Finance and accounting - Chapter 1 (LO1, 1, 1, 1) Accounting information: a means to an end The - Studeersnel (2024)

Chapter 1 (LO1, 1, 1, 1)Accounting information: a means to an endThe primary objective of accounting is to provide information that is useful for decision-making purposes.Accounting is also referred to as the language of business. Cost, rices, sales volume, profits, and return oninvestment are all accounting measurements. Investors, creditors, manager, and other who have financialinterest in an enterprise need a clear understanding of accounting terms and concepts if they are tounderstand and communicate about the enterprise.

Accounting from a user’s perspectiveThe primary goals of the book is to develop your ability to understand and use accounting information inmaking economic decisions. To do this, you need to understand the following:

- The nature of economic activities that accounting information describes

- The assumptions and measurement techniques involved in developing accounting information

- The information that is most relevant for making various types of decisions

How economic activities flow into the accounting process:Types of accounting information

- Financial accounting: it refers to information describing the financial resources, obligations, and activities

of an economic entity. It is used primarily to assist investors and creditors in deciding where to placetheir scarce investment resources

- Mangement accounting: It involves the development and interpretation of accounting information

intended specifically to assist management in operating the business. It is used to set goals, evaluatingperformance, deciding to introduce a new product.

- Tax accounting: The preparation of income tax returns is a specialised field within accounting to a great

extent, tax returns are based on financial accounting.

Financial accounting informationExternal users of accounting information

External users of accounting information are individuals and other enterprises that have a current orpotential financial interest in the reporting enterprise, but that are not involved in the day-to-dayoperations of that enterprise. Examples:

- Owners

- Creditors

- Potential investors

- Labor unions

- Governmental agencies

- Suppliers

- Customers

- Trad associations

- General public

Investors are individuals and other enterprises that own the reporting enterprise. Creditos, are individualsand other enterprises to whom the sporting entity owes money goods, or serviced.

Objectives of external financial reportingCash flow prospects

- Return of your investment: When you want the return to you at some furure date of the amount you

had invested or loaned

- Return on you investment: When you expect the company o pay you something for the use of your

funds.Providing information for you to assess your friend’s ability to meet his cash flow commitment to you isessentially what financial reporting is about. You need information to assess the risk you are taking and theprospects that your friend will be able to deliver 108000 to you one year from the time you loan hime100000The accounting profession has identified certain objectives of external financial reporting to guid its effortsto refine and improve the reporting of information to external decision makers. These are displayed below

- The first is to provide information the is useful in making investment and credit decisions.

- The second is to provide information that is useful in assessing the amount, timing, and uncertainty of

future cash flows

- The last is to provide information about the enterprise’s resources, claims to those resources, and how

both the resources and claims to resources change over time. These resources are often called assetsA financial statement is simply a monetary declaration of what is believed to be true about an enterprise.Financial statements prepared for periods of time shorter than one year are referred to as interim financialstatements. The financial statements are:

- Balance sheet: a position statement that shows where the company stands in financial terms at a specific

date

- The income statement is an activity statement that shows details and results of the company’s profit-

related activities for a period of time

- The statement of cash flows is an activity statement that shows the details of the company’s activities

involving cash during a period of time.

Characteristics of external reported informationThe qualities that must be understood to have maximum usefulness are:

- Financial reporting - a means: The ultimate outcome of providing financial information is to improve the

quality of decision making by external parties. Financial statements themselves are simply a means bywhich the end is achieved

Many enterprises use a database warehousing approach for the creation of accounting informationsystems. This approach, coupled with user-friendly software, allows management and other designatedemployees access to information cot create a variety of accounting reports, including required external

financial reports.Objectives of management accounting informationEnterprises have mission statement that describes their goals. The objectives of accounting systems beginat the most general level with the objectives and mission of the enterprise. These general organisationalgoals create a need for information. The enterprise gathers historical and future information from bothinside the enterprise and external sources. The information is used by the decision makers who haveauthority over the firm’s resources and who will be evaluated and rewarded based on their decisionoutcomes.

Characteristics of management accounting informationInternal accounting information characteristics are:

- Importance of timeliness: In addition to needing timely information for planning purposes, enterprises

are constantly monitoring and controlling ongoing activities

- Identity of decision maker: Information that is produced to monitor and control processes needs to be

provided to those who have decision-making authority to correct problems

- Oriented towards the future: although some accounitng information, like financial accounting

information, is historical in nature, the purpose in creating and generating it is to affect the future.

- Measures of efficiency and effectiveness: Accounting information measures the efficiency and

effectiveness of resource usage. By comparing the enterprise’s resource inputs and outputs withmeasures of competitors’ effectiveness and efficiency, and assessment can be made of how effectivemanagement is in achieving the organisation’s mission.

- Management accounting information - a means: As with financial accounting information, management

accounting information is a means to an end, not an end in and of itself. The ultimate objective is to

design and use an accounting system that helps management achieve the goals and objectives of theenterprise.

Careers in accountingCareer opportunities in accounting may be divided into four broad areas:

- Public accounting

- Managerment accounting

- Governmental accounting

- Accounting education

Public accountingThe work of public accountants consist primarily of auditing financial statements, income tax, andmanagement advisory services. Certified public accounting’s (CPA) advice management on such diverseissues as international mergers, manufacturing processes, and the introduction of new products. CPA’sassist management because financial considerations enter into almost every business decision. The criteriato become CPA are extensive university education requirement, passing the CPA examination, and meetinga practice experience requirement.

Management accountingThe management accountant works for one enterprise. Management accountants develop and interpretaccounting information designed specifically to meet the various needs of management. Managementaccountants in a organisation are called chief accounting officer (CAO) or controller. They operate thecompany’s accounting system, including the recording of transactions and the preparation of financialstatements, tax returns, and other accounting reports. Or specialisations like financial forecasting, costaccounting, and internal auditing.

Governmental accountingGovernmental agencies use accounting information in allocating their resources and in controlling theiroperations.

- The gap: who audits the government? The government accountability office (GAO) audits many agencies

of the federal government, as well as some private organisations doing business with the government.GAO investigations may be designed either to evaluate the efficiency of an entity’s operations or todetermine the fairness of accounting information reported\

- The IRS: audits of income tax: Another governmental agency that performs extensive auditing work is

the internal revenue service (IRS). The IRS handles the millions of income tax returns filed annually byindividuals and business organisations and frequently perform auditing functions to verify datacontained in these returns.

- The sec: the watchdog of financial reporting: The sec word closely with the FASB in establishing generally

accepted accounting principles.

BookkeepingBookkeeping is the recording of routine transactions and day-to-day record keeping.

- Retained earnings: the accumulated earrings of previous years that remain within the enterprise

The concept of the business entityA business entity is an economic unit that engages in identifiable business activities.

AssetsAssets are economic resources that are owned by a business and are expected to benefit furtheroperations positive further cash flows may come directly as the asset is converted into cash.

The cost principleWhen we say that an asset is shown at its historic cost, we mean the original amount the business entitypaid to acquire the asset. This policy of counting for many assets at their cost is often referred to as the costprinciple of accounting

The going-concern assumptionAssets like land and buildings are being used to house the business and were acquired for use and not forresale; in fact, these assets usually could not be sold without disrupting the business. The balance sheet of abusiness is prepared on the assumption that the business is a continuing enterprise, or a going concern.Consequently, the present estimated prices at which assets like land and buildings could be sold are of lessimportance than if these properties were intended for sale.

The objectivity principleAnother reason for using cost rather than current market values in accounting for many assets is the needfor a definite, factual basis for valuation. Accountants use the term objective to describe asset valuationthat are factual and ca be verified by independent experts.

The stable-dollar assumptionThe value of the monetary unit or dollar is not always stable. Inflation is a term used to describe thesituation where the value of the monetary unit decreases, meaning that t will purchase less than it didpreviously. Deflation is the opposite in which the value of the monetary unit increases, meaning that it willpurchase more than it did previously. The stable dollar assumption work well in periods of stable prices buare less satisfactory under conditions of rapid inflation.

Liabilities are financial obligations or debts. The person or organisation to whom the debt is owed is called acreditor. A note payable is a written promise to repay the amount owed by a particular date and usuallycalls for the payment of interest. Accounts payable involves no written promises and generally do not callfor interest payments. Accrued is an accounting term communicating that the payment of certain expenseshas been delayed or deferred.

Owners’ equityOwners’ equity represents the owners’ claims on the assets of the business

An increase in owners’ equity in a business comes from two primary sources

- investments of cash or other assets by owners

- Earnings from profitable operation of the business

An decrease in owners’ equity also are caused in two ways

- Payments of cash or transfers of other assets to owners

- Losses form unprofitable operation of the business

The accounting equationAssets = liabilities + owners’ equity

The effects of business transactions: An illustrationThe statement of financial position is a picture of the results of past business transactions that has beencaptured by the company’s information system and organised into a concise financial description of wherethe company stands at a point of time.

Income statement (P/L)The income statement is a summarisation of the company’s revenue and expense transactions for a periodof time. The income statement is particularly important for the company’s owners, creditors, and otherinterested parties to understand. Revenues are increases in the company’s assets from its profit-directedactivities, and they result in positive cash flow. Expenses are decreases in the company’s assets from itsprofit-directed activities, and they result in negative cash flow. Net income is the difference between therevenues and expenses for a specified period of time. Should a company find itself in the undesirablesituation of having expenses greater than revenues, we call the difference a net loss.

Statement of cash flowsThe statement classifies the various cash flows into three categories, operating, investing, and financing,and relates these categories to the beginning and ending cash balances. Cash flows from operatingactivities are the cash effect of revenue and expense transaction that are included in the income statement.

Evaluation short-term liquidityOne key indicator of short-term liquidity is the relationship between an entity’s liquid assets and theliabilities requiring payment in the near future.

The need for adequate disclosureAdequate disclosure means that users of financial statements are informed of all information necessary forthe proper interpretation of the statements. It is made in the body of the financial estaminets and thenotes accompanying these statements. A company should sickles all financial information that a reasonablyinformed person would consider necessary for the proper interpretation of the financial statements. Eventsthat clearly are unimportant do not require disclosure.

Management’s interest in financial statementsWhile we have emphasised the importance of financial statements to investors and creditors, themanagement of a business organisation is vitally concerned with the financial position of the business andwith its profitability and cash flows. Therefore, management is anxious to receive financial statements asfrequently and as quickly as possible so that it may take action to improve areas of weak performance.Managers have a special interest in the annual financial statements, because these statements are used bydecision makers outside of the organisation. For example, if creditors view the annual financial statementsas strong, they will be more willing to extend credit to the business than if they regard the company’sfinancial statements as weak. A strong statement of financial position is one that shows relatively little debtand large amounts of liquid assets relative to the liabilities due in the near future. A strong income stamenis one that shows large revenues relative to the expenses required to earn the revenues. A strongstatement of cast flow is one the not only shows a strong cash balance but also indicates that cash is beinggenerated by operations.Window dressing: measures taken by management to make the company appear as strong as possible in itsfinancial statements.

Chapter 3Business accumulate the effects of individual transactions in their accounting records. At regular intervalsthe data is used to prepare financial statements. The accounting cycle consists of 8 steps

- Journalise (record) transactions

- Post each journal entry to the appropriate ledger accounts

- Prepare a trail balance

- Include making end-of-period adjustments

- Preparing and adjusted trail balance

- Preparing financial statements

- Journalising and posting closing entries, and preparing an after closing trail balance

The role of accountingManagers and employees of a business frequently use the information stored in the accounting records forsuch purposes as:

- Establishing accountability for the assets and/or transactions under an individual’s control

- Keeping track of routine business activities , such as the amounts of money in company bank accounts,

amounts due from credit customers, or amounts owed to suppliers

- Obtaining detailed information about a particular transactions

- Evaluating the efficiency and performance of various departments within the organisation

- Maintaining documentary evidence of the company’s business activities. (tax laws require companies to

maintain accounting records supporting the amounts reported in tax returns.

Debit and credit entriesAn amount recorded on the left, or debit, side of an account is called a debit, or a debit entry. An amountentered on the right, or credit, side is called a credit, or a credit entry.

Determining the balance of a T accountThe balance of an account is the difference between the debit and credit entries in the account. If the debitexceeds its a debit balance, if the credit exceeds it is a credit balance. The difference represents the entresult. This would be cash on a balance sheet.

Debit balances in asset accountsAll asst accounts normally have debit balances. The debit side is an increase and the credit side is andecrease of an account

Credit balances in liability and owners’ equityThe realtionship between entries in these accounts and their position on the balance sheet may besummed up as follows

- Liabilities and owners’ equity belong on the right side of the balance sheet

- An increase in a liability or an owners’ equity account is recorded on the right side of the account

- Liability and owners’ equity accounts normally have credit balances.

Concise statement of the debit and credit rules

The effects of net income on the basic accounting equation are illustrated as follows:Retained earningsCorporations follow a policy of distributing to their stockholder some of the resources geared by profitableoperations. Distributions of this nature are termed dividends. The balance in the retained earnings accountrepresents the total net income of the corporation over the entire lifetime of the business, minus all thedividends.

The income statementIn this statement, net income is determined by comparing sales prices of goods or services sold during theperiod with the costs incurred by the business in delivering these goods and services. The technicalaccounting terms for these components of net income are revenue and expenses. Should expenses exceedrevenue, a net loss results.

Income must be related to a specified period of time.

Accounting periodsThe period of time is termed accounting period. Net income is measured for relatively short accountingperiods of equal length. This is called time period principle. The 12-month accounting period used by anentity is called its fiscal year. This ends on December 31.

RevenueRevenue is the price of gods sold and services rendered during a given accounting period.

The realisation principle: when to record revenueThe realisation principle should be recognised at the time goods are sold or services are rendered. Therevenue is recognised when it is earned, without regard to when a contract is signed or when cash paymentfor providing goods or served is received.

ExpensesExpenses are the costs of the goods and services used up in the process of earning revenue. An expensealways cases a decrease in owners’ equity. The related changes in the accounting equation can be either adecrease in assets or an increase in liabilities.Revenue should be offset ball the expenses incurred in producing that revenue. This concept of offsettingexpenses on a basis of cause and effect is called the matching principle.Accountants require objective evidence that an expenditure will produce revenue in future periods beforethey will view the expenditure as creating an asset. Conservatism means applying the accounting treatmentthat results in the lowest estimate of net income for the current period.

Accrual basis of accountingThe policy of recognising revenue in the accounting records when it is earned and recognising expenseswhen the related goods or services are used is called the accrual basis of accounting. The purpose is tomeasure the profitability of the economic activities conducted during the accounting period. An alternativeto the accrual basis is called cash basis accounting. Under cash basis accounting, revenue is recognisedwhen cash is collected from the customer, taters the when the company sells goods or enders services. Thisdoes not provide a good measure of the profitability of activities undertaken during the period.

debit and credit rules for revenue and expensesThe rules to cover revenue and expense accounts are:

- Revenue increases owners’ equity; therefore, revenue is recorded by credits

- Expenses decrease owners’ equity; therefore, expenses are recorded by debits

DividendsA dividend is a distribution of assets by a corporation to its stockholders. Dividends are not viewed as anexpense, and they are not deducted from revenue in the income statement. The reason why dividend arenot viewed as an expense is that these payments do not serve to generate revenue. They are a distributionof profits to the owners of the business. The debit-credit rules for revenue, expenses, and dividends aresummarised below