fianancial accounting unit1

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INTRODUCTION

TO

FINANCIAL ACCOUNTING

DISTANCE EDUCATION CENTRE

The University of the West Indies

DEC


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The University of the West Indies, 1999

UWI Course Team

This Study Guide is one of a series produced for the B.Sc. Management Distance Programme.

ISBN: 976-41-1028-3

The University wishes to acknowledge the contribution of the Dutch government to the preparation of materials

on which this Study Guide is partially based.

This publication may only be reproduced, stored or transmitted, in any

form by any means, with prior permission, in writing, from The Univer-

sity of the West Indies. Enquiries concerning reproduction or licensingshould be forwarded to the following address:

Directors Office

Distance Education Centre

The University of the West Indies

P.O. Box 64

Bridgetown, Barbados

Arlene Chambers

Charmaine McKenzie

Charmaine McKenzie

Donna-mae TibbyKarlem Mair

Writer:

Editor:

Proofreading:

Page Composition:Instructional Design & Coordination:


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Contents

Introduction to the Course ..................................................................................................... 5

Unit 1 Introduction to Financial Accounting.............................................................. 7

Overview .....................................................................................................................................7

Objectives ...................................................................................................................................7

Session 1 Definition, Need and Use of Accounting......................................................................................9

Session 2 Business Organisations and Accounting Concepts .....................................................................15

Unit 2 The Basics of Accounting ............................................................................... 23

Overview ...................................................................................................................................23

Objectives .................................................................................................................................23

Session 1 Classification of Accounts and the Accounting Cycle ................................................................. 25Session 2 Recording Accounting Information ............................................................................................31

Session 3 Rules for Posting Transaction .....................................................................................................41

Unit 3 The Trial Balance and Its Uses ....................................................................... 55

Overview ...................................................................................................................................55

Objectives .................................................................................................................................55

Session 1 The Trial Balance .......................................................................................................................57

Session 2 Preparing Simple Financial Statements ......................................................................................67

Session 3 Errors and the Correction of Errors .............................................................................................71

Unit 4 Adjustments ................................................................................................... 83

Overview ...................................................................................................................................83

Objectives .................................................................................................................................83

Session 1 Accruals and Prepayments .........................................................................................................85

Session 2 Bad Debts..................................................................................................................................91

Session 3 Bad Debts Provision................................................................................................................... 95

Unit 5 Fixed Assets and Depreciation.....................................................................101

Overview .................................................................................................................................101

Objectives ...............................................................................................................................101

Session 1 Depreciation Expense ..............................................................................................................103

Session 2 Disposal of Fixed Assets ...........................................................................................................115


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Introduction to the Course

This course, Introduction to Financial Accounting, (MS15A) is designed to

introduce you, the learner, to the fundamental principles and underlying

assumptions of financial accounting. It is a three-credit, one-semester course

and is a compulsory course for persons intending to pursue degrees in

Management Studies, Accounting or Economics. Persons who intend to

pursue intermediate studies in financial accounting and financial manage-

ment will also find it particularly useful.

There are 10 units in this book, each subdivided into two or three sessions.

Monthly teleconferences with the course coordinator are also part of the

package. In addition, weekly tutorials are provided where qualitative prob-

lems are worked in detail and any problems you have may be addressed. You

should be able to complete each session, including the activities and practice

exercises, in an hour.

The 10 units of the course are:

1. Introduction to Financial Accounting

2. The Basics of Accounting

3. The Trial Balance and Its Uses

4. Adjustments

5. Fixed Assets and Depreciation

6. Preparing Final Accounting Statements

7. Partnership Accounts

8. Company Accounts

9. Internal Control Systems

10. Not-for-Profit Organisations

By the end of the course, you should be able to complete basic book-keeping

functions such as recording and summarising accounting information, and

prepare financial statements for single-owner businesses, partnerships and

not-for-profit organisations.

While we do not use a recommended text for this course, if you wish to

further reinforce the material in this book, you may use any text that is used

by secondary schools in your country to prepare students for the Carib-

bean Examinations Council (CXC) examinations. This will provide you with

additional practice exercises.

A word of advice: there are three ways to ensure that you succeed in any

accounting course: practice, practice, practice!


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Introduction toFinancial Accounting

Overview

In this unit we introduce you to accounting. We start with a definition of

accounting and explain the need for accounting information. An outline of

the features of a practical accounting system then follows. This unit also gives

you an insight into the users of accounting information, the career opportu-

nities available for accountants, and the major forms of business organisa-

tions in the Caribbean region. The unit concludes with a review of the con-

cepts and conventions governing the practice of accounting.

Objectives

After reading the unit text, and completing the supplementary learning

activities, you will be able to:

1. State the purpose of accounting

2. Describe the main features of an accounting system

3. Describe the conventions and concepts used in an accounting system

4. Define the various types of business organisations

5. List the various types of financial statements

6. Define the term balance sheet

7. Define the term profit and loss account (income statement)

8. List the elements of the accounting equation

9. State the purpose of the accounting equation

10. Define the terms assets, capital and liability

Unit 1


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Definition, Need and Use of

Accounting

Introduction

Accounting is the language of business and financial decisions. It has its own

vocabulary which should be carefully studied if accounting problems and

issues are to be understood and correctly interpreted. The accounting vocabulary

is continually expanding to meet the growing needs of commerce, industry and

technology.

Accounting provides an international yardstick for measuring the performance

of businesses of diverse nature so that their relative economic performance

may be readily compared.Accounting deals only with business events that can be

quantified and expressed in monetary terms. There are many important facts

concerning an enterprise that will not be disclosed from an examination of

the accounting records. Some examples of these are:

The health, age, qualifications and reputation of the enterprises executives

The rate of labour turnover and the number of employees

The existence of an industrial dispute

A new product put on the market by a competitor A profitable contract being negotiated

The current market price of the business

Accounting data must therefore be interpreted with these limitations in view.

Definition of Accounting

There is no standard definition of accounting. It is often defined as the process

of: accumulating, analysing, quantifying, classifying, recording, summarising,

interpreting, and reporting datarelating to the economic resources of an enterprise, to

all interested parties. In summary, it is a discipline that provides relevantinformation to decision makers, internal and external to the enterprise.

Accounting and book-keeping must not be confused. Book-keeping is the

recording aspect of accounting. Accounting may be classified under two main

headings financial accountingand management accounting.

Session 1


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The fundamental differences between financial accounting and management

accounting as given by Davidson, Maher, Stickney and Well inManagerial

Accountingare outlined in Table 1.

Table 1.1 Differences between Financial and Managerial Accounting

Financial Accounting Managerial Accounting

Users External users of information Internal users of information

Generally

accepted Compliance with generally Uses methods not necessarily

accounting accepted principles of in compliance with principles

principles accounting

Future Uses historical data in Uses estimates of the future

versuspast evaluating performance of for decision making purposesthe business and its managers and historical data for internal

performance evaluation

Reporting Regulations often specify how Internal cost-benefit analysis

requirements much information is enough evaluation determines how

much information is enough

Detail Summary data presented More detailed data required

presented about product cost, revenue

and profits

The Need for Accounting

The income tax laws require annually, a return showing the statutory

income of individuals and the profit or loss of businesses in each financial

year. In the absence of such a return, a commissioner of income tax is

authorised to raise an arbitrary assessment on such an individual or

business. Without proper accounting records, it would be impossible to

successfully resist an overassessment of tax.

Should an individual or a business become insolvent, that is, unable to

pay its debts, and be taken before the bankruptcy courts, they would haveto satisfy the trustee in bankruptcy, from their records, of the cause or

causes of their financial failure. Failure to do this would expose them

to the maximum penalty of two years imprisonment for the misdemeanour.

As a business grows, additional capital will be required. To obtain

additional capital by way of bank loans, overdrafts, shares and debentures,

for example, the credit-worthiness of the business must be established by

the accounting records. On the other hand, if a business has to be sold in


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whole or in part, the records would provide the proprietors with an

invaluable basis for negotiating a reasonable price. Proper financial

records also provide information either in summary form or in detail,

of the amounts owing to the business by its debtors and the amounts

owing by the business to its creditors.

The business may be a member of a trade association (e.g., master builders

association, manufacturers association, retail traders association) which

requires its members to furnish at periodic intervals, data relating to sales,

purchases, wages, etc. In addition, the business may be required to produce

information to a trade board in support of an application for license for

the purchase of items from other countries, or to a price control board in

support of a submission for price increases. In all these cases, the chief

source of information will be the books of accounts.

Many businesses are incorporated or formed under what in many

countries is called the Companys Act. The Companys Act usually

prescribes the minimum accounting records that should be maintainedand also specifies that a profit and loss account, a balance sheet and a

statement of changes in financial position should be submitted to the

shareholders or owners of such companies at annual intervals. In a special

sense, the directors of a company can be regarded as trustees of the share

holders and they must give an annual accounting of their stewardship.

In order to promote efficiency in a continuing business, the managers of

the business must be furnished with relevant accounting information

frequently, regularly and on a timely basis. This will enable them to make

proper decisions, control and direct the activities of the business and also

assist them in formulating future policies.

Where the workers of a business are represented by a trade union, the

union may require accounting information in the course of negotiation of

claims for increased wages and other benefits. In addition, it is not

unusual for enlightened management to provide employees with

accounting information on an annual basis.

Finally, accounting information is also useful for preparing schedules of

assets for insurance purposes.

Accounting MethodsAccounting may be carried out manually, mechanically and electronically

(electronic data processing). We shall be focusing attention on the manual

method of accounting. In this way, you will be provided with a background

without which it would be difficult to understand and appreciate the controls

necessary in the mechanical and electronic methods.


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Features of a Practical Accounting System

The following features should be expected of a practical and workable system

of accounting:

It should be very simple, so that even the least experienced member of

the accounting staff may understand it.

It should be flexible, so as to adapt itself to the changing needs of the

business.

It should provide a record of the transactions entered into now and at

any future date.

It should furnish, in an adequate manner, a true and fair view of the

resources invested in the business and the income derived from the use

of such resources.

Users of Accounting Information

Based on what we have stated so far, it should be clear that the main users of

accounting information are:

1. Owners of businesses, who use the information to help them assess the

soundness of their investment and to decide whether to change their

ownership interests.

2. Trade and loan creditors, either present or potential of the business,

who use it to help them to decide whether it is safe to extend credit to

the business.

3. Statutory agencies, such as income tax departments, registrars of

companies and trade administrators need financial statements to help in

evaluating tax returns for assessment and compliance with government

rules, regulations and laws.

4. Employees and trade unions use accounting information to assist them

in making various employment decisions and in negotiating contracts

and benefits.

5. Financial analysts need information so they can evaluate the soundness

of businesses for their clients who may wish to make investment decisions,

or for stock exchange purposes.

6. Customers of businesses look at accounting information to help them in

evaluating their relationship with businesses and in taking decisions

concerning possible future business relationships.

7. The managers of the business need information to assist them in decision

making, controlling and directing the day to day course of the business,

and in helping them to formulate policies and plans for its future.


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Opportunities for Gainful Employment

There are many employment opportunities for people trained in accounting.

Some of the more common ones are listed here.

Financial controllers are the chief accounting officers of a business,

responsible for supervising the accounting activities of the business. Insmall businesses, the position is often called chief accountant.

Cost accountants are responsible for the processing and reporting of

information on the cost of services or of manufactured products. The

information is designed to assist management in improving the efficiency

of current activities and in increasing profitability.

An internal auditoris responsible for investigating and evaluating, in a

systematic manner, the functioning of the accounting systems and

procedures of a company. The internal auditor also recommends changes

where necessary and establishes the extent to which management policiesand requirements are being implemented and are achieving their objectives.

A book-keeperperforms the task of recording and processing accounting

data.

These and other related opportunities for gainful employment can be found in:

1. An income tax department, a revenue board, auditor generals department

and the accounts branch of various government and quasi-government

agencies

2. Firms of practising accountants that perform professional auditing,accounting, taxation and management consultancy services as well as

secretarial services on behalf of their clients

3. Accounting and internal audit positions in banking, commerce, industry,

utilities, service clubs, cooperatives, charitable institutions, the offices of

attorneys and insurance companies

4. Academic institutions

Accounting: Definition, Need and Use

1. How would you define financial accounting?

2. How does financial accounting differ from managerial accounting?

3. What are the essential features of a practical accounting system?

4. Name four entities that would use the accounts of a firm. Why would

each of these entities need to use the accounts of the firm?

Activity 1.1


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common end through the formation of a democratically controlled organisa-

tion, making equitable contributions to the capital required and accepting a

fair share of the risks and benefits of the undertaking in which the members

actively participate. Cooperatives have considerable freedom to draw up

their own bylaws, but there are certain principles and practices setting off a

cooperative from a private business, to which all cooperatives must adhere.1

These principles include the following:

1. Voluntary membership without artificial restrictions or any social, political

or religious discrimination to all persons who can make use of the services

of the cooperative and who are willing to accept the responsibility of

membership.

2. Cooperative affairs should be administered by persons elected or

appointed in a manner agreed by the members and accountable to them.

3. Share capital should receive only a strict limited rate of interest, if any.

4. The economic benefits resulting from the operations of the cooperative

belong to its members and should be distributed in such a manner as

would avoid one member gaining at the expense of others.

5. All cooperatives should make provision for the education of their

members, officers and employees, and the general public, in the principles

and techniques of cooperation, both economic and democratic.

6. All cooperative organisations, in order to serve the best interest of their

members and their communities, should actively cooperate in every

practical way with other cooperatives at local, national and internationallevels.

Financial Accounting Statements

When all the accounting information is collected and recorded in the appro-

priate accounts for a particular time period, various financial statements can

be prepared. The two financial statements that we will be focusing on in this

course are:

1. The trading and profit and loss account

2. The balance sheet

The trading and profit and loss account is used to determine whether the

entity has made a profit or incurred a loss for the period under review. The

trading and profit and loss account is also referred to as an income state-

ment.

1Financial Reporting for Cooperative Businesses by Margaret Mendes, Caribbean Finance andManagement, 1993


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The balance sheet shows a summary of the balances on the various accounts

at a particular point in time. The balance sheet actually shows the financial

position of the entity, as it reflects the sources of funds and how these funds

have been used.

The Accounting EquationWe pointed out above that the balance sheet indicates the sources of funds

and how these funds were used. Funds are normally necessary to start a

business or to finance the business during its operation. These funds may

either be supplied by the owner or by a loan from a lending institution, for

example. The funds supplied by the owner are referred to as capital, whereas

loans to the business are referred to as liabilities. In broad terms, a liability is

anything owed by the entity to outsiders. Capital is a special type of liability,

as it represents funds owed by the entity to the owner. Liabilities may also be

incurred when goods are bought on credit or when amounts become due and

are not paid within the period in which they become due.

Funds received are used to acquire property for the business such as furniture,

plant, machinery and stock. These properties are referred to as assets. Assets

may be defined as anything owned byor owing to the entity.

From the foregoing, it should be clear to you that the funds supplied by the

owners and others are used for the acquisition of assets. Therefore, the sum of

the capital (C) and liabilities (L) must be equal to the assets (A). This is repre-

sented here in the following simple equation:

C + L = A

This is referred to as the basic accounting equation.

Accounting Conventions, Assumptions and Principles

Accounting principles are built on the foundation of a number of basic

concepts that accountants regard as self-evident. When such concepts are

followed unquestioned for generations by the accounting profession, they are

called conventions and for accountants, they have acquired a force akin to

law. Some of these concepts and basic assumptions are being challenged by

economists, securities commissions, businessmen and even accountants

themselves. Nevertheless, in order to understand accounting as it now exists,one must understand what the underlying concepts, assumptions and princi-

ples are. These concepts, conventions, principles and practices are referred to

as Generally Accepted Accounting Principles, abbreviated GAAP.


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The Entity Concept

Accounts are kept for each economic unit, called an entity, as distinct from

the persons who own the entities. For example, John Brown may own

several businesses; however, separate accounts showing the transactions, the

profitability and the financial position must be kept for each business. In

small businesses, particularly corporate businesses, problems may arise indistinguishing between the owners and the entity. In companies that have

subsidiaries, there may be important problems involved in defining the

entity for which consolidated accounts are prepared. In government and

non-profit organisations that do not control sub-units by stock, there are

great difficulties in defining the entity.

The concept of entity, although applicable to sole traders and partnerships

for purposes of accounting, is not recognised legally and in the case of

bankruptcy, all the personal assets of the sole trader or partner must be used

to satisfy the debts of the business. In accounting, the business owns the

resources and not the owner. For example, ifMrs. A starts a business with$100,000, from the point of view of the business, the owner,Mrs.A is a

long-term creditor of the business and the business therefore owesMrs. A

$100,000. Each entity is assumed to own its assets and incurs its liabilities.

The assets, liabilities and activities of the business are kept separate from

those of the owner of the business and from the assets, liabilities and

activities of other businesses, even though they may be owned by the

same person. Separate sets of accounting records are maintained for each

business and the financial statements must reflect the financial position and

results of the operations of that business alone.

Cost ConceptThe resources of a business are recorded in the accounts at the amounts paid

to acquire them rather than at current market prices. Cost, therefore, is the

basis for the future accounting for the resources. This concept provides an

objective basis for accounting as the figures are largely verifiable, thus limiting

the scope for subjective considerations. It should be noted that there are

exceptions to the cost concept. Inventories of finished goods, raw materials

and marketable securities are shown in the balance sheet at cost or net realis-

able value, whichever is lower. Depreciation and write-off of fixed assets do not

reflect changes in the market value of the asset, hence the cost concept is

maintained.

Going Concern Concept

Accounting assumes that the business will continue to operate indefinitely

and that it is not about to be liquidated or scaled down substantially. The

concept of the going concern does not assume that the business will exist

forever, but that it will operate long enough to use up its fixed assets and to

pay off its long-term loans as they mature, that is, for the foreseeable future.


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This explains why accounting does not attempt to record the liquidation or

current market value of individual fixed assets.

Money Measurement Concept

This concept provides a common denominator for measuring the results of

diverse business activities. Accounting deals with facts that can be measured

in monetary terms with a fair degree of objectivity. There are no exceptions

to this concept, although business information that cannot be quantified is

often provided in supplementary statements, such as directors reports.

Although the purchasing power of the monetary unit may change because

of inflation or deflation, accounting does not normally reflect these changes

in purchasing power except in supplementary financial data which some

companies publish. Accordingly, the monetary unit used in accounting is

not a unit of constant purchasing power.

Dual ConceptThe total amount of assets equals the total of the owners equity (financial

interest) and total liabilities. There are absolutely no exceptions to this

concept. It is important because conceptually, it aids in understanding the

effects of transactions on an accounting entity. If you understand that

for every debit there must be a credit, you will recognise the dual aspect of

transactions.

Time Period Concept

Accounting measures activities for a special period of time, usually one year;

it does not measure at the completion of each project or venture. Reportingthe results to management and to third parties at frequent intervals is obvi-

ously necessary. The necessity of doing this causes much of the difficulty in

accounting. There are problems associated with accrual accounting, which

we will look at in detail in a later unit. However, in measuring the net

income of an accounting period, the revenues and the expenses that

belong to that accounting period must be estimated. These estimates de-

pend in part on what is going to happen in future periods and this is often

mere conjecture.

Conservative or Prudence Concept

Revenues are recognised only when they are reasonably certain, whereas

expenses are recognised as soon as they can be reasonably estimated. This

concept explains why bad debt provision is made in the period in which the

related revenue is recorded. It also explains why stocks, that is, inventories

of finished goods or raw material, are valued at lower costs or market value.


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Realisation Concept

This concept states that revenues should be recorded in the period when the

goods are delivered to the customer or when the services are rendered. The

amount recognised is the amount that the customer has a legal obligation to

pay. Many problems arise as to both the period in which the revenue for a

given transaction should be recognised, and the amount of such revenue. Anexample of one such problem would be a contract for the sale of sugar at a

later date where the price is decided upon now.

Matching or Accrual Concept

Where a given event affects both revenues and expenses, the effect of each

must be recognised in the same accounting period. This therefore means that

revenue must be matchedagainst the costs incurred in earning such revenue.

Costs are reported as expenses in the period:

1. Where there is a direct association between costs and revenue of the period2. When costs are related to the activities of the period itself

3. When costs cannot be associated with revenues of any future period

Differences of opinion about the application of this concept and the realisa-

tion concept are at the heart of many accounting controversies.

Consistency Concept

Once an entity has decided upon a certain accounting method or treatment,

it is expected that it will treat subsequent transactions of the same character

and nature in the same fashion unless there is reasonable justification for

doing otherwise, such as a method of valuing stock or method of depreciation

of certain fixed assets. The concept is usually followed in theory, but the

practical problem is to decide when a sound reason for change exists.

Although the desire to increase the amount of net revenue reported in a

current period is at the root of some changes in method, this is definitely not

an acceptable reason for a change. A statement of standard accounting prac-

tices requires that a change of this nature should be reported as a change in

accounting policy and that the effect on profits should be stated.

Materiality Concept

Materiality is used in accounting to refer to the relative size or importance ofan item or event. What is material in one business may be insignificant in

another. For example, small expenditure in the acquisition of fixed assets may

be immediately expensed instead of being capitalised and depreciated over

the useful life of the asset. This is usually done to reduce the clerical labour

involved and the expenditure that would be incurred to keep the records, as

this would be out of proportion to the advantage to be gained.


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In essence, the concept allows insignificant events to be disregarded in the

accounts but requires full disclosure of all important information. An item is

deemed to be material if there is reasonable expectation that the knowledge

of it would influence the decision of the users of the financial statements. The

general notion is that an item is material if its disclosure is likely to lead the

user of the accounting information to act differently or to come to a different

conclusion if it were not disclosed.

Business Types and Accounting Concepts

1. What is a sole proprietorship?

2. What is a cooperative?

3. What are the two financial statements prepared from the accounts of a

firm? What is the purpose of each statement?

4. Explain the accrual concept, the dual concept and the materiality

concept.

Practice Exercises

Here are some questions and statements that will help you to determine how

well you have understood what we covered in this unit. The answers are all to

be found in what you just read. Respond to the questions and statements in

your own words and without looking back at the text. We suggest that you

put them in a special notebook that you will use throughout this course. Whenyou have finished, go back and check your answers against the material in this

study guide.

1. Describe the concept of accounting.

2. What is the difference between accounting and book-keeping?

3. Describe at least three cases that demonstrate the need for accounting.

4. List and describe at least five users of accounting information.

5. List and describe some of the job opportunities and where one

might find gainful employment in the accounting field.

6. Describe the three main types of business organisations.

7. Define the following terms: capital, liabilities, assets.

8. Write out and explain the accounting equation.

Activity 1.2


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9. What does GAAP represent?

10. Write brief notes to explain each of the following concepts:

(i) entity (v) time period

(ii) cost (vi) realisation

(iii) money measurement (viii) going concern

(iv) conservative (prudence) (ix) consistency

(v) going concern

fianancial accounting unit1

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