Shanghai University of Finance & Economics

Shanghai University of Finance & Economics Accounting/Business Diploma Programmes Principles of Accounting

Definition of Financial Accounting • Financial accounting is the process of identifying, measuring and communicating economic information about a business organisation in order to permit informed judgements by users of that information. [American accounting association]

The Process of Financial Accounting & classifying the assets, liabilities, capital, income & expenses recording each transaction of the business in the form of periodic financial statements to users/stakeholders in the business IDENTIFYING SUMMARISING COMMUNICATING

Who are the Stakeholders ? Suppliers Managers Shareholders/ investors Investment analysts Accounting information Employees General public Competitors Lenders/ creditors Customers Government

How will Stakeholders use accounting information ? • Review their past decisions & commitments to the business • Use past financial performance information as a ”guide” to forming expectations of the future • Make decisions based upon those expectations to maintain, increase or withdraw their commitment / interest in the business

Necessary qualities of financial information. accuracy clarity Accounting Information reliability consistency timeliness relevance

Main forms of business enterprise [entity]. Non - profit co-op charity public body Sole trader Business organisation partnership Private limited liability company Public limited liability company [plc]

Accounting Concepts • Accounting statements could be prepared in a variety of ways which would be confusing • Therefore, they are regulated by both law and by professional standards • These laws and standards are based on underlying concepts • The most important is for accounting statements to give a true and fair view • This means they should disclose all relevant information for stakeholders to be able to act with confidence

Accounting Statements • Profit and Loss Account • Look at account on page 29 • What is the final profit • What is the value of sales • Sales can be for cash or credit • Costs/expenses should match the period over which sales are made • Total Revenues – Total Expenses = Net Profit

The Balance Sheet • Look at the Balance Sheets on page 31 • Compare the date headings of the balance sheets with the profit and loss accounts • What is the main difference ? • The balance sheet shows • The Assets owned • The Liabilities owed • The Value of the owners’ investment in the Business

Balance Sheet Items • Assets are things the business owns • Fixed Assets are used in the business and are not for resale. They are usually depreciated • Current Assets are cash or assets expected to be turned into cash within one year

Financial Accounting Concepts • Entity • Separates business and personal affairs • Read example 1 – page 39 • J Soap’s business is all that is shown – the other £20,000 is irrelevant • In fact he would be personally liable for any business debts • Contrast this with limited companies whose shareholders are not personally liable

Money Measurement • Accounts include only information which can be expressed in monetary terms • This seems an obvious fact but read Example 3 – page 40 • The message is clearly that not all important information can be shown in the accounts

Going Concern • Assets in the Accounts are valued on the basis that the business will continue for the foreseeable future • This is very important as assetsd may have very different values if business closed • Read Example 4 – Page 41 • Clearly this value is only justified by the continued mining for gold

Cost concept • Often referred to as historic cost • The assets of a business are shown at their cost of purchase and may not represent their “true” value • Some assets will have this historic cost written off over time as depreciation

Realisation Concept • Accounts will record profit when a sale is made. • This means that general increases in asset values are not recorded • Also means that cash does not have to exchanged • Read example 8 – page 45 • Accounts would record the sale on Jan 1

Accruals Concept • Revenues and expenses are included in accounts NOT to the extent that they have been paid but to the extent that they relate to the period of account • E.g. A company hires new machinery and pays £50,000 per year in advance on 1st July 2003. Only £25,000 expenses should be included in accounts to 31st December 2003

Matching Concept • In calculating profit, revenues should be matched with their relevant expenses • Read Example 11 – page 46 • Only the expenses to buy the 1,000 tins which have actually been sold are included in the calculation of profit

Periodicity Concept • Accounts cover a period of time – typically one year • Read Example 13 – page 48 • The accounting profit will necessarily only reflect transactions completed in the period • This may not reflect the longer term financial position

Consistency/Prudence Concepts • Consistency is desirable as it allows accounts to be compared for different years and for different businesses • Prudence means that generally accounts should avoid overstating asset values, should not anticipate profits and should provide for losses

The Accounting Equation. ASSETS = LIABILITIES + CAPITAL Resources Who supplied funding to buy the resources

The Accounting Equation. ASSETS - LIABILITIES = CAPITAL What What What business businessbusiness owns owesis worth

Total Assets Land & buildings machinery vehicles goodwill FIXED ASSETS TOTAL ASSETS CURRENT ASSETS Stocks Debtors Investments Cash

Total Liabilities debentures / loan stock LONG MATURING TOTAL LIABIL - ITIES CURRENT LIABILITIES trade creditors overdraft tax & dividend due

Capital SHAREHOLDER OWNERSHIP CAPITAL REVENUE Retained profit REVALUATION RESERVES

Exercises • Now try questions 1 & 2 on page 94 • These questions will help us to understand the accounting equation and the financial statements

Next Step • Now we understand the accounting equation and the general format of the Profit & Loss Account and Balance Sheet • The next step is to look at the process of recording financial transactions

Principles of Accounting Recording Accounting Transactions

Transactions & the Accounting Equation • It is possible to use the Accounting Equation to show a new Balance Sheet after each transaction • Look at pages 76 – 78 to demonstrate this • Many businesses have thousands of transactions so we do not want to draw up a Balance Sheet after each one • Instead we use double-entry bookkeeping

DOUBLE ENTRY SYSTEM ‘T’ - ACCOUNT “ACCOUNT NAME” DEBIT £CREDIT £ date referencedate reference

DOUBLE ENTRY SYSTEM ‘T’ - ACCOUNT RECORD DEBIT CREDIT ASSETSINCREASE DECREASE LIABILITIES DECREASE INCREASE CAPITAL DECREASEINCREASE

DOUBLE ENTRY SYSTEM LINK WITH BALANCE SHEET EQUATION ASSETS = LIABILITIES + CAPITAL + DEBIT - CREDIT + DEBIT + CREDIT - CREDIT - DEBIT + DEBIT + CREDIT - CREDIT - DEBIT

The concept of flows • An easy way to understand the process is to think of it as a flow • The flow outwards is shown on the right hand side of the account (credit) • The flow inwards is shown on the left hand side of the account (debit)

Rules for double entry system • The most important rule is that ALL transactions will have two entries • A credit entry and a debit entry • This means that all the flows of money stay within the accounting system • This also means that at any time the total of all debits and all credits must be equal

Calculating the balances on Accounts • To calculate the balance on the account, simply add up both sides of the account and calculate the difference • After the accounts are balanced (usually at the end of accounting period) this balance is brought down on the other side of the account • We can look at an example

DOUBLE ENTRY SYSTEM ‘T’ - ACCOUNT BANK ACCOUNT Debit £Credit £ date capital a/c 160 000 datepremises 90 000 datevehicle 20 000 date purchases 60 000

Class Exercise • Now let’s try a class exercise to practice making double entries and calculating balances • See attached notes for Tom Watson exercise

DOUBLE ENTRY SYSTEM PERIOD END TRIAL BALANCE Each debit or credit balance from each individual account is listed in a columnar TRIAL BALANCE. The debit balances are listed on the left and the credit balances on the right It is from the Trial balance that the Profit & Loss Account and Balance Sheet are constructed.

Errors in the Accounts • If the Trial Balance does not balance then an error has been made in the process of inputting data • However not all errors will have this result • E.g. if a transaction is completely overlooked

Class Exercises • Bringing accounts to Trial Balance stage is a very important part of Financial Accounting • Pages 90 – 93 give a long example which we should study • Look at how we deal with opening balances • Class exercises to practice are questions 3, 6 and 7 on pages 94 - 96

Principles of Accounting Periodic Measurement

Introduction • Double-entry bookkeeping is a system for recording accounting transactions • Business usually continues through time (i.e. it does not stop) but there is a general requirement for measurement of its performance at set time intervals • This is done by Profit & Loss Account (for the year) and Balance Sheet (at the year end)

Main problems • 1. Must identify the revenues for the year • And – need to match expenses to these revenues • 2. Need to make adjustments to determine whether revenues > expenses (profit) or expenses > revenues (loss) • These adjustments may involve use of judgement

Revenues & Expenses • The Trial Balance is the base for calculating profit • Look at the Trial Balance on Page 101 • Which are the flows for profits and which are capital flows ? • Which expenditure is directly to earn revenue and which to purchase assets ?

Revenue & Expenses • Revenue is money arising from the trading activities of the business • Revenue expenses are the costs of running the business during the accounting period (the period being measured) • Look at the figures on page 102 – do they match these definitions

The Accruals Concept • Now we have to make sure the revenues and expenses relate to this accounting period. This is the accruals concept • Expenses may have been paid in advance (prepayments) or may be due but not yet paid (accruals) • It is also possible that revenue may have accrued

Accrued Income • This is much less common than accrued expenses • It can apply to income other than sales • E.g. rent receivable • As this area is less important we can briefly review the workings on pages 103 - 104

Accrued expenses • This is a very important area • When possible businesses will delay payments • We have to check whether there are extra amounts due in accounts such as rent, wages and electricity • It is also possible that money may have been paid in advance • Two adjustments • Accruals for expenses of the year not yet paid • Exclude any payements already made that relate to the next year (these are prepayments)

Examples • The example on pages 104 – 108 demonstrates how this works • Once we understand this we can try Question 2 on page 112 – 113 • These is a further example of these principles on pages 109 - 110

Stock Adjustments • Most businesses buy goods for resale at a profit • Sometimes as finished items and sometimes as raw materials requiring further work • In our current system these goods will be showing as an expense under purchases • We should only charge this expense to profit to the extent that these goods have been sold and generated revenue (the matching concept) • Those purchases which are not sold should not be an expense against profit but should be recorded as stock • See page 110 – 111 and attempt question 1 on page 112 • Finally we should try question 4 on page 113

Shanghai University of Finance & Economics