Accounting Unit 1

The process of identifying, recording, summarizing, and analyzing an entity's financial transactions and repoering them in financial statements.

Assets

Resources owned or controlled by a business that have a measurable monetary value from which future economic benefits or service potential is expected to flow to the entity.

Liabilities

A business entity’s current financial debts or obligations owed to third parties (e.g. lenders, suppliers, creditors) arising from past transactions

Equity

(shareholder/owner’s equity): residual value of a company’s assets after deducting liabilities; represents a business’ net worth or owner’s stake.

Accounting Standards

Specific rules that dictate how financial transactions and events should be reported in financial statements

Accounting standards are derived from and aligned with conceptual frameworks to…

ensure consistency, transparency, and comparability in financial reports

conceptual framework

Acts as overarching set of principles and guidelines that manage the development of specific accounting standards.

the conceptual framework provides

the theoretical foundation and guidelines for financial reporting and setting standards

the conceptual framework defines

the objective of financial reporting, key qualitative characteristics of financial info, and the elements that should be recognized in financial statements

CF defined:

a formal way of thinking about a process or system under study

limitations of cf

• can be too general in nature

  • therefore, principles may not help when actually producing the financial statements

• there may be further disagreement as to the content of the framework and the contents of standards

financial performance

ability of the entity to earn profit

financial position

the state/shape/situation of the entity regarding the effects of economic resources/capital it uses

fundamental qualitative characteristics of financial statements

relenance and faithful representation

enhancing qualitative characteristics of financial statements

comparability and verifiability

comparability

information is presented in a way that the decision-maker can recognize similarities, differences, and trends between different companies or time periods; requires consistent application of accounting principles & standards

verifiability

independent and knowledgeable individuals can reach a consensus; not necessarily in full agreement. E.g., verifiability is generally supported by reliable data and audit processes to confirm the accuracy of financial statements

understandability

information must be presented clearly and concisely so that users with (only) reasonable knowledge of BM and accounting can comprehend it without inordinate effort; info should be presented in a logical and easy-to-comprehend manner

timeliness

information must be provided to users within the time period in which it is most likely to affect their decisions; outdated info may lose its relevance

asset recognition criteria

a resource…

• controlled by the entity,

• as a result of past events,

• from which future economic benefits or service potential is expected to flow to the entity, eg. equipment, furniture, etc

The main objective of the financial statement is to provide relevant information about the entity's…

Economic activities

liability recognition criteria

a liability is…

• recognized when an entity has a present obligation (that must be measurable in monetary terms),

• resulting from past events,

• and it is expected that an outflow of resources will be required to settle the obligation.

income/revenue recognition criteria

• increase in economic benefits during the accounting period

• in the form of inflow of resources/assets

• results in increases in equity

expense recognition criteria

• decreases the economic benefits during the accounting period

• in the form of outflow or depletion of resources/assets

• results in a decrease in equity

equity recognition criteria

• claim of the owner on the assets of the entity

• net assets that the owner can withdraw for personal use

• equity is the leftover interest in the assets of the entity, eg.

  • assets - liabilities = capital (syn for equity)

• NB: capital is the most common example of equity

GAAP stands for

Generally Accepted Accounting Principles

accounting entity concept

• The economic activities of the owner are to be treated as separate and distinct from the activities of the business

• economic events recorded from pov of the business

accounting entity justification

To provide a clear and accurate assessment of the business's performance and financial health. Specifically, it allows interested parties to see:

• Profitability: It enables the calculation of the actual profit made by the business operations alone, without being clouded by the owner's personal spending or income

• Capital Investment: It helps track the specific amount of capital employed in the business, which is essential for evaluating the return on investment

accounting entity drawback

Artificial and may not align with legal or practical realities.

• Legal Reality: In many cases, such as with sole proprietorships, the law does not recognise a distinction between the owner and the business; the assets and liabilities legally belong to the proprietor, not to an "artificial" accounting entity

• Economic Reality: The separation often does not reflect economic reality, particularly in small or family-owned businesses where the owner and business are closely intertwined financially and operationally

  • In these scenarios, the owner may withdraw or inject funds at will, and the business's success is directly tied to the owner's personal financial well-being

monetary (money measurement concept)

All transactions should be recorded in monetary terms (dollars & cents)

Justification: common unit of measurement

monetary concept drawback

• Non-monetary transactions are not considered, eg. brand reputation/satisfied customers

• The concept assumes a stable value of assets; in reality, inflation can distort the value of assets, liabilities, & income over time

  • Inflation erodes the purchasing power (amount of goods or services one unit of currency can buy; measurement of money’s value) of money over time

Historical Cost

All business transactions are recorded at their og cost at the time of the transaction

Justification: objective and verifiable

Historical Cost Drawback

• During inflation, the values for cost allocation may not reflect current dollar values

• Assets purchased years ago may be significantly more or less valuable now, but their book value remains the og cost

  • Can make financial statements less useful, esp for assets whose value fluctuates over time (eg. properties, investments, securities)

continuity (going concern)

• Assumes that the business will continue operating indefinitely & is unlikely to cease operations in the foreseeable future

• Assets will be valued as historical concept

going concern justification

• justifies the use of historical costs rather than current market values in measuring assets bc it is assumed that assets are held in the business to earn revenue or realize future potential benefits

going concern drawback

overstatement of asset values if business is nearing closure or liquidation

Accounting Period

• The life of the business entity is divided into equal financial periods, usually one year

• Profit or loss is determined within this period

• Requires that a balance sheet and an income statement be produced at regular intervals

Accounting Period Justification

Ongoing information about a business is required at regular intervals

Accounting Period Drawback

Seasonality or cyclical fluctuations not fully captured within a fixed period. The accounting period concept may not accurately reflect the performance of such businesses if the financial statements are not adjusted for seasonality or cycles.

Revenue Recognition/realization

• All items of revenue should be recognised in the accounting period when they are earned (not necessarily when cash is received)

• This is when goods/services are delivered/provided by the business, hence the buyer is legally liable to pay.

Matching

The revenues earned in an accounting period should be matched or offset against the expenses incurred to help earn that revenue in the determination of profit.

Depreciation Example: If a machine is purchased for $10,000 and has a useful life of 5 years, the company will recognize $2,000 in depreciation expense each year for 5 years, matching the expense to the revenue generated by the use of the machine during that period

Matching Justification

• To ensure that revenues and expenses are aligned in the period in which they occur

• To reflect the actual cost of generating revenue

Matching Drawbacks

The difficulty of determining which costs are associated with particular revenues

accruals principle

• revenues and expenses should be recorded in the periods in which they are earned or incurred, regardless of when cash transactions occur

justification

• closely tied to the matching principle, which states that expenses should be recorded in the same period as the revenues they help generate

• gives a more accurate picture of profitability

Conservatism (Prudence)

• accountants should never anticipate profits until they are realised, but should make provisions for all losses

• encourages caution and requires that accountants recognise expenses and liabilities as soon as possible, but only recognise revenues and assets when they are certain

Justification

The accountants are cautious people. That is, when it is felt that where doubt exists, it is better to go wrong on the safe side.

Consistency

• A principle requiring procedures once adopted by a company to remain in use from one accounting period to the next

  • unless the users of financial statements are informed by a means of footnote (disclosure) Footnotes (disclosure) = extra explanations attached to financial statements

  • They tell users:

    • what accounting methods were used

    • what changed

    • why it changed

    • and how it affects the numbers

Justification

• Comparability across periods