1

Topic 1:

Introduction to Financial Accounting

Learning outcomes

• What is a business?

• Business transactions

• Asset and Liabilities and Capital

• Accounting Principles and Characteristics

• Accounting Equation

• Financial Statements

What is a business?

The purpose of a business is to make a profit for its owner(s)

Profit = income less expenditure

A business is a separate entity from its owner

Every financial transaction has a dual effect

Double entry bookkeeping accounts for the dual aspect of financial transactions

What is a business ?

A business of whatever size or nature exists to make a profit.

Types of business entity

Sole traders – refers to ownership, sole traders can have employees

Partnerships – two or more people working together to earn profits

Limited liability company – owners have liability limited to the amount they pay for their shares

A limited liability company has a separate legal identity from its owners

2

Business Transactions

Wherever property changes hands there has been a business transaction.

A cash transaction is where the buyer pays cash to the seller when goods are transferred.

A credit transaction is a sale or purchase which occurs earlier than cash is received or paid.

Assets and liabilities 1

Assets are items of value which a business owns or has the use of.

Assets are categorised as either non-current or current.

• Non-current assets are those acquired for us over more than one accounting period, e.g.

land and buildings, machinery, computers and vehicles.

• Current assets are those owned by the business with the intention of turning them into

cash, e.g. inventory and receivables.

Liabilities represent amounts that are owed by the business.

Liabilities are categorised as either non-current or current.

• Non-current liabilities are those that are not payable within one year, e.g. mortgages, a 5

year bank loan, amounts used in respect of hire purchase agreements.

• Current liabilities are those that are payable within one year, e.g. amounts owed to

suppliers, overdrafts repayable on demand.

3

The Accounting Equation

The purpose of a business is to make a profit (excess of income over expenditure) for its owner.

Under the business entity concept, the assets and liabilities of a business must be kept separate

from the assets and liabilities of its owner.

The accounting equation:

Accounting Equation 1

Assets = Capital + Liabilities

Accounting Equation 2

Assets = (Capital introduced + Retained Profits) + Liabilities

Accounting Equation 3

Assets = Capital introduced + (Earned Profit - Drawings) + Liabilities

Accounting Principles and Characteristics

Basic accounting principles and characteristics are the broad assumptions which underlie the

financial accounts of business entities.

There are five important ones to understand:

• Going concern

• Accruals

• Objectivity

• Consistency

• Historical cost

4

Going concern: the business will continue to operate into the foreseeable future at its current

activity level

Accruals: revenue must be matched with the costs incurred in earning it

Objectivity: amounts recorded in the accounting records are based on objective evidence.

Consistency: similar items should be given similar treatment, which is applied from one

accounting period to the next

Historical cost: transactions are stated in the accounts at their historical amount

Amounts are initially recorded in the accounting records at their cost or purchase price.

Example:

Other accounting principles and characteristics:

Business entity principle (a business is separate from its owners or managers)

Only business activities are recorded and not personal activities of the owner.

Every business transaction is recorded form the viewpoint of the business.

Double entry bookkeeping (every transaction gives rise to a debit and a credit entry)

Money measurement (accounts only deal with items to which a monetary value can be attributed):

Economic data are recorded in dollars.

Use dollar amount as a common denominator.

5

Financial Statements:

The financial statements of a business are represented by several elements, the most basic being

the Statement of Financial Position and the Statement of Profit or Loss.

Statement of Profit or Loss

The statement of profit or loss (or profit and loss account) shows how the profit or loss for the

period has been made.

Key items on the statement of profit or loss are gross profit and net profit.

Gross profit = Sales – Cost of goods sold

Cost of goods sold represents the purchase or production costs of goods sold

Net Profit = Gross profit + Other income – Other expenses

Other expenses are overheads incurred in running the business e.g. advertising costs, office

building rental costs, postage costs etc.

Revenue: Resources earned by the business. Increase owner’s equity as a result of selling

services or products to customers.

Expenses : Resources used up to earn revenue. Using up of assets or consuming services in

the process of generating revenues.

Revenue Expenses Expenses Expenses

Fees revenue Salaries exp Sundry exp Discount allowed

Sales revenue Rental exp Staff welfare exp

Interest earned Utilities exp Interest exp

Rent earned Advertising

exp

Bad debts exp

Commission

received

Insurance exp Repairs and

maintenance exp

Discount received Carriage

outwards exp

Entertainment exp

Carriage

inwards

Office supplies exp

6

Statement of Financial Position

The Statement of Financial Position (or balance sheet) shows the assets, liabilities and capital of

the business at the period end.

It represents the accounting equation.

It distinguishes between non-current and current assets, and non-current and current liabilities.

The Accounting Equation:

Assets = Liabilities + Capital

Assets: Resources owned by the business

Fixed Assets Current Assets

Land and building (Premises) Cash

Motor vehicle Stock/ Inventory

Office equipment Debtors/ Accounts receivable/ credit

customers

Furniture and fittings Prepaid expense

Plant and machinery Accrued revenue

Notes receivable

Liabilities: Resources owing by the business or Resources contributed by non-owners such

as bankers and credit suppliers.

Current Liabilities Non-current liabilities

Creditors/ Accounts payable/ credit

suppliers

Bank loan

Bank overdraft Mortgage loan

Short term loan Debenture bonds/Bonds payable

Unearned revenue Notes payable

Accrued expense/Expense due/

Expense owing/ expense outstanding

Notes payable

Capital/ Owner’s equity: Resources contributed by the owner into the business.

Drawings: Resources taken out by owner from business for personal use

7

Recording business transactions using Accounting Equation

A business transaction is an economic event or condition that directly changes an entity’s

financial condition or its results of operations.

Transactions

January 2012

1 Nancy deposited $50,000 in a bank account in the name of Nancy Trading.

8 Nancy Trading bought furniture worth $12,500 paying by cheque.

10 Supplies of $6,300 was bought on credit.

16 Nancy Trading received $2,880 for rental from tenants through GIRO.

20 The following expenses were paid by cheques: wages $1,500, utilities $350

and repairs $550.

24 Nancy Trading paid creditors $3,400 with a cheque.

31 Nancy determined that the unused supplies was $1,900.

31 Nancy withdrew $ 2,100 from Nancy Trading for her personal use.

Assets = Liabilities + Owner’s Equity

8

Financial Statements

Statement of Comprehensive Income/ Income Statement: Shows the financial performance of a

business. Based on matching concept.

Statement of Owner’s Equity

Statement of Financial Position/ Balance Sheet: Shows the financial position of a business.

Based on the accounting equation.

Cash Flow Statement (Topic 9)

The Accounting Equation Expanded:

Assets = Liabilities + Capital + Revenues - Expenses

Assets = Liabilities + Capital + Net Profit

Assets = Liabilities + Capital - Net Loss

9

Sample: Excel Company Trading, Profit and Loss Account for the year ended 30 April 2012

$ $ $

Sales 100,000

Less: Return Inwards (9,000)

Net Sales 91,000

Less: Cost of Goods Sold

Opening Stock 12,000

Purchases 56,000

Less: Return outwards (11,000)

Carriage inwards

Customs duties

2,500

1,800

Less: Closing Stock (20,000)

Cost of Goods Sold (41,300)

Gross Profit 49,700

Add: Commission received 2,600

Discount received

Interest received

Rent received

Less: Expenses

1,600

3,400

10,800

68,100

Insurance 7,500

Bad debts expense 3,700

Increase in PFDD 5,700

Depreciation 4,500

Carriage outwards 2,450

Salaries and wages 12,800

Interest expense 1,500

Rent expense 6,500

Utilities expense 6,900

Discount allowed 1,060 (52,610)

Net Profit 15,390

Excel Company Statement of Owner’s Equity for the year ended 30 April 2012

Opening Capital 110,000

Add; New Capital 0

Add: Net Profit 15,390

Less: Drawings (6,030)

Closing Capital 119,360

10

Excel Company

Balance Sheet as at 30 April 2012

$ $ $

Current Assets

Stock 20,000

Trade receivable/Accounts receivable 45,000

Less: Allowance for doubtful debts (11,500) 33,500

Prepaid expense 6,890

Accrued revenue 5,670

Cash 13,600 79,660

Fixed Assets

Premises 100,000

Less: Accumulated depreciation (45,000) 55,000

Motor vehicle 55,000

Less: Accumulated depreciation (12,500) 42,500

Plant and machinery 60,000

Less: Accumulated depreciation (16,900) 43,100

Office Equipment 29,000

Less: Accumulated depreciation (9,800) 19,200

Furniture and fittings 23,000

Less: Accumulated depreciation (8,500) 14,500 174,300

253,960

Current Liabilities

Trade payables/Accounts payable

Accrued expense

Unearned revenue

Short term loan

Non Current Liabilities

Loan from OCBC /Mortgage loan

Owner’s Equity

37,000

8,700

10,500

8,400

64,600

70,000

Opening Capital 110,000

Add: Net Profit 15,390

Less: Drawings (6,030)

Closing Capital 119,360

253,960

11

Topic 1 Practice Qn 2

A Park

Balance Sheet as at 30 April 2012

Current assets

Cash in hand 2,900

Cash at Bank 1,600

Accounts receivable 4,100

Inventory 8,600 17,200

Fixed assets

Fixtures 9,600

Car 12,300 21,900

Total assets 39,100

Current liabilities

Accounts payable 7,400

Long term Liabilities

Owner's equity

Capital 31,700

Total liabilities & OE 39,100

12

1-49

1-50

Practice Questions

Question 2

A. Park has the following items in her statement of financial position on 30 April

2012: Capital $31,700; Accounts payable $7,400; Fixtures $9,600; Car

$12,300; Inventory $8,600; Accounts receivable $4,100; Cash at bank

$1,600; Cash in hand $2,900.

Draw up A Park’s statement of financial position as at 30 April 2012.

Question 3

During the first week of May 2012, Mary entered into the following transactions:

a. She bought a piece of furniture for $1,100 on credit.

b. One of the debtors paid her $450 by cheque.

c. She paid $60 for stationery expenses.

d. She put an extra $500 into the business in cash.

Show how the accounting equation is affected with the above transactions

Review Chapter Round up , Quick Quiz and Answers to Quick Quiz