FAC3704 Financial Accounting I: Financial Accounting Concepts, Principles, and Procedures

Basic Principles and Spheres of Accounting

Learning Outcomes

Describe, calculate, and record the financial performance and position of a sole proprietor.
Use the basic accounting equation and the double-entry system to record transactions.

Study Units

Basic concepts, principles, and objectives of accounting.
Financial position.
Financial performance (result).
Double-entry system and the accounting process.

Basic Concepts, Principles, and Objectives of Accounting

Explain the nature of accounting, accounting principles, policy, practices, and procedures.

Key Concepts

Financial information, decision-making, nature of accounting, unit of measurement.
Forms of ownership, fields of accounting.
Accounting principles, international financial reporting standards.
Accounting statements, accounting policy, going concern.
Qualitative characteristics, elements of financial statements.

Introduction

Accounting developed with the economic system and serves an important function in society.
Activities are expressed in money terms and recorded, whether manually or by computer.
Understanding manual systems is essential to understand computerized systems.

What is Accounting?

Definition: Orderly recording of monetary values of financial transactions and reporting results through financial statements.
Enables users to make informed decisions.

Accounting Activities:

Identifying economic activity (transactions).
Recording monetary value of transactions to provide a financial history.
Communicating information to users through financial statements.

Objectives of Accounting

Enable users to ascertain financial results and position.
Answer questions such as:
- Profit or loss?
- Income and expenses?
- Debts owed?
- Amounts owed by customers?
- Nature and value of assets?
- Amount of capital (equity)?

Accounting vs. Bookkeeping

Bookkeeping is the daily recording of transactions.
Accounting includes bookkeeping but is broader.
Accounting involves the aspects of bookkeeping, focusing on recording financial transactions.

The Nature of Accounting

A specialized means of communication conveying financial information.
Users must understand the message (concepts, principles, procedures).
Financial information is used by everyone involved in an entity.
Knowledge of accounting helps manage personal finances.
Accounting is a "language" to convey financial information.

The Purpose of Accounting

Provides financial information to users for decision-making.
Presents financial information truly and fairly.
Aims to provide quantitative information to answer questions like:
- Can the entity generate enough income?
- What are the entity’s expenses in relation to sales?
- Is inventory being kept at correct levels?
- Should the entity expand operations?
- Is the pricing policy correct?

The Accounting Process

Functions as an information system.
Business transactions are measured, classified, summarized, and recorded continuously.
This process is called the financial accounting cycle.

Financial Accounting Cycle Elements:

Transaction data input.
Source documents.
Subsidiary journals.
General ledger.
Subsidiary ledgers.
Trial balance.
Financial statements.
Analysis and interpretation.
Decision-making by management.

Why Study Accounting?

Systematic recording of entity activities (transactions).
Records monetary value of transactions to ascertain financial position and results.

Advantages for Individuals:

Understand business terms and concepts.
Promotes logical thought processes.
Plan and systematize personal finances.
Work accurately.
Develop a sense of responsibility.
Understand the value of money.

Advantages for Entities:

Communicate financial information.
Keep accurate records of daily activities.
Determine profit or loss.
Calculate total assets and liabilities.
Function effectively and efficiently.

Developments in Accounting

Economic activities involve transactions between interested parties.
Entities record transactions for control.
Accounting records and reports financial transactions for informed decisions.
Historical development influenced by economic and social circumstances.
Financial records existed in ancient civilizations (Babylonia, Greece, Rome).
Increased trading led to improved financial information recording for better decisions.
Before 1494: No systematic method.
Modern accounting originated in Italy during the Renaissance.
Luca Pacioli described double-entry principle in 1494.
Computerized systems are now common, but basic principles remain unchanged.
Understanding manual systems is important for computerized systems.
Standardization improves comparability.
SA GAAP was harmonized with IFRS (International Financial Reporting Standards) in 1995.
IFRS for SMEs is a scaled-down version for small and medium entities.
Financial Reporting Standards Council (FRSC) governs financial information recording and reporting in South Africa.
Ensures similar transactions are recorded in the same way for comparability.

The Function of Accounting

Orderly identification and recording of monetary values of financial transactions.
Reporting results through financial statements for decision-making.
A specialized method of communicating financial information.

Accounting Activities:

Identification: Selecting relevant economic events (transactions).
Recording: Monetary value of transactions, chronological diary, classification, and summarization.
Communication: Preparing and distributing accounting reports (financial statements).

Financial Statements:

Statement of financial position.
Statement of profit or loss and other comprehensive income.
Statement of changes in equity.
Statement of cash flow.
Notes, comprising a summary of significant accounting policies and other explanatory notes.
The word "entity" can refer to a business, educational, or religious institution, or a private household.

Universal Accounting Denominator

Money is the common unit of measurement.
The currency in South Africa is the rand.

Limitations:

Not all events can be expressed in monetary terms.
The value of money is unstable due to inflation.

The Entity Concept

Business entities are either service entities or trading entities.

Service Entities:

Render services for a fee (e.g., transport, repairs, personal services).

Trading Entities:

Specialize in buying and selling merchandise (e.g., florists, outfitters, grocers).
Some entities render services and sell merchandise.
A business is separate from its owner(s).

Forms of Ownership

Refer to how businesses are owned and managed.

Forms of Ownership in South Africa:

Sole trader.
Partnership.
Close corporation.
Profit company (SOC Ltd, (Pty) Ltd, Inc, Ltd).
Non-profit company (NPC).

Users of Financial Information

Financial statements are prepared annually for various users and decision-making purposes.

User Categories and Information Needs:

Clients/customers: Assess going concern.
Employees: Assess job stability and remuneration.
Government: Regulate activities, compile statistics, determine tax policies.
Investors: Assess investment risk and return.
Lenders: Assess ability to pay interest and repay loans.
Suppliers: Assess ability to pay amounts owing.
Management: Plan, control, and evaluate.
The public: Entity’s contribution to the economy, work opportunities, taxes, and charitable causes.
Not all employees have unlimited access to accounting records.
Users need information on efficient and effective use of resources.
This is known as stewardship, corporate governance, and accountability.

The Fields of Accounting

Internal users (management, employees) and external users (investors, creditors, government).

Two Fields of Accounting:

Financial accounting: Providing information to external parties.
Management accounting: Providing information to people within an entity.

Financial Accounting

Measures and records transactions for periodic reports (financial statements).
Provides information for managers, owners, creditors, and the public.
Governed by international financial reporting standards for comparability.

Management Accounting

Concerns historical and estimated data for management decisions.
Provides specific information about specific aspects of an entity’s activities.
Financial and management factors are part of the same information system.
Overlaps with financial accounting.
This course concerns financial accounting.

The Objective of General-Purpose Financial Reporting

Provide information about financial position, performance, and changes for a wide range of users in making economic decisions.
Users’ decisions involve buying, selling, holding equity or debt; providing or settling loans; and influencing management’s actions.
Users assess prospects for future net cash inflows and management’s stewardship.
Users need information about economic resources, claims, and changes, and how efficiently management has used resources.

Information Provided in Financial Statements:

Statement of financial position: Economic resources, claims (Assets = Equity + Liability), liquidity, and solvency.
Statement of profit or loss: Financial performance (Income – Expenses) using accrual accounting.
Statement of changes in equity: Changes in equity structure, capital transactions, and distributions to owners.
Statement of cash flows: Changes to assess investing, financing, and operating activities, cash acquisition and distribution.
Notes: Additional information and accounting policies.

Accounting Principles

Techniques based on conceptual and theoretical ideas.

Accounting Policy

Guideline on how to act in repetitive situations.
Ensures consistent handling of similar transactions.

Disclosure of Accounting Policy

Entity must disclose its accounting policy in financial statements.
E.g., the basis used for depreciation of property, plant, and equipment.

International Financial Reporting Standards (IFRS)

Generally applicable language and grammar rules for accounting.
Avoids chaos by ensuring financial reports are prepared according to common rules.

Accounting Standards and Statements

Limit the variety of accounting practices without strict uniformity.
Encourage widespread use of particular standards.

The Conceptual Framework for Financial Reporting 2018

Not a standard but sets out the objectives and concepts underlying financial statements.

The Objective of Financial Statements

Refer to section 1.10 (page 16).

Underlying Assumption

Going concern: the entity will continue to operate for the foreseeable future.

The Qualitative Characteristics of Useful Financial Information

Must be relevant and provide a faithful representation.

Fundamental Qualitative Characteristics:

Relevance: Influences economic decisions by helping evaluate past, present, or future events and confirm past evaluations.
- Predictive value and confirmatory value.
- Materiality: Information is material if its omission or misstatement could influence decisions.
Faithful representation: Faithfully represents the substance of what it reports, must be complete, neutral, and free from error.

Enhancements to Qualitative Characteristics:

Comparability: Able to compare financial statements over time and between entities.
- Consistency across items, periods, and similar entities.
Verifiability: Users can confirm information presented.
- Direct verification (counting cash) and indirect verification (recalculating inventory).
Timeliness: Recent and reliable information is more useful.
Understandability: Readily understood by the average user with reasonable knowledge and willingness to study.
- Complex information should be included if the benefits outweigh the costs.
Financial statements report financial position, changes, and performance.

Statements Used:

Statement of financial position: Reports financial position.
Statement of cash flows: Reports change in financial position.
Statement of profit or loss: Reports financial performance.

Financial Statements and the Reporting Entity

Reporting entity: Required or chooses to prepare financial statements.
Not necessarily a legal entity.
Financial statements: Form of financial reports providing information about assets, liabilities, equity, income, and expenses.

The Elements of Financial Statements

Elements measuring financial position: assets, liabilities, and equity.
Elements measuring profitability: income and expenses.

The Statement of Financial Position

Reports financial position, summarizing assets, liabilities, and equity.

Elements Definitions:

Assets: Present economic resources controlled by the entity as a result of past events.
Equity: Residual interest in assets after deducting liabilities (ownership).
Liabilities: Present obligations to transfer economic resources as a result of past events.

The Statement of Profit or Loss and other Comprehensive Income

Reports financial performance.

Elements Definitions:

Income: Increases in assets or decreases in liabilities that result in increases in equity (e.g. sales, rental income, commission).
Expenses: Decreases in assets or increases in liabilities that result in decreases in equity (e.g. cost of sales, water and electricity, salaries and wages, interest expenses, stationery, credit losses).

Recognition and Measurement of the Elements of Financial Statements

Recognition: Incorporating an item in the statement of financial position or profit or loss if it meets the definition of an element and recognition criteria.
An item should be recognized if future economic benefits are probable and the item’s cost or value can be measured reliably.

Measurement Bases:

Historical cost: Information derived from the price of the transaction.
- Reduced for impairment of assets and increased for onerous liabilities.
- May be applied at amortized cost.
Current value: Updated to reflect conditions at the measurement date.
- Includes fair value, value in use, fulfillment value, and current cost.
Fair value: The price to sell an asset or transfer a liability in an orderly transaction between market participants.
Value in use: The present value of cash flows from the use of an asset.
Fulfillment value: The present value of cash outflows to settle a liability.
Current cost: Amount to acquire an equivalent asset or take on an equivalent liability.

Exercise and Solution

Revision Questions:

Discuss the nature of accounting (Refer to section 1.2.2).
What is the common unit of measurement in accounting? (Money)
Name the four main forms of ownership in South Africa (Sole trader, Partnership, Close corporation, Company).
Discuss the different users of financial information (See section 1.8).
Differentiate between financial accounting and management accounting (See section 1.9).
Name the qualitative characteristics of financial information (See section 1.15.2.3).
Define the concept of accounting policy (See section 1.12).
What is meant by disclosure of accounting policy? (See section 1.13).
Describe the concept of international financial reporting standards (See section 1.14).
Discuss the underlying assumption in the preparation of financial statements (See section 1.15.2.2).
Name the fundamental qualitative characteristics of financial statements (Relevance, Faithful representation).
Name the elements of financial statements (Assets, Liabilities, Equity, Income, Expenses).

Self-Assessment

Describe the importance of financial information for decision-making.
Discuss the different users of financial information and their needs.
State the different forms of ownership.
Discuss the nature of accounting.
Explain the difference between financial and management accounting.
Name the qualitative characteristics of financial statements.
Explain what is meant by accounting policy.
Explain what is meant by the disclosure of accounting policy.
Explain what is meant by international financial reporting standards.
Explain what is meant by accounting standards and statements.