Introduction to Accounting

Introduction to Accounting

                                                                                                                                      

Accounting: Accounting is a way of recording, analyzing and summarizing transactions of an entity.

·        The transactions are recorded in “books of original entry”.

·        The transactions are then analyzed and posted to the ledgers.

·        Finally the transactions are summarized in the financial statements.

BAS= Bangladesh Accounting Standard.                                                                       

BFRS= Bangladesh Financial Reporting Standards.

Balance Sheet: A list of all the assets controlled and all the liabilities owed by a business as at a particular date: it is a snapshot of the financial position of the business at a particular moment.

Equity: The amount invested in a business by the owners.

Income Statement: A record of income recognized and expenditure incurred over a given period. It is a record of the entity’s financial performance over a period of time. The statement shows whether the business has more revenue than expenditure (a profit) or (a loss).

Capital expenditure: Expenditure which results in the acquisition of long-term assets, or an improvement or enhancement of their earning capacity.

Long-term assets are those which will be kept in the entity for more than one year.

• Capital expenditure is not charged as an expense in the income statement.
• Capital expenditure on long-term assets appears in the balance sheet.

Revenue expenditure: Expenditure which is incurred either

• For trade purpose. This includes purchases of raw materials or items for resale, expenditure on wages and salaries, selling and distribution expenses and finance costs or
• To maintain the existing earning capacity of long-term assets.

Revenue expenditure is charged to the income statement of a period, provided that relates to the trading activity and sales of that particular period.

Capital income: Proceeds from the sale of non-current assets.

The profits (or losses) from the sale of long-term assets are included in the income statement for the accounting period in which the sale takes place. For instant, the business may sell machinery or property which it no longer needs.

Revenue income: Income derived from

• The sale of trading assets, such as goods held in inventory.
• The provision of services.
• Interest and dividends received from business investments.

The Accounting Equation

Asset: Something valuable which a business owns or has control over. BAS Framework states that an assets is a resource controlled by the entity as a result of past events from which future economic benefits are expected to flow. Assets are key elements of financial statements.

Liability: Something which is owed to a third party. “Liability” is the accounting term for the debts of a business. BAS Framework states that a liability is a present obligation arising from past events, the settlement of which is expected to result in an outflow of resources from the business embodying economic benefits. Liability is key elements of financial statements.

Business Entity Concept: A Business is a separate entity for its owners.

Although this may seem logical and unrealistic you must try to appreciate it, as it is the basis of a fundamental rule of accounting, which is that the liabilities plus the capital of the business must always equal its assets. We will look at this rule in more detail later in this chapter, but a simple example now will clarify the idea of a business as a separate entity for its owners.

Capital: The amount an entity “owes” to its owner. BAS Framework states that capital is the residual interest in the assets of the entity after deducting all its liabilities. Equity is a key element of financial statements.

Accounting equation: ASSETS = CAPITAL + LIABILITIES.

Historical cost: Transactions are recorded at their cost when they were incurred.

ASSETS = Capital + Profit

Profit: The excess of income over expenses.

Loss: The excess of expenses over income.

Income: Increases in economic benefits over a period in the form of inflows or increases of assets or decreases in liabilities, resulting in increases in capital/equity (Framework). It can include both revenue and gains.

Expenses: Decreases in economic benefits over a period in the form of outflows or depletion of assets or increases in liabilities, resulting in decreases in capital/equity (Framework).

Drawing: Money and goods taken out of a business by its owner.

Creditor: Person to whom a business owes money.

Debtor: Person who owes money to the business.

Accruals concept: The accruals concept requires earned is matched with the expenses incurred in earning it.

NET ASSETS: Assets less Liabilities

Current Liabilities: are debts which are payable within one year.

Non-current Liabilities: are debts which are payable after one year.

Non Current assets: this are acquired for long term use within the business. They are normally valued at cost less accumulated Depreciation.

Current Asset: This are expected to be converted into cash within one year.

Gross profit: Revenue from sales, less (-) cost of sales.

Net profit: Gross profit less expense plus (+) non trading income.

Accrued Expense are added to expense in the income statement and shown as balance sheet payables, because they relate to the current period but have not been paid as cash in the period.

    Gross profit

Gross profit margin =                            × 100

      Revenue

Business Expenses not directly related to cost of sales appear in the income statement under one of three headings.

Distribution Costs Expenses associated with selling and delivering goods to customers.

Administrative costs Expenses of providing management and administrative for the business.

Finance costs

Ø      Dividends on redeemable preference shares

Ø      Interest on loans

Ø      Bank overdraft interest

Recording Financial Transactions

Invoice: Invoices are used to record transactions which have been made on credit. This is where goods or services are supplied but payment is not made straight away as there is a Period of credit before they are actually due for payment. An invoice may relate to a sales or purchase order. Invoices are source documents for credit transaction.

Credit note: A document issued to a customer relating to returned goods or refunds when a customer has been overcharge for whatever reason. It can be regarded as a negative invoice. It is a source documents for credit transaction.

Debit notes: A debit note might be issued to a supplier as a means of formally requesting a credit note from that supplier. A debit note is not a source document.

Delivery notes: When goods or services are delivered to a customer in respect of a sale, they are usually accompanied by a delivery note prepared by the seller. The delivery note is not a source document for credit transactions.

Books of original entry: The records in which the business first records transactions.

The main books of original entry are:

1.      Sales day book

2.      Purchases day book

3.      Cash book

4.      The payroll

5.      The journal

Sales day book: The books of original entry in respect of credit sales, including both invoices and credit notes.

Purchases day book: The books of original entry in respect of credit purchases, including both invoices and credit notes.

Cash Book: The books of original entry for receipts and payments in the business’s bank account.

What is the cash book used for?

The cash book is used to record money received and paid out by the business. The cash book deals with money paid into and out of the business bank account. This could be money received on the business premises in notes. Coins and cheques and subsequently paid into the bank. There are also receipts and payments made by bank transfer, standing order, direct debit and online transfer, plus bank interest and charges made directly by the bank.

Petty cash book: The book of original entry for small payments and receipts of cash.

Payroll: The book of original entry for recording staff costs.

Ledger Accounting and Double Entry

Nominal Ledger: An accounting record which analyses the financial records of a business.

Double Entry Bookkeeping: Each transaction has an equal but opposite effect. Every accounting event must be entered in ledger accounts both as a debit and a credit.

Receivable ledger: The ledger for customer’s personal accounts. It is not part of the nominal ledger or the double entry system, but double entry rules apply to the receivables ledger account.

Payable ledger: The ledger for supplier’s personal accounts. It is not part of the nominal ledger or part of the double entry system, but double rules apply to the payables account.

Trade discount: A reduction in the cost of goods, owing to the nature of the trading transaction. It usually results from buying goods in bulk. It is deducted from the list price of goods sold to arrive at a final sales figure. There is no separate ledger account for trade discount.

Cash discount: A reduction in the amount payable in return for immediate payment in cash, or for payment with in an agreed period. There are separate ledger accounts for cash discounts: one for discount allowed to customers, and one for discount received from suppliers.

VAT:  is an indirect tax on the supply of goods and services. Tax is collected at each transfer point in the chain from prime producer to final consumer. Eventually the consumer bears the tax in full and any tax paid earlier in the chain can be recovered by a registered trader who paid it.

Preparing Basic Financial Statements

Trial Balance:  A list of nominal ledger balances shown in debit & credit columns, as a method of testing the accuracy of double entry bookkeeping.

To a debit balance: in the TB, add debits & subtract credits from the adjustments columns. If the result is positive, insert it in the debit column. If it is negative, insert it in the credit column.

To a credit balance: in the TB, subtract debits & add credit. If the answer is positive, insert it in the credit column .If it is negative, insert it in the debit column.

Control Accounts, Errors & Omissions

Control Account: Nominal ledger account in which a record is kept of the total value of a number of similar individual items. Control accounts are used chiefly for trade receivables   and payables.

A receivable control account is a nominal ledger account in which records are kept of transactions involving all receivables in total. The balance on the receivables control account at any time will be the total amount due to the business from all its credit customers.

A payable control account is a nominal ledger account in which records are kept of transactions involving all payables in total and the balance on this account at any time will be the total amount owed by the business to all its credit suppliers.

Contra: When a person business is both a customer & a supplier, amounts owed by and owed to the persons maybe “netted off” by means of a contra.

Irrecoverable Debt: When a debt owed by a customer will never be paid, the total amount is removed.

Dishonored  Cheque: when a customer cheque is paid into the business’s bank but the customer’s bank refuses to honor payment of it, it is ‘written back’ so as to remove the receipt of the cheque from the books.

Bank Statement: A record of transactions on the business bank account maintained by the bank in its own books.

Bank Reconciliation: A comparison of a bank statement (sent monthly, weekly or even daily by the bank) with the cash book. Differences between the balance on the bank statement and the balance in the cash book should be identified and satisfactorily reconciled.

Transposition errors: When two digits in an amount are accidentally recorded the wrong way round.

Error of omission: Failing to record a transaction at all or making a debit or credit entry but not the corresponding double entry.

Error of principal: Making double entry in the belief that transaction is being entered in the correct accounts, but subsequently finding out that the accounting entry breaks the ‘rules’ of an accounting principal or concept. A typical example of such an error is to treat revenue expenditure incorrectly as capital expenditure.

Errors of commission: A mistake is made recording transaction in the ledger accounts.

Compensating errors: Errors which are, coincidentally, equal and opposite to one another.

Suspense account: An account showing a balance equal to the difference in a trail balance.

Accounting concepts and conventions

Fair presentation: The faithful representation of the effects of transactions, other events and conditions in accordance with BAS Framework so that the reliability of financial statements in maintained.

Accounting policies: The specific principals, bases, conventions, rule and practices applied by an entity in preparing and presenting financial statements.

Going concern: The entity is viewed as continuing in operation for the foreseeable future. It is assumed that the entity has neither the intention nor the necessity of liquidation or of ceasing to trade.

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Accrual basis of accounting: Item are recognized as assets, liabilities, equity, income & expenses (the elements of financial statements) when they satisfy the definitions & recognition criteria for those elements in BAS framework.

Material: Omissions or misstatements of items are material if they could, individually or collectively; influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size & nature of the omission or misstatement judged in the surrounding circumstances. The size or the nature of an item, or a combination of both, could be the determining factor.

Prudence: The inclusion of a degree of caution in the exercise of the judgments needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated & liabilities or expenses are not understated  & so financial statements retain their reliability.

Substance over form: Transactions & other events are accounted for & presented in accordance with their substance & economic reality & not merely their legal form. Doing so enhances faithful presentation & reliability.

Money measurement concept: Financial statements only deal with those items to which a monetary value can be attributed.

Historical cost: Transaction are recorded at their cost  when  they occurred.

Realizations concept: Income & profits are recognized when realized.

Cost of Sales, Accruals & Prepayments

Cost of sales: Opening inventory + carriage inwards – closing inventory. This amount is then deducted from revenue to arise at the business gross profit.

Accruals (accrued expenses): Expenses which are charged against the profit for a particular period, even though they have not yet been paid for.

Prepayments (prepaid expenses): Expenses which have been paid in one accounting period, but are not charged against profit until a later period, because they relate to that later period.

Irrecoverable debts and allowances

Irrecoverable debt: A debt which is not expected to be paid.

Writing off: Charging the cost of the debt against the profit for the period.

Allowance for receivables: An amount in relation to specific debts that reduces the receivables assets to its prudent valuation in the balance sheet. It is offset against trade receivables, which are shown at the net amount.

Inventories

Cost of inventories: All costs of purchase of conversion and of other costs incurred in bringing the items to their present location and condition.

Cost of purchase: The purchase price, import duties and other non-recoverable taxes, transport, trading, handing and other costs directly attributable to the acquisition of finished goods and materials.

Conversion costs: Any cost involved in converting raw materials into final product, including labour, expenses directly related to the product and an appropriate share of production overheads 9but not sales, administrative or general overheads).

FIFO (first in, first out): Items are used in the order in which they are received from suppliers, so oldest items are issued first. Inventory remaining is therefore the newer items.

LIFO (last in, first out): Items issued originally formed part of the most recent delivery, while oldest consignments remain in the bin.

AVCO (average cost): As purchase prices can change with each new consignment received, the average value of an item is constantly changing. Each item at any moment is assumed to have been purchased at the average price of all the items together, so inventory remaining is therefore valued at the most recent average price.

Standard cost: All inventory items are valued at a pre-determined cost. If this standard cost differs from prices actually paid during the period the differences is written off as a ‘variance’ in the income statement.

Replacement cost: The cost of an inventory unit is assumed to be the amount it would cost now to replace it. This is often (but not necessarily) the unit cost of inventories purchased in the next consignment following the balance sheet date.

Non- current assets and depreciation

Useful life: The estimated economic life (rather than the potential physical life) of the non-current asset.

Depreciation: The systematic allocation of the cost or valuation of an asset, less its residual value, over its useful life.

Residual Value: The estimated amount that the entry would currently obtain disposing of the asset after deducting estimated disposal costs.

Carrying amount: Cost less accumulated depreciation.

Accumulated depreciation: The amount of depreciation deducted from the cost of a non-current asset to arrive at its carrying amount will build up over time, as more depreciation is charged in each successive accounting period. This is called accumulated depreciation.

Straight line depreciation: The depreciable amount is charged in equal installments to each accounting period over the expected useful life of the assets.

Reducing balance depreciation: The annual depreciation charge is a fixed percentage of the brought forward carrying amount of the asset.

Accumulated depreciation: The total amount of the asset’s depreciation amount that has been allocated to accounting period o date.

Assets register: A listing of all non-current assets owned by the organization, broken down by department, location or asset type, and containing non-financial information (such as chassis numbers and security codes) as well as financial information.

Purchased goodwill: The excess of the purchase consideration paid for a business over the fair value of the individual assets and liabilities acquired.

Company Financial Statements

Rights Issue: New share are offered to existing shareholders in proportion to their existing shareholding, usually at a discount to the current market price.

Retained earnings: An equity reserve used to accumulate the company’s retained earnings.

Bonus issue (or Capitalization issue or Scrip issue): An issue of fully paid shares to existing shareholders, free of charge, in proportion to their existing shareholding.

Retrospective application: Applying the new policy as if it had always been in use, by adjustments in both the current accounting period and the previous one. The reasons for and effects of the changes must also be disclosed.

Change in accounting estimate: An adjustment of the carrying amount of an assets or a liability that results from assessment of the present status of and expected future benefits and obligations associated with assets and liabilities. Changes in accounting estimates result from new information or new developments and accordingly are not corrections of errors.

Prospective application: Recognizing the effect of a change in accounting estimate in the current and future periods affected by the change.

Prior period errors: Omissions from and misstatements in financial statements for prior periods in relation to information which was available when those statements were prepared and could reasonably be expected to have been taken into account at that time.

Sole Trader and Partnership Financial Statements

Partnership: The relationship which exists between persons carrying on a business in common with a view of profit.

Appropriation of profit: Sharing out profits in accordance with the partnership agreement.

Current Account: A record of the Profits retained in the business by the partner.