INTRODUCTION TO FINANCIAL ACCOUNTING
The most widely used definition of accounting is:-
“The process of identifying, measuring and communicating economic information to
permit informed judgements and decisions by users of the information.”
In financial accounting, the information is communicated by means of accounts or
financial statements (which include an income statement and a statement of
financial position). The form, size and complexity of the financial statements depend
on the type of organisation or business entity. There are three main types of
business entity:-
Sole traders
Partnerships
Limited companies
A sole trader owns a business himself. In a partnership there are two or more
owners of the one business. Limited companies are owned by the shareholders,
whose liability is limited to the amount of capital they have invested in the business.
Whatever the type of business, there will be users of the accounts, who require
information for various reasons about the activities of the business. Possible users of
accounts are:-
Owners of the business - the sole trader, a partner or the shareholders
Managers
Employees
Lenders
Customers
Suppliers
The Government
Potential investors
Financial analysts and advisers
The public
THE PROFESSIONAL and REGULATORY FRAMEWORK
It is difficult to produce one set of information suitable for so many user groups. It is
therefore essential that accounting information remains objective, and that there is
uniformity across different sets of accounts. Most accounts are prepared by a
professionally qualified accountant. There are six major professional accountancy
bodies in Great Britain, namely:-
Institute of Chartered Accountants of Scotland (ICAS)
Institute of Chartered Accountants in England and Wales (ICAEW)
, Institute of Chartered Accountants in Ireland (ICAI)
Chartered Association of Certified Accountants (ACCA)
Chartered Institute of Management Accountants (CIMA)
Chartered Institute of Public Finance and Accountancy (CIPFA)
In 1978 these accounting bodies formed an Accounting Standards Committee (ASC).
The ASC issued a series of Statements of Standard Accounting Practice (SSAPs). The
aim was to reduce the possibility of large variations in the reporting of profits. In
1990 the accountancy bodies replaced the ASC with the Accounting Standards
Board (ASB). Any standards produced by the ASB are called Financial Reporting
Standards (FRSs), with SSAPs being gradually superseded by new FRSs. Anyone
preparing financial statements for publication must comply with the reporting
standards.
Most UK companies, particularly larger ones, now prepare accounts using
International Accounting Standards (IASs) and International Financial Reporting
Standards (IFRSs). Small companies generally prepare their accounts under FRSSE –
Financial Reporting Standard for Smaller Entities.
OBJECTIVITY & SUBJECTIVITY
Objectivity – use a method that arrives at a value agreed because it is based on a
factual occurrence.
Subjectivity – use judgement to arrive at a value.
FUNDAMENTAL ACCOUNTING CONCEPTS
There are several accounting rules or concepts which traditionally underlie the
preparation of financial accounts. The underlying accounting concepts are:-
Historical Cost
Assets are normally shown at cost price as a basis for valuation.
Money Measurement
Accounting information covers the measurement in monetary units and most people
can agree that value.
Business entity
The affairs of the business are treated separately from the owner’s non-business
activities.
Dual aspect
Two aspects of accounting are always equal to each other. This forms the accounting
equation, discussed in more detail below.
Time interval
1
,An underlying principle is that accounts are prepared at regular intervals, usually
once per year.
There are also two assumptions that the International Accounting Standards
Board list, namely:
Going Concern
Accounts are prepared on the basis that the business will continue to operate for the
foreseeable future unless there is strong evidence to indicate that this is not the
case. Assets are normally valued at their original cost price. If the business were not
going to continue, it would be necessary to value them at their realisable value.
Accruals or Matching
All income and charges relating to a financial period should be taken into account,
regardless of whether cash has been received or paid.
Additionally, there are some attributes of accounting information that make it
useful.
Understandability
Relevance
o Materiality
Reliability
o Faithful representation
o Substance over form
o Neutrality
o Prudence
o Recognition of profits & gains
o Completeness
Comparability
Constraints on relevant & reliable information
Timeliness
Balance between benefit & cost
Balance between qualitative characteristics
THE ACCOUNTING EQUATION
In accounting, terms are used to describe things. The amount of funds that an owner
introduces into the business is known as capital (equity). The actual resources of the
business are known as assets. When the owner introduces capital into the business,
he also introduces the asset of cash. Therefore,
2
, Assets = Capital
The two sides of the equation will have the same totals. This is because we are
dealing with the same thing from two different points of view, i.e.:
Resources in the business = Resources supplied by the owner
(Assets) (Capital)
This booklet will introduce Ross and how he goes about recording his accounting
information. It is necessary to buy the core text for this module.
Example
Ross has just received a gift of £50,000 from his elder brother. He spends £10,000 on
a holiday to Greece, and uses the remaining £40,000 to set up a business called
Rossco on 30th September 20X6. He opens a bank account in the business name.
The capital which Ross has invested in the business is £40,000. The business now has
an asset – a bank account with £40,000 in it.
Assets = Capital
£40,000 £40,000
Suppose Ross buys a van to use in his business for £10,000.
Assets = Capital
Bank 30,000
Van 10,000
40,000 40,000
However, sometimes the owner may owe money to other people for assets or stock.
The name liabilities is given to those amounts owing.
It may well be that Ross does not provide all the finance for the business himself, but
takes out loans, or buys goods on credit. These require at some point in the future to
be paid back, i.e. are liabilities. Because of this, we need to expand the accounting
equation to read:-
Assets = Capital + Liabilities
The two sides of the equation will have the same totals. This is because we are
dealing with the same thing from two different points of view, i.e.:
Resources: what they are = Resources who supplied them
(Assets) (Capital + Liabilities)
3
The most widely used definition of accounting is:-
“The process of identifying, measuring and communicating economic information to
permit informed judgements and decisions by users of the information.”
In financial accounting, the information is communicated by means of accounts or
financial statements (which include an income statement and a statement of
financial position). The form, size and complexity of the financial statements depend
on the type of organisation or business entity. There are three main types of
business entity:-
Sole traders
Partnerships
Limited companies
A sole trader owns a business himself. In a partnership there are two or more
owners of the one business. Limited companies are owned by the shareholders,
whose liability is limited to the amount of capital they have invested in the business.
Whatever the type of business, there will be users of the accounts, who require
information for various reasons about the activities of the business. Possible users of
accounts are:-
Owners of the business - the sole trader, a partner or the shareholders
Managers
Employees
Lenders
Customers
Suppliers
The Government
Potential investors
Financial analysts and advisers
The public
THE PROFESSIONAL and REGULATORY FRAMEWORK
It is difficult to produce one set of information suitable for so many user groups. It is
therefore essential that accounting information remains objective, and that there is
uniformity across different sets of accounts. Most accounts are prepared by a
professionally qualified accountant. There are six major professional accountancy
bodies in Great Britain, namely:-
Institute of Chartered Accountants of Scotland (ICAS)
Institute of Chartered Accountants in England and Wales (ICAEW)
, Institute of Chartered Accountants in Ireland (ICAI)
Chartered Association of Certified Accountants (ACCA)
Chartered Institute of Management Accountants (CIMA)
Chartered Institute of Public Finance and Accountancy (CIPFA)
In 1978 these accounting bodies formed an Accounting Standards Committee (ASC).
The ASC issued a series of Statements of Standard Accounting Practice (SSAPs). The
aim was to reduce the possibility of large variations in the reporting of profits. In
1990 the accountancy bodies replaced the ASC with the Accounting Standards
Board (ASB). Any standards produced by the ASB are called Financial Reporting
Standards (FRSs), with SSAPs being gradually superseded by new FRSs. Anyone
preparing financial statements for publication must comply with the reporting
standards.
Most UK companies, particularly larger ones, now prepare accounts using
International Accounting Standards (IASs) and International Financial Reporting
Standards (IFRSs). Small companies generally prepare their accounts under FRSSE –
Financial Reporting Standard for Smaller Entities.
OBJECTIVITY & SUBJECTIVITY
Objectivity – use a method that arrives at a value agreed because it is based on a
factual occurrence.
Subjectivity – use judgement to arrive at a value.
FUNDAMENTAL ACCOUNTING CONCEPTS
There are several accounting rules or concepts which traditionally underlie the
preparation of financial accounts. The underlying accounting concepts are:-
Historical Cost
Assets are normally shown at cost price as a basis for valuation.
Money Measurement
Accounting information covers the measurement in monetary units and most people
can agree that value.
Business entity
The affairs of the business are treated separately from the owner’s non-business
activities.
Dual aspect
Two aspects of accounting are always equal to each other. This forms the accounting
equation, discussed in more detail below.
Time interval
1
,An underlying principle is that accounts are prepared at regular intervals, usually
once per year.
There are also two assumptions that the International Accounting Standards
Board list, namely:
Going Concern
Accounts are prepared on the basis that the business will continue to operate for the
foreseeable future unless there is strong evidence to indicate that this is not the
case. Assets are normally valued at their original cost price. If the business were not
going to continue, it would be necessary to value them at their realisable value.
Accruals or Matching
All income and charges relating to a financial period should be taken into account,
regardless of whether cash has been received or paid.
Additionally, there are some attributes of accounting information that make it
useful.
Understandability
Relevance
o Materiality
Reliability
o Faithful representation
o Substance over form
o Neutrality
o Prudence
o Recognition of profits & gains
o Completeness
Comparability
Constraints on relevant & reliable information
Timeliness
Balance between benefit & cost
Balance between qualitative characteristics
THE ACCOUNTING EQUATION
In accounting, terms are used to describe things. The amount of funds that an owner
introduces into the business is known as capital (equity). The actual resources of the
business are known as assets. When the owner introduces capital into the business,
he also introduces the asset of cash. Therefore,
2
, Assets = Capital
The two sides of the equation will have the same totals. This is because we are
dealing with the same thing from two different points of view, i.e.:
Resources in the business = Resources supplied by the owner
(Assets) (Capital)
This booklet will introduce Ross and how he goes about recording his accounting
information. It is necessary to buy the core text for this module.
Example
Ross has just received a gift of £50,000 from his elder brother. He spends £10,000 on
a holiday to Greece, and uses the remaining £40,000 to set up a business called
Rossco on 30th September 20X6. He opens a bank account in the business name.
The capital which Ross has invested in the business is £40,000. The business now has
an asset – a bank account with £40,000 in it.
Assets = Capital
£40,000 £40,000
Suppose Ross buys a van to use in his business for £10,000.
Assets = Capital
Bank 30,000
Van 10,000
40,000 40,000
However, sometimes the owner may owe money to other people for assets or stock.
The name liabilities is given to those amounts owing.
It may well be that Ross does not provide all the finance for the business himself, but
takes out loans, or buys goods on credit. These require at some point in the future to
be paid back, i.e. are liabilities. Because of this, we need to expand the accounting
equation to read:-
Assets = Capital + Liabilities
The two sides of the equation will have the same totals. This is because we are
dealing with the same thing from two different points of view, i.e.:
Resources: what they are = Resources who supplied them
(Assets) (Capital + Liabilities)
3
