negative/contra Liabilities

Where a value-added tax payable is reduced/offset by the amount of tax already paid

Owner’s Drawings

Offset/negative/contra Owner’s Equity

Where the total capital invested by the owners remains intact but is offset/reduced by the amount of money withdrawn from the business by the owner’s drawings

Sales Returns

Offset/negative/contra Revenue

Where the gross sales is offset/reduced by the amount of customer returns

Discounts Received

Offset/negative/contra Expenses

Where purchases are offset/reduced by the amount of the discounts claimed under the terms of trade

WHAT IS AMORTISATION IN ACCOUNTING? Amortisation in accounting is the process of expensing (writing off) the value of the intangible (non-physical) assets of a business. Amortisation for intangible assets is the same concept in accounting as depreciation is for fixed (physical) assets. Amortisation of intangible assets takes place periodically over the period

covering the estimate useful economic life of the intangible assets. Intangible assets typically include intellectual property costs and incorporation costs. BACKGROUND TO AMORTIZATION IN ACCOUNTING The term amortisation is used in both accounting and finance.  

In finance, amortisation describes a process of gradually reducing debt through systematic payments at regular intervals until the debt is gone. In accounting, amortisation specifically refers to the process of expensing the value of the intangible assets of the business over a period of time.

Not all the assets of a business are physical or tangible. Some assets are nonphysical and are called intangible assets. For example, patents, trademarks, brands, goodwill, copyrights, licenses, computer software, costs of incorporation and internet domains are all intangible assets. Even though these assets are invisible (or cannot be touched), they still contribute to the revenue growth of a business and so must be expensed against the revenues as they are earned. Intangible assets are treated in the same way as physical assets that are depreciated (expensed) and so their value is systematically transferred from an asset on the Balance Sheet item to an expense item (Amortisation) on the Income Statement.

A

mortisation reflects the consumption, expiration, obsolescence or other decline in value of the intangible asset as a result of use or the passage of time.

KeyFACTS 

Amortisation is underpinned by the matching principle in accounting.



The matching principle in accounting ensures that the financial reports of the business give an accurate view of the financial position and performance of the business to the decision-making



stakeholders of a business. Under the matching principle, accountants are required to match the revenue for each accounting period with the actual expenses incurred in earning that revenue for the period.

In the example in the ‘for example’ box on the next page, it would not give an accurate view of the profitability of the business if the patent costs were expensed only in the year the costs were paid. Also, a Balance Sheet that showed a patent still worth $20,000 in the 19th year would not give an accurate

view of the value of that asset, given that its value is just 12 months away from being worthless. So, instead of taking either of the two options listed above, accountants will amortise the cost of the intangible asset over the estimated useful economic life of the intangible asset. The process of amortisation, then, gives a more accurate view of the financial performance and position of the business to the decision-making stakeholders of the business. APPLICATION OF AMORTISATION IN ACCOUNTING Under International Financial Reporting Standards, guidance on accounting for the amortisation of intangible assets is contained in IAS 38. Not all intangible assets are amortised. Some intangible assets may be considered to have an indefinite useful economic life and are considered to offer continual earning potential to the business for the foreseeable future. A domain name and brands could be included in this category. Either way these intangible assets with an indefinite useful economic life still need to be assessed each year to make sure that their value in the Balance Sheet is not overstated. This checking process is called the impairment test. The method used to amortise those intangible assets with a set useful economic life is the straight-line method—that is, where the cost of acquiring the intangible asset is written off (amortised) over the estimated useful economic life of the asset. For example, if the business had spent $20,000 in legal fees to secure a patent that gave the business certain rights over the next 20 years, the value of the intangible asset (Patents) would be expensed or amortised by $20,000/20years = $1,000 each year for the next 20 years. This means that $1,000 would appear each year in the Income Statement as Amortisation expense, with a corresponding adjustment being made directly to the intangible asset Patents in the Balance Sheet. (Note: Unlike depreciation of tangible assets, intangible assets do not have a contra account called Accumulated Amortisation. The unamortised/unimpaired cost of intangible assets is positioned in a separate section of the Balance Sheet immediately following Property, Plant and Equipment.)

AMORTISATION PERIODS OF INTANGIBLE ASSETS IN ACCOUNTING The amortisation period selected can have a significant impact on the reported income for a business. The shorter the estimated useful economic life, the Patents ownersexpense an greater theprovide amortisation and therefore the lower the net profit reported. exclusive right to use or So, it is important that the amortisation period closely matches its revenue manufacture a particular generation capacity. product. The cost of a patent Copyrights give owners the Figure 36be presents some examples. should amortised over its exclusive right to produce or sell useful life but not exceeding the an artistic work. While a patent’s legal life of 20 years. copyright has a legal life equal The Patent account should to the life of the creator + 70 include only the cost of a patent years, the economic useful life purchase and costs relating to is usually much shorter. The the registration of the patent, shorter economic life is the like legal fees. appropriate amortisation period

A franchise license gives owners the right to manufacture or sell certain products or perform certain services on an exclusive basis. The cost of a franchise license is recorded in the Balance Sheet as an intangible asset, and should be amortised over the estimated useful life identified in the franchise agreement.

Trademarks/brands/internet domains have fairly short legal lives; however, because they can be continually renewed, they are deemed to have an indefinite life.

Goodwill is a unique intangible asset that is deemed to have an indefinite life.

Figure 36 Some examples of amortisation periods of intangible assets WHAT IS COST OF GOODS SOLD? Cost of goods sold (COGS) is the total of the costs incurred in producing the product. The COGS is also called cost of sales. COGS is the total of those costs directly related to the costs of production. They are the expenses associated with production activities. Some typical COGS are shown in Figure 37. The COGS does not include indirect costs (overheads such as rent and administration costs) which are not directly related to the production of products. COGS are typically included in financial statements for those businesses that make money from the sale of inventory (whether this be in retail, wholesale or manufacturing). EXPENSES TO INCLUDE IN COGS Expense items included in the COGS vary from business to business. Businesses can obtain helpful advice from their accountant, industry association or

government tax agency in identifying those items to include in the COGS and those to include as overheads. Sometimes the accounting standards to which accountants adhere may even include different COGS items from those required under tax law. COGS - INVENTORY However, there are general principles that all parties follow: 1. Firstly, COGS only applies where there is a sale of inventory. So those business that sell only services (like, for instance, lawyers and accountants) do not usually have COGS. 2. Secondly, COGS are the total direct cost incurred in acquiring or converting inventories for sale (that is, in getting products into inventory and then getting them ready for sale). 3. Finally, COGS expenses change in proportion to changes in sales or production (as opposed to fixed costs/overheads/indirect costs such as rent that do not change in proportion to changes in sales and production). So, if the expense is likely to change in relation to changes in sales or production, it is most likely a COGS. Retail businesses will usually include the cost of buying inventory for resale plus the freight inwards costs in the COGS. Manufacturing businesses will include the cost of raw materials, cost of parts and direct labour costs used to manufacture the product ready for sale. By deducting COGS from the sales for a given accounting period, we can determine the gross profit of the business.

P p a t e ,F u b D f y r Im lig d n H s o c x N v w h Pu h rc i a p e s g ta e p i ro D o lb rd u d ,tc f c y t Imp rt d o ti e u s a le s ns a H o c td g lin re c e v o n ra N x ta ls b - e ig h re F t aa rw u s in s in rd e c n r w F t h ig e s rd a

Figure 37 Some typical COGS WHAT ARE BAD DEBTS IN ACCOUNTING? Bad debts occur when customer debts owed to the business for goods or services provided cannot be collected. Bad debts are usually the result of customer bankruptcy, company liquidation or where the extra cost of pursuing the debt is more than the amount of money that the business could ever collect. When a customer debt is classified as ‘bad’, it is written off in the books of the business. This transaction reduces the value of the Accounts Receivable in the Balance Sheet as it increases the expenses of the business in the Income Statement. BACKGROUND TO BAD DEBTS IN ACCOUNTING Very few businesses can operate on a cash-only basis. (‘Cash-only basis’ means being able to get the cash payment for goods and services at the time they are provided.) For many reasons it has become the norm in most businesses to provide goods and services on credit. (‘On credit’ means that the goods and services are given to the customer on the understanding that the customer will pay for them at a predetermined time in the future.)

T

he system of allowing customers to pay for goods and services after they have received them is known as extending credit, or buying on credit terms, or charging goods and services to the customer’s account. Selling goods and services on credit has benefits for the business. But there are also risks in extending credit to customers. The primary risk is that the customer will not pay for the goods and services according to the prearranged payment terms. This failure of the customer to pay for goods and services is often caused by personal bankruptcy or company liquidation but can also be caused by unethical business practices. Businesses that extend credit to customers do all that they can to minimise this risk of non-payment by doing background checks on the customer’s prior history and gathering sufficient information about the customers to assess their financial position and earning potential. In spite of the best possible checks, though, unforeseen circumstances make it impossible to eliminate all the risk. So in the normal course of business, there will be times when customers just cannot pay their bills. When the business extending the credit recognises this fact, the debt outstanding will be written off as a bad debt in the books of the business, as mentioned above. What this means is this: the business will record details of the bad debt adjustment in the financial accounting system. The bad debt adjustment transaction will reduce:  

the amount of money expected from the Accounts Receivables and reported in the Balance Sheet the profit expectation of the business by increasing the expenses in the Income Statement.

The decision to write off bad debts is usually determined by the organisation’s credit policy. This may be done in the month that the debt is recognised as bad, or the bad debt may be written off systematically—quarterly, half yearly or annually. Publicly listed companies will usually write off bad debts on a 6-monthly cycle to coincide with their corporate governance and reporting requirements. RECOGNISING BAD DEBTS IN ACCOUNTING How long a debt has been outstanding and unpaid can be one indicator of bad debt. Many businesses consider that a debt that is overdue by more than 6

months should be considered a bad debt. The truth is, any debt can become bad at any time particularly if there is a liquidation of a company’s business due to, say, unforseen natural disasters. Recognising bad debts is a judgement of the management of the business. That judgement is applied on an account-by-account basis. Deciding on and recognising bad debt generally follows one or more of the guidelines listed in Figure 38.

The business receives advice from a solicitor, collection agent or insolvency practitioner that the customer has gone bankrupt or the company has gone into liquidation. If a customer has not paid the debt and the cost of recovering the debt is greater than the potential benefits, it is more profitable to write off the debt. If the customer disputes the debt and the business cannot produce documentary 'proof of delivery', the debt may need to be written off. It may be the result of the credit policy of the business that all customer debts greater than 1 year must be written off as bad debts. The customer owing the money has not contacted the business and they cannot be contacted so the debt is written off.

Figure 38 Deciding on and recognising bad debt BAD DEBTS AND THE TAX DEPARTMENT The decision to write off debts as bad reduces the income reported by the business for the year. This reduction in income has a direct impact on the tax payable by the business. For this reason, tax offices have set guidelines that must be followed in order to claim bad debts as a deduction against assessable income for tax purposes. As a rule, when claiming bad debt as an expense of the business in tax reports, it is best to have some written confirmation/advice from an independent third party, like an external administrator, solicitor or collection agent, of the likely loss to be incurred by the business. For example, the tax office in Australia has issued a tax ruling (TR 92/18) that clarifies the circumstances in which a deduction for bad debts will be allowable. These circumstances are:

  

 

the debtor has died leaving no, or insufficient, assets out of which the debt may be satisfied the debtor cannot be traced and the creditor has been unable to ascertain the existence of, or whereabouts of, any assets against which action could be taken where the debt has become statute barred and the debtor is relying on this defence (or it is reasonable to assume that the debtor will do so) for nonpayment if the debtor is a company, it is in liquidation or receivership and there are insufficient funds to pay the whole debt, or the part claimed as a bad debt where, on an objective view of all the facts or on the probabilities existing at the time, the debt, or a part of the debt, is alleged to have become bad, there is little or no likelihood of the debt, or the part of the debt, being recovered.

WHAT ARE DOUBTFUL DEBTS IN ACCOUNTING? Doubtful debts are part of the end-of-period adjustment made by accountants to the financial accounts of a business. The doubtful debt adjustment is made to reflect the likelihood that debts owed to the business by some customers may not be collected. The doubtful debts concept is built on the accounting principle of conservatism which directs accountants to ‘anticipate no profit, but anticipate all losses’. The doubtful debt adjustment made by the accountant will increase expenses (Doubtful Debts expense) and reduce Accounts Receivable. The reduction in Accounts Receivable is done by creating a separate contra account in the Balance Sheet called Provision for Doubtful Debts. BACKGROUND TO DOUBTFUL DEBTS IN ACCOUNTING Accountants operate under a set of guidelines known as the accounting principles, concepts and conventions. Most of these accounting principles, concepts and conventions have been included in government-required accounting standards that direct accountants on how they are to prepare the financial statements for a business. One of these principles is known as the conservatism principle.

T

heconservatism principle is best summed up in the quote by Bliss in 1924 — ‘anticipate no profit, but anticipate all losses’. In other words, accountants should not recognise/record profits until there is a legal claim to the revenues that generate the profits, but they should recognise/record losses if there is a

likelihood that either the revenues or the assets of the business could be overstated. One asset that could be overstated in the Balance Sheet of a business is the Accounts Receivable. Accounts Receivable is the monies owed to the business by customers who have purchased goods and services on credit. These customers are called debtors of the business. Accounts Receivables can become overstated because not all customers will pay all of the money they owe. Before preparing the financial statements of a business, the accountant will review the Accounts Receivables to determine which of the debtor accounts should be recorded as bad debts or doubtful debts under the conservatism principle. Businesses generally look on bad debts and doubtful debts as the cost of doing business. There are significant profit benefits to be gained for a business in extending credit to customers and so bad debts and doubtful debts are just some of the costs that need to be offset against those benefits. The matching principle in accounting directs accountants to record the bad and doubtful debts in the period in which the revenue was recorded. This is why the bad and doubtful debts are included in the end-of-period adjustments made at the end of the accounting cycle, before the financial statements of the business are prepared. ESTIMATING DOUBTFUL DEBTS The end of the accounting cycle for most businesses is annual; however, some publicly listed companies may make this adjustment half-yearly or quarterly. Accounting for doubtful debts varies from business to business, with some businesses making a provision of 1/12th of the annual amount in each monthly reporting period. Most businesses will have a policy on how the doubtful debts are to be accounted for. While bad debts are identified specifically and can be pinpointed to specific accounts and invoices that will never be repaid (for example, due to bankruptcy), doubtful debts are a provision based on past history and current trends. Doubtful debts are accounted for where it can be reasonably estimated that a certain amount of the current Accounts Receivable will not be collected—that is, where today’s estimated doubtful debts will eventually materialise into specific bad debts at some time in the future. What accountants are trying to do by including doubtful debts in the financial reports is to explain to business stakeholders that it is reasonable to assume that not all the monies owed by customers will be collected. Accountants are saying to shareholders that they should take doubtful debts into account when assessing the financial performance and financial position of the business. It should be remembered that while bad debts represent the actual monies owed that will not be collected, doubtful debts are only an estimate. Based on previous

history and current trends, businesses may estimate the value of doubtful debts in a number of ways as shown in Figure 39.

As a % of annual turnover made on account As a % of total current debtors As a total of specifically identified debtors As a % of debtors using the ageing analysis (i.e. over 90 days overdue) As a set value based on past bad debt expenses

Figure 39 Some ways that businesses may estimate doubtful debts DOUBTFUL DEBTS When making adjustments to the financial accounts of a business based on a judgement, accountants prefer to highlight the adjustment as a contra account in the financial statements rather than including it as just another transaction in the main account. So when recording doubtful debts, accountants create a contra account called Provision for Doubtful Debts, which will be a negative offset account for the asset —Accounts Receivable. So the doubtful debts transaction that needs to be entered into the books of the business via the general journal before preparing the financial statements is: Doubtful Debts expense $x,xxx Dr Provision for Doubtful Debts $x,xxx Cr This transaction then reduces the profit reported by the business and also reduces the amount of money expected to be received from the customers of the business. The Balance Sheet will then display the following in the Current Assets section:

Accounts Receivables $xx,xxx Less Provision for Doubtful Debts $x,xxx This statement tells the stakeholders of the business that while $xx,xxx is the amount of money that is owed to the business from customers, based on past experience and current trends the business expects that $x,xxx of that money will not be collected and will eventually become bad debts. It should be noted that while doubtful debts are recognised as an expense of the business when preparing financial reports for most stakeholders, tax laws do not allow doubtful debts to be claimed as a cost until they become bad debts (that is, until it is certain that they cannot be collected). WHAT IS THE DIFFERENCE BETWEEN BAD DEBTS AND DOUBTFUL DEBTS IN ACCOUNTING? A bad debt is the ultimate recognition of loss created when a specific debtor(s) is acknowledged as being unable to pay the debt they owe to the business. This loss, recorded in the Income Statement of a business assesses that, at this point in time, the money owed to the business will never be received. Doubtful debts on the other hand are an interim recognition of possible losses caused by an irrecoverable (bad) debt that may take place sometime in the future. Bad debts will be linked to specific debtors and written off in the period in which the revenue was earned. Doubtful debts are an estimate only, and a provision for future business losses—usually based on previous history. BACKGROUND TO BAD DEBTS AND DOUBTFUL DEBTS IN ACCOUNTING Accounting is a process of recording financial transactions so that financial reports can be produced for the stakeholders of a business. Stakeholders use these reports to make decisions about the allocation of the scarce resources within their control. For this reason, it is important that the financial reports are accurate and present a true picture of the financial performance and financial position of the business. A key requirement for accountants then is to ensure that the assets of the business are not overstated. One asset that is looked at closely by accountants before preparing the financial reports is the Accounts Receivable account or Debtors. Before producing the financial reports, accountants want to make sure that the Accounts Receivable (the money the business expects to collect from its debtors) is not overstated. As we have already seen, many businesses need to extend credit to their customers to keep their custom. Otherwise, businesses may lose them, particularly if other business competitors are able to extend generous credit

terms to the customers. However, inevitably, there will be some of these customers who will not be able to pay their debts. So these irrecoverable debts (whether bad debts or doubtful debts) are a cost of doing business and need to be declared as expenses so that the profit will not be overstated in the financial reports to stakeholders. These debts are an attempt to better match the cost of offering credit with the beneficial revenue that is generated from a credit policy. BAD DEBTS AND DOUBTFUL DEBTS IN ACCOUNTING The Accounts Receivable account could be overstated if it was obvious that an amount of money owed to the business by a customer (debtor) has no chance of being collected or paid by the debtor. As already indicated, this mostly occurs when a debtor goes bankrupt or their company goes into liquidation. 

An accountant would not be presenting a true and accurate financial report for stakeholders if they continued to report this debt as an asset of the business and continued to report the sale that created the debt as revenue.

In this situation accountants will record the irrecoverable money as a loss in the Income Statement to offset the revenue and will write-off the value of that particular debt from the Accounts Receivable asset as reported in the Balance Sheet. When preparing accurate financial reports that present a true picture of the financial performance and financial position of the business, accountants must also consider the previous history of the business in relation to the debt collection of the account receivables. If previous history indicates that, typically, bad debts represent, say, 5% of the Accounts Receivable balance, it would not be accurate to report 100% of the Accounts Receivable as an asset. So, accountants provide for this potential loss from Accounts Receivables that history suggests will ultimately turn into bad debts. This involves creating an expense for doubtful debts to reduce the profit reported for the period as well as making a provision for doubtful debts to the Accounts Receivable to show that it is not expected that 100% of the accounts receivable will be collected. Providing or allowing for doubtful debts is an attempt to match the costs of offering credit to customers with the revenue that a credit policy generates.

Table 20 Characteristics of bad and doubtful debts Bad debts

Doubtful debts

Bad debts occur when a specific account receivable has been clearly identified as not being collectible.

Doubtful debts occur when an accountant make an assessment, based on previous history, that a % of the current accounts receivables will eventually turn into bad

Bad debts occur when all reasonable

efforts have been exhausted to collect the amount owned but they still remain outstanding.

debt.

Bad debts are assessed as either never being collectible or not cost-effective to pursue.

So, as part of the accountant’s duty to prepare accurate financial reports that reflect a true picture of the financial performance and position of the business, the accountant will make a provision for doubtful debts in the books of the business.

Bad debts are treated as an expense that reduces the profit of the business as reported in the Income Statement.

Doubtful debts are treated as an expense that reduces the profit of the business as reported in the Income Statement.

Bad debts are losses that have actually happened.

Doubtful debts are losses that have not yet happened but they are anticipated.

Bad debts are deleted/written off directly from the Debtors (Accounts Receivable).

Doubtful debts are not deleted/written off directly from the Debtors (Accounts Receivable) but are posted as a contra/offset account of the Accounts Receivable called Allowance for Doubtful Debts.

Bad debts is a nominal account that is closed every year.

Allowance for doubtful debts is a permanent account that is carried over into the new financial period.

Bad debts are tax deductible.

Doubtful debts are not tax deductible.

WHAT IS A 10-COLUMN WORKSHEET IN ACCOUNTING? A 10-column worksheet is a columnar template that helps accountants and bookkeepers plan and facilitate the end-of-period reporting process. A 10-column worksheet is not a mandatory step in the accounting process but is often completed to help eliminate errors associated with the end-of-period adjustments. The 10-column worksheet conveniently ensures that all of the details related to the end-of-period accounting and statement preparation have been properly accounted for at the end of each fiscal period. BACKGROUND TO 10-COLUMN WORKSHEET IN ACCOUNTING One of the most important support tools to assist accountants and bookkeepers is the electronic worksheet (for example, Microsoft Excel). There are times in the accounting process when tasks are best handled by the electronic spreadsheet. 

This is because accounting software is designed as a database—a collection of records organised and stored in formats that allow for easy access and management.

Compared with spreadsheets, databases have very limited analysis functions and are not suited for demonstrating on one form the effect of multiple transactions. Apart from budget variance analysis and financial ratio analysis, you will often see electronic spreadsheets being used by accountants and bookkeepers in areas such as:   

depreciation schedules asset registers end-of-period adjustments.

The spreadsheet used to assist accountants and bookkeepers in calculating the end-of-period adjustments is called the 10-column worksheet. PURPOSE OF THE 10-COLUMN WORKSHEET The primary purpose of preparing a 10-column worksheet is to help eliminate errors that can be created by the complications involved in identifying, calculating and correctly allocating the journal entries required in the end-ofperiod adjustment process. These errors could include:   

failing to include key end-of-period adjustments failing to adhere to the double-entry bookkeeping process allocating the end-of-period adjustments to the wrong account.

The 10-column worksheet gives an entire overview of all the end-of-period adjustments that need to be made and the columns are totalled to ensure that the double-entry bookkeeping system is properly applied. Also, the 10-column worksheet, when approved by an appropriated authority, will provide source document evidence for audit purposes. Without the 10-column worksheet, these internally created end-of-period transactions would not have a source document to support their entry into the general journal. STRUCTURE OF THE 10-COLUMN WORKSHEET The 10-column worksheet covers five key areas relating to the end-of-period adjustments that each have debit and credit components. So, five areas multiplied by two columns each creates the 10-column worksheet. The five key areas are explained in Table 21.

Table 21 Five key areas of the 10-column worksheet Key area

Comment

Trial balance

These columns record the complete list of account balances currently in the General Ledger.

End-of-period adjustments

These columns record the end-of-period adjustments and

involve such transactions as accruals, deferrals, depreciation, bad and doubtful debts, and inventory adjustments. Adjusted trial balance

These columns calculate the new account balances based on the effect of the end-of-period adjustments. (Note: Some 10-column worksheets may change this column to Trading account, which calculates the gross profit by recording the revenue accounts and the cost of goods sold accounts.)

Income Statement

These columns record the revenue and expense account balances from the adjusted trial balance. In the 10column worksheet, the debit and credit totals in the Income Statement column will not be equal. The difference between the total debits and credits in the Income Statement column is the net profit or loss for the business in the period under review. 



Balance Sheet

If the credit total in the Income Statement column is greater than the debit total, the business has made a profit. This amount should be then recorded in the Current Period Earnings account in the Balance Sheet as a credit. If the debit total in the Income Statement column is greater than the credit total, the business has made a loss. This amount should then be recorded in the Current Period Earnings account in the Balance Sheet column as a debit.

These columns record the Assets, Liabilities and Owner’s Equity account balances from the adjusted trial balance. The total of the debits and credits in this column will balance only if the difference between the debit and credit totals in the Income Statement is recorded in the equity account Current Period Earnings account.

FINANCIAL STATEMENTS AND STANDARDS HOW IS IFRS DIFFERENT FROM GAAP? The Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) are the predominant accounting standards used today. GAAP is the American standard and IFRS is the predominant European standard, used in 120 countries. GAAP is moving toward IFRS. GAAP is rule based, whereas IFRS is principle based. Under GAAP, the methodology to assess an accounting treatment is more focused on the literature, whereas under IFRS, the review of the facts pattern is more thorough. According to the website : ‘The biggest difference between US GAAP and IFRS is that IFRS provides much less overall detail. Its guidance regarding revenue recognition, for example, is significantly less extensive than the US GAAP. IFRS also contains relatively little industry specific instructions’.

WHO ARE THE STAKEHOLDERS OF A BUSINESS? Stakeholders are those affected (in a good or bad way) by the activities of a business. There are many stakeholders in a business, internal and external. Internal stakeholders are directly involved with the day-to-day operations of the business, while external users are not.

EMPLOYEES Stakeholders engaged, for various time periods, to help a business achieve its objectives. Financial statements help employees decide their long-term commitment to the business. A growing, profitable and financially strong business is more likely to attract and keep highly valued employees. Financial statements also help employees when negotiating collective bargaining agreements with management.

Figure 40 Internal

MANAGERS AND OWNERS/OPERAT ORS

Stakeholders employed by the Board of Directors and responsible for managing business resources to achieve the objectives of the business’s strategic plans. Analysing financial statements helps managers make informed decisions about the economic achievements of the business and so adjust strategies to exploit identified opportunities and mitigate potential threats. stakeholders

BOARD OF DIRECTORS Stakeholders who set the strategic direction and objectives for the business and who engage managers to achieve them. Financial statements allow the Board of Directors to review the performance of the management in respect to achieving objectives.

Stakeholders of a business:  

are vitally interested in knowing about the present condition and future prospects of the business need to make decisions about their involvement with the business



want to know how strong and sustainable the business is financially so they can make good decisions.

Investors

Lenders

Stakeholders who buy shares in a company. Shares entitle the investor to a proportional share of the company’s equity and profits. Shares in public companies are traded on stock exchanges and provide investors with dividends. Investors use financial statements to assess the financial strength of a company, which impacts on their investment decisions.

Stakeholders who supply funds to the business on short- and/or long-term basis. Lenders are typically financial institutions that provide, say, short-term overdrafts, invoice financing for debtors, term loans for expansion plans, leasing finance for equipment purchases ,or mortgages for property purchases.



Suppliers and customers Suppliers are stakeholders who provide products and services to the business on credit terms that allows the business to pay for the goods and services at a later time. Suppliers use financial statements to assess the creditworthiness of the business.

Existing equity investors use Customers are stakeholders financial statements to monitor their who use financial statements to investments and evaluate evaluate the financial strength management performance . and staying power of the Financial Institutions use  Prospective equity investors use business as a dependable financial statements to financial statements to decide if resource for their business. investing in the company. Investment decide if to grant a Media business fresh working decisions are supported by capital or to extend debt Stakeholders who use the investment analysts who use securities (such as a long- information supplied by enterprises financial statements with their term bank loan) to buy/sell/hold recommendations. to publish in their mass finance expansion and  Rating agencies like Moody's use communication outlets. The media financial statements to assign credit other significant use financial statements to analyse ratings to companies—this also helps and comment on the performance investors make their investment and position of an enterprise they decisions. think would interest their  Other investors who may use readership. financial statements in their decision Competitors making include potential joint venture partners and either Stakeholders who compete for customers in the same market as franchisers or franchisees . the enterprise. Competitors use financial statements to Government benchmark their own financial results to identify variances to departments and target for improvement or exploit as an opportunity. Potential agencies competitors may use financial statements to assess how Stakeholders that profitable it may be to enter an industry. regulate the way Supporters and opponents companies conduct their Labour unions business including the Stakeholders who represent Other external stakeholders include payment of taxes and the best interest of the people who may support or oppose the other duties owed. They employees of an enterprise. actions and activities of an enterprise. use financial statements They use financial statements They include politicians, lobbyists, issue to ascertain the propriety to gauge how much of a pay groups, consumer advocates, and accuracy of taxes and increase an enterprise is able environmental lists, think tanks and other duties declared and to afford in an upcoming foundations. They use financial paid by a company. wages negotiation. statements to provide objective evidence for their position.

Figure 41 External stakeholders

WHAT ARE FINANCIAL STATEMENTS IN ACCOUNTING? Financial statements are a set of numeric records that summarise the financial activities of a business and so describe the financial position and performance of a business. Financial statements are used by stakeholders (internal and external) to assess the financial position and performance of a business. The information provided by the financial statements helps supports their decisions and actions about the allocation of resources within their control. For example, financial statements:   



help investors assess the viability and financial performance of the business that they have invested in, particularly in relation to the profit/loss trends help creditors/lenders determine their credit limits and loan exposures with the business help the internal managers respond to current opportunities and pinpoint unexpected expense increases and to predict future performance via the budgetary process provide a basis for calculating the income tax liability of the business by the government tax office.

The three statements that make up these financial reports are: • Income Statement, or Profit and Loss Statement (also called Statement of Financial Performance) • Balance Sheet (also called Statement of Financial Position) • Cash Flows Statement. INCOME STATEMENT (STATEMENT OF FINANCIAL PERFORMANCE) The Income Statement (besides the alternative terms given above, also sometimes called the Revenue Statement, the Earnings Statement, the Operating Statement or the Statement of Operations) describes the financial sustainability of the business. That is, it lists and totals the revenue earned (for example, from inventory sales or service fees), and takes away from the revenue total the total of the costs (expenses) in earning that income, such as wages and salaries, administration costs, financial and occupancy costs. This produces the net profit or loss for the business.  

A positive result is profit, which increases the net worth of the business and makes the business more sustainable. A negative result is a loss, which decreases the net worth of the business and makes the business less sustainable.

In other words, the Income Statement measures the change in net worth and sustainability of the business.

The Income Statement also provides information relating to the adequacy of the selling prices (via the gross profit %) and the sufficiency of the profit in relation to the owner’s investment (via a Return on Investment calculation). The net profit for the period appears in the equity section of the Balance Sheet as Current Earnings. The Income Statement is produced annually so that the income tax owed by the business to the tax office can be calculated. However, Income Statements are also often produced monthly or quarterly to update management regularly and help them with their decision making. However frequently it is produced, the Income Statement is prepared for a past period (yearly, quarterly or monthly). The statement is headed with the line: ‘for the [period] ending [date]’. EXTRA THINGS TO CONSIDER While accounting attempts to produce a ‘true and fair’ picture of the financial performance of a business via the Income Statement, there are some issues that will impact of this goal. Some examples are given below. 





There are some valuable items that while very relevant to a business are not measured by the accounting system and so are not reported on the Income Statement. These items could include such things as brand recognition, organisational reputation or customer loyalty. Different valuation methods allowable in accounting will produce different profit results. For example the valuation of inventory using the FIFO (first in, first out), LIFO (last in, first out) or Item Cost method will each produce a different profit result. Some values reported on the Income Statement depend on judgments and estimates. For example, depreciation expense is calculated based on the estimated useful life and estimated salvage value of the fixed asset.

BALANCE SHEET (STATEMENT OF FINANCIAL POSITION) The Balance Sheet (also known as the Statement of Financial Position) describes the financial strength of a business at a particular point in time. That is, it identifies, at a specific point in time, the value of the assets controlled by the business as well as the entities that have claims (creditors, funders and owners) over those assets. It presents the accounting ‘net worth’ of the business that demonstrates its financial status and strength. All financial transactions of a business change values in this statement. The Balance Sheet is, in effect, a detailed representation of the accounting equation. The accounting equation lists the assets and then represents the liabilities and owner’s equity that have a claim over these assets.

T

he strength of a business is represented by the percentage of the assets that are controlled by the owners—and not by others.

Analysis of the Balance Sheet gives significant insights into the management of the business. These ratios include liquidity, solvency and efficiency. While the Balance Sheet looks back on a prior trading period (last month, last quarter, last year), the Profit and Loss Statement looks at a business as a ‘snapshot‘ in time. This is why the Balance Sheet is headed up with the line: ‘as at [date]’. CASH FLOWS STATEMENT Any movement of cash in or out of a business is referred to as cash flow. The Cash Flows Statement ties together all the details from the Income Statement and the Balance Sheet to summarise the overall picture of cash inflows and outflows over a given period. In particular, it reports on the inflow and outflow of cash in relation to operating activities, investing activities and financing activities. It compares the opening balances with the closing balances on cash or cash equivalent accounts. One of the key interests by stakeholders is the net worth, and changes in net worth of a business. Net worth is also known as owner’s equity (or equity) or net assets. (Net worth is the money that would be left over if all the assets of the business were sold and the liabilities fully repaid.) The Cash Flows Statement informs decision makers about the movement of cash funds between where the cash funds came from and how those funds have been used. This movement of cash in an organisation is calculated by comparing the financial statements of two consecutive periods. By ignoring the non-cash activity (that is, depreciation, credit sales and purchases, bad and doubtful debt, prepayments and so on), the Cash Flows Statement is able to show in detail how and where the cash balance of the business increased and decreased.

T

he Cash Flows Statement demonstrates the source of funds and how they were applied and the ability of the business to pay its bills as they become due.

A Cash Flow Statement is usually prepared alongside the Income Statement and Balance Sheet. While the latter reports are about an organisation’s financial sustainability and financial strength, respectively, the Cash Flow Statement reports on the organisation’s ability to continue to pay its bills as they fall due. HOW DO YOU READ AND UNDERSTAND A BALANCE SHEET? As explained earlier, a Balance Sheet is a financial report supplied to the internal and external stakeholders of the business. The Balance Sheet helps stakeholders to determine a business’s financial strength. The Balance Sheet presents the financial status of the business at a specific point in time. BALANCE SHEET BASICS The Balance Sheet is a financial statement or report that:  

itemises the things of value that the business owns/controls (Assets) lists the entities which have legal claims over those assets. These claims are made by two groups: (1) the external funding entities (Liabilities) and (2) the internal investors (Owner’s equity).

It is called a Balance Sheet (or Statement of Financial Position) because the total value of the Assets will always equal the total value of the Liabilities and the Owner’s Equity combined. This formula is known as the accounting equation. The Assets and Liabilities listed on the Balance Sheet are further subdivided as:  

current non-current.

This separation helps stakeholders to understand the expected timeframes of these amounts.  Debts due within the next 12 months are categorised as current liabilities.  Assets that can be readily converted into cash (usually within the next 12 months) are categorised as current assets.  All other assets and liabilities as categorised as non-current. The total amount of the Owner’s Equity is also known as the Net Worth of the company. Net Worth is the amount of money that would be left over if all the Assets were sold at Balance Sheet values and the external funders (Liabilities) were paid out in full. Total Owner’s Equity is the first and obvious read of a Balance Sheet in relation to a business’s financial strength. Total Owner’s Equity quantifies how much the business is worth from an accounting point of view. (Note: An accounting point of view does not take into account any value for future profit potential. The accounting point of view also values assets at the time of purchase, not at what they might be worth today. Owner’s Equity is typically made up of the shareholders/owners initial and additional investments (Capital), the profits from previous periods that have not yet been distributed to the shareholders/owners

(Retained Earnings) and the profits earned from the current trading period (Current Earnings).) FINANCIAL RATIOS Understanding the financial strength of a business from reading a Balance Sheet generally requires a certain amount of analysis and comparison. It also requires access to the Income Statement (also known as the Statement of Financial Performance). This analysis of the Balance Sheet is called the Financial Ratio and Trend Analysis. By comparing this period’s calculated financial ratios with those of prior periods, with industry benchmarks and with generally accepted sound operating levels, healthy/unhealthy trends in the financial strength of the business can be identified.

Whether Whether returns returns from from the the business business are are competitive competitive with with other other investment investment options options

Whether Whether the the company company is is becoming becoming more more or or less less profitable profitable

Whether Whether the the company company is is becoming becoming more more or or less less dependent dependent on on external external funders funders Whether Whether the the company company is is becoming becoming better better or or less less able able to to meet meet its its financial financial obligations obligations when when they they become become due due or or more more or or less less efficient efficient at at managing managing the the assets assets of of the the company. company.

Figure 42 What stakeholders can determine by calculating and comparing financial ratios There are many different types of financial ratios but they are generally collated into four groups, listed in Figure 43, and described further below.

Liquidity/solvency ratios

Leverage ratios

Types of financial ratios Profitability ratios

Operational ratios

Figure 43 Types of financial ratio LEVERAGE RATIOS These ratios calculate the extent to which the company uses external debt in its capital structure rather than using equity funders. Over-relying on external debt makes the profitability of a business more vulnerable to interest rate raises, and the business more vulnerable to liquidation actions by creditors and financial institutions during an economic downturn. The most common leverage ratio is the debt to equity ratio. For example, assume there is a total debt of $850,000 and a total owner’s equity of $425,000. The debt to equity ratio here would be ... Total debt (850,000) / Total owner’s equity (425,000) = 2.0. What this means is this: for every $1 that the owners have invested in the business, external funders have committed $2. This company would generally be considered highly geared or leveraged.

LIQUIDITY/SOLVENCY RATIOS These ratios calculate the business’s ability to pay its debts as they become due. Some businesses might be profitable but unable to pay critical payments, such as staff salaries, loan repayments or rent, because the money of the business is tied up in debtors (money owned to the company by customers) or in inventory. The most common Liquidity/Solvency ratio is the quick ratio. For example, assume that current assets total $355,000, Inventory totals $250,000 and current liabilities total $150,000. The quick ratio would be ... (Current assets (355,000) less inventory (250,000) / Current liabilities (150,000) = 0.70.What this means is this: for every $1 due for payment in the next month or so, the business has $0.70 in liquid (cash or soon to be cash) assets. Generally a quick ratio of 1.00 is considered a safe operating ratio.

OPERATIONAL RATIOS These ratios calculate the efficiency of a business’s management operations and use of assets. Typical ratio efficiencies deal with stock turn and debtor days.  

Stock turn measures the optimum amount of stock required to achieve sales targets. Debtor days measure how many days it takes for the business to get paid by its customers.

Generally, a business would not want to overstock and would want its debtors to pay in the shortest possible time. PROFITABILITY RATIOS These ratios calculate the profitable return on sales and capital tied up in the business. These ratios are usually expressed as a % and monitored over timeconsecutive periods to help identify healthy or unhealthy trends. Typical profitability ratios are:    

gross profit as a % of sales net profit as a % of sales net profit as a % of assets net profit as a % of owner’s equity. For example, assume that current earnings total $75,000, total assets total $1,275,000 and owner’s equity totals $425,000:  net profit as a % of assets would be ... current earnings (75,000) / total assets (1,275,000) = 5.9%  net profit as a % of owner’s equity would be ... current earnings (75,000) / total owner’s equity (425,000) = 17.6%. This means that if competing investment opportunities provide a lower return than 17.6 %, then the investment in this business remains worthwhile.

By comparing Balance Sheet report ratios with those for prior periods, with commonly agreed safe operating levels and with industry benchmarks, the changing financial strength/health of the business can be more easily understood. HOW DO YOU READ AND UNDERSTAND THE INCOME STATEMENT? As indicated earlier in this section, the Income Statement, along with the Balance Sheet, is a key financial report produced by the accounting information system. These financial reports convey to management and other stakeholders a concise picture of the profitability and financial position of a business. 

The Balance Sheet reports on the financial position, strength and net worth (Owner’s Equity) of a business at a specific point in time.

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The Income Statement reports on the viability, profitability and ‘bottom line (net profit/loss) of a business for a given accounting period. These accounting periods are typically monthly, quarterly or annually.

So, while net profit results from deducting from the revenue the expenses incurred in earning that revenue, net earnings for a period further deducts the interest and tax expense and adds/subtracts gains/losses from non-core business activities (for example, foreign exchange, asset sales). The net earnings amount from the bottom line of the Income Statement is reported in the account Current Year Earnings, which is part of the Owner’s Equity section of the Balance Sheet.

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hanges in Owner’s Equity then occur directly in proportion to those transactions involving earning revenue and incurring expenses. This is why in double-entry bookkeeping, increases in revenue are treated in the same way as increases in Owner’s Equity— as a credit— because the potential profits that revenues produce are due to the owners of the business. The Income Statement primarily addresses the question regarding the economic performance of the business. The Income Statement answers the question: Did the business do well (make a profit) or did it do badly (incur a loss)? Earning revenue and incurring expenses is so critical to the viability of a business that it requires this separate and detailed Income Statement report to periodically monitor the operating results of a business.

KeyFACTS An Income Statement describes: 

firstly, the outcomes derived from a business generating revenue as it exchanges goods or

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services with its customers in return for money or other assets secondly, the outcomes in relation to the expenses incurred in exchanging its goods and services

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with these customers in the pursuit of revenue lastly, the net income or profit realised from offsetting the expenses against the revenues that they generated. If the revenue exceeds the expenses, the business generates a profit. If the expenses exceed the revenue, the business incurs a loss.

INCOME STATEMENT DETAILS REVENUES EARNED AND EXPENSES INCURRED IN EARNING THAT REVENUE The Income Statement summarises the revenues earned and subtracts the expenses incurred in earning that revenue to calculate the resulting net profit or loss for a given accounting period. The Income Statement contains the often referred to ‘bottom line’ of a business in that it calculates the net profit or losses for a given period and reports this as the last line on the Income Statement. MONEY RECEIVED FROM SALE OF PRODUCTS OR PROVISION OF SERVICES At the top of the Income Statement is the total amount of money received from the sale of products or the provision of services. This top line may also be referred to as sales or gross revenues because expenses have not yet been deducted. If sales returns and allowances have been given in the period, these will be deducted from gross sales to produce the net sales. Not all Income Statements follow the exact same format due to the fact that not all revenue and expense accounts are used by all businesses to produce net profit. Businesses selling tangible goods will usually separate the cost of goods sold from other expenses so that a gross profit result can be calculated. Other manufacturing and service industries may deduct direct costs from the sales/fees earned to calculate their gross profit or gross margin. Gross profit directly reflects the pricing policies of a business, which can be easily compared to industry benchmarks and competitor results. Other revenues are then added to the gross profit to calculate the total revenue for the period. OPERATING EXPENSES Operating expenses is the next section summarised on the Income Statement. These are the costs of doing business or the expenses incurred in earning the revenue. Under the matching principle applied in accrual accounting, all expenses incurred in earning the revenue for the given accounting period should be included in the Income Statement regardless of their paid or unpaid status. These expenses are typically summarised and reported by expense classifications including:   

Selling and Distribution (often referred to as ‘selling expenses’) General and Administration Expense Financial Expense.

These expenses are totalled and subtracted from the gross profit to produce the net profit or EBIT. (Earnings Before Interest and Tax). This result is often called Income from Operations. Net earnings (after interest and taxes have been deducted) is the amount that is reported as Current Earnings in the Owner’s Equity section of the Balance Sheet.

Non-profit organisations do not generally produce an Income Statement. They produce a statement of activities which compares funding sources with program expenses, administrative costs and other operating commitments to arrive at a surplus or shortfall in funds. WHAT IS THE FINANCIAL RATIO ANALYSIS? Financial ratio analysis uses the information contained in the financial statement of a business to assess the current financial performance and position of a business relative to its prior years and industry benchmarks. Financial analysis ratios are typically grouped into:     

liquidity ratios debt ratios profitability ratios efficiency ratios value ratios.

Assessment of the financial performance and position of a business using financial ratio analysis is usually made after reviewing multiple financial ratios and calculations. BACKGROUND TO FINANCIAL RATIO ANALYSIS Most analysis of publicly traded companies is done via the computation of financial ratios—that is, calculating the relationship between two sets of financial numbers reported by the company in their financial statements. The two key financial statements used in this regard are the Balance Sheet and the Income Statement. 

The Balance Sheet reports on the company's financial strength at a particular point in time and the Income Statement reports on the financial performance of the company over a past period of time (usually the past 12 months).

The calculated ratio for a particular period has only limited value in terms of insight into the financial performance of a company, but when it is compared to (a) prior years (b) same industry benchmarks (c) cross-industry benchmarks and (d) company budgets, it can provide insights into both the immediate, developing and structural problems of a company and the opportunities that should be exploited. There are hundreds of financial ratios that can be calculated; however, most can be grouped into the one of the following aspects of diagnostics described below.  

Liquidity: These ratios measure how quickly a company can convert assets into cash to meet its immediate financial obligations. Debt: These ratios measure the company’s reliance on debt funds and its ability to meet the obligations of those funds.

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Profitability: These ratios measure the growth and level of profitability in relation to a company’s assets, sales and shareholder investment. Efficiency: These ratios measure the performance of the company’s executives in relation to the efficient management of the assets under their control. Value: These ratios measure the value of a company’s shares/stock from an investors point of view.

These ratios should not be interpreted on a stand-alone basis, but each should be assessed in combination with other ratios to help establish a picture of the current and developing financial position and performance of the company. TYPES OF FINANCIAL RATIO ANALYSIS ANALYSING LIQUIDITY RATIOS The most common financial ratios used when analysing a business’s liquidity are:  

current ratio = (total current assets) / (total current liabilities) quick ratio = (total current assets inventories) / (total current liabilities)

ANALYSING DEBT RATIOS The most common financial ratios used when analysing a business’s debt position are:  

debt ratio = (total debt) / (total assets) interest cover ratio = (earnings before interest tax) / (annual interest expense)

ANALYSING PROFITABILITY RATIOS There are many profitability ratios that can be calculated but the most common ones used when analysing a business’s profitability are:   

gross margin = (gross margin $) / (total sales) EBIT % = (earnings before interest tax) / (net sales) return on equity = (earnings after tax) / (shareholder equity)

ANALYSING EFFICIENCY RATIOS There are many efficiency ratios that can be calculated but the most common ones used when analysing a business’s efficiency are:  

inventory turnover = (cost of goods sold) / (average inventory) average collection period = ((Accounts Receivable) / (net sales)) x 365

ANALYSING VALUE RATIOS

The most common ratios used by shareholders when analysing a business’s value are:  

earnings per share = (net earnings) / (number of shares issued) P/E = (market price per share) / (earnings per share)

LIST OF ACCOUNTING TERMS AND ABBREVIATIONS The following is a list of accounting terms, and the alternative terms and abbreviations that, while meaning the same thing, are commonly substituted for these terms in accounting literature. ‘Keeping the books’: bookkeeping The ‘bottom line’: earnings, net Income, net profit The ‘top line’: turnover, revenue, fees earned, sales A/C: account A/P: Accounts Payable, Payables, Trade Creditors A/R: Accounts Receivable, Receivables, Trade Debtors, Debtors Book ABN: Australian Business Number Account categories: elements of the accounts, five account groups Account customers: trade debtors, debtors, A/R, Debtors Book Accounting clerk: bookkeeper, accounting technician Accounting entity: business entity, organisational entity Accounting system: double-entry bookkeeping system, Venetian method Accounting technician: accounting clerk, bookkeeper Accounts receivable: receivables, trade debtors, A/R, debtors book Acid test ratio: quick ratio, liquidity ratio ACN: Australian Company Number Adjusting journal entries: end-of-period adjustments, balance-day adjustments, year-end adjustments Allowance for bad and doubtful debts: provision for doubtful debts, bad debts reserve, allowance for doubtful accounts ARR: average rate of return ATO: Australian Taxation Office Bad debts: uncollectible debts, bad debt expense, uncollectable accounts Bad debts reserve: provision for doubtful debts, allowance for bad and doubtful debts, allowance for doubtful accounts

Balance day adjustments: adjusting journal entries, end-of-period adjustments, year-end adjustments Balance Sheet: Statement of Financial Position, Statement of Net Assets, Statement of Financial condition Balance Sheet accounts: permanent accounts, real accounts BAS: Business Activity Statement, Australia Book of accounts: General Ledger, nominal ledger Book of final entry: nominal ledger, book of accounts, GL, General Ledger Book of original Entry: journal, day book Book value: carrying value, written-down value Bookkeeper: accounting clerk, accounting technician Bookkeeping: keeping the books Burden cost: indirect costs, overheads, facilities and administrative costs Business entity: accounting entity CA: chartered accountant Capital: net worth, equity, shareholder’s equity, owner’s equity Capital asset: fixed asset, non-current asset, long-term asset, tangible asset Carrying value: book value, written-down value Cash accounting: cash method, cash basis Cash basis: cash method, cash accounting Cash book: cash receipts and cash payments journal Cash Flow Statement: Statement of Cash Flows, Funds Flow Statement, Funds Statement Cash method: cash accounting, cash basis Cash Receipts and Cash Payments Journal: cash book CGT: Capital Gains Tax, Australia COA: Chart of Accounts COGS: cost of goods sold, cost of sales Contra accounts: valuation allowances accounts

Cost of goods sold: COGS, cost of sales Cost of sales: COGS, cost of goods sold CPA: certified practicing accountant Cr: credit Current ratio: working capital ratio Day book: journal, book of original entry Debt service ratio: interest coverage ratio Debt to equity ratio: gearing ratio, leverage ratio Debtors: trade debtors, account customers Debtors Book: receivables, accounts receivable, debtors, account customers, trade debtors Declining balance method: reducing balance method, diminishing balance method, diminishing value method Diminishing balance method: declining balance method, reducing balance method, diminishing value method Diminishing value method: reducing balance method, diminishing balance method, declining balance method Double-entry bookkeeping system: accounting system, Venetian method Dr: debit Earnings: net profit, net income, the ‘bottom line’ Earnings before taxes: net profit before tax, pre-tax book income, net operating income before taxes, pre-tax income Earnings statement: Profit and Loss Statement, Income Statement, P&L, Operating Statement, Statement of Operations, Statement of Financial Performance EBDTA: earnings before depreciation, taxes and amortisation EBIDTA: earnings before interest, depreciation, taxes and amortisation EBIT: earnings before interest and tax EBITDA: earnings before interest, tax, depreciation and amortisation Elements of the accounts: five account groups, account categories

End-of-period adjustments: Balance day adjustments, adjusting journal entries, year-end adjustments EPS: earnings per share Equity: net worth, owner’s equity, shareholders’ equity, capital Equity Statement: Statement of Retained Earnings, Statement of Owner’s Equity, equity report EVA: economic value added Exclusions: excluded income Excluded income: exclusions Expenses: expired costs, revenue expenditures Expired costs: expenses, revenue expenditures Facilities and administrative costs: indirect costs, overheads, burden cost FBT: Fringe Benefit Tax, Australia Fees earned: turnover, revenue, the ‘top line’, sales FIFO: first in, first out Five account groups: elements of the accounts, account categories Fixed asset: non-current asset, long-term asset, capital asset, tangible asset Fixed instalment: Straight-line method, prime cost method, flat rate method Flat rate method: Straight-line method, prime cost method, fixed instalment Funds Flow Statement: Statement of Cash Flows, Cash Flow Statement, Funds Statement Funds Statement: Statement of Cash Flows, Cash Flow Statement, Funds Flow Statement FYE: fiscal year end GAAP: generally accepted accounting principles Gearing: leverage Gearing ratio: leverage ratio, debt to equity ratio General Ledger: nominal ledger, book of accounts, GL, book of final entry GL: nominal ledger, book of accounts, book of final entry, General Ledger Going concern assumption: Going concern concept

Going concern concept: Going concern assumption GST: Goods and Services Tax, Australia IAS: Instalment Activity Statement, Australia Imprest fund: petty cash Income Statement: Profit and Loss Statement, Statement of Financial Performance, P&L, Earnings Statement, Operating Statement, Statement of Operations Indirect costs: overheads, facilities and administrative costs, burden cost Interest coverage ratio: debt service ratio Inventory: stock, stock on hand, trading stock Inventory turnover ratio: stock turn, stock turnover Journal: book of original entry, day book Leverage: gearing Leverage ratio: gearing ratio, debt to equity ratio LIFO: last in, first out Liquidity ratio: acid test ratio, quick ratio LOC: line of credit Long-term asset: fixed asset, non-current asset, capital asset, tangible asset Long-term liability: non-current liability Mixed costs: semi-variable costs Net income: net profit, net earnings, the ‘bottom line’ Net operating income before taxes: earnings before taxes, pre-tax book income, pre-tax income, net profit before tax Net profit: earnings, net income, the ‘bottom line’ Net profit before tax: earnings before taxes, pre-tax book income, net operating income before taxes, pre-tax income Net worth: equity, owner’s equity, shareholders’ equity, capital Nominal accounts: temporary accounts Nominal ledger: General ledger, book of accounts Non-current asset: fixed asset, long-term asset, capital asset, tangible asset

Non-current liability: long-term liability Non-operating revenue: other revenue NOP: net operating profit NOPAT: net operating profit after tax NPAT: net profit after tax NPBIT: net profit before interest and tax NPBT: net profit before tax NPV: net present value Operating statement: Profit and Loss Statement, Income Statement, P&L, Earnings Statement, Statement of Financial Performance, Statement of Operations Other revenue: non-operating revenue Other revenue: non-operating revenue Overheads: indirect costs, facilities and administrative costs, burden cost Owner’s equity: net worth, equity, shareholders’ equity, capital P&L: Profit and Loss Statement, Income Statement, Statement of Financial Performance, Earnings Statement, Operating Statement, Statement of Operations Payables: accounts payable, A/P, trade creditors PAYGI: Pay As You Go Instalment, Australia PAYGW: Pay As You Go Withholding, Australia Petty cash: imprest fund Permanent accounts: real accounts, Balance Sheet accounts PP&E: property, plant and equipment Pre-payments: prior payments Pre-tax book income: earnings before taxes, net profit before tax, net operating income before taxes, pre-tax income Pre-tax income: earnings before taxes, pre-tax book income, net operating income before taxes, net profit before tax Prime cost method: flat rate method, straight-line method, fixed instalment Prior payments: pre-payments

Profit and Loss Statement: Income Statement, Statement of Financial Performance, P&L, Earnings Statement, Operating Statement, Statement of Operations Provision for doubtful debts: allowance for bad and doubtful debts, bad debts reserve, allowance for doubtful accounts Quick ratio: acid test ratio, liquidity ratio Real accounts: permanent accounts, Balance Sheet accounts Receivables: accounts receivable, A/R, trade debtors, debtors book Reducing balance method: declining balance method, diminishing balance method, diminishing value method Retained earnings: retentions Retentions: retained earnings Residual value: salvage value, trade-in value Revenue: sales, turnover, fees earned, the ‘top line’ Revenue expenditures: expenses, expired costs ROA: return on assets ROE: return on equity ROI: return on investment Sales: turnover, revenue, fees earned, the ‘top line’ SAG expenses: selling, administrative and general expenses; SA&G SA&G: selling, administrative and general expenses; SAG expenses Salvage value: residual value, trade-in value Semi-variable costs: mixed costs SGC: Superannuation Guarantee Charge, Australia Shareholders’ equity: net worth, owner’s equity, equity, capital Statement of Cash Flows: Funds Flow Statement, Cash Flow Statement, Funds Statement Statement of Financial Condition: Balance Sheet, Statement of Financial Position, Statement of Net Assets

Statement of Financial Performance: Profit and Loss Statement, Income Statement, P&L, Earnings Statement, Operating Statement, Statement of Operations Statement of Financial Position: Balance Sheet, Statement of Net Assets, Statement of Financial condition Statement of Net Assets: Balance Sheet, Statement of Financial Position, Statement of Financial Condition Statement of Operations: Profit and Loss Statement, Income Statement, P&L, Earnings Statement, Operating Statement, Statement of Financial Performance Statement of Owner’s Equity: Statement of Retained Earnings, Equity Statement, Equity report Statement of Retained Earnings: Equity Statement, Statement of Owner’s Equity, Equity report Stock: inventory, stock on hand, trading stock Stock on hand: inventory, stock, trading stock Stock turn: stock turnover, inventory turnover ratio Stock turnover: stock turn, inventory turnover ratio Straight-line method: flat rate method, prime cost method, fixed instalment Tangible asset: fixed asset, non-current asset, capital asset, long-term asset Temporary accounts: nominal accounts TFN: Tax File Number, Australia Trade creditors: accounts payable, A/P, payables Trade debtors: receivables, accounts receivable, debtors, account customers, debtors book Trade-in value: salvage value, residual value Trading stock: inventory, stock, stock on hand Turnover: sales, revenue, fees earned, the ‘top line’ Uncollectible debts: bad debts, bad debt expense, uncollectable accounts Valuation allowances accounts: contra accounts VAT: value added tax Venetian method: double-entry bookkeeping system, accounting system

WIP: work-in-progress Working capital ratio: current ratio Written-down value: carrying value, book value Year-of-end adjustments: end-of-period adjustments, balance day adjustments, adjusting journal entries.

GLOSSARY OF ACCOUNTING TERMS ‘Account for’ or ‘bring to account: accounting phrase used to describe the recording of a financial transaction that is required under the generally accepted accounting principles. ‘The books’: accounting phrase use to describe the accounting records of a business that are used to enter transactions into journals, then classify them into ledger accounts and ultimately produce the financial statements. Accounting: the process of recording, analysing, reporting and interpreting the financial effect of business activities. Accounting basis: refers to how financial transactions are measured for recording purposes (that is,cash basis vs accrual basis, historical cost basis, going concern basis). Accounting cycle: the complete process from identifying and recording the financial transactions of the business to their eventual summarisation in the Balance Sheet at the end of an accounting period, which then forms the start point for the financial activities in the next accounting period. Accounting equation: Assets = Liabilities + Owner’s equity. It means that the amount of money that owners (owner’s equity) and non-owners (liabilities) have provided to the business will always be represented by the total value of the assets that the business legally controls. The accounting equation is represented in the Balance Sheet of the business. Accounting entity: a business or organisation that is regarded as having a separate identity from that of the owners and will only record and report on financial transactions where it is a party (for example, sole proprietor, partnership, company). Accounting standards: the rules that guide the application of accounting principles for specific situations. Accounting system: that part of the MIS (Management Information System) that provides financial information for management for decision making purposes or to produce financial reports under compliance obligations. Accounts payable:the money value of goods and services that a business has acquired, but has not yet paid for. Accounts Payable Ledger: a subsidiary ledger that holds the account details and amounts owing to the suppliers of a business (essentially, the business’s promise to pay a vendor for goods or services provided). Accounts receivable: the amount of money customers owe a business for products and services they have bought from the business, but have not yet paid for.

Accounts Receivable Ledger: a subsidiary ledger that holds the account details and amounts owed by the customers of the business. Accounts: one part in a General Ledger devoted to recording details about a single aspect of a business (for example, Cash at Bank account, Advertising Expense account, Merchandise Sale account). Subcategories include Assets, Liabilities, Equity, Revenue, and Expenses. Accrual basis accounting: one of the bookkeeping processes that can be followed in preparing a business’s financial statements. Accrual basis accounting records revenue and expenses as they are earned or incurred regardless of when the money exchanges (cash received or paid). Accruals: transactions created under the accrual basis of accounting. Accruals bring to account revenue and expenses that have been earned and incurred but have not yet been invoiced (for example, prepaid expenses, unearned revenue). Accumulated Depreciation Account: the total amount of depreciation expense that has been written off against the asset from the time it was purchased. It is a contra asset account that reflects depreciation expense taken in the current and previous periods. Accelerated depreciation: a method of depreciation in which a greater amount of depreciation expense is recorded in the earlier years of an asset’s useful life than in later years. Aging schedule: a schedule that classifies accounts receivable by the amount of days the receivable has been unpaid. Amortisation: a process of writing off the value of intangible assets to acknowledge their loss of value. Similar to depreciation for tangible assets. Assets: items of future economic value that the business owns or controls (for example, cash, inventory, equipment, patents). They are tangible or intangible things that allow a firm to produce goods or services. Audit trail: a chronological list of a transaction’s process through the accounting system, from the source document to financial statements. Audit: a set of tests and procedures applied by an independent accounting firm to determine the accuracy of financial statement information. Audits are designed to provide reasonable assurance to third parties that the financial statements represent a true and fair view of the financial performance and position of the business. Bad Debts Account: an account in the nominal ledger to record the value of unrecoverable debts from customers. Balance Sheet: a financial statement that reflects the financial position of a business on a specific date and outlined according to the accounting equation

(that is, Assets = Liabilities + Owner’s equity). It is one of the basic financial statements used to assess the financial condition of a business. Balance day adjustments: the procedure to ensure that all items of revenue and expense are recorded in their correct accounting periods. Typically these include accruals, depreciation, actual stocktakes, bad and doubtful debts. Bank statement: a statement supplied by the bank that details the monies received and paid for a customer’s account. Bank reconciliation: a process that demonstrates how the cash details recorded in the books of the business match the statement supplied by the bank. Bookkeeping: the physical recording of the financial transactions of the business. Books of original entry: specially designed forms on which transactions are initially recorded. Book value: the historical cost of an asset less the value of the accumulated depreciation. Also referred to as the written down value. Business firm: an organisation established to earn a profit by the selling of goods or services. Capital expenditure: the expenditure on fixed assets that are expected to provide economic benefits over several accounting periods (for example, the purchase of a building, an upgrade to equipment). Cash accounting: a simplified form of bookkeeping for small businesses that delays the recording of revenue and expenses until the cash is actually exchanged (that is, when cash for goods or services provided is actually received or paid). Cash at bank: an account kept in the books of a business that records the amount of money held in the bank account. Cash Flow Statement: a financial statement that reports cash flows from operating, financing and investing activities. Cash on hand: an account kept in the books of a business that records the amount of money held on the business premises (usually undeposited funds or cash register floats). Cash register float: a term used to describe the amount of money perpetually held in cash registers to provide change in relation to customer sales. Chart of Accounts: a complete listing of every account in the accounting system. Company: a separate legal entity owner by shareholders that is created for the purpose of conducting business activities.

Contra account: an account created in the same account group that is an offset to another account (for example, accumulated depreciation, sales discounts). Control account: an account held in a general ledger that summarises the balance of all the accounts in the subsidiary ledger (for example, the Accounts Receivable control account is the total of all the customer accounts held in the Debtors Subsidiary Ledger). Corporation: a common form of limited liability firm that is created and recognised as a separate legal entity by the corporation’s law of the country. Cost of goods sold: a formula for working out the direct costs of stock sold over a particular period. The formula is: Opening stock + purchases closing stock; it calculates all the direct costs associated with selling goods (inventory). Credit: one of the two aspects of a double-entry bookkeeping system. For every entry into the books of a business, there must be a credit entry and it must equal the debit entry amount made to another account. Creditors: a list of suppliers to whom the business owes money, typically listed in the Creditors Ledger. Current assets: assets that could be converted into cash easily (for example, inventory, accounts receivable). Current liabilities: monies owed to external parties and due for payment within the next 12 months (for example, credit cards, trade creditors, tax payable). Debit: one of the two aspects of a double-entry bookkeeping system. For every entry into the books of a business, there must be a debit entry and it must equal the credit entry amount made to another account. Debtors: a list of the customers who owe money to the business, typically listed in the Debtors Ledger. Deferred revenue: cash collected from customers or clients before the delivery of goods and services. Depreciation expense: accounting for the loss of economic value of a fixed asset . This is done by expensing (writing off) a portion of the fixed asset according to its useful life. Also the portion of an asset’s cost allocated to the current accounting period. Direct costs: expenses that can be directly tracked to a specific job. If the job did not happen, the direct costs would not have been incurred (for example, materials, delivery costs, stock purchases). Dissolution: the disposal of the assets of a sole trader that has ceased trading. Dividends: cash distributions from corporate profits to the corporation’s shareholders.

Double-entry accounting: an accounting system used to keep track of business activities that requires a debit and credit entry to be made into two or more accounts for every financial transaction. Doubtful debts: a provision in the financial statements that identifies amounts owed by debtors that may not be paid in part or in full. Drawings: the money taken out of a business by its owner(s) for personal use. EBIT: the abbreviation for ‘earnings before interest and tax’ (that is, profit before any interest or taxes have been deducted). Entry: part of a transaction recorded in a journal or posted to a ledger. Equity: the value of the business owing to the owners of the business. It is made up of the initial investment by the owners and the unpaid earnings of the business to date—the difference between a firm’s assets and its liabilities. Expense: goods or services purchased directly for the running of the business that have completely spent their economic value at the time the financial statements are prepated (for example, wages expense, bank charges, electricity expense). It is the use of resources to produce the good and services sold to customers and clients. Extraordinary items: those items of revenue or expense that occur outside the normal activities of the business (for example, the sale of equipment used to produce products for the business). FIFO: an abbreviation of ‘first in, first out’. FIFO is a flow assumption in valuing ending inventories that assumes that the first goods sold were the first ones purchased. Financial accounting: a system of reporting on the financial activities of a business according to the requirements of external stakeholders. The format and information required is usually prescribed by governments agencies and accounting standards. Financial statements: reports provided to the stakeholders of the business that detail the financial performance and position of the business. They key financial statements are the Balance Sheet, the Income Statement and the Cash Flow Statement. Fiscal year: the term used for a business’s accounting year (calendar (31 December close) or financial (30 June close)). Fixed assets: also known as non-current assets, these are tangible assets that have a future economic value of greater than 1 year (for example, buildings, equipment, vehicles, furniture).

Fixed Asset Schedule: a record of a firm’s assets that tracks acquisition dates and costs, depreciation methods used and cumulative amounts of depreciation taken. Functional classification: a term to describe the grouping of expenses into classifications when presenting the financial statements (for example, Financial, Sales and distribution, Administration). General Ledger: a place in the accounting system where all the individual accounts from the Chart of Accounts are collected. Also, the collection of all accounts used by a firm to record changes in assets, liabilities, revenue, expense and equity. Generally Accepted Accounting Principles: abbreviated as GAAP; the most widely accepted rules of financial accounting. Going concern: an assumption that a business will continue to sell products and/or provides services into the foreseeable future. Going concern value: the combined value of a firm’s assets that would be paid by a purchaser who intended to continue operating the business. Goodwill: the difference between a firm’s going concern value and its liquidating value. Gross margin: how much money is left after the direct costs are subtracted from the selling price: when this calculation is expressed as a percentage, it is called the gross margin. It is the difference between sales and cost of goods sold. Historical cost: describes an accounting practice where assets are recorded in the books of a business at the prices for which they were acquired. It is the listing of asset values based upon their acquisition price rather than their current market value. Imprest: an amount of cash provided in advance to an authorised person that allows them to make cash payments for incidental expenses (for example, petty cash). Income Statement: also known as the Profit and Loss Statement, the P&L or the Statement of Financial Position. The Income Statement is a financial report that shows the changes in the equity of the business as a result of its operations. It lists the revenues, subtracts the expenses and so measures the economic performance (profit or loss) of the business for a given accounting period. Incurred: describes the act of becoming legally liable for something. Indirect cost: also known as an overhead; an expense that is not directly related to the services provided to customers.

Internal control: a system implemented and maintained by a business to ensure the protection of its assets, the reliability of its financial information and to prevent fraud. Insolvent: describes an enterprise which has a total value of liabilities greater than a total value of assets. Intangible asset: an item of economic value that is of a non-physical or financial nature (for example, patents, trademarks, goodwill). Inventory: also known as stock; goods or materials held by the business with the intent to sell them to customers for a profit. Invoice: an original document either issued by a business for the sale of goods on credit (a sales invoice) or received by the business for goods bought (a purchase invoice). Journal entries: the recording of transactions in a journal. Journal: where in the accounting system transactions are first entered. A journal records business activities in a chronological order ensuring that the debit amount of each transaction is matched with a credit amount (for example, Sales Journal, Purchases Journal, Cash Receipts Journal, Cash Payments Journal, General Journal). Legal entity: a person or non-person (for example, a company) who is recognised by law as having the right to buy and sell property and to sue or be sued. Leverage: the degree to which a firm uses debt to finance its operations. Liabilities: the value of monies owed to someone other than the owners (for example, to creditors, tax department, a financial institution that provided a loan to the business). Liabilities are an enterprise’s obligations to its creditors LIFO: an abbreviation for ‘last in, first out’; an inventory flow assumption that the most recently sold inventory is also the most recently purchased. Limited liability firm: firms that is organised under special state statutes that insure that the owners’ liabilities for the firm’s actions are limited to their investment. Liquidating value: the amount that would be paid for a firm’s assets on a piece meal basis. Liquidity: the availability of cash in a business. Long-term liabilities: also known as non-current liabilities; typically, any debts owed to funders or creditors that lasts for more than 1 year (for example, a mortgage for a property purchase). Loss: the excess of expenses over revenue.

Management accounting: a system of reporting on the financial activities of a business according to the needs of the managers and other internal stakeholders (for example, budgeting, variance reporting, weekly sales reports, business unit profitability reports). Matching principle: an accounting principle that directs accountants to prepare the Income Statement so that the revenue and the expenses incurred in earning that revenue are recorded and reported in the same accounting period. The matching principle is the idea behind accrual accounting, which holds that revenue should be recognised at the same time as associated expenses are incurred. Materiality: a threshold amount accountants use in deciding if adjustments are needed to particular accounts. MIS: an abbreviation of Management Information System; a system of reporting that assists decision makers in their evaluation planning, organising, leading and controlling functions. Money: the medium used to exchange goods and services for other goods and services. Narrative: a comment added to an entry in a journal. It can describe the nature of the transaction, or the other side of the debit/credit entry. Net income: also known as net profit, net earnings, current earnings or bottom line. Net income is the money left over in a specific period after deducting from the revenue the expenses incurred in earning that revenue. This amount is reported as the bottom line of the Income Statement and as current earnings in the equity section of the Balance Sheet. Net worth: also known as owner’s equity. It is the accounting value of a business and is determined by subtracting the value of the liabilities of the business from the total value of its assets. It represents the value of the owner’s investment in the business. Operating cycle: The stages involved and the time taken to turn purchased goods into cash receipts from customers. e.g. purchase inventory from cash at bank, Store inventory, Sell inventory on account, Accounts receivable collected to cash at bank Operating expenses: those expenses incurred in producing revenue from the normal activities of the business (for example, wages expense, rent, electricity). Overheads: also known as indirect costs; costs of a business that do not change in proportion to business activity and cannot be directly attributed to a revenue item (for example, rent, property insurance, land rates). Owner’s equity: the value of the owner’s investment in the business (that is, initial capital + retained earnings from past periods + current earnings).

Partnership: a form of unlimited liability firm with more than one owner. Periodic inventory method: a method of recording inventory purchases that reflects adjustments to the inventory account only at the end of an accounting period. Perpetual inventory method: a method of recording inventory purchases that changes the inventory account balance as purchases are made. Petty cash: a system designed to ensure the simple management of incidental payments (for example, purchasing emergency stationery supplies or staff lunch room supplies). Posting: an accounting term used to describe the transfer of entries from one part of the accounting process to the next (that is, from the journals to the ledgers). Also, the process of transferring transaction information recorded in books of original entry to general ledger ‘T’ accounts. Provisions: one or more accounts set up to account for expected future costs (that is, provision for doubtful debts to provide for possible non-payment of customer debts). Prepaid expenses: an accrual account created during the balance day adjustment process that recognises as assets those expense amounts that still have future economic value (for example, insurance paid in advance). Also, a firm’s payment to vendors for goods and services to be provided at some later point. Profit: the excess of revenues over expenses. Ratio analysis: a collection of calculations performed on the financial statements that gives insights into the liquidity, profitability and management efficiency of a business (for example, current ratio, gross profit %, inventory stockturn). Reconciling: the process of checking entries made in the books of a business with those on a statement sent by a third person (that is, checking a bank statement against a business’s own financial records). Retained earnings: the amount of net income owed to the owners but still retained by the business, usually to fund expansion of the business. Also, the undistributed profits of a corporation. Retainers: a form of deferred revenue collected by attorneys or other service businesses. Residual value: the estimated value of an asset that is likely to remain at the end of its useful life. Revenue: the monies received by a business for the goods and services provided (that is, merchandise sales, fees earned, interest received from

investments). Also, cash or receivables received from customers or clients in exchange for goods and services provided. Segregation of duties: an internal control that insures that employees with access to assets have no access to accounting records. Shareholders: the owners of a business or corporation. Shares: the official documentation issued by businesses to the owners of the business. The percentage of shares held compared with the total shares issued identifies the percentage of the company’s equity and profits that one is entitled to. Shares can also be called ‘stock’. SME: abbreviation for ‘small and medium enterprises’. The definition of what quantifies an SME varies in each country. Sole proprietor: the self-employed owner of a business. Sole proprietorship: an unlimited liability firm with one owner. Source document: the original documentation that evidenced the financial event and becomes the basis for the entry of the financial transaction into the books of the business (for example, deposit book, check butts, purchase and sales invoices). Straight-line depreciation: a method of depreciation expense that allocates an asset’s purchase cost evenly over the asset’s expected useful life. Statutory bodies: agencies established by the government to monitor and control specific laws (for example, corporate regulators). Subsidiary ledgers: ledgers used to record the details of the General Ledger’s control accounts. They are typically used for individual customers (Debtors) and individual suppliers (Creditors). Suspense Account: a temporary account used to record that part of a transaction that is not yet able to be recorded to a nominal account (that is, the current unknown origin of a deposit in the Bank account). Also, special records that detail the sales and payment histories for individual customers in the case of accounts receivable, or purchase and payment histories for individual vendors, in the case of accounts payable. ‘T’ accounts: General Ledger accounts that have a ‘T’ format that clearly demarcate a left side and right side. Tangible assets: assets or items of economic value that are of a physical nature like land, buildings, vehicles and equipment. Transaction: the original entry into the books of the business that records the debit and credit aspects of the source documents that evidence a financial event. Also, any event that causes a change in assets, liabilities, equity, revenue, or expense.

Ten (10)-column worksheet: a device created to assist in identifying and allocating the effects of the balance day adjustments on the preparation of period-end financial statements (for example, accruals, depreciation, bad and doubtful debts, inventory adjustments). Trial balance: an internal report that checks to see if the double-entry bookkeeping principles have been properly applied for all transactions. It is a list of all the accounts from the General Ledger together with their individual debit or credit balances. The General Ledger is said to be in balance if the total of the debit balances is equal to the total of the credit balances. Unearned revenue: an accrual account created as part of the balance day adjustments to record as a liability that revenue that has not yet been earned (for example, fees received in advance). Unlimited liability firms: businesses whose owners remain liable for the actions of a business beyond the amount they actually invest. Working capital: the ongoing capital required by the business to pay its bills as they become due. It is calculated by subtracting the current liabilities from the currents assets of the business. Weighted average cost method: an ending inventory valuation method based upon the weighted average of purchase costs during the accounting period. Work in progress: the value of partly finished goods. Typically found in manufacturing businesses.

FAQ Basic Accounting Concepts

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