Financial Accounting Lecture 1 Chara Charalambous

Aims of the Lecture What is Accounting and the purpose of Accounting. The use of Financial Statements Users of Financial Statements Accounting cycle during a period The accounting equation Generally accepted accounting principles Solution of exercises Chara Charalambous

What is Accounting? A service that is systematically recording and summarizing the financial (economic) transactions of a business and then analyzing, verifying (confirming) and reporting the results. The person in charge for the execution of accounting is known as an Accountant, and this individual is typically required to follow a set of rules and regulations of the IFRS (International Financial Reporting Standards). Chara Charalambous

Purpose of Accounting Accounting allows a company to analyze the financial performance of the business and look at statistics such as net profit. Therefore the management is able to make informed judgment and better decision. Also Accounting aims to show the relationship of the business with its environment which includes its customers (debtors), suppliers (creditors), employees owners and lenders. Chara Charalambous

Accounting is concerned with: Identification and recording of transactions: A transaction is an economic event which affect the financial situation of the business. A transaction could be: a sale of a product, the purchases of raw materials , purchase of a machine, payment of salaries or the receive of a loan. The accounting system must be well organized so as all transactions are recognized when they take place and then are recorded in the books of the business using the book-keeping function. A double-entry bookkeeping system is a set of rules for recording financial information in a financial accounting system in which every transaction or event affects at least two different nominal ledger accounts. The accounting process includes the bookkeeping function, but is just one part of the accounting process Chara Charalambous

Classification and measurement of transactions after they have been recorded. Economic events may create assets (items which the business owns) or liabilities (what is due by the business to others) or revenues (income from sales) or costs/expenses (amounts incurred to make products or operate the business). Therefore correct classification is important. Measurement follows the classification and by this we mean: how mush of the costs or revenues concern this year and how mush must be carried forward to the next year. Summarization and communication. Since the Accountant has record all the transactions a summary is extracted which show the performance of the business during a period – a month or a year . This summary is shown through the financial statements which they communicate information regarding the financial position of the business to a wide range of users. Chara Charalambous

Financial Statements The Accounting service is analyzing data with the preparation of financial statements. The most widely used financial statements are: The Statement of Financial Position (Balance Sheet) and The Income Statement (Trading and Profit & Loss account). To achieve its goals, an accounting system may make use of computers and video displays as well as handwritten records and reports printed on paper Chara Charalambous

Financial Statements 1. Balance Sheet: is a statement of the assets, liabilities and owners’ equities as at a specific point in time (next day things could be different). Assets – are things owned by the business such as motor vehicles, machinery, inventory (goods manufactured or purchased for resale), money owed by debtors, balance at bank and prepaid expenses. Assets are divided into fixed assets: A long-term tangible  piece of property that a firm owns and uses in the production of its income and is not expected to be consumed or converted into cash any sooner than at least one year's time, and current assets: the value of all assets that are reasonably expected to be converted into cash within one year in the normal course of business. . Goodwill is an Intangible F.A. Liabilities – are amounts owed such as money due to creditors, bank overdrafts, short term loans. Owners’ equity – is a type of liability but this amount is due to the owner of the business rather than to ‘outsiders’. It increases by any new capital brought in and by the net profit made by the business and reduces by any amounts withdrawn by the owner. Chara Charalambous

Statement of Financial Position (Balance Sheet) as at 31st December 20YY € € Fixed Assets Capital X X Land and Buildings Add Net Profit X X Furniture and Fittings Less Drawings X X Motor Vechicles X Long-term Liabilities (repayable later than one year) X X Goodwill Long-term Loan Current Assets X Current Liabilities (amounts due within a year) Stock X X Debtors Creditors X Accrued Expenses X Prepayment of Expenses X Bank Overdraft X Bank Short Term Loan X X Cash X X Chara Charalambous

Balance Sheet as at 31 December Year 20XX Fixed Assets € Land and Buildings Furniture and fittings x Motor Vehicles Goodwil Current Assets Closing Inventory Debtors Prepayments Bank Cash xxxxxx Capital Account Add Net Profit Less Drawings Long-trrm Liabilities Long term loan Current Liabilities Creditors Accruals Bank Overdraft Short term loan X Chara Charalambous

The Accounting Equation Assets = Liabilities + Capital Or otherwise : Capital=Assets-Liabilities The balance sheet must always balance which means must always satisfy the above equation, at any time assets equals liabilities plus the capital . Chara Charalambous

2. Income Statement: Presents the results of operations for a period of time. It usually covers a year of business activity in contrast to balance sheet which is as at a specific point in time. The income statement is prepared following the accruals concept: the income and expenses are recorded as they occurred regardless of whether cash has been received or paid . Income – the sales revenue shows the income from goods/services sold in the year. Expenses – in order to make revenues we must incur expenses: an outflow of money to pay for an item or service e.g. wages, rents, electricity e.t.c The income statement is split into two parts a) the Trading account which gives the gross profit and b) the Profit & Loss account which gives us the Net Profit. Chara Charalambous

Trading and Profit & Loss account € € X X Sales Opening Stock Less Sales Returns X X X Add Purchases X Less Purchases Return X Less Closing stock Cost of Sales X Gross Profit c/d X X X X Gross Profit b/d Wages and Salaries X Discounts Received X Insurance X Rent X Depreciation of motor vehicles and Furniture's X Bad Debts X Office Expenses Discount allowed X X Net Profit Chara Charalambous X

The modern-vertical layout is as follows: The above layout of the income statement is not mainly useful but is assists the appreciation of the actual double entry processes and the realization that the income statement is part of the double entry. The modern-vertical layout is as follows: Income statement: Trading and Profit & Loss account Sales x Less Cost of Sales: Op. Stock x Purchases x Less Closing stock (x) (x) GROSS PROFIT xx Less Expenses (x) NET PROFIT xxx Chara Charalambous

The modern-vertical layout of Income Statement is as follows: Income statement: Trading and Profit & Loss account Net Sales x Less Cost of Sales: Op. Stock x Purchases x Less Closing stock (x) (x) GROSS PROFIT xx Plus Other income xx Less Operating Expenses: Wages / Salaries x Heating & Lighting x Rent x Insurance x Advertising x Bad Debts x Depreciation x Stationery x Commission Paid x Bank interest & charges x Cleaning x Office Expenses x (x) NET PROFIT xxx Chara Charalambous

USERS OF FINANCIAL STATEMENTS The financial accounts provide a wealth of information that is useful to various users of financial information INVESTORS CUSTOMERS MANAGEMENT OWNERS SUPPLIERS EMPLOYEES USERS LENDERS THE PUBLIC COMPETITORS GOVERNMENT Chara Charalambous

Managers: need information on a monthly basis to control the business, plan for the future and evaluate profitability. They prepare budgets based on past performance and they compare it to actual results. Owners: The financial Statements tell the owners just how successful the business has been and also summarise in brief form its present financial position Investors: are concerned with how secured and the profitable is their investment in the specific company. This is shown in the income statement. Employees: are interested to know if an employer can offer secure employment, possible salary increases and retirement benefits. They are also interested in the pay and benefits obtained by senior management! Chara Charalambous

Lenders: Banks and other financial institutions who lend money to a business require to know if they will be repaid. This is shown in the balance sheet which displays the solvency of the firm. Government: need to know how the economy is performing so as to plan financial policies. Also the tax authorities evaluate the tax witch is payable by the companies with the use of financial statements. Suppliers: need to know if the business is able to pay short-term debt when it falls due. Competitors: wish to compare their own performance against that of other firms that are operating in the same sector. Chara Charalambous

Accounting Cycle During Period Also known as “bookkeeping cycle ”, is the process of recording and processing the accounting events of a company. The series of steps begin when a transaction occurs and end with its inclusion in the financial statements. The main steps of the accounting cycle are:   Collecting and analyzing data from transactions and events. Posting entries to the general ledger. Adjusting entries appropriately. Preparing an adjusted trial balance. Organizing the accounts into the financial statements. Closing the books. Preparing a post-closing trial balance to check the accounts. .  Chara Charalambous

Main Types of Business Transactions Duality Concept: Each and every transaction that the business makes has two aspects and has a double effect on the business and accounting equation. B/ce Sheet Incm Stat. 1. SALES OF GOODS: If with cash cash sales If with credit debtors sales 2. PURCHASES: If with cash cash stock If with credit creditors stock 3. PURCH. OF FIXED ASSETS: If with cash cash F. A If with credit creditors F.A Chara Charalambous

4. PAYMENT OF EXPENSES: cash expense B/ce Sheet Incm Stat 4. PAYMENT OF EXPENSES: cash expense 5. BRING NEW CAPITAL: cash capital 6. DRAWINGS: cash capital Chara Charalambous

The business entity concept Accepted accounting principles require that a set of financial statements describe a specific business body, which is called business entity. Financial Accounting information relates only to the activities of the business entity and not to the activities of its owner. For e.g. if the owner buys a car for him and his family to use personally this transaction will not influence the balance sheet elements at all. The business entity is treaded as separate from its owners. Chara Charalambous

Forms of business organizations Sole Trader: Owned and operated by one person, although there might be any number of employees. A Sole Trader is fully and personally liable for any losses that the business might take. Partnership: Owed and operated by two or more people called the ‘partners’. Partners are ‘jointly and severally’ liable for any losses that the business might make. Traditionally the big accounting firms have been partnerships

Company: Owned by many people (shareholders) and operated by many people (thought not necessarily the same). There can be one shareholder or many thousands of shareholders. Each shareholder owns part of the company. As a group, they elect the directors who run the business. Directors often own shares in theirs companies. Not all shareholders are directors. Companies are almost always limited companies (This means that the shareholders will not be personally liable for any losses the company incurs). Their liability is limited to the nominal value of the shares that they own.

Capital For all three types of organization, the money contributed by the individual, the partners or the shareholders is referred to as the business capital. In the case of a company the capital is divided into shares.

Statement of Standard Accounting Practice (SSAP) Is concerned with the disclosure (notification , communication) of accounting policies – the guidelines and rules that must followed when preparing the financial statements. The 4 fundamentals accounting concepts mentioned by the standard are: The going-concern concept The accruals concept The consistency concept The prudence concept Chara Charalambous

Going concern: the business for which we are preparing the financial statements is going to continue in operation for an undetermined period. Before the accounts are certified as showing a true and fair view , the auditor must be satisfied that the company is a going concern and that it will continue to function successfully in the future. The auditor in order to assume that the company is a going concern is based on the following factors: the demand of the company’s product in the market , if the company have sufficient cash to respond to its liabilities in the future and if it is profitable. Also if the company has sound capital to face any future unexpected events and finally if the company is competive enough regarding its products, its ability to acquire raw materials and labor. Chara Charalambous

The income statement for a period is prepared following the accruals concept: the income and expenses are recorded as they happened in the period regardless of whether cash has been received or paid : Costs which are paid but they are concerning a future period must be carried forward as a prepayment and charged in the period they concern not in the current profit and loss account. The same for income: if there is an income received but it regards a future period for e.g. next year it will not included in the income statement of this period but of the next and for the current year it will consider as prepayment Expenses of the period not yet paid and not entered in the books must be estimated and inserted as accruals. Chara Charalambous

Prudence concept: Business transactions are sometimes uncertain Prudence concept: Business transactions are sometimes uncertain. While making judgment we need to be careful and prudent. Prudence is a key accounting principle which makes sure that assets and income are not overstated and liabilities and expenses are not understated. Accountants must not be very optimism and overstate profits and causing by this unrealized profits to be paid out of capital in the form of dividends. Because there is a danger that the profit might not finally realised since some of the clients of the company might declared bankruptcy and not pay. Therefore Accountants must be strict with profits but take in mind all possible losses. Chara Charalambous

Consistency: with many accounting transactions there is more than one method which can be used. For example the depreciation method and policy. Accountants must use their judgment to select the most appropriate method, but once that choice is made the same method must be used with consistency (stability) in forthcoming periods. Such consistency enables users to make a useful comparison of results over time. Thus investors can see the level of profit or loss, comparing this year with the last year , and make their investment decisions accordingly. The methods used should only be changed if the new method selected improves the true and fair value given by the accounting statements. Chara Charalambous

Exercises of the handout Chara Charalambous