CHAPTER 1&2

The role of accounting

& Financial statements
for decision making
Lecturer: Uyen Thy
Email: [email protected]
 LEARNING OBJECTIVES

1. The nature of accounting and its main functions

2. Potential users of accounting information
3. Financial accounting & management accounting
4. Financial statements and their underlying
assumptions and qualitative characteristics
5. Accounting equation
6. Main practice areas for accountants
7. Ethics in business and accounting
 THE NATURE OF ACCOUNTING

 What is Accounting?
 Accounting is the process of identifying, measuring, recording
and communicating economic information to assist users to
make decisions
 Its function is to provide and interpret financial information to
assist in decision making
 Accounting is used in a range of organizations
 Business

 Government

 Charities

 Not-for-profits
 ACCOUNTING DEFINED

Identification
Transactions (internal/external)

Measurement
Quantification in monetary terms ($)

Recording
Recording; classification; summarization

Communication
Accounting reports Analysis and interpretation
 USERS OF ACCOUNTING INFORMATION

Internal Users External Users

 How much profit?  Should I invest?
 What should be  Can the business pay?
produced?  Wages? Loans?

 What resources are  Will they make a profit?

available?  Are they behaving
 How much does it cost? ethically?
 How much do we owe?  Is the business socially
 What would happen if…? and environmentally
 Do we have enough cash? friendly?
 FINANCIAL REPORTS AND USERS

Tax Accounting

Management Financial
Accounting Accounting
Designed to meet the needs of the widest range of users
 FINANCIAL ACCOUNTING

 Financial accounting focuses on the provision of

information to users external to the enterprise
 The focus is on reporting financial position and
financial performance
 It produces four financial statements:
Balance sheet
Income statement
Statement of cash flows
Statement of changes in equity
Notes
 FINANCIAL ACCOUNTING

 Definitions:
Financial performance: Generating new resources
from operations over a period of time
Financial position: Entity’s set of financial resources
and obligations at a point in time
Financial statements: Reports describing financial
performance and position of an entity
USERS OF FINANCIAL ACCOUNTING

• Owners (Investors) • Tax authorities,

• Potential owners regulators, and other
government bodies
• Creditors and potential and agencies
creditors • Competitors
• Managers • Researchers
• Politicians, reporters,
• Employees judges and so on
• Financial and market
analysts
 MANAGEMENT ACCOUNTING

 Management accounting will be the focus of later

courses
 Management accounting focuses on the provision of
information to users within the enterprise (to aid in
operational planning and control decisions)
 MANAGEMENT VS. FINANCIAL ACCOUNTING

MANAGEMENT ACCOUNTING FINANCIAL ACCOUNTING

• Internal Focus • External Focus

- Planning • Reporting Information
- Decision-making - Performance
- Controlling - Position
• Cost Behaviour/Break-even • Financing and Investing
• Budgeting • Legal compliance
• Strategy • Highly Regulated
 BASIC FINANCIAL STATEMENTS

 Accounting is an information system

 Designed to communicate financial information

 To interested users

 For making economic decisions

 Financial statements
 Are the outcome of the accounting process

 Are a primary information source for users

 Are useful for many decisions

 3 PRIMARY INFORMATION TYPES

What information do users want/need?

 Financial Performance
 The ability of the entity to utilise its assets effectively and
efficiently.
 What are the business goals (i.e. profit/nor for profit)?
 Financial Position
 The financial resources controlled by the entity

 Financial structure

 Measure of liquidity and solvency

 3 PRIMARY INFORMATION TYPES

 Cash Movements (business activities)

The ability of the entity to generate cash flow, focussing on
three areas:
1. Operating Activities
The provision of and payment for goods and services
2. Investing Activities
The acquisition and disposal of long term assets
3. Financing Activities
The raising of funds for an entity to carry out its operating and
investing activities.
 THE BALANCE SHEET

 Reports financial position of an entity at a specific

point in time
 Shows resources (assets) and claims on those
resources (liabilities and equity) at a point in time
 Represents the accounting equation

Assets = Liabilities + Equity

 Alternative formats (same information)
Account format
Narrative format
 THE ACCOUNTING EQUATION

Assets = Liabilities + Equity

Resources = Claims
A =L+E (Account format)
A–L=L–L+E
A–L=L–L+E
A–L=E (Narrative format)
Same equation – different format
 THE ACCOUNTING EQUATION:
THE EFFECTS OF TRANSACTIONS

Assets = Liabilities + Equity

 The accounting equation always balances
 Transactions result in changes in assets, liabilities
and owners equity
 Elements of the accounting equation change with
each transaction, but equality of accounting
equation remains unchanged
 This can be demonstrated by looking at the first 3
transactions from the example in the text
 THE ACCOUNTING EQUATION:
THE EFFECTS OF TRANSACTIONS

Example: Cynthia’s Beauty Services

1. Cynthia Jones deposits $53000 in a business bank
account
Assets = Liabiliti + Equity
es
Cash at C. Jones,
Bank Capital
(1) $53 000 = $53000
 THE ACCOUNTING EQUATION:
THE EFFECTS OF TRANSACTIONS

2. Cynthia purchases a van for $32000 and

massage and manicuring tables for $6000

Assets = Liabiliti + Equity

es
Cash at Massage Van C. Jones,
Bank & Capital
Manicure
tables
(1) $53 000 = $53 000
(2) -38 000 + 6 000 + 32 000
15 000 + 6 000 + 32 000 = $53 000

$53 000 = $53 000

 THE ACCOUNTING EQUATION:
THE EFFECTS OF TRANSACTIONS

3. Cynthia purchases nail supplies for $2500

on credit
Assets = Liabiliti + Equity
es
Cash at Assets Van
Massage Nail = Liabiliti
Accounts + C.
Equity
Jones,
Bank & Supplies es
Payable Capital
Cash at Manicure
Massage Van C. Jones,
Bank tables
& Capital
(1) $53 000 Manicure = $53 000
tables
(2) -38 000 + 6 000 + 32 000
(1) $53 000 = $53 000
15 000 + 6 000 + 32 000 = $53 000
(2) -38 000 + 6 000 + 32 000
(3) + 2 500 = + 2 500
15 000 + 6 000 + 32 000 = $53 000
15 000 + 6 000 + 32 000 + 2 500 = + 2 500 $53 000

$53 000 = $53 000

$55 500 = $55 500
 THE ACCOUNTING EQUATION:
THE EFFECTS OF TRANSACTIONS

Key points from the example:

 Every transaction affects at least two components of

the equation
 This gives rise to the term:
Double-Entry Accounting
 After each transaction is recorded the accounting
equation must remain balanced
 THE BALANCE SHEET (Account Format)

MINH’S TV REPAIRS
Balance Sheet
As at 30 June 2016
ASSETS LIABILITIES
Cash at bank $ 25 Accounts payable $ 10
170 380
Accounts receivable 8 895 Mortgage payable 100
500
Repair Supplies 7 305 110 880
Repair Equipment 55 350
Land 30 000 EQUITY
Building 127 Minh Vu, Capital 143
500 340

A=L+E $254
220
$254
220
 THE BALANCE SHEET (Narrative format)
MINH’S TV REPAIRS
Balance Sheet
As at 30 June 2016
ASSETS
Cash at bank $ 25 170
Accounts receivable 8 895
Repair Supplies 7 305
Repair Equipment 55 350
Land 30 000
Building 127 500
$254 220
A–L=E
LIABILITIES
Accounts payable $ 10 380
Mortgage payable 100 500
110 880

EQUITY
Minh Vu, Capital 143 340
$254 220
THE BALANCE SHEET: Definitions of elements

 Assets
 Resources controlled by the entity as a result of past
transactions or events from which future economic benefits are
expected to flow to the entity
 Liabilities
 Present obligations of an entity arising from past transactions
or events, the settlement of which is expected to result in an
outflow of resources from the entity
 Liabilities are future sacrifices of economic benefits that an
organization is presently obliged to make to other
organizations or individuals as a result of past transactions or
events (Financial Accounting – Trotman 5e.)
THE BALANCE SHEET: Definitions of elements

 Equity
 The residual interest of the owner(s) in the assets (less
liabilities) of the entity

Assets - Liabilities = Net Assets

Net Assets = Equity

 Sometimes called Capital or Accumulated Surplus/Funds

 THE INCOME STATEMENT

 Reports financial performance over a specific time

period (e.g. month, year, etc.)
 Reports income earned during a period of time with
expenses incurred in earning that income
 Shows income and expenses
 Income > Expenses = Profit
 Income < Expenses = Loss
 Sometimes called profit or loss statement or
Operating Statement
THE INCOME STATEMENT

MINH’S TV REPAIR
Income Statement
For the year ended 30 June 2016

INCOME
Repair income $221 250
EXPENSES
Advertising expense $ 10 125
Repair supplies expense 45 855
Salaries and wages expense 63 900
Rent expense 20 130
Telephone expense 10 095
Light and power expense 23 970 174 075
PROFIT $47 175
 THE INCOME STATEMENT: Definitions of elements

 Income
 Increases in economic benefits in the form of inflows or
enhancements of assets or decreases of liabilities that results
in increases in equity, other than those relating to equity
participants
 Expenses
 Decreases in economic benefits in the form of outflows or
incurrences of liabilities that result in decreases in equity,
other than those relating to equity participants
 THE STATEMENT OF CASH FLOWS

 The income statement reports in income earned and

expenses incurred – NOT on cash flows
 A statement of cash flows is therefore necessary to
report on the cash inflows and outflows of the entity
 This allows users to assess the sources and
applications of cash
 Also the ability of the entity to remain solvent
 MINH’S TV REPAIRS
Statement of Cash Flows
THE STATEMENT OF CASH FLOWS
For the year ended 30 June 2016
CASH FLOWS FROM OPERATING ACTIVITIES 30

Cash received from customers $ 212 355

Cash paid to suppliers and employees (171 000)
Net cash from operating activities $41 355
CASH FLOWS FROM INVESTING ACTIVITIES

Purchases of land and buildings (157 550)

Purchases of repair equipment (55 300)
Net cash from investing activities (212 850)
CASH FLOWS FROM FINANCING ACTIVITIES

Amount borrowed under mortgage 100 500

Investment by owner 118 665
Drawings by owner (22 500)
Net cash from financing activities 196 665
Net increase (decrease) in cash held 25 170
Cash at beginning of year -
Cash at end of year $ 25 170
 THE STATEMENT OF CHANGES IN EQUITY

“Linking” statement between the

Income Statement and the Balance Sheet
DON’S AUTO REPAIR
Statement of Changes in Equity
For the year ended 30 June 2012
From
Income
Don Brady, Capital – 1 July 2011 $437 330 Statement

Add: Profit for the year 136 350

573 680
Shown on
Less: Drawings 87 000 Balance Sheet

Don Brady, Capital – 30 June 2012 $486 680

 THE STATEMENT OF CHANGES IN EQUITY

Balance sheet Income statement Balance sheet

as at beginning of year for the period as at beginning of year

A1 – L1 = E1 Inc – Exp = Profit A2 – L2 = E2

2
1
4
Statement of owner’s equity
For the period
E1 + Profit – Drawings = E2

3
 RELATIONSHIP BETWEEN FINANCIAL STATEMENTS

Balance Sheet 2012 2013 Cash Flow Statement

Cash 1,400 2,000 From operating activities 2,500
Other assets 114,000 118,000 From investing activities (2,300)
Total assets 115,400 120,000 From financing activities 400
Liabilities 51,400 53,000 Total net cash flows 600
Share capital` 40,000 40,000 Opening balance 1,400
Retained profits 24,000 27,000 Closing balance 2,000
Total liabilities and
shareholders’ equity 115,400 120,000

Retained Profits Note Income Statement

2012 balance 24,000 Revenues 21,000
+ Net profit 6,000 Expenses* 15,000
30,000 Net profit 6,000
- Dividends 3,000
2013 balance 27,000
 UNDERLYING ASSUMPTIONS OF
FINANCIAL STATEMENTS

 Accounting Entity Assumption

 Identify clearly the boundaries of the entity being accounted for

 Personal transactions of the owner must remain separate from
the transactions of the entity
 Economic entity – a group of entities where the goals of the
controlling entity are pursued (e.g. companies, partnerships,
funds, associations, public sector bodies)
 UNDERLYING ASSUMPTIONS OF
FINANCIAL STATEMENTS

 Going Concern Assumption

 Unless we have evidence to the contrary, we assume an entity
will continue to operate in the future (foreseeable future)

 Period Assumption
 The life of the entity can be “broken up” into equal time intervals

 Profit is determined for particular periods of time in order to be

comparable.
 UNDERLYING ASSUMPTIONS OF
FINANCIAL STATEMENTS

 Monetary Assumption
 Universally accepted medium of exchange

 Measure economic activity by a common denominator

 Accrual Basis Assumption

 Accounting is an “event” driven process

 The effects of transactions are recognized when they occur, not

when the cash is received/paid
 OTHER ACCOUNTING PRINCIPLES

 Conservatism Principle
 Recognizing expenses and liabilities as soon as possible when there is
uncertainty about the outcome, but to only recognize revenues and
assets when they are assured of being received
 Matching Principle
 Requires that revenues and any related expenses be recognized
together in the same reporting period
 Cost Principle
 Requires transactions are initially recorded at their original cost &
treating assets in terms of their use rather than for resale
 Revenue Recognition Principle
 One should only record revenue when it has been earned, not when the
related cash is collected
 QUALITATIVE CHARACTERISTICS OF
FINANCIAL STATEMENTS

Fundamental Qualitative Characteristics:

 Relevance
 Information is useful for decision making

 Can influence economic decisions by users

 Faithful Representation
 Information presented complete, faithfully, without bias or undue
error
 Economic substance over form
 QUALITATIVE CHARACTERISTICS OF
FINANCIAL STATEMENTS

Enhancing Qualitative Characteristics

 Comparability and Consistency
 Users can identify similarities and differences between two sets of
economic data
 Use the same accounting policies and procedures
 Verifiability
 Different, independent observers can reach consensus that information
faithfully represents what it claims to
 Understandability
 Expect a reasonable knowledge of business and economic activity and
financial accounting
 Study the information with reasonable diligence
 QUALITATIVE CHARACTERISTICS OF
FINANCIAL STATEMENTS

Constraints:

 Materiality
 The extent to which omission or misstatement would be
misleading to users

 Benefits and Costs

 Benefits of providing information must justify cost of providing
 PUBLIC ACCOUNTING

 Accountants who offer their professional services to

the public for a fee
 Can vary in size from quite small to large
international organizations
 Four main areas with many specialties
 Auditing and assurance services
 Taxation services
 Advisory services
 Insolvency and administration
 ACCOUNTING IN COMMERCE AND
INDUSTRY

 Accountants who are employed in business entities

 Many areas of interest
 General accounting

 Cost accounting

 Accounting information systems design

 Budgeting

 Taxation accounting

 Internal auditing and audit committees

 NOT-FOR-PROFIT ACCOUNTING

 Many accountants work in the not-for-profit area

 This requires a slightly different approach as profit is
not the primary focus
 Includes a range of organizations
 Government
 NGO
 Charities
 ETHICS AND ACCOUNTANTS

 Ethics in business
 Important in all business dealings

 More recent failures has raised awareness

 Ethics and professional accounting bodies

 Important for the standing of the profession

 Ethics in practice
 Identify the ethical issue

 Analyse key issues and stakeholders

 Assess consequences

 Select appropriate course of action