1 and 2 -fundamentals of accounting

8/6/2019 1 and 2 -Fundamentals of Accounting

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1Financial Accounting 2010 - Helena Isidro

Financial Accounting

An Introduction


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Topics covered by the course1 - The background of accounting

Background of financial reporting

Users of accounting information

International harmonization of financial reporting

2 - Fundamental accounting concepts and financial reports

Characteristics and components of financial information

The concept of profit and the income statement

The concepts of asset and liability and the balance sheet

Recording business transactions The double-entry bookkeeping

Cash versus accrual

Impairment and provisions


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Topics covered by the course

3 Current and non-current assets

The concept of inventory The perpetual and permanent system of recording inventory transactions Cost of sales under different cost flow assumptions

The concept of non-current asset Depreciation Disposal of non-current assets


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Assessement

Exam 80%

Class participation and exercise preparation 20%


5/685Financial Accounting 2010 - Helena Isidro

The power of accounting numbers


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7/687Financial Accounting 2010 - Helena Isidro

Accounting and business

Business

Resources:Materials, labour, services

Cash out:Payment of resourcesacquired

Outputs:Products, services

Cash in:Receipt for goodsand services soldDecisions & Actions

Accounting:Help making decisions about business


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Accounting definitionsDefinition of accounting

Accounting is a decision-support tool for users:

Identifies, measures and communicates financial information about anentity to permit informed judgements and decisions by users of theinformation

Two types of accounting

Financial accounting: designated to users external to the entity Managerial accounting: designated to users internal to the entity


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Accounting regulationAccounting regulation (standards)

Set of rules defining how to measure and report information about theentity economic activity

GAAP Generally accepted accounting principle is a generic term thatrefers to the set of rules and standards issued by various regulatory

bodies which companies are expected to comply with

Why do we need accounting standards?

For efficient decision-making investors, creditors, auditors and users ingeneral must have reliable, transparent and comparable financialinformation


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Accounting regulationAccounting standards have two objectives:

Define how to record individual business transactions. What methods touse

Define how to summarise these transactions into a form understandable

and useful to users. This involves the definition of:

Types and formats for financial statements, namely for the balancesheet and profit and loss account (income statement)

Disclosure requirements of relevant information


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Accounting regulationWho sets the rules? Economic and business conditions evolved differently in different countries and

consequently accounting systems of rules have also evolved differently acrosscountries

Sources of accounting regulation:

Legislation such as Commercial Code, Tax Code, Companies Act Rules issued by departments of the government (e.g. Ministry of Finance) Rules from the stock exchange entity (e.g. CMVM) Accounting standards issued by the accountancy profession Accounting standards issued by private organisations acting for the public

bodies


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Accounting standard setting In most countries accounting regulation is set through: code/law and a

standard setting body

Examples of standard setting bodies:

Portugal: Comissao Normalizacao Contabilistica www.cnc.min-financas.pt The

U.S.: Financial Accounting Standards Board (FASB) www.fasb.orgInternational Accounting Standard Board (IASB) www.iasb.org
http://www.fasb.org/http://www.iasb.org/http://www.iasb.org/http://www.fasb.org/


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Accounting standards. Does it matter?


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Accounting standards. Does it matter?

In 2002, Is BCP profitable?

If an investor wants to compare ROE from BCP with other investments.How much is ROE?

The business is unique. Different rules result in different performances?

Negative market reaction in the US market to BCP earningsannouncement. The company decided to delist


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Accounting standards. Does it matter?Portugal's biggest bank to drop Wall Street listing

11 January 2003Agence France-Presse

Portugal's largest private bank, Banco Comercial Portugues (BCP), will delistfrom the New York Stock Exchange because differences between US and European

accounting rules require it to present different sets of financial results, BCP presidentJorge

Jardim Goncalves said in an interview published on Saturday."In some circumstances we had to present reports and numbers which, no matter how many explanations were offered, were disturbing


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Accounting harmonisation European (EC) Directives (4 th, 1978 and 7 th,1983)

European Commission gave support to the increasingly important IASBby requiring listed f irms to prepare consolidated financial statements inaccordance with IFRS, from 1 January 2005 onwards

Currently, there are two major international sets of rules: IFRS and US GAAP

- Likely to converge

- November 2007, SEC (Securities and Exchange Commission) announcedthe decision to eliminate the reconciliation requirement for IFRS companies(effective March 2008)

- IFRS is expected to be mandatory in the US in the near future (3-5 years)


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Objective of financial informationAccounting standards identify usefulness to users as the main

objective of financial reporting

Provide information about the financial position, performance and changesin the financial position of an enterprise that is useful to a wide range ofusers in making economic decisions

IASB, framework

Provide information that is useful to present and potential investors,

creditors and other users in making rational investment, credit and similardecisions

FASB, Statement of Financial Accounting Concepts No 1


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Characteristics of financial information

Understandability Relevance Reliability Comparability

Predictivevalue

Feed-backvalue

Materiality

Substance over form

Neutrality

Faithful representation

Prudence

Completeness

Consistency

Timeliness Balancebenefit/costConstrains on reliable and relevant

information

According to IASB framework, useful financial information has the following attributes:


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Components of financial reporting Narrative information (e.g. auditors report, directors report, governance

report)

Financial statements (IAS 1)

Balance Sheet Profit and Loss Account/Income Statement

Cash Flow Statement Notes Statement of Movements in Shareholders Funds


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Balance sheet A balance sheet is a summary of the financial position of the

business at a particular point in time

It is a list of the business resources (assets) and the financingof those resources (liabilities and equity)

Resources / Investments

Sources / Financing

Cash in bank100,000 Own money100,000

Example: open a bank account to start a mobile-phone business


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Balance sheet

Resources /

Investments

Sources /

financingCash in bank100,000

Own money100,000

Inventory20,000

Credit to invent supplier20,000

Buy inventory (mobile-phones) to the business on credit

AssetsEquity

Liabilities


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Balance sheet equation

Resources /

Investments

Sources /

financingCash in bank100,000

Own money100,000

Inventory20,000

Credit to invent supplier20,000

AssetsEquity

Liabilities

Investments Financing

Assets = Equity + Liabilities

100,000 + 20,000 = 100,000 + 20,000


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Balance sheet equation

Assets = Equity + Liabilities

The fundamental accounting equation is

Assets - Liabilities = Equity

Or

In other words, Equity (Shareholders funds) is a residual interest whichis a claim on all assets after meeting the business liabilities

Total investments are financed by own capital and borrowed capital


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Brisa


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Brisa


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Balance sheet elementsAssets

(a) Resources controlled by the business as a result of past events (b) fromwhich future economic benefits are expected to flow to the business (c) can bemeasure with reliability

Current versus non-current (fixed) assets

Are these assets?

Brisa has built highways that will revert to the State at the end of theconcession contract without any compensation (note 2.6)

Brisa is developing an environmental project with Companhia dasLezirias to create bird observation zone in Ponta da Erva/Salinas deSaragoca (Environmental report note 6)


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Balance sheet elementsLiabilities

(a) present obligation of the entity arising from past events, (b) the settlementof which is expected to result in an outflow of resources, (c) measured withreliability

Current versus non current liabilities

Is this a liability?

The group (Brisa) has assumed the commitment to provide its employees withretirement pensions supplement under a defined benefits plan, havingconstituted autonomous pension funds for the purpose (note 2.16)

Equity

Residual interest in the assets of the entity after deducting all its liabilities


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Profit concept

Assets Equity

Cash in bank 100,000 +35,000 Share capital 100,000Profit +15,000

115,000

Liabilities

Inventory 20,000 -20,000 Accounts payable 20,000135,000 135,000

Sell all inventory to clients by 35,000 cash

Profit (15,000) is the difference between revenues (35,000) and expenses

(20,000)

Profit is the income generated by the business activity and it is part of ownersfunds (equity)


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Income statement The income statement (or profit and loss account) is a

summary of the financial performance of the business overa particular period in time

I/S reports the detailed elements of profit: Revenues (gains)

Sales turnover, interest revenue, extraordinary gains Expenses (costs)

Cost of sales, personnel expenses, interest expense, extraordinarylosses, tax expense

Profit = Revenues - Expenses

Brisa


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The fundamental equation revisitedRecall the fundamental accounting equation:

Assets = Liabilities + Equity

Assets = Liabilities + [ Capital&OthEquity + Profit ]

Extending equity into components:

For each individual transaction this relation is also true

Assets = Liabilities + [ Capital&OthEquity + Revenues Expenses ]

Assets = Liabilities + [Capital&OthEquity + Revenues Expenses ]


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Recording transactionsPaul&Mary FineFood restaurant

Transaction 1:Paul and Mary deposit 1,000 in a bank account to start the business


+ 1000 (Bank) = + 1000 (Share capital)


+ 250 (Inventory)- 250 (Bank)

Transaction 2:Purchase of 250 cash of goods for stock

Corresponds to the exchange of one asset (cash in bank) by another (inventory)


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Recording transactions

Transaction 3:Purchase of restaurant equipment on credit for 300


+ 300 (Fixed assets) = + 300 (Accounts payable)


- 240 (Bank) = - 240 (Accounts payable)

Transaction 4:Payment of 80% of the equipment bill

Part of accounts payable (liabilities) disappear from the balance sheet


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Recording transactionsTransaction 5:

Sale of meals for 150 cash which cost 100 Assets = Liabilities + Equity

- 100 (Inventory)

+ 150 (Bank)

= + 50 (profit)


- 30 (Bank) = - 30 (profit)

Transaction 6:Weekly salaries of 30 are paid to Paul and Mary

In Income Statement:

Sales revenue 150Cost of sales (100)

Profit 50

In Income Statement:

Salaries expense (30)

Profit (30)


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ASSETS = LIABI-LITIES

EQUITY

Transactions FixedAssets

Stock Cash&Bank

AccountsPayable

ShareCapital

RetainedProfit

Profit(I/S)

Initial capital 1 +1000 +1000Purchase pizzas 2 +250 -250Purchase of equi 3 +300 +300Payment equip 4 -240 -240Sales pizzas 5 +150 +150Cost of sales 5 -100 -100

Salaries 6 -30 -30

Closing balances 300 150 630 60 1000

Recording transactions in a worksheet

Use profitcolumn toprepare theincomestatement

Use this column toprepare the cash flowstatement

Use closing balancerow to preparebalance sheet


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Profit retention Profit retention means that profit should be transferred from the

income statement to the balance sheet

Specifically, the profit is transferred from profit for the year , a I/Saccount, and stocked in retained profit , which as an account withinequity

Sometimes this is recorded at year (U.K, U.S.) sometimes in the

following year (European countries)

Equity

Retained profit

Profit for the year

+20

-20


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ASSETS = LIABI-LITIES +

EQUITY

Transactions FixedAssets Inventory

Cash&Bank

AccountsPayable

ShareCapital

RetainedProfit

Profit(I/S)

Initial capital 1 +1000 +1000Purchase pizzas 2 +250 -250Purchase of equi 3 +300 +300Payment equip 4 -240 -240Sales pizzas 5 +150 +150

Cost of sales 5 -100 -100Salaries 6 -30 -30

Transfer toRetained profit

+20 -20

Closing balances 300 150 630 60 1000 +20

Profit retention


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Accounting principlesIn order to achieve the financial reporting objectives of providing useful information

for economic decision, financial statements must be prepared in accordance withfundamental accounting principles (IASB framework)

Going Concern

Assumes that business will continue to operate for the foreseeable future

Accrual Basis

Revenues and expenses are recognised when earned/incurred, not when moneyis received/paid

In most cases this will be achieved through matching revenues withcorresponding expenses


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Accrual principle: Cash and ProfitWhy is Cash different from Profit ?

Accounting numbers focus on the concept of economic profit

Income statement provides information on generation and consumptionof economic resources rather than on cash generation and expenditure

Timing of receipt/payment of income/expense is irrelevant - whatmatters is when revenue (income) and expenses are recognised

In one reporting period:

PROFITS AND CASH ARE NOT THE SAME

Brisa (2007)Profit = 255 mCash = 103 m


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Cash and Accounting ProfitExample:

Period 1 purchase of merchandise worth 10,000 on cash

Period 2 sale of all merchandise on credit for 15,000

Period 3 receipt of 15,000 from client

f


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Cash and Accounting ProfitPeriod 1 Period 2 Period 3 End of businessPurchase

merchandise on cash

Salemerchandise

on credit

Receiptfromclient

Revenue 15,000 15,000

Expense 10,000 10,000

Profit - 5,000 - 5,000Cash inflow 15,000 15,000

Cash outflow 10,000 10,000

Net cash (10,000) - 15,000 5,000

P r of i t =

C a s h

A t en

d of

t h e b u s i n

e s s

In individual periods cash is not equal to profit

d (C i )


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Prudence (Conservatism) A degree of caution should be applied in exercising judgment and making the

necessary estimates

In particular, gains should be treated as realized only when realized in the form ofcash. Losses are recognized faster (in profit) than gains

Examples :Doubts about the capability of a client to pay

Reduce profit immediately as if the client would not pay

Stocks bought for 1,000 have now a market value of 1,500

Do not recognize the gain until stock is actually sold

D f l d l


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Deferrals and accrualsFour major transactions create differences between cash and profits:

1. Expenses paid but not consumed

Prepayment or deferred expense

2. Expenses consumed but not paid

Accrued expense3. Revenues/income received in cash but not earned

Unearned revenue/income or deferred revenue/income

4. Revenues/income earned but not received in cash

Accrued revenue/income

P (d f d )


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Prepayments (deferred expenses) Prepayment is generated when a cash payment is made (or any other

asset given up) for an expense, which relates to a future accountingperiod

Example :Suppose that on 1 September 2008, a company pays an insurance

premium of 1.200 for the year ending 30 August 2009. If the companyproduces accounts with a year-end of 31 December, how should thisitem be treated?

P t


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Prepayments

1 Sept 31 Dec 2008 1 Jan 30 Aug 2009

Insurance usage/expense1,200/12 months x 4 = 400

Payment = 1,200

Prepayment/deferred = 800expense

Insurance usage/expense1,200/12 months x 8 = 800

Payment = -

Cancel prepayment = 800

A ti g f t


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Accounting for prepayments

Assets Equity

Deferredexpenses Cash Profit(I/S)2008Payment of insurance (1,200) (1,200)Defer to 2008 800 800

Closing balance 2008 800 (1,200) (400)2009

Opening balance 800 (1,200)Insurance expense (800) (800)

Closing balance 2009 0 (1,200) (800)

In the B/S worksheet

current assets

Acco nting for prep ments


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Accounting for prepaymentsIn the journal (excl. profit appropriation)

Dr insurance expense 1,200Cr cash 1,200

Dr deferred expense 800Cr insurance expense 800

Year 2008

Dr insurance expense 800Cr deferred expense 800

Year 2009

Accrued expenses


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Accrued expenses The accrual principle requires that we record a liability for all expenses

which have been incurred but not paid

If a bill/invoice is received, usual to classify liability as a trade

creditor/accounts payable if no bill/invoice received, classify as an accrued expense/liability

Example:

Company A closes account on 31 Dec. At the end of December2008, the company received the electricity bill for Nov/Dec 2008which will be paid in January 2009, in the amount of 500.

Company A did not received the telephone bill for the last quarterof 2008 but estimates a cost of 1,000

Accounting for accrued expenses


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Assets Liabilities EquityCash Accounts

payableProfit(I/S)

2008Electricity expense 500 (500)

2009

Payment of bill (500) (500)

Electricity bill



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Assets Liabilities EquityCash Accrued

expenseAccountspayable

Profit(I/S)

2008

Telephone expense 1,000 (1,000)

2009Receipt of bill (1,000) 1,000

Payment of bill (1,000) (1,000)

Telephone expense

current liabilities



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What if the telephone bill is 1,100?


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Unearned or deferred revenue


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Unearned or deferred revenue Cash received prior to the goods/service have been provided

We need to record the cash receipt but not the revenue in the I/S,as the accrual principle requires revenue to be recognised when

earned not when receipt occurs The way to do this is to set up a category of liability called

unearned or deferred revenue (income)

Example:

Homes plc, a letting agency, closes accounts on 31 Dec. At end ofDecember 2008, the company received rents of Jan and Feb 2009in the amount of 2,000

Accounting for deferred revenue


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Assets Liabilities Equity

Cash Deferred

revenue

Profit

(I/S)2008

Receipt of 2009 rents 2,000 2,000

2009

Rents revenue of2009

(2,000) 2,000

Accounting for deferred revenue

Accrued revenue


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Accrued revenue Revenue is earned but cash will be received only in future periods

Following the accrual principle, we recognise revenue but a cashinflow cannot be recorded

The way to do this is to set up a category of asset called accruedrevenue (income)

Example:

At 1 Oct 2008, Gameover plc invested 100,000 in GovernmentBonds. The bonds pay annual interests at 5% rate every 30 Sept.

The company prepares annual reports at 31 Dec.

Accounting for accrued revenue


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Interests earned in 2008 = (100,000 x 5%) / 12 x 3 = 1,250

Interests earned in 2009 = (100,000 x 5%) / 12 x 9 = 3,750

Assets EquityCash Accrued

revenueProfit(I/S)

2008

Interests earned 1,250 1,250

2009

Receipt of interestsearned in 2008

1,250 (1,250)

Interests earned andreceived in 2009 3,750 3,750

Accounting for accrued revenue

Impairment


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Impairment

Recall the prudence concept: A degree ofcaution/conservantism should be applied in exercising judgment

and making the necessary estimates An asset is impaired and impairment losses are incurred if there

is objective evidence of a loss event that has an impact on the

estimated future cash flows

Impairment of receivables


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Impairment of receivablesFor receivables, consider the following events:

(a) significant financial difficulty of borrower

(b) a breach of contract, such as a default or delinquency in interest orprincipal payments

(c) the lender granted to the borrower a concession that the lender wouldnot otherwise consider

(d) becomes probable that the borrower will enter bankruptcy or other

financial re-organisation



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Impairment of receivablesConsider the following example:

In period X1, company Zett plc sold goods to a client in the amount of 15,000,giving the client three-month credit

During X1, the client paid only 14,000. Despite being contacted several times bythe company the client did not to pay the remaining 1,000

At X2, the client reported financial difficulties and the debt was declared difficult tocollect

When should the loss be recognised in Zett plc accounts? In X2 only?

Recognition of the expense only in X2 and doing nothing in X1 is not a prudent

attitude. As a consequence, accounts in period X1 would reflect:- Overstatement of assets (accounts receivable) by 1,000

- Overstatement of profit (no recognition of the loss) by 1,000



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p

Assets EquityCash Impairment

ofreceivables(*)

Accreceivable

Profit(I/S)

Period X1

Sale 15,000 15,000

Receipt from sales 14,000 (14,000)

Impairment (1,000) (1,000)

Closing balance 14,000 (1,000) 1,000 14.000

The accounting entries are:

(*) also referred to as provision for doubtful debts



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p Note that in the B/S the impairment reduces the accounts receivable

account. Sometimes is referred to as adjustment to asset or contra-asset

Note also that in the I/S the impairment loss is a separate operationalexpense and is not deducted from sales revenue

Accounts receivable 1,000

Less

Impairment (1,000)

Sales revenue 15,000

Impairment loss (1,000)



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pWhat happens in period X2?

Client financial troubles are resolved and he agrees to pay 60% of the debt.

The remaining 40% will not be collected (becoming a bad debt)

The credit is solved and there no need to keep the impairment in the B/S:

reverse the impairment loss

Reverse impairment loss


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p

Assets EquityCash Impairment Acc

receivableProfit(I/S)

Retainedprofit

Period X2

Opening balance 14,000 (1,000) 1,000 14,000

Cash received 600 (1,000) (400)Reversion impair. 1,000 1,000

Part of the credit is collected (600), part is transferred to bad debt expense(400), the B/S allowance for impairment is cancelled (1,000) against the I/S(revenue)

Bad debt expenseOperational revenue

Provisions


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Provisions are represented in B/S as liabilities. These include: Restructuring provisions (e.g. future termination of a line of business, a

business in a country)

Environmental provisions (e.g. environmental liabilities, such as remediationcosts, related to past mining activities)

Decommissioning provisions (e.g. oil rig or nuclear power station needs to bedismantled at the end of its life)

Litigation and other legal claims


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Provisions for legal disputes


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Assets Liabilities EquityCash Provision Profit

(I/S)Retained

profit

2005Recognition provision 100.000 (100.000)

Closing balance 100,000 (100.000)

2006Opening balance 100.000Settlement / cancelprovision (90.000) (100.000) 10.000

Closing balance (90.000) 0 (90.000)

Provisions: British Airways plc


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LONDON: British Airways PLC was fined almost US$550 million(400 million) on Wednesday by U.S. and British regulators after theairline admitted to colluding with rival Virgin Atlantic over fuelsurcharges on long-haul flights

The Associated PressPublished: August 1, 2007

Suppose BA has recognized a provision of US$450 million in 2006 accountsconcerning these overcharge penalties. What accounting entries should BA do in2007 accounts (after regulators issued the fines of $US550)?

Provisions: British Airways plc


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The Associated PressPublished: August 1, 2007

What accounting entries should BA do in 2007 accounts in light of the prudenceprinciple?

In addition, U.S. officials said BA and Korean Air Lines were involved in aconspiracy with German carrier Lufthansa AG to fix charges for internationalcargo shipments."When British Airways, Korean Air and their co-conspirators got together andagreed to raise prices for passenger and air cargo fares, American consumersand businesses ended up picking up the tab for their illegal conduct," said ActingAssociate Attorney General William W. Mercer.In May, British Airways set aside US$710 million to pay for any possible fines as aresult of the investigations

1 and 2 -fundamentals of accounting

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