Introduction to Basic accounting

Lecture 1: Purpose of Accounting and the Accounting Equation

Definition

Accounting may be defined as a series of processes and techniques used to identify, measure and communicate economic information which users find helpful in making decisions.

Points to note about the above definition

1. Accounting is a process. It must identify, record, analyse and summarise economic events. Record: entering the transaction evidenced by some sort of source document into the accounting system. Analyse: grouping similar transactions together after the initial recording. Summarise: produce reports or financial statements at regular intervals i.e. reporting. Economic events: events that will have a measurable financial or cash flow impact on the enterprise. 2. Accounting is a communication device. Accounting is not an end in itself; it provides/comminicates valuable economic information to users of accounts (who are they?) to enable them to make informed judgements and decisions. This begs the following question: when is information communicated valuable? To answer this question, we need to know WHO is going to use the information and what TYPES OF DECISIONS will have to be made. If we know the decision under consideration, it will be possible to identify the particular information requirements.

Unit 2

Introduction to Basic accounting

Users of information and their information requirements What decision? Has the company been employing its resources in the most effective way to maximise shareholder wealth? Has the company been a good corporate citizen? Are all our product lines profitable? How many units should we sell to break even? Should we invest in a new machine or undertake XYZ project? Make or buy decisions Buy, sell or hold shares? Will the company provide attractive remuneration, career path and retirement benefits? Is the business credit worthy and can it settle its debts as and when they fall due? Will interest and principal be repaid? What are the taxable profit of the company? Information requirements Profit for the whole enterprise Profit margins for individual products Costs absorbed in 1 unit of output Incremental future cashflows of a project and the cost of capital Sales by region Available resources (physical and intangible)

USERS Internal Owner-manager Directors/executives/functional managers

External Shareholders/ investors Employees

Suppliers

Overall profits of the enterprise Resources available Cash flow position of the enterprise

Lenders Tax authorities

The link between users of accounting information and branches of accounting

The above tale shows that users of accounting can be grouped into internal users and external users. External users (shareholders, suppliers, lenders, customers) are interested in the profits, financial position and cash flow reported by the business. Financial Accounting is that branch of Accounting that produces general-purpose financial statements aimed at providing information about the financial position (the balance sheet) and performance of the enterprise (the profit and loss account and cash flow statement).
Unit 2 2

Introduction to Basic accounting

Internal users (i.e management of all functions, production, marketing, administration, finance) are interested in obtaining relevant and timely information to assist them in their short term and long term decision making. Short-term decisions are based on the environment of today, and the physical, human and financial resources presently available to the firm. Long run or strategic decisions will commit the resources of the firm for a lengthy period of time and as such will have a profound effect on the firm's future financial position. Cost and Management accounting is that branch of accounting which is on the one hand concerned with ascertaining the cost of a product for stock valuation and profit measurement purposes and on the other provides relevant information to internal users to help them (i) make better short term and long term decisions (ii) effect control by comparing actual and planned outcomes. Relevance of information is at the heart of management accounting; if information is not relevant to the decision to be made, it has no value.

The accounting equation

How does a business make money? Well, first of all to start a business one needs funds or capital. Capital comes from two broad sources: the owner's past savings (known as equity) and/or borrowings (known as debt capital or liabilities). To make money, the business will then have to use the funds have to acquire resources (known as assets e.g plant, motor vehicles, stock for resale, land). At any point in time, therefore, the following relationship (known as accounting equation) will hold: Sources of Funds = Resources (uses of funds) Equity + Debt (or liabilities) = Assets

Equity = Assets - liabilities Assets are rights or access to future economic benefits controlled by an entity as a result of past transaction or events. Liabilities are the obligation of an entity to transfer economic benefits as a result of past events. Equity or ownership interest is the residual amount found by deducting all of the entity's liabilities from the entity's assets.

How does equity change from one period to the next?

3

Unit 2

Introduction to Basic accounting

Increases in Equity: 1. 2. 3. 4. Injection of new capital Profit ( Income > Expenses) Income Revaluation surpluses Revenue increases the companys assets. Expenses are costs that are incurred in earning revenue. To earn revenue the company must make use of its assets. Therefore expenses are that part of the cost of the assets which have been consumed by the business to earn revenue.

Decreases in Equity: 1. 2. 3. 4. Withdrawal of goods/stock/cash/other assets from the business for personal use. Loss (Income < Expenses) Expenses Revaluation deficits

The Extended Accounting Equation Equity + ( Income - Expenses ) + Liabilities

Assets =

Assets + Expenses = Equity + Income + Liabilities

The extended accounting equation and debits and credits

Debits and credits

Assets + Expenses

Equity + Revenue + Liabilities

Debit items

Credit items

All items to the left of the equation (assets and expenses) will be known as debit items.

All items to the right of the equation (equity, revenue and liabilities) will be known as credit items.

Unit 2

Introduction to Basic accounting

It follows that the sum of debits must equate with the sum of credits. This is the basis of the double-entry system.

If we debit a debit item, this means we are increasing the debit item. For instance, if we debit an asset item (remember an asset is a debit item), then we are increasing the asset item.

If we credit a credit item, this means we are increasing the credit item. For instance, if we credit revenue (remember revenue is a credit item), then we must be increasing revenue.

If we credit a debit item, this means that we are reducing the debit item. For instance, if we credit assets (remember asset is a debit item), then we must be decreasing the asset item.

If we debit a credit item, this means that we are reducing the credit item. For instance, if we debit liabilities (remember liabilities is a credit item), then we must be reducing the liability item.

All increase in asset accounts are typically shown as debit whilst all increases in liabilities and owners capital accounts are shown as credits. Revenue items will also have credit balances since revenue transactions result in increases in owners capital (or equity). Conversely, expense items normally have debit balances since these transaction result in decreases to owners capital (or equity).

Illustration of a T account

Dr Asset Account Increase Debit Decrease Credit

Cr

Dr Decrease Debit

Liability Account Increase Credit

Cr

Unit 2

CPAF I Lec I

ASSETS Dr Debit = Increase Credit = Decrease Cr

= Dr

LIABILITES Cr Debit = Decrease Credit = Increase

OWNERS CAPITAL (EQUITY) Dr Cr Debit = Decrease Credit = Increase

EXPENSES ITEMS

OWNERS DRAWINGS *

OWNERS CAPITAL

REVENUE ITEMS

Debit = Increase

Credit = Decrease

Debit = Credit = Increase Decrease

Debit = Decrease

Credit = Increase

Debit = Decrease

Credit = Increase

* NOTE: IN A COMPANY CONTEXT, TYPICAL WITHDRAWALS OF CAPITAL ARE KNOWN AS DIVIDENDS. DIVIDENTS ARE NOT EXPENSES.

CPAF I Lec I

SUMMARY RULES OF DEBIT AND CREDIT

General Ledger Account Type
Assets

Side of Account in which INCREASES are recorded

Debit

Side of Account in which

Typical

or

NORMAL

DECREASES are recorded BALANCE of the Account

Credit Debit

Liabilities Owners Account Owners Capital

Credit

Debit

Credit

Credit

Debit

Credit

Revenues Owners Drawings

Credit

Debit

Credit

Debit

Credit
Credit

Debit
Debit

Expenses

Debit

CPAF I Lec I

Tutorial: Peter (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) Peter started business with capital of Rs5,000 cash obtained from personal savings. Borrowed Rs1,000 from the bank. Bought 300 units @ Rs5 per unit, 60% being paid in cash and 40% on credit. Bought van costing Rs2,000 cash. Interest of Rs100 is paid. Sold 200 units of stock at Rs8 per unit, 40% paid in cash and 60% on credit. Create a provision for bad debts amounting to 5% of debtors at end of period. The van is to be depreciated by 10%. Tax of 25% is levied on accounting profits and is paid in the period in which the profit is earned.

Required: (a) (b) (c) Prepare the accounting equation. Prepare the profit and loss account for the period. Prepare the balance sheet.

CPAF I Lec I

Tutorial: Adam Smith (with answer to part (a) only) Transaction Adam smith deposited Rs50,000 into a business bank account to commence operations as "Adam's Gym Equipment shop" Purchased a motor vehicle for Rs32,000 by cash. Purchased office furniture on credit from HN Ltd for Rs3,000. Borrowed Rs35,000 from PH Finance Co. Purchased inventory for Rs25,000 cash from Wholesale Health Equipment Ltd. Paid Rs2,000 cash to HN Ltd as part payment of amount owed. Purchased inventory for Rs13,000 cash from Wholesale Health Equipment Ltd. Sold inventory (cost Rs2,700) for Rs 3,600. Sold inventory (cost Rs30,000) for Rs55,000 to Award Fitness on credit. Paid advertising account Rs250. Paid telephone bill Rs150. Paid wage Rs450. Adam Smith withdrew Rs350 from the business bank account for his own use. Received Rs55,000 from Award fitness in full payment of amount owed.

Date 1 July 7 July 8 July 10 July 12 July 12 July 13 July 14 July 16 July 18 July 18 July 18 July 20 July 21 July

Required: Assuming (I) a perpetual inventory system (a) Prepare the accounting equation. (b) Journalise the above transactions. (c) Prepare T accounts. (d) Extract a trial balance (list of balances) at 31 July. (e) Prepare the profit and loss statement (or Income statement) for the month of July. (f) Prepare a balance sheet at 31 July.

CPAF I Lec I

(a) The accounting equation under the perpetual inventory system

DEBIT ITEMS Date Mot. Vehi. @ cost Rs 32,000 3,000 35,000 -25,000 -2,000 -13,000 3,600 -250 -150 -450 -350 55,000 70,400 25,000 13,000 -2,700 -30,000 furni. @ cost Rs stock @cost Rs Cost of sales Rs = Owners Capital Rs 50,000 CREDIT ITEMS

1-Jul 7-Jul 8-Jul 10-Jul 12-Jul 12-Jul 13-Jul 14-Jul 16-Jul 18-Jul 18-Jul 18-Jul 20-Jul 21-Jul Total

Bank Rs 50,000 -32,000

Debtors Rs

Expenses Rs

Drawings

55,000

2,700 30,000 250 150 450 350

32,000

3,000

5,300

-55,000 0

32,700

850

350

= = = = = = = = = = = = = = = = =

Creditors Rs

Loan Rs

Revenue Rs

3,000 35,000 -2,000 3,600 55,000

50,000

1,000

35,000

58,600

10

11 Explanatory notes on the accounting equation: (i) (ii) (iii) (iv) All items to the left of the equation are debit items and all items to the right are credit items. Debit items include both assets and expenses/cost of sales. Credit items include owners capital, liabilities and Revenue. Expenses are debit items because they reduce owners capital. Since owners capital is a credit item, expenses must necessarily be a debit item. In fact, mathematically if expenses were shifted to the righthand side of the equation, expenses would have a minus sign indicating that owners equity would be reduced. Similarly, revenue is a credit item because it increases owners equity. (v) Cost of sales is a debit item because it is in fact an expense. An expense is basically incurred when an asset is consumed or used up to generate revenue. Cost of sales is therefore an expense since stock an asset - has to be used up or sold in order to generate revenue. Thus, the cost of the stock which has been sold constitutes the expense cost of sales. (vi) Therefore, when an item is sold there are in effect two double entries: (vii) Dr cost of sales AND Cr stock Dr Cash/ debtors (if sale is for cash/ if sale is on credit) AND Cr Revenue.

A perpetual inventory system is one where stock is continuously tracked. This implies that each time an item of stock is bought and sold, stock quantities and values are automatically updated. The key point about this system is that each time an item of stock is sold, the inventory system knows exactly the cost of that sold stock item and can therefore update the value of stock currently on hand. For instance, on the 14th of July, inventory costing Rs2,700 was sold for Rs 3,600. To update the value of stock, the perpetual inventory system must know the COST of the stock which has been sold i.e. Rs2,700! Thats why on the 14th July, the stock account in the accounting equation is reduced by Rs2,700.

M. Lamport/ F2/ Purpose of Accounting and A/c Equation