Principles of Accounting

Introduction to Accounting
Accountancy is the process of communicating financial information about a business entity to

users such as shareholders and managers (Elliot, Barry & Elliot, Jamie: Financial accounting and
reporting).
Accounting has been defined as:
the art of recording, classifying, and summarizing in a significant manner and in terms of
money, transactions and events which are, in part at least, of financial character, and
interpreting the results thereof.(AICPA)
Users of Accounting Information - Internal & External
Accounting information helps users to make better financial decisions. Users of financial
information may be both internal and external to the organization.
Internal users (Primary Users) of accounting information include the following:
Management: for analyzing the organization's performance and position and taking
appropriate measures to improve the company results.
Employees: for assessing company's profitability and its consequence on their future
remuneration and job security.
Owners: for analyzing the viability and profitability of their investment and determining
any future course of action.
Accounting information is presented to internal users usually in the form of management

accounts, budgets, forecasts and financial statements.
External users (Secondary Users) of accounting information include the following:
Creditors: for determining the credit worthiness of the organization. Terms of credit are
set by creditors according to the assessment of their customers' financial health. Creditors
include suppliers as well as lenders of finance such as banks.
Tax Authourities: for determining the credibility of the tax returns filed on behalf of the
company.
Investors: for analyzing the feasibility of investing in the company. Investors want to
make sure they can earn a reasonable return on their investment before they commit any
financial resources to the company.
Customers: for assessing the financial position of its suppliers which is necessary for
them to maintain a stable source of supply in the long term.
Regulatory Authorities: for ensuring that the company's disclosure of accounting

information is in accordance with the rules and regulations set in order to protect the
interests of the stakeholders who rely on such information in forming their decisions.
External users are communicated accounting information usually in the form of financial
statements. The purpose of financial statements is to cater for the needs of such diverse users of
accounting information in order to assist them in making sound financial decisions.
Accountancy encompasses the recording, classification, and summarizing of transactions and
events in a manner that helps its users to assess the financial performance and position of the
entity. The process starts by first identifying transactions and events that affect the financial
position and performance of the company. Once transactions and events are identified, they are
recorded, classified and summarized in a manner that helps the user of accounting information in
determining the nature and effect of such transactions and events.
Accounting is a very dynamic profession which is constantly adapting itself to varying needs of
its users. Over the past few decades, accountancy has branched out into different types of
accounting to cater for the different needs of the users.
Types of Accounting
Accounting is a vast and dynamic profession and is constantly adapting itself to the specific and
varying needs of its users. Over the past few decades, accountancy has branched out into
different types of accounting to cater for the diversity of needs of its users.
Main types of accounting
are as follows:
1. Financial
2. Management
3. Governmental
4. Tax
5. Forensic
6. Project
7. Social
Financial Accounting, or financial reporting, is the process of producing information for external
use usually in the form of financial statements. Financial Statements reflect an entity's past
performance and current position based on a set of standards and guidelines known as GAAP
(Generally Accepted Accounting Principles). GAAP refers to the standard framework of
guideline for financial accounting used in any given jurisdiction. This generally includes
accounting standards (e.g. International Financial Reporting Standards), accounting conventions,
and rules and regulations that accountants must follow in the preparation of the financial
statements.
Management Accounting produces information primarily for internal use by the company's
management. The information produced is generally more detailed than that produced for
external use to enable effective organization control and the fulfillment of the strategic aims and
objectives of the entity. Information may be in the form budgets and forecasts, enabling an
enterprise to plan effectively for its future or may include an assessment based on its past
performance and results. The form and content of any report produced in the process is purely
upon management's discretion.
Cost accounting is a branch of management accounting and involves the application of various
techniques to monitor and control costs. Its application is more suited to manufacturing concerns.
Governmental Accounting, also known as public accounting or federal accounting, refers to the
type of accounting information system used in the public sector. This is a slight deviation from
the financial accounting system used in the private sector. The need to have a separate
accounting system for the public sector arises because of the different aims and objectives of the
state owned and privately owned institutions. Governmental accounting ensures the financial
position and performance of the public sector institutions are set in budgetary context since
financial constraints are often a major concern of many governments. Separate rules are followed
in many jurisdictions to account for the transactions and events of public entities.
Tax Accounting refers to accounting for the tax related matters. It is governed by the tax rules
prescribed by the tax laws of a jurisdiction. Often these rules are different from the rules that
govern the preparation of financial statements for public use (i.e. GAAP). Tax accountants
therefore adjust the financial statements prepared under financial accounting principles to
account for the differences with rules prescribed by the tax laws. Information is then used by tax
professionals to estimate tax liability of a company and for tax planning purposes.
Forensic Accounting is the use of accounting, auditing and investigative techniques in cases of
litigation or disputes. Forensic accountants act as expert witnesses in courts of law in civil and
criminal disputes that require an assessment of the financial effects of a loss or the detection of a
financial fraud. Common litigations where forensic accountants are hired include insurance
claims, personal injury claims, suspected fraud and claims of professional negligence in a
financial matter (e.g. business valuation).
Project Accounting refers to the use of accounting system to track the financial progress of a
project through frequent financial reports. Project accounting is a vital component of project
management. It is a specialized branch of management accounting with a prime focus on
ensuring the financial success of company projects such as the launch of a new product. Project
accounting can be a source of competitive advantage for project-oriented businesses such as
construction firms.
Social Accounting, also known as Corporate Social Responsibility Reporting and Sustainability
Accounting, refers to the process of reporting implications of an organization's activities on its
ecological and social environment. Social Accounting is primarily reported in the form of
Environmental Reports accompanying the annual reports of companies. Social Accounting is still
in the early stages of development and is considered to be a response to the growing
environmental consciousness amongst the public at large.
Statement of Financial Position [Balance Sheet]

Definition
Statement of Financial Position, also known as the Balance Sheet, presents the financial position
of an entity at a given date. It is comprised of three main components: Assets, liabilities and
equity.
Statement of Financial Position helps users of financial statements to assess the financial
soundness of an entity in terms of liquidity risk, financial risk, credit risk and business risk.
Example
Following is an illustrative example of a Statement of Financial Position prepared under the
format prescribed by IAS 1 Presentation of Financial Statements.
Statement of Financial Position as at 31st December 2013

2013
Notes
USD
ASSETS
2012
USD
Non-current assets
Property, plant & equipment
Goodwill
Intangible assets
9
10
11
130,000
30,000
60,000
220,000
120,000
30,000
50,000
200,000
Current assets
Inventories
Trade receivables
Cash and cash equivalents
12
13
14
12,000
25,000
8,000
45,000
265,000
10,000
30,000
10,000
50,000
250,000
100,000
50,000
15,000
165,000
100,000
40,000
10,000
150,000
TOTAL ASSETS
EQUITY AND LIABILITIES
Equity
Share capital
Retained earnings
Revaluation reserve
Total equity
Non-current liabilities
Long term borrowings
35,000
50,000
Current liabilities
Trade and other payables
Short-term borrowings
Current portion of long-term borrowings
7
8
6
35,000
10,000
15,000
25,000
8,000
15,000
Current tax payable
Total current liabilities

Total liabilities
TATAL EQUITY AND LIABILITIES
5,000
65,000
100,000
265,000
2,000
50,000
100,000
250,000
You may download a free blank excel template of the statement of financial position. The
template is pre-linked with the cash flow statement and statement of changes in equity.
Classification of Components
Statement of financial position consists of the following key elements:
Assets
An asset is something that an entity owns or controls in order to derive economic benefits from
its use. Assets must be classified in the balance sheet as current or non-current depending on the
duration over which the reporting entity expects to derive economic benefit from its use. An asset
which will deliver economic benefits to the entity over the long term is classified as non-current
whereas those assets that are expected to be realized within one year from the reporting date are
classified as current assets.
Assets are also classified in the statement of financial position on the basis of their nature:
Tangible & intangible: Non-current assets with physical substance are classified as
property, plant and equipment whereas assets without any physical substance are
classified as intangible assets. Goodwill is a type of an intangible asset.
Inventories balance includes goods that are held for sale in the ordinary course of the
business. Inventories may include raw materials, finished goods and works in progress.
Trade receivables include the amounts that are recoverable from customers upon credit
sales. Trade receivables are presented in the statement of financial position after the
deduction of allowance for bad debts.
Cash and cash equivalents include cash in hand along with any short term investments
that are readily convertible into known amounts of cash.
Liabilities
A liability is an obligation that a business owes to someone and its settlement involves the
transfer of cash or other resources. Liabilities must be classified in the statement of financial
position as current or non-current depending on the duration over which the entity intends to
settle the liability. A liability which will be settled over the long term is classified as non-current
whereas those liabilities that are expected to be settled within one year from the reporting date
are classified as current liabilities.
Liabilities are also classified in the statement of financial position on the basis of their nature:
Trade and other payables primarily include liabilities due to suppliers and contractors for
credit purchases. Sundry payables which are too insignificant to be presented separately
on the face of the balance sheet are also classified in this category.
Short term borrowings typically include bank overdrafts and short term bank loans with a
repayment schedule of less than 12 months.
Long-term borrowings comprise of loans which are to be repaid over a period that
exceeds one year. Current portion of long-term borrowings include the installments of
long term borrowings that are due within one year of the reporting date.
Current Tax Payable is usually presented as a separate line item in the statement of
financial position due to the materiality of the amount.
Equity
Equity is what the business owes to its owners. Equity is derived by deducting total liabilities
from the total assets. It therefore represents the residual interest in the business that belongs to
the owners.
Equity is usually presented in the statement of financial position under the following categories:
Share capital represents the amount invested by the owners in the entity
Retained Earnings comprises the total net profit or loss retained in the business after
distribution to the owners in the form of dividends.
Revaluation Reserve contains the net surplus of any upward revaluation of property, plant
and equipment recognized directly in equity.
Rationale - Why the balance sheet always balances?

The balance sheet is structured in a manner that the total assets of an entity equal to the sum of
liabilities and equity. This may lead you to wonder as to why the balance sheet must always be in
equilibrium.
Assets of an entity may be financed from internal sources (i.e. share capital and profits) or from
external credit (e.g. bank loan, trade creditors, etc.). Since the total assets of a business must be
equal to the amount of capital invested by the owners (i.e. in the form of share capital and profits
not withdrawn) and any borrowings, the total assets of a business must equal to the sum of equity
and liabilities.
This leads us to the Accounting Equation: Assets = Liabilities + Equity
Purpose & Importance
Statement of financial position helps users of financial statements to assess the financial health of
an entity. When analyzed over several accounting periods, balance sheets may assist in
identifying underlying trends in the financial position of the entity. It is particularly helpful in
determining the state of the entity's liquidity risk, financial risk, credit risk and business risk.
When used in conjunction with other financial statements of the entity and the financial
statements of its competitors, balance sheet may help to identify relationships and trends which
are indicative of potential problems or areas for further improvement. Analysis of the statement
of financial position could therefore assist the users of financial statements to predict the amount,
timing and volatility of entity's future earnings.
Income Statement | Profit & Loss Account
Definition
Income Statement, also known as Profit & Loss Account, is a report of income, expenses and the
resulting profit or loss earned during an accounting period.
Topic contents:
1. Definition
2. Example
3. Basis of preparation
4. Components
5. Purpose & Use
6. Template
Example
Following is an illustrative example of an Income Statement prepared in accordance with the
format prescribed by IAS 1 Presentation of Financial Statements.
Income Statement for the Year Ended 31st December 2013
Notes
Revenue
Cost of Sales
16
17
Gross Profit
2013
USD
120,000
(65,000)
2012
USD
100,000
(55,000)
55,000
Other Income
Distribution Cost
Administrative Expenses
Other Expenses
Finance Charges
18
19
20
21
22
(15,000)
40,000
Profit before tax

Income tax
Net Profit
17,000
(10,000)
(18,000)
(3,000)
(1,000)
23
45,000
12,000
(8,000)
(16,000)
(2,000)
(1,000)
(15,000)
30,000
(12,000)
(9,000)
28,000
21,000
Basis of preparation
Income statement is prepared on the accruals basis of accounting.
This means that income (including revenue) is recognized when it is earned rather than when
receipts are realized (although in many instances income may be earned and received in the
same accounting period).
Conversely, expenses are recognized in the income statement when they are incurred even if
they are paid for in the previous or subsequent accounting periods.
Income statement does not report transactions with the owners of an entity.
Hence, dividends paid to ordinary shareholders are not presented as an expense in the income
statement and proceeds from the issuance of shares is not recognized as an income. Transactions
between the entity and its owners are accounted for separately in the statement of changes in
equity.
Components
Income statement comprises of the following main elements:
Revenue
Revenue includes income earned from the principal activities of an entity. So for example, in
case of a manufacturer of electronic appliances, revenue will comprise of the sales from
electronic appliance business. Conversely, if the same manufacturer earns interest on its bank
account, it shall not be classified as revenue but as other income.
Cost of Sales
Cost of sales represents the cost of goods sold or services rendered during an accounting period.
Hence, for a retailer, cost of sales will be the sum of inventory at the start of the period and
purchases during the period minus any closing inventory.
In case of a manufacturer however, cost of sales will also include production costs incurred in the
manufacture of goods during a period such as the cost of direct labor, direct material
consumption, depreciation of plant and machinery and factory overheads, etc.
You may refer to the article on cost of sales for an explanation of its calculation.
Other Income
Other income consists of income earned from activities that are not related to the entity's main
business. For example, other income of an entity that manufactures electronic appliances may
include:
Gain on disposal of fixed assets
Interest income on bank deposits
Exchange gain on translation of a foreign currency bank account
Distribution Cost
Distribution cost includes expenses incurred in delivering goods from the business premises to
customers.
Administrative Expenses
Administrative expenses generally comprise of costs relating to the management and support
functions within an organization that are not directly involved in the production and supply of
goods and services offered by the entity.
Examples of administrative expenses include:
Salary cost of executive management
Legal and professional charges
Depreciation of head office building
Rent expense of offices used for administration and management purposes
Cost of functions / departments not directly involved in production such as finance

department, HR department and administration department
Other Expenses
This is essentially a residual category in which any expenses that are not suitably classifiable
elsewhere are included.
Finance Charges
Finance charges usually comprise of interest expense on loans and debentures.
The effect of present value adjustments of discounted provisions are also included in finance
charges (e.g. unwinding of discount on provision for decommissioning cost).
Income tax
Income tax expense recognized during a period is generally comprised of the following three
elements:
Current period's estimated tax charge
Prior period tax adjustments
Deferred tax expense
Prior Period Comparatives

Prior period financial information is presented along side current period's financial results to
facilitate comparison of performance over a period.
It is therefore important that prior period comparative figures presented in the income statement
relate to a similar period.
For example, if an organization is preparing income statement for the six months ending 31
December 2013, comparative figures of prior period should relate to the six months ending 31
December 2012.
Purpose & Use
Income Statement provides the basis for measuring performance of an entity over the course of
an accounting period.
Performance can be assessed from the income statement in terms of the following:
Change in sales revenue over the period and in comparison to industry growth
Change in gross profit margin, operating profit margin and net profit margin over the
period
Increase or decrease in net profit, operating profit and gross profit over the period
Comparison of the entity's profitability with other organizations operating in similar

industries or sectors
Income statement also forms the basis of important financial evaluation of an entity when it is
analyzed in conjunction with information contained in other financial statements such as:
Change in earnings per share over the period
Analysis of working capital in comparison to similar income statement elements (e.g. the
ratio of receivables reported in the balance sheet to the credit sales reported in the income
statement, i.e. debtor turnover ratio)
Analysis of interest cover and dividend cover ratios
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Statement of Cash Flows
Definition
Statement of Cash Flows, also known as Cash Flow Statement, presents the movement in cash
flows over the period as classified under operating, investing and financing activities.
Topic Contents:
1. Definition
2. Example
3. Basis of Preparation
4. Operating Activities
5. Investment Activities
6. Financing Activities
7. Purpose & Importance
8. Template
Example
Following is an illustrative cash flow statement presented according to the indirect method
suggested in IAS 7 Statement of Cash Flows:
ABC PLC
Statement of Cash Flows for the year ended 31 December 2013
2013
Notes
USD
2012
USD
Cash flows from operating activities

Profit before tax
Adjustments for:
Depreciation
Amortization
Impairment losses
Bad debts written off
Interest expense
Gain on revaluation of investments
Interest income
Dividend income
Gain on disposal of fixed assets
Working Capital Changes:
4
4
5
14
16
15
40,000
35,000
10,000
8,000
12,000
500
800
(21,000)
(11,000)
(3,000)
(1,200)
8,000
7,500
3,000
1,000
(9,500)
(2,500)
(1,850)
35,100
40,650
Movement in current assets:

(Increase) / Decrease in inventory
Decrease in trade receivables
(1,000)
3,000
550
1,400
Movement in current liabilities:

Increase / (Decrease) in trade payables
2,500
(1,300)
Cash generated from operations
39,600
41,300
Dividend paid
Income tax paid
(8,000)
(12,000)
Net cash from operating activities (A)
19,600
(6,000)
(10,000)
25,300
Cash flows from investing activities

Capital expenditure
Purchase of investments
Dividend received
Interest received
Proceeds from disposal of fixed assets
Proceeds from disposal of investments
4
11
Net cash used in investing activities (B)
(100,000)
(25,000)
5,000
3,500
18,000
2,500
(85,000)
3,000
1,000
5,500
2,200
(96,000)
(73,300)
1000,000
(100,000)
(3,600)
100,000
(7,400)
Cash flows from financing activities

Issuance of share capital
Bank loan received
Repayment of bank loan
Interest expense
Net cash from financing activities (C)
896,400
Net increase in cash & cash equivalents (A+B+C)

Cash and cash equivalents at start of the year
Cash and cash equivalents at end of the year
Basis of Preparation
820,000
77,600
897,600
24
92,600
44,600
33,000
77,600
Statement of Cash Flows presents the movement in cash and cash equivalents over the period.
Cash and cash equivalents generally consist of the following:
Cash in hand
Cash at bank
Short term investments that are highly liquid and involve very low risk of change in value
(therefore usually excludes investments in equity instruments)
Bank overdrafts in cases where they comprise an integral element of the organization's
treasury management (e.g. where bank account is allowed to float between a positive and
negative balance (i.e. overdraft) as opposed to a bank overdraft facility specifically
negotiated for financing a shortfall in funds (in which case the related cash flows will be
classified under financing activities).
As income statement and balance sheet are prepared under the accruals basis of accounting, it is
necessary to adjust the amounts extracted from these financial statements (e.g. in respect of non
cash expenses) in order to present only the movement in cash inflows and outflows during a
period.
All cash flows are classified under operating, investing and financing activities as discussed
below.
Operating Activities
Cash flow from operating activities presents the movement in cash during an accounting period
from the primary revenue generating activities of the entity.
For example, operating activities of a hotel will include cash inflows and outflows from the hotel
business (e.g. receipts from sales revenue, salaries paid during the year etc), but interest income
on a bank deposit shall not be classified as such (i.e. the hotel's interest income shall be presented
in investing activities).
Profit before tax as presented in the income statement could be used as a starting point to
calculate the cash flows from operating activities.
Following adjustments are required to be made to the profit before tax to arrive at the cash flow
from operations:
1. Elimination of non cash expenses (e.g. depreciation, amortization, impairment losses, bad
debts written off, etc)
2. Removal of expenses to be classified elsewhere in the cash flow statement (e.g. interest
expense should be classified under financing activities)
3. Elimination of non cash income (e.g. gain on revaluation of investments)
4. Removal of income to be presented elsewhere in the cash flow statement (e.g. dividend
income and interest income should be classified under investing activities unless in case
of for example an investment bank)
5. Working capital changes (e.g. an increase in trade receivables must be deducted to arrive
at sales revenue that actually resulted in cash inflow during the period)
Investing Activities
Cash flow from investing activities includes the movement in cash flow as a result of the
purchase and sale of assets other than those which the entity primarily trades in (e.g. inventory).
So for example, in case of a manufacturer of cars, proceeds from the sale of factory plant shall be
classified as cash flow from investing activities whereas the cash inflow from the sale of cars
shall be presented under the operating activities.
Cash flow from investing activities consists primarily of the following:
Cash outflow expended on the purchase of investments and fixed assets
Cash inflow from income from investments
Cash inflow from disposal of investments and fixed assets
Financing activities
Cash flow from financing activities includes the movement in cash flow resulting from the
following:
Proceeds from issuance of share capital, debentures & bank loans
Cash outflow expended on the cost of finance (i.e. dividends and interest expense)
Cash outflow on the repurchase of share capital and repayment of debentures & loans

Statement of cash flows provides important insights about the liquidity and solvency of a
company which are vital for survival and growth of any organization. It also enables analysts to
use the information about historic cash flows to form projections of future cash flows of an entity
(e.g. in NPV analysis) on which to base their economic decisions. By summarizing key changes
in financial position during a period, cash flow statement serves to highlight priorities of
management. For example, increase in capital expenditure and development costs may indicate a
higher increase in future revenue streams whereas a trend of excessive investment in short term
investments may suggest lack of viable long term investment opportunities. Furthermore,
comparison of the cash flows of different entities may better reveal the relative quality of their
earnings since cash flow information is more objective as opposed to the financial performance
reflected in income statement which is susceptible to significant variations caused by the
adoption of different accounting policies.
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Statement of Changes in Equity
Definition
Statement of Changes in Equity, often referred to as Statement of Retained Earnings in U.S.
GAAP, details the change in owners' equity over an accounting period by presenting the
movement in reserves comprising the shareholders' equity.
Movement in shareholders' equity over an accounting period comprises the following elements:
Net profit or loss during the accounting period attributable to shareholders
Increase or decrease in share capital reserves
Dividend payments to shareholders
Gains and losses recognized directly in equity
Effect of changes in accounting policies
Effect of correction of prior period error
Example
Following is an illustrative example of a Statement of Changes in Equity prepared according to
the format prescribed by IAS 1 Presentation of Financial Statements.
ABC Plc
Statement of changes in equity for the year ended 31st December 2012
Balance at 1 January 2011
Share
Capital
Retained
Earnings
Revaluation
Surplus
Total
Equity
USD
USD
USD
USD
100,000
30,000
130,000
Changes in accounting policy

Correction of prior period error
Restated balance
100,000
30,000
130,000
Changes in equity for the year 2011

Issue of share capital
Income for the year
Revaluation gain
Dividends
Balance at 31 December 2011
25,000
(15,000)
10,000
10,000
25,000
10,000
(15,000)
100,000
40,000
150,000
30,000
(20,000)
5,000
-
30,000
5,000
(20,000)
100,000
50,000
15,000
165,000
Changes in equity for the year 2012

Issue of share capital
Income for the year
Revaluation gain
Dividends
Balance at 31 December 2012
Components
Following are the main elements of statement of changes in equity:
Opening Balance
This represents the balance of shareholders' equity reserves at the start of the comparative
reporting period as reflected in the prior period's statement of financial position. The opening
balance is unadjusted in respect of the correction of prior period errors rectified in the current
period and also the effect of changes in accounting policy implemented during the year as these
are presented separately in the statement of changes in equity (see below).
Effect of Changes in Accounting Policies
Since changes in accounting policies are applied retrospectively, an adjustment is required in
stockholders' reserves at the start of the comparative reporting period to restate the opening
equity to the amount that would be arrived if the new accounting policy had always been applied.
Effect of Correction of Prior Period Error
The effect of correction of prior period errors must be presented separately in the statement of
changes in equity as an adjustment to opening reserves. The effect of the corrections may not be
netted off against the opening balance of the equity reserves so that the amounts presented in
current period statement might be easily reconciled and traced from prior period financial
statements.
Restated Balance
This represents the equity attributable to stockholders at the start of the comparative period after
the adjustments in respect of changes in accounting policies and correction of prior period errors
as explained above.
Changes in Share Capital
Issue of further share capital during the period must be added in the statement of changes in
equity whereas redemption of shares must be deducted therefrom. The effects of issue and
redemption of shares must be presented separately for share capital reserve and share premium
reserve.
Dividends
Dividend payments issued or announced during the period must be deducted from shareholder
equity as they represent distribution of wealth attributable to stockholders.
Income / Loss for the period
This represents the profit or loss attributable to shareholders during the period as reported in the
income statement.
Changes in Revaluation Reserve
Revaluation gains and losses recognized during the period must be presented in the statement of
changes in equity to the extent that they are recognized outside the income statement.
Revaluation gains recognized in income statement due to reversal of previous impairment losses
however shall not be presented separately in the statement of changes in equity as they would
already be incorporated in the profit or loss for the period.
Other Gains & Losses
Any other gains and losses not recognized in the income statement may be presented in the
statement of changes in equity such as actuarial gains and losses arising from the application of
IAS 19 Employee Benefit.
Closing Balance
This represents the balance of shareholders' equity reserves at the end of the reporting period as
reflected in the statement of financial position.
Statement of changes in equity helps users of financial statement to identify the factors that cause
a change in the owners' equity over the accounting periods. Whereas movement in shareholder
reserves can be observed from the balance sheet, statement of changes in equity discloses
significant information about equity reserves that is not presented separately elsewhere in the
financial statements which may be useful in understanding the nature of change in equity
reserves. Examples of such information include share capital issue and redemption during the
period, the effects of changes in accounting policies and correction of prior period errors, gains
and losses recognized outside income statement, dividends declared and bonus shares issued
during the period.
Relationship between Financial Statements
Explanation
Financial Statements reflect the effects of business transactions and events on the entity. The
different types of financial statements are not isolated from one another but are closely related to
one another as is illustrated in the following diagram.
Balance Sheet
Balance Sheet, or Statement of Financial Position, is directly related to the income statement,
cash flow statement and statement of changes in equity.
Assets, liabilities and equity balances reported in the Balance Sheet at the period end consist of:
Balances at the start of the period;
The increase (or decrease) in net assets as a result of the net profit (or loss) reported in the
income statement;
The increase (or decrease) in net assets as a result of the net gains (or losses) recognized
outside the income statement and directly in the statement of changes in equity (e.g.
revaluation surplus);
The increase in net assets and equity arising from the issue of share capital as reported in
the statement of changes in equity;
The decrease in net assets and equity arising from the payment of dividends as presented
in the statement of changes in equity;
The change in composition of balances arising from inter balance sheet transactions not
included above (e.g. purchase of fixed assets, receipt of bank loan, etc).
Accruals and Prepayments
Receivables and Payables
Income Statement
Income Statement, or Profit and Loss Statement, is directly linked to balance sheet, cash flow
statement and statement of changes in equity.
The increase or decrease in net assets of an entity arising from the profit or loss reported in the
income statement is incorporated in the balances reported in the balance sheet at the period end.
The profit and loss recognized in income statement is included in the cash flow statement under
the segment of cash flows from operation after adjustment of non-cash transactions. Net profit or
loss during the year is also presented in the statement of changes in equity.
Statement of Changes in Equity
Statement of Changes in Equity is directly related to balance sheet and income statement.
Statement of changes in equity shows the movement in equity reserves as reported in the entity's
balance sheet at the start of the period and the end of the period. The statement therefore includes
the change in equity reserves arising from share capital issues and redemptions, the payments of
dividends, net profit or loss reported in the income statement along with any gains or losses
recognized directly in equity (e.g. revaluation surplus).
Cash Flow Statement
Statement of Cash Flows is primarily linked to balance sheet as it explains the effects of change
in cash and cash equivalents balance at the beginning and end of the reporting period in terms of
the cash flow impact of changes in the components of balance sheet including assets, liabilities
and equity reserves.
Cash flow statement therefore reflects the increase or decrease in cash flow arising from:
Change in share capital reserves arising from share capital issues and redemption;
Change in retained earnings as a result of net profit or loss recognized in the income
statement (after adjusting non-cash items) and dividend payments;
Change in long term loans due to receipt or repayment of loans;
Working capital changes as reflected in the increase or decrease in net current assets
recognized in the balance sheet;
Change in non current assets due to receipts and payments upon the acquisitions and
disposals of assets (i.e. investing activities)
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Purpose of Financial Statements
The objective of financial statements is to provide information about the financial position,
performance and changes in financial position of an enterprise that is useful to a wide range of
users in making economic decisions (IASB Framework).
Financial Statements provide useful information to a wide range of users:
Managers require Financial Statements to manage the affairs of the company by assessing its
financial performance and position and taking important business decisions.
Shareholders use Financial Statements to assess the risk and return of their investment in the
company and take investment decisions based on their analysis.
Prospective Investors need Financial Statements to assess the viability of investing in a company.
Investors may predict future dividends based on the profits disclosed in the Financial Statements.
Furthermore, risks associated with the investment may be gauged from the Financial Statements.
For instance, fluctuating profits indicate higher risk. Therefore, Financial Statements provide a
basis for the investment decisions of potential investors.
Financial Institutions (e.g. banks) use Financial Statements to decide whether to grant a loan or
credit to a business. Financial institutions assess the financial health of a business to determine
the probability of a bad loan. Any decision to lend must be supported by a sufficient asset base
and liquidity.
Suppliers need Financial Statements to assess the credit worthiness of a business and ascertain
whether to supply goods on credit. Suppliers need to know if they will be repaid. Terms of credit
are set according to the assessment of their customers' financial health.
Customers use Financial Statements to assess whether a supplier has the resources to ensure the
steady supply of goods in the future. This is especially vital where a customer is dependant on a
supplier for a specialized component.
Employees use Financial Statements for assessing the company's profitability and its
consequence on their future remuneration and job security.
Competitors compare their performance with rival companies to learn and develop strategies to
improve their competitiveness.
General Public may be interested in the effects of a company on the economy, environment and
the local community.
Governments require Financial Statements to determine the correctness of tax declared in the tax
returns. Government also keeps track of economic progress through analysis of Financial
Statements of businesses from different sectors of the economy.
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Limitations of Accounting & Financial Reporting
Accountancy assists users of financial statements to make better financial decisions. It is
important however to realize the limitations of accounting and financial reporting when forming
those decisions.
Following are the main limitations
of accounting and financial reporting:
1. Different accounting policies
2. Accounting estimates
3. Professional judgment
4. Verifiability
5. Use of historical cost basis
6. Measurability
7. Limited predictive value
8. Fraud and error
9. Cost benefit compromise
1. Different accounting policies and frameworks
Accounting frameworks such as IFRS allow the preparers of financial statements to use
accounting policies that most appropriately reflect the circumstances of their entities.
Whereas a degree of flexibility is important in order to present reliable information of a
particular entity, the use of diverse set of accounting policies amongst different entities impairs
the level of comparability between financial statements.
The use of different accounting frameworks (e.g. IFRS, US GAAP) by entities operating in
different geographic areas also presents similar problems when comparing their financial
statements. The problem is being overcome by the growing use of IFRS and the convergence
process between leading accounting bodies to arrive at a single set of global standards.
2. Accounting estimates
Accounting requires the use of estimates in the preparation of financial statements where precise
amounts cannot be established. Estimates are inherently subjective and therefore lack precision
as they involve the use of management's foresight in determining values included in the financial
statements. Where estimates are not based on objective and verifiable information, they can
reduce the reliability of accounting information.
3. Professional judgment
The use of professional judgment by the preparers of financial statements is important in
applying accounting policies in a manner that is consistent with the economic reality of an
entity's transactions. However, differences in the interpretation of the requirements of accounting
standards and their application to practical scenarios will always be inevitable. The greater the
use of judgment involved, the more subjective financial statements would tend to be.
4. Verifiability
Audit is the main mechanism that enables users to place trust on financial statements. However,
audit only provides 'reasonable' and not absolute assurance on the truth and fairness of the
financial statements which means that despite carrying audit according to acceptable standards,
certain material misstatements in financial statements may yet remain undetected due to the
inherent limitations of the audit.
5. Use of historical cost

Historical cost is the most widely used basis of measurement of assets. Use of historical cost
presents various problems for the users of financial statements as it fails to account for the
change in price levels of assets over a period of time. This not only reduces the relevance of
accounting information by presenting assets at amounts that may be far less than their realizable
value but also fails to account for the opportunity cost of utilizing those assets.
The effect of the use of historical cost basis is best explained by the use of an example.
Company A purchased a plant for $100,000 on 1st January 2006 which had a useful life of 10
years.
Company B purchased a similar plant for $200,000 on 31st December 2010.
Depreciation is charged on straight line basis.
At the end of the reporting period at 31st December 2010, the balance sheet of Company B
would show a fixed asset of $200,000 while A's financial statement would show an asset of
$50,000 (net of depreciation).
The scenario above presents an accounting anomaly. Even though the plant presented in A's
financial statements is capable of producing economic benefits worth 50% of Company B's asset,
it is carried at a historical cost equivalent of just 25% of its value.
Moreover, the depreciation charged in A's financial statements (i.e. $10,000 p.a.) does not reflect
the opportunity cost of the plant's use (i.e. $20,000 p.a.). As a result, over the course of the asset's
life, an amount of $100,000 would be charged as depreciation in A's financial statements even
though the cost of maintaining the productive capacity of its asset would have notably increased.
If Company A were to distribute all profits as dividends, it will not have the resources sufficient
to replace its existing plant at the end of its useful life. Therefore, the use of historical cost may
result in reporting profits that are not sustainable in the long term.
Due to the disadvantages associated with the use of historical cost, some preparers of financial
statements use the revaluation model to account for long-term assets. However, due to the
limited market of various assets and the cost of regular valuations required under revaluation
model, it is not widely used in practice.
An interesting development in accounting is the use of 'capital maintenance' in the determination
of profit that is sustainable after taking into account the resources that would be required to
'maintain' the productivity of operations. However, this accounting basis is still in its early stages
of development.
6. Measurability
Accounting only takes into account transactions that are capable of being measured in monetary
terms. Therefore, financial statements do not account for those resources and transactions whose
value cannot be reasonably assigned such as the competence of workforce or goodwill.
7. Limited predictive value
Financial statements present an account of the past performance of an entity. They offer limited
insight into the future prospects of an enterprise and therefore lack predictive value which is
essential from the point of view of investors.
8. Fraud and error
Financial statements are susceptible to fraud and errors which can undermine the overall
credibility and reliability of information contained in them. Deliberate manipulation of financial
statements that is geared towards achieving predetermined results (also known as 'window
dressing') has been a unfortunate reality in the recent past as has been popularized by major
accounting disasters such as the Enron Scandal.
9. Cost benefit compromise
Reliability of accounting information is relative to the cost of its production. At times, the cost of
producing reliable information outweighs the benefit expected to be gained which explains why,
in some instances, quality of accounting information might be compromised.
Accounting Concept and Principles
Accounting Concepts and Principles are a set of broad conventions that have been devised to
provide a basic framework for financial reporting. As financial reporting involves significant
professional judgments by accountants, these concepts and principles ensure that the users of
financial information are not mislead by the adoption of accounting policies and practices that go
against the spirit of the accountancy profession. Accountants must therefore actively consider
whether the accounting treatments adopted are consistent with the accounting concepts and
principles.
In order to ensure application of the accounting concepts and principles, major accounting
standard-setting bodies have incorporated them into their reporting frameworks such as the IASB
Framework.
Following is a list of the major
accounting concepts and principles:
Relevance
Reliability
Matching Concept
Timeliness
Neutrality
Faithful Representation
Prudence
Completeness
Single Economic Entity Concept
Money Measurement Concept
Comparability/Consistency
Understandability
Materiality
Going Concern
Accruals
Business Entity
Substance over Form
Realization Concept
Duality Concept
In case where application of one accounting concept or principle leads to a conflict with another
accounting concept or principle, accountants must consider what is best for the users of the
financial information. An example of such a case would be the trade off between relevance and
reliability. Information is more relevant if it is disclosed timely. However, it may take more time
to gather reliable information. Whether reliability of information may be compromised to ensure
relevance of information is a matter of judgment that ought to be considered in the interest of the
users of the financial information.
Elements of the financial Statements

Elements of the financial statements include Assets, Liabilities, Equity, Income & Expenses. The
first three elements relate to the statement of financial position whereas the latter two relate to
the income statement.
The first three elements relate to the statement of financial position while the latter two relate to
income statements.
Assets
Definition
Asset is a resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity (IASB Framework).
Explanation
In simple words, asset is something which a business owns or controls to benefit from its use in
some way. It may be something which directly generates revenue for the entity (e.g. a machine,
inventory) or it may be something which supports the primary operations of the organization
(e.g. office building).
Classification
Assets may be classified into Current and Non-Current. The distinction is made on the basis of
time period in which the economic benefits from the asset will flow to the entity.
Current Assets are ones that an entity expects to use within one-year time from the reporting
date.
Non Current Assets are those whose benefits are expected to last more than one year from the
reporting date.
Types and Examples

Following are the most common types of Assets and their Classification along with the economic
benefits derived from those assets.
Asset
Classification Economic Benefit
Machine
Non-current
Used for the production of goods for sale to customer.
Office
Building
Non-current
Provides space to employees for administering company affairs.
Vehicle
Non-current
Used in the transportation of company products and also for

commuting.
Inventory
Current
Cash is generated from the sale of inventory.
Cash
Current
Cash!
Receivables
Current
Will eventually result in inflow of cash.
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oncept of Double Entry
Every transaction has two effects. For example, if someone transacts a purchase of a drink from a
local store, he pays cash to the shopkeeper and in return, he gets a bottle of dink. This simple
transaction has two effects from the perspective of both, the buyer as well as the seller. The
buyer's cash balance would decrease by the amount of the cost of purchase while on the other
hand he will acquire a bottle of drink. Conversely, the seller will be one drink short though his
cash balance would increase by the price of the drink.
Accounting attempts to record both effects of a transaction or event on the entity's financial
statements. This is the application of double entry concept. Without applying double entry
concept, accounting records would only reflect a partial view of the company's affairs. Imagine if
an entity purchased a machine during a year, but the accounting records do not show whether the
machine was purchased for cash or on credit. Perhaps the machine was bought in exchange of
another machine. Such information can only be gained from accounting records if both effects of
a transaction are accounted for.
Traditionally, the two effects of an accounting entry are known as Debit (Dr) and Credit (Cr).
Accounting system is based on the principal that for every Debit entry, there will always be an
equal Credit entry. This is known as the Duality Principal.
Debit entries are ones that account for the following effects:
Increase in assets
Increase in expense
Decrease in liability
Decrease in equity
Decrease in income
Credit entries are ones that account for the following effects:
Decrease in assets
Decrease in expense
Increase in liability
Increase in equity
Increase in income
Double Entry is recorded in a manner that the Accounting Equation is always in balance.
Assets - Liabilities = Capital
Any increase in expense (Dr) will be offset by a decrease in assets (Cr) or increase in liability or
equity (Cr) and vice-versa. Hence, the accounting equation will still be in equilibrium.
Examples of Double Entry
1. Purchase of machine by cash
Debit
Credit
Machine (Increase in Asset)

Cash (Decrease in Asset)
2. Payment of utility bills

Debit
Credit
Utility Expense (Increase in Expense)

Cash (Decrease in Asset)
3. Interest received on bank deposit account

Debit
Credit
Cash (Increase in Asset)

Finance Income (Increase in Income)
4. Receipt of bank loan principal

Debit
Credit

Bank Loan (Increase in Liability)
5. Issue of ordinary shares for cash

Debit
Credit
Share Capital (Increase in Equity)
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Debits & Credits in Accounting
What are debits and credits?
Debit and Credit are the respective sides of an account.
Debit refers to the left side of an account.
Credit refers to the right side of an account.
Topic Contents:
1. Definition
2. Explanation
3. Illustration
4. Examples
Explanation
In accounting, every account or statement (e.g. accounting ledger, trial balance, profit and loss
account, balance sheet) has 2 sides known as debit and credit.
In a typical accounting ledger (often referred to as a T-Account) the debit and credit sides are
split horizontally as shown below:
Date
01-Dec-14
Particulars
Sales
XYZ Receivable A/C

$
Date
12,500 10-Dec-14
10-Dec-14
12,500
Particulars
Discount allowed
Bank
$
500
12,000
12,500
According to the dual aspect principle, each accounting entry is recorded in 2 equal debit and
credit portions. In other words, the total amount that will be recorded in the left side (debit) of
accounting ledgers will always equal to the total amount recorded on the right side (credit).
For example, you may consider how the accounting entries have been recorded in the Receivable
A/C shown above.
The ledger has been debited on account of credit sales amounting $12,500 and (as can be
ascertained from the particulars) the same amount has been credited in the Sales A/C. Similarly,
the credit entries in the Receivable A/C relating to discount allowed and bank receipts are
matched with equal amounts recorded on the debit sides of Discount Allowed A/C and Bank A/C
respectively.
In case of any confusion, please refer Accounting for Sales section for more thorough
explanation of the accounting entries discussed above.
Now the question arises, how do we know what to record on the debit side of an account and
what to record on the credit side?
Accounting has specific rules regarding what should be debited and what should be credited as
summarized in the chart below:
Debit Entries account for:
Increase in assets
Increase in expenses
Decrease in liabilities
Decrease in income
Decrease in equity
Credit Entries account for:

Decrease in assets
Decrease in expenses
Increase in liabilities
Increase in income
Increase in equity
Assets, expenses, liabilities, income & equity are the 5 elements of financial statements. For
explanation and examples of the various elements, please refer elements of financial statements
section.
As with accounting ledgers, all accounting statements are based on the rules of debit and credit.
For example, in a balance sheet, assets are reported on the debit side whereas liabilities and
equity are presented on the credit side. Although traditional accounts and statements are
presented in a T-Account format as above (which makes understanding debits and credits a bit
easier for beginners) many accounts and statements nowadays are reported in a vertical format.
But fear not! As long as you master the rules of debit and credit, you shall have no problem in
understanding their application and presentation.
Example
Record the debit and credit entries of the following transactions:

a) Purchase of an office building for $1 million via funds transfer
b) Bonus payable to various employees amounting $5 million
c) Credit Sales during the period amounting $7 million
d) Issuance of ordinary shares at par for $10 million
a) Purchase of an office building
Debit
Credit
Account
Office Building
Bank
$
1,000,000
1,000,000
Effect
Increase in Asset
Decrease in Assets
$
5,000,000
5,000,000
Effect
Increase in Expense
Increase in Liabilities
$
7,000,000
7,000,000
Effect
Increase in Asset
Increase in Income
$
10,000,000
10,000,000
Effect
Increase in Asset
Increase in Equity
b) Performance Bonus
Debit
Credit
Account
Salaries, wages and benefits
Bonus Payable
c) Credit Sales
Debit
Credit
Account
Accounts Receivables
Sales Revenue
d) Issuance of ordinary shares
Debit
Credit
Account
Bank
Share Capital
If you face any problem in understanding the double entries, please refer double entry
accounting section.
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Ledger Accounts
Accounting Entries are recorded in ledger accounts. Debit entries are made on the left side of the
ledger account whereas Credit entries are made to the right side. Ledger accounts are maintained
in respect of every component of the financial statements. Ledger accounts may be divided into
two main types: balance sheet ledger accounts and income statement ledger accounts.
Balance Sheet Ledger Accounts
Balance Sheet ledger accounts are maintained in respect of each asset, liability and equity
component of the statement of financial position.
Following is an example of a receivable ledger account:
Debit
Balance b/d
Sales
1
2
500
1000
1500
Receivable Account
$
Credit
Cash
Balance c/d
$
3
4
500
1000
1500
Balance brought down is the opening balance is in respect of the receivable at the start of
the accounting period.
These are credit sales made during the period. Receivables account is debited because it
has the effect of increasing the receivable asset. The corresponding credit entry is made to
the Sales ledger account. The account in which the corresponding entry is made is always
shown next to the amount, which in this case is the Sales ledger.
This is the amount of cash received from the debtor. Receiving cash has the effect of
reducing the receivable asset and is therefore shown on the credit side. As it can seen, the
corresponding debit entry is made in the cash ledger.
This represents the balance due from the debtor at the end of the accounting period. The
figure has been arrived by subtracting the amount shown on the credit side from the sum
of amounts shown on the debit side. This accounting period's closing balance is being
carried forward as the opening balance of the next period.
Similar ledger accounts can be made for other balance sheet components such as payables,
inventory, equity capital, non current assets and so on.
Income Statement Ledger Accounts
Income statement ledger accounts are maintained in respect of incomes and expenditures.
Following is an example of electricity expense ledger:
Debit
Cash
$
1
1,000
1,000
Electricity Expense Account

Credit
Income Statement
$
2
1,000
1,000
This is the amount of cash paid against electricity bill. The expense ledger is being
debited to account for the increase in expense. The corresponding credit entry has been
made in the cash ledger.
This represents the amount of expense charged to the income statement. The balance in
the ledger has been recycled to the income statement which is being debited by the same
amount. Unlike balance sheet ledger accounts, there is no balance brought down or
carried forward. Instead, the income statement ledger is closed each accounting period
end with the balancing figure representing the charge to income statement.
Similar ledger accounts can be made for other income statement components.
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Accounting Equation
Double entry is recorded in a manner that the accounting equation is always in balance:
Assets = Liabilities + Equity
Assets of an entity may be financed either by external borrowing (i.e. Liabilities) or from internal
sources of finance such as share capital and retained profits (i.e. Equity). Therefore, assets of an
entity will always equal to the sum of its liabilities and equity.
The accounting equation may be re-arranged as follows:
Assets - Liabilities = Equity
We may test the Accounting Equation by incorporating the effects of several transactions to see
whether it still balances as theorized in the accountancy literature. For the purpose of this test, we
may classify accounting transaction into the following generic types:
Transactions that only affect Assets of the entity
Transactions that affect Assets and Liabilities of the entity
Transactions that affect Assets and Equity of the entity
Transactions that affect Liabilities and Equity of the entity
Note:
For all the examples on the next pages, it will be assumed that before any transaction, Assets of
ABC LTD are $10,000 while its Liabilities and Equity are $5,000 each.
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Sales
Definition
Revenue is the gross inflow of economic benefits during the period arising in the course
of the ordinary activities of an entity when those inflows result in increase in equity, other
than increases relating to contributions from equity participants (IAS 18).
Explanation
Sale Revenue is the gross inflow of economic benefits. It must not be netted off against
expenses. Sale is generated through the ordinary activities of the business. Incomes generated
through activities that are not part of the core business operations of the business are not
classified as sale revenue but are classified instead as gains. For instance, sale revenue of a
business whose main aim is to sell biscuits is income generated from selling biscuits. If the
business sells one of its factory machines, income from the transaction would be classified as a
gain rather than sale revenue.
Sale revenue is an increase in equity during an accounting period except for such increases
caused by the contributions from owners (equity participants). Sale revenue must result in
increase in net assets (equity) of the entity such as by inflow of cash or other assets. However,
net assets of an entity may increase simply by further capital investment by its owners even
though such increase in net assets cannot be regarded as sale revenue.
Sale revenue may arise from the following sources:
Sale of goods
Provision of services
Revenue from use of entity's assets by third parties such as interest, royalties and
dividends.
Accounting for Sales

As sale results in increase in the income and assets of the entity, assets must be debited whereas
income must be credited. A sale also results in the reduction of inventory, however the
accounting for inventory is kept separate from sale accounting as will be further discussed in the
inventory accounting section.
A sale may be made on cash or on credit.
Cash Sale
When a cash sale is made, the following double entry is recorded:
Debit
Cash
Credit
Sales Revenue (Income Statement)
Cash is debited to account for the increase in cash of the entity.

Sale Revenue is credited to account for the increase in the income.
Credit Sale
In case of a credit sale, the following double entry is recorded:
Debit
Receivable
Credit
Sales Revenue (Income Statement)
The double entry is same as in the case of a cash sale, except that a different asset account is
debited (i.e. receivable).
When the receivable pays his due, the receivable balance will have be reduced to nil. The
following double entry is recorded:
Debit
Cash
Credit
Receivable
Recognition of Sales
It may be confusing to identify the point when a sale occurs. Do we recognize sale when the
goods are dispatched to customers, when the customer receives those goods, or when we receive
the payment in respect of those goods? In case of sale of goods, sale is generally said to occur
when the seller transfers the risks and rewards pertaining to the asset sold to the buyer. This
generally happens when buyer has received the asset. The receipt of payment from the customer
is not relevant to the recognition of sale since income is recorded under the accruals basis.
Sales Tax
Sales Tax, also known as Value Added Tax, is applied on most goods and services. It is a form of
indirect tax bourne by the ultimate customer. Company making sales to a customer collects the
sales tax from the customer on behalf of the tax authorities. The company is therefore acting as
an agent of government as a collector of sales tax.
A company itself also pays tax in respect of the purchases of goods and services from other
suppliers. However, the company would be able to recover the tax paid on such purchases from
the tax authorities. What the company finally pays or receives is the difference between sales tax
it collected from customers (output tax) and sales tax it paid on purchases (input tax). If the
output tax exceeds the input tax, the company will pay the difference to tax authorities.
Conversely, if input tax exceeds the output tax, then it may recover the difference from tax
authorities. The settlement of sales tax is processed by the submission of periodic tax returns by
the company.
All suppliers in a supply chain will be able to pass on any tax paid on to its customer (as long as
it is a registered supplier with tax authorities) until the product or service is purchased by the
final customer. Such customers cannot recover the sales tax they pay on their purchase and are
therefore the ultimate payers of sales tax. Companies are also final consumers in respect of
certain goods and services they consume and must therefore bear sales tax on such purchases.
Accounting for Sales Tax
Since an entity is only collecting sales tax on behalf of tax authorities, output tax must not be
shown as part of income. Therefore, sales revenue is shown net of any sales tax received from
customers. The accounting entry to record the sale involving sales tax will therefore be as
follows:
Debit
Credit
Credit
Cash / Receivable (Gross Amount)

Sales (Net Amount)
Sales (Tax Amount)
The receivable includes the amount of sales tax since it will be recovered from the customer.
Sales is recorded net of sales tax because any sales tax received on the sales will be returned to
tax authorities and hence, does not form part of income.
Sales tax account is credited since this is the amount of tax payable that will be paid to tax
authorities.
Where the initial sale was made on credit, subsequent receipt of dues from the customer will
result in the following double entry:
Debit
Credit
Cash (Gross Amount)

Receivable (Gross Amount)
Sales Tax Example

Bike LTD sells a mountain bike to XYZ for $115 on credit. Sales tax is 15%.
As the sale of $115 includes an element of sales tax, we need to first separate tax from the gross
amount. Sales tax on the transaction may be calculated as follows:
Sales Tax: 115 x 15/115 = $15
Deducting sales tax from the gross sale revenue, we may now arrive at the tax exclusive sale
value:
Tax Exclusive Sales: 115 - 15 = $100
This is the amount to be recognized as sales in the income statement. The accounting entry will
therefore be as follows:
$
Debit
Credit
Credit
XYZ (Receivable)
Sales
Sales Tax
$
115
100
15
Upon receipt of the amount receivable from XYZ, following double entry will be made:
$
Debit
Credit
Cash
XYZ (Receivable)
$
115
The sales tax payable of $15 will stand until it is paid to the tax authorities.
Sales Returns
Sales returns, or returns inwards, are a normal part of business. Goods may be returned to
supplier if they carry defects or if they are not according to the specifications of the buyer.
Accounting for Sales Returns
There is need to account for sale returns as though no sale had occurred in the first place.
115
Hence, the value of goods returned must be deducted from the sale revenue.
If sale was initially made on credit, the receivable recognized must be reversed by the amount of
sales returned. If the sales in respect of the returns were made for cash, then a payable must be
recognized to acknowledge the liability to reimburse the customer the amount he had paid for
those purchases.
Sales Return - Credit Sale
In case of credit sale, the following double entry must be made upon sales returns:
Debit
Credit
Sales Return (decrease in income)

Receivable (decrease in asset)
Example:
Bike LTD sells a mountain bike to XYZ for $100 on credit. XYZ later returns the bike to Bike
LTD due to a serious defect in the design of the bike.
The initial sale will be recorded as follows:
$
Debit
Credit
XYZ (Receivable)
Sales
$
100
100
Upon the return of bike, the following double entry will be passed:
$
Debit
Credit
Sales Return
XYZ (Receivable)
$
100
No further entry will be required as the receivable due from XYZ has been reversed.
Sales Returns - Cash Sales
In case of cash sale, the following double entry must be made upon sales returns:
Debit
Credit
Sales Return (decrease in income)

Payable (increase in liability)
Example:
Bike LTD sells a mountain bike to XYZ for $100 on cash. XYZ later returns the bike to Bike
LTD due to a serious defect in the design of the bike.
100
The initial sale will be recorded as follows:

$
Debit
Credit
Cash
Sales
$
100
100
Upon the return of bike, the following double entry will be passed:
$
Debit
Credit
Sales Return
XYZ (Payable)
$
100
100
When Bike LTD will pay XYZ $100 in respect of the sales return, the following double entry
will be recorded:
$
Debit
XYZ (Payable)
Credit
Cash
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$
100
100
Accounting Treatment for Discounts on Sales

Discounts may be offered on sales of goods to attract buyers. Discounts may be classified into
two types:
Trade Discounts: offered at the time of purchase for example when goods are purchased in bulk
or to retain loyal customers.
Cash Discount: offered to customers as an incentive for timely payment of their liabilities in
respect of credit purchases.
Trade Discount
Trade discounts are generally ignored for accounting purposes in that they are omitted from
accounting records.
Therefore, sales, along with any receivables in the case of a credit sale, are recorded net of any
trade discounts offered.
Example:
Bike LTD as part of its sales promotion campaign has offered to sell their bikes at a 10%
discount on their listed price of $100.
Sales will be recorded net of trade discount, i.e. $90 per bike.
Cash Discount
Cash discounts result in the reduction of sales revenue earned during the period. However, not all
customers may qualify for the cash discount. It is therefore necessary to record the initial sale at
the gross amount (after deducting any trade discounts!) and subsequently decreasing the sale
revenue by the amount of discount that is actually allowed.
Following double entry is required to record the cash discount:
Debit
Credit
Discount Allowed (income statement)

Receivable
Debiting discount allowed ledger has the effect of reducing gross sales revenue by the amount of
cash discount allowed. Consequently, receivables are credited to reduce their balance to the
amount that is expected to be recovered from them, i.e. net of cash discount.
Example:
Bike LTD as part of its sales promotion campaign has offered to sell their bikes at a 10%
discount on their listed price of $100. If customers pay within 10 days from the date of purchase,
they get a further $5 cash discount. Bike LTD sells a bike to XYZ who pays within 10 days.
Before we proceed with the accounting entries, it is necessary to first distinguish between the
two types of discounts being offered by Bike LTD. The 10% discount is a trade discount and
should therefore not appear in Bike LTD's accounting records. The $5 discount is a cash discount
and must be dealt with accordingly.
The initial sale of the bike will be recorded as follows:
$
Debit
Credit
XYZ (receivable)
Sales
90
90
As XYZ qualifies for the cash discount, the following double entry will be required to record the
discount allowed:
$
Debit
Credit
Discount Allowed (income statement)

XYZ (receivable)
$
5
5
The above entries have resulted in sales of Bike LTD being reduced to $85 (100-90-5). The
receivable from XYZ has also been reduced to this amount effectively.
Cash Transactions
Cash transactions are ones that are settled immediately in cash. Cash transactions also include
transactions made through cheques. Cash transactions may be classified into cash receipts and
cash payments.
Cash Receipts
Cash receipts are accounted for by debiting cash / bank ledger to recognize the increase in the
asset.
Following are common types of cash receipt transactions along with relevant accounting entries:
Cash Sale:
Debit
Cash
Credit
Sales
Cash receipt from receivable:

Debit
Cash
Credit
Receivable
Capital contribution from shareholders:

Debit
Bank
Credit
Share Capital
Receipt of loan from a bank:

Debit
Bank
Credit
Loan
Cash Payments
Cash payments are accounted for by crediting the cash / bank ledger to account for the decrease
in the asset.
Following are common types of cash payment transactions along with relevant accounting
entries:
Cash payment to a payable:
Debit
Payable
Credit
Cash
Purchase of inventory for cash:

Debit
Purchases
Credit
Cash
Purchase of a machine for cash:

Debit
Machinery - Asset
Credit
Cash
Cash Drawings by owner:

Debit
Drawing
Credit
Cash
Repayment of loan installment:

Debit
Loan
Credit
Cash
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Methods of calculating inventory cost
As inventory is usually purchased at different rates (or manufactured at different costs) over an
accounting period, there is a need to determine what cost needs to be assigned to inventory. For
instance, if a company purchased inventory three times in a year at $50, $60 and $70, what cost
must be attributed to inventory at the year end? Inventory cost at the end of an accounting period
may be determined in the following ways:
First In First Out (FIFO)
Last In First Out (LIFO)
Average Cost Method (AVCO)
Actual Unit Cost Method
This method assumes that inventory purchased first is sold first. Therefore, inventory cost under
FIFO method will be the cost of latest purchases. Consider the following example:
Example
Bike LTD purchased 10 bikes during January and sold 6 bikes, details of which are as follows:
January 1 Purchased 5 bikes @ $50 each
January 5 Sold 2 bikes
January 10 Sold 1 bike
January 15 Purchased 5 bikes @ 70 each
The value of 4 bikes held as inventory at the end of January may be calculated as follows:
The sales made on January 5 and 10 were clearly made from purchases on 1st January. Of the
sales made on January 25, it will be assumed that 2 bikes relate to purchases on January 1
whereas the remaining one bike has been issued from the purchases on 15th January. Therefore,
the value of inventory under FIFO is as follows:
Date
Jan 1
Jan 5
Jan 10
Jan 15
Jan 15
Jan 25
Purchase
Units $/Units
5
50
70
$ Total
250
Issues
Units $/Units
$ Total
2
1
50
50
100
50
2
1
50
70
100
70
350
Inventory
Units $/Units
5
50
3
50
2
50
5
70
7
$ Total
250
150
100
350
450
280
70
As can be seen from above, the inventory cost under FIFO method relates to the cost of the latest
purchases, i.e. $70.
- See more at: http://accounting-simplified.com/financial-accounting/accounting-forinventory/fifo-method.html#sthash.NZXXf6Te.dpuf


Example
Date
Purchase
Issues
Inventory
Units
5
Jan 1
Jan 5
Jan 10
Jan 15
Jan 15
Jan 25
$/Units
50
70
$ Total
250
Units
$/Units
$ Total
2
1
50
50
100
50
2
1
50
70
100
70
350
Units
5
3
2
5
7
$/Units
50
50
50
70
$ Total
250
150
100
350
450
70
280

Example

Date
Jan 1
Jan 5
Jan 10
Jan 15
Jan 15
Jan 25
Purchase
Units $/Units
5
50
70
$ Total
250
Issues
Units $/Units
$ Total
2
1
50
50
100
50
2
1
50
70
100
70
350
Inventory
Units $/Units
5
50
3
50
2
50
5
70
7
$ Total
250
150
100
350
450
280
70
Fixed Assets
Definition and Explanation
Fixed assets, also known as Property, Plant and Equipment, are tangible assets held by an entity
for the production or supply of goods and services, for rentals to others, or for administrative
purposes.
These assets are expected to be used for more than one accounting period. Fixed assets are
generally not considered to be a liquid form of assets unlike current assets. Examples of common
types of fixed assets include buildings, land, furniture and fixtures, machines and vehicles.
The term 'Fixed Asset' is generally used to describe tangible fixed assets. This means that they
have a physical substance unlike intangible assets which have no physical existence such as
copyright and trademarks.
Fixed assets are not held for resale but for the production, supply, rental or administrative
purposes. Assets that held for resale must be accounted for as inventory rather than fixed asset.
So for example, if a company is in the business of selling cars, it must not account for cars held
for resale as fixed assets but instead as inventory assets. However, any vehicles other than those
held for the purpose of resale may be classified as fixed assets such as delivery trucks and
employee cars.
Fixed assets are normally expected to be used for more than one accounting period which is why
they are part of Non Current Assets of the entity. Economic benefits from fixed assets are
therefore derived in the long term.
In order for fixed assets to be recognized in the financial statements of an entity, the basic criteria
for the recognition of assets laid down in the IASB Framework must be met:
The inflow of economic benefits to entity is probable.
The cost/value can be measured reliably.
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Bank Reconciliation
Bank reconciliation statement is a report which compares the bank balance as per company's
accounting records with the balance stated in the bank statement.
It is normal for a company's bank balance as per accounting records to differ from the balance as
per bank statement due to timing differences. Certain transactions are recorded by the entity that
are updated in the bank's system after a certain time lag. Likewise, some transactions are
accounted for in the bank's financial system before the company incorporates them into its own
accounting system. Such timing differences appear as reconciling items in the Bank
Reconciliation Statement.
The purpose of preparing a Bank Reconciliation Statement is to detect any discrepancies
between the accounting records of the entity and the bank besides those due to normal timing
differences. Such discrepancies might exist due to an error on the part of the company or the
bank.
Importance of Bank Reconciliation
Preparation of bank reconciliation helps in the identification of errors in the accounting

records of the company or the bank.
Cash is the most vulnerable asset of an entity. Bank reconciliations provide the necessary
control mechanism to help protect the valuable resource through uncovering irregularities
such as unauthorized bank withdrawals. However, in order for the control process to
work effectively, it is necessary to segregate the duties of persons responsible for
accounting and authorizing of bank transactions and those responsible for preparing and
monitoring bank reconciliation statements.
If the bank balance appearing in the accounting records can be confirmed to be correct by
comparing it with the bank statement balance, it provides added comfort that the bank
transactions have been recorded correctly in the company records.
Monthly preparation of bank reconciliation assists in the regular monitoring of cash flows
of a business.
Preparing a Bank Reconciliation Statement

Following is a sample Bank Reconciliation Statement:
ABC LTD
Bank Reconciliation Statement as at 31 December 2011
Balance as per corrected Cash Book
Add:
Unpresented Cheques
Less:
Deposits in Transit
Errors in Bank Statement
xxx
xxx
3
4
(xxx)
(xxx)
Balance as per Bank Statement
xxx
1. Balance as per corrected Cash Book:

This is the starting point of a bank reconciliation. Corrected bank balance is calculated by
adjusting the cash book ledger balance for transactions that are recorded by the bank but not by
the entity as shown below:
Balance as per Cash Book
Add:
Direct Credits
Interest on Deposit
Less:
Bank Charges
Direct Debits
Standing Order
xxx
5
6
xxx
xxx
7
8
9
(xxx)
(xxx)
(xxx)
Errors in Cash Book
10
Balance as per corrected Cash Book

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(xxx)
xxx
What is a Trial Balance?

1. Purpose of Trial Balance
2. Example of Trial Balance
3. Limitations of Trial Balance
Trial Balance is a list of closing balances of ledger accounts on a certain date and is the first step
towards the preparation of financial statements. It is usually prepared at the end of an accounting
period to assist in the drafting of financial statements. Ledger balances are segregated into debit
balances and credit balances. Asset and expense accounts appear on the debit side of the trial
balance whereas liabilities, capital and income accounts appear on the credit side. If all
accounting entries are recorded correctly and all the ledger balances are accurately extracted, the
total of all debit balances appearing in the trial balance must equal to the sum of all credit
balances.
Purpose of a Trial Balance
Trial Balance acts as the first step in the preparation of financial statements. It is a
working paper that accountants use as a basis while preparing financial statements.
Trial balance ensures that for every debit entry recorded, a corresponding credit entry has
been recorded in the books in accordance with the double entry concept of accounting. If
the totals of the trial balance do not agree, the differences may be investigated and
resolved before financial statements are prepared. Rectifying basic accounting errors can
be a much lengthy task after the financial statements have been prepared because of the
changes that would be required to correct the financial statements.
Trial balance ensures that the account balances are accurately extracted from accounting
ledgers.
Trail balance assists in the identification and rectification of errors.
Example
Following is an example of what a simple Trial Balance looks like:
ABC LTD
Account Title
Trial Balance as at 31 December 2011

Debit
Share Capital
Furniture & Fixture
Building
Creditor
Debtors
Cash
Sales
Cost of sales
General and Administration Expense
Total
Credit
$
$
15,000
5,000
10,000
5,000
3,000
2,000
10,000
8,000
2,000
30,000
30,000
Title provided at the top shows the name of the entity and accounting period end for
which the trial balance has been prepared.
Account Title shows the name of the accounting ledgers from which the balances have
been extracted.
Balances relating to assets and expenses are presented in the left column (debit side)
whereas those relating to liabilities, income and equity are shown on the right column
(credit side).
The sum of all debit and credit balances are shown at the bottom of their respective
columns.
Limitations of a trial balance

Trial Balance only confirms that the total of all debit balances match the total of all credit
balances. Trial balance totals may agree in spite of errors. An example would be an incorrect
debit entry being offset by an equal credit entry. Likewise, a trial balance gives no proof that
certain transactions have not been recorded at all because in such case, both debit and credit
sides of a transaction would be omitted causing the trial balance totals to still agree. Types of
accounting errors and their effect on trial balance are more fully discussed in the section on
Suspense Accounts.
Current Ratio - Liquidity Ratio - Working Capital Ratio
Topic Contents:
1. Definition
2. Formula
3. Explanation
4. Example
5. Interpretation & Analysis
6. Industry Standards
7. Importance
1. Definition
Current ratio, also known as liquidity ratio and working capital ratio, shows the proportion of
current assets of a business in relation to its current liabilities.
2. Formula
Current Assets
Current Ratio
=
Current Liabilities
3. Explanation
Current ratio expresses the extent to which the current liabilities of a business (i.e. liabilities due
to be settled within 12 months) are covered by its current assets (i.e. assets expected to be
realized within 12 months). A current ratio of 2 would mean that current assets are sufficient to
cover for twice the amount of a company's short term liabilities.
4. Example
ABC PLC has the following assets and liabilities as at 31st December 2012:
$m
$m
Non Current Assets

Goodwill
Fixed Assets
75
75
150
25
50
25
100
200
100
60
160
50
25
75
Current Assets
Cash in hand
Cash in bank
Inventory
Receivable
Current Liabilities
Trade payables
Income tax payables
Non Current Liabilities
Bank Loan
Deferred tax payable
Current ratio will be calculated as follows:
Current Assets
Current Ratio
200
=
Current Liabilities
1.25
160
5. Interpretation & Analysis

Current ratio is a measure of liquidity of a company at a certain date. It must be analyzed in the
context of the industry the company primarily relates to. The underlying trend of the ratio must
also be monitored over a period of time.
Generally, companies would aim to maintain a current ratio of at least 1 to ensure that the value
of their current assets cover at least the amount of their short term obligations. However, a
current ratio of greater than 1 provides additional cushion against unforeseeable contingencies
that may arise in the short term.
Businesses must analyze their working capital requirements and the level of risk they are willing
to accept when determining the target current ratio for their organization. A current ratio that is
higher than industry standards may suggest inefficient use of the resources tied up in working
capital of the organization that may instead be put into more profitable uses elsewhere.
Conversely, a current ratio that is lower than industry norms may be a risky strategy that could
entail liquidity problems for the company.
Current ratio must be analyzed over a period of time. Increase in current ratio over a period of
time may suggest improved liquidity of the company or a more conservative approach to
working capital management. A decreasing trend in the current ratio may suggest a deteriorating
liquidity position of the business or a leaner working capital cycle of the company through the
adoption of more efficient management practices. Time period analyses of the current ratio must
also consider seasonal fluctuations.
6. Industry standards
Current ratio must be analyzed in the context of the norms of a particular industry. What may be
considered normal in one industry may not be considered likewise in another sector.
Traditional manufacturing industries require significant working capital investment in inventory,
trade debtors, cash, etc, and therefore companies operating in such industries may reasonably be
expected to have current ratios of 2 or more.
However, with the advent of just in time management techniques, modern manufacturing
companies have managed to reduce the size of buffer inventory thereby leading to significant
reduction in working capital investment and hence lower current ratios.
In some industries, current ratio of lower than 1 might also be considered acceptable. This is
especially true of the retail sector which is dominated by giants such as Wal-Mart and Tesco.
This primarily stems from the fact that such retailers are able to negotiate long credit periods
with suppliers while offering little credit to customers leading to higher trade payables as
compared with trade receivables. Such retailers are also able to keep their own inventory
volumes to minimum through efficient supply chain management.
Current ratios of Wal-Mart Stores, Inc and Tesco PLC as per 2011 annual reports are 0.88 and
0.65 respectively.
7. Importance
Current ratio is the primary measure of a company's liquidity. Minimum levels of current ratio
are often defined in loan covenants to protect the interest of the lenders in the event of
deteriorating financial position of the borrowers. Financial regulations of various countries also
impose restrictions on financial institutions to lend credit facilities to potential borrowers that
have a current ratio which is lower than the defined limits.
- See more at: http://accounting-simplified.com/financial/ratioanalysis/current.html#sthash.KUTfLTMk.dpuf
What is a Trial Balance?
1. Purpose of Trial Balance
2. Example of Trial Balance
3. Limitations of Trial Balance
Trial Balance is a list of closing balances of ledger accounts on a certain date and is the first step
towards the preparation of financial statements. It is usually prepared at the end of an accounting
period to assist in the drafting of financial statements. Ledger balances are segregated into debit
balances and credit balances. Asset and expense accounts appear on the debit side of the trial
balance whereas liabilities, capital and income accounts appear on the credit side. If all
accounting entries are recorded correctly and all the ledger balances are accurately extracted, the
total of all debit balances appearing in the trial balance must equal to the sum of all credit
balances.
Purpose of a Trial Balance
Trial Balance acts as the first step in the preparation of financial statements. It is a
working paper that accountants use as a basis while preparing financial statements.
Trial balance ensures that for every debit entry recorded, a corresponding credit entry has
been recorded in the books in accordance with the double entry concept of accounting. If
the totals of the trial balance do not agree, the differences may be investigated and
resolved before financial statements are prepared. Rectifying basic accounting errors can
be a much lengthy task after the financial statements have been prepared because of the
changes that would be required to correct the financial statements.
Trial balance ensures that the account balances are accurately extracted from accounting
ledgers.
Trail balance assists in the identification and rectification of errors.
Example
Following is an example of what a simple Trial Balance looks like:
Account Title
ABC LTD
Trial Balance as at 31 December 2011
Debit
Share Capital
Furniture & Fixture
Building
Creditor
Debtors
Cash
Sales
Cost of sales
General and Administration Expense
Total
Credit
$
$
15,000
5,000
10,000
5,000
3,000
2,000
10,000
8,000
2,000
30,000
30,000
Title provided at the top shows the name of the entity and accounting period end for
which the trial balance has been prepared.
Account Title shows the name of the accounting ledgers from which the balances have
been extracted.
Balances relating to assets and expenses are presented in the left column (debit side)
whereas those relating to liabilities, income and equity are shown on the right column
(credit side).
The sum of all debit and credit balances are shown at the bottom of their respective
columns.
Limitations of a trial balance

Trial Balance only confirms that the total of all debit balances match the total of all credit
balances. Trial balance totals may agree in spite of errors. An example would be an incorrect
debit entry being offset by an equal credit entry. Likewise, a trial balance gives no proof that
certain transactions have not been recorded at all because in such case, both debit and credit
sides of a transaction would be omitted causing the trial balance totals to still agree. Types of
accounting errors and their effect on trial balance are more fully discussed in the section on
Suspense Accounts.

Principles of Accounting

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Principles of Accounting

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Introduction to Accounting

Accountancy is the process of communicating financial information about a business entity to

Accounting information is presented to internal users usually in the form of management

Regulatory Authorities: for ensuring that the company's disclosure of accounting

Statement of Financial Position [Balance Sheet]

Statement of Financial Position as at 31st December 2013

Current tax payable

Total current liabilities

Rationale - Why the balance sheet always balances?

Profit before tax

Gain on disposal of fixed assets

Interest income on bank deposits

Exchange gain on translation of a foreign currency bank account

Examples of administrative expenses include:

Salary cost of executive management

Legal and professional charges

Depreciation of head office building

Rent expense of offices used for administration and management purposes

Cost of functions / departments not directly involved in production such as finance

Current period's estimated tax charge

Prior period tax adjustments

Deferred tax expense

Prior Period Comparatives

Comparison of the entity's profitability with other organizations operating in similar

Change in earnings per share over the period

Analysis of interest cover and dividend cover ratios

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Cash flows from operating activities

Working Capital Changes:

Movement in current assets:

Movement in current liabilities:

Cash generated from operations

Net cash from operating activities (A)

Cash flows from investing activities

Net cash used in investing activities (B)

Cash flows from financing activities

Net cash from financing activities (C)

Net increase in cash & cash equivalents (A+B+C)

Cash outflow expended on the purchase of investments and fixed assets

Cash inflow from income from investments

Cash inflow from disposal of investments and fixed assets

Proceeds from issuance of share capital, debentures & bank loans

Purpose & Importance

Net profit or loss during the accounting period attributable to shareholders

Increase or decrease in share capital reserves

Dividend payments to shareholders

Gains and losses recognized directly in equity

Effect of changes in accounting policies

Effect of correction of prior period error

Balance at 1 January 2011

Changes in accounting policy

Changes in equity for the year 2011

Changes in equity for the year 2012

Balances at the start of the period;

Accruals and Prepayments

Receivables and Payables

Change in long term loans due to receipt or repayment of loans;

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5. Use of historical cost

Single Economic Entity Concept

Money Measurement Concept

Substance over Form

Elements of the financial Statements

Types and Examples