FIA FA1 Study Notes FREE PakAccountants Com PDF

CHAPTER
1 Understanding the role of Accounting in Business
Study
FIA FA1 Notes
By:
Hasaan Fazal
Recording Financial
Transactions
UPDATED FOR
2011
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EXAMSPage |1
CHAPTER
FIA FA1
Study
Notes
Recording Financial
Transactions
By: Hasaan Fazal
Page |2
CHAPTER
1
TABLE OF CONTENTS
Understanding the role of Accounting in Business
Chapter # Title of Chapter Page #

1 Understanding the role of accounting in
business 05
2 Financial Accounting – Introduction 15
3 Accounting framework 22
4 Non-current assets – tangible 37
5 Inventory 50
6 Events after the reporting period 58
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CHAPTER
1
Understanding the
CHAPTER role of Accounting
in Business
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CHAPTER
1 Why study ACCOUNTING?

1.1 What is business? – The real reason behind accounting
Business is any activity undertaken with a motive to earn profit.
Though it is a narrow definition of business activity and is focusing just on profitability.

However, if we study businesses all around the world and the way they are run,
everything is done with a reason to earn profit or maximize profits ultimately.
1.2 Understanding the relationship of business activity and

profits – How it all started and how it works
No human can live alone as they cannot fulfill every need themselves. No one can be
completely self-dependent. That is why humans interact.
But talking in strict business perspective, humans interact so that they can exchange
goods and services with an objective that their personal needs can be met. And this
exactly is business activity.
Businesses all around the world understood this concept and they learnt that by fulfilling
other needs they can earn money, or in a deeper perspective, profits.
So what actually started as a need is now a subject of our daily life and is also a tool to
survive. Let’s understand why business is that important. As said earlier, that it all
started as a need, still today this is the case. Business identify the requirements, needs
and wants of households (those who want to fulfill their needs) and offer (sell) goods and
services to them in return of something (e.g. money) that is capable of fulfilling the needs
of businesses in return. But before they can offer something to customer they have to
acquire (purchase) resources which are also known as factors of production which are
provided by households.
This is how very simplistic economy runs and almost every economic event that
happens inside that economy is business activity.
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CHAPTER
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Page |7
CHAPTER
2 Who runs businesses?

2.1 Business Organizations
Businesses are run by organizations.
Organization mean: A group of people that come together (not as a result of some
accident rather formation of group itself is a thoughtful process) to achieve a unified goal
or to fulfill some specific purpose.
2.1 Types of organizations
Organizations can be classified in different ways. It is up to the observer that from which
perspective he is studying an organization. We can classify organizations on the
following basis:
1. Legal structure
2. Liability
3. Nature of Operations Manufacturing, Service
4. Industrial sector Primary secondary tertiary
5. Public or private sector
6. Profit or non-profit
7. Size
8. Geographical area national local multinational
There are still so many other ways to classify organizations for example whether they
are exempted from taxes or duties, organizational structure they posses, concentration
of decision making power etc but the ones listed above are the most basic and important
ways to classify business organizations and it will be good if we understand about them
right at initial stage.
Legal structure means the status of an organization in the eyes of law and in which
segment it places an organization. From legal point of view organizations can be of three
different kinds:
1. Sole traderships
2. Partnerships
3. Companies
From the perspective of liability of the owners towards the people outside the
organizations (creditors, lenders etc), we have two different kinds of organizations in
which owners of the organizations have:
1. Limited liability
2. Unlimited liability
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Nature of business refers to the fact that whether business is manufacturing something
or just providing services.
We can also classify organizations according to the industrial sector to which they
belong. Industrial sector is of three different types:
1. Primary industrial sector

2. Secondary industrial sector
3. Tertiary industrial sector
Organizations can also be classified on the basis whether the organization is owned by
an individual or group of individuals i.e. private sector organization or it is owned by a
government or by a body working under government i.e. public sector organization.
Most of the organizations exist to earn and maximize profits but some organizations
exist for purposes other than making profits. Thus organization with profit motive are
called as profit making organization and the ones with purpose other than profit are
called non-profit organizations
We can find organizations of different sizes. Some are small where some are considered
very large organizations. We can relate the term size to many different aspects such as
we can relate it to the number of employees working in an organization. Size can also be
in terms of products or services a certain organization is providing compared to others. It
can also be stated as number of offices it has in a country or countries. We can also
measure size in relation to the customer base of an organization etc.
Another way of classifying the organization is by observing their scope of operations. If it

is limited to just one city then it can be termed as local organization but if operation of a
certain organization are spread all over a country then it will be called national
organization and if its operations are spread across the borders i.e. to other countries
also and are controlled from one country then it will be termed as international
organization and if organization carries its operations from different countries i.e. holds
offices in different countries then it is called as multinational organization.
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CHAPTER
3 Business and role of Accounting

3.1 How accounting helps organizations
Organizations run businesses with many goals. To make profits (profit oriented
organizations), to provide human rights (non-profit organizations) etc. Goals vary with
every organization where some are common among many organizations.
Achievement of such goals, are the reasons why organizations exists and it will be true if
we say that organizations can only exist if they fulfill their purpose/goal.
Achievement of purpose depends heavily on whether organizations are making the right
decisions at the right time or not.
To make right decisions, organizations need accurate information.
Such information needs are fulfilled by Accounting.
As many says that accounting is a language of business. But it will be more appropriate
if we call the debits and credits to be the language of the business as this is what we use
to prepare books of accounts by recording business transactions.
Transaction means any business event which has some financial implications on any of
the five elements i.e. increase or decrease in revenue, cost, expenses, capital, liabilities
and/or assets.
Transactions can be on cash basis or credit basis. We will discuss more about this later.
3.2 Functions of Accounting

Accounting serves three major functions:
1. Identifying that business activity or transaction took place

2. Recording all the transaction related financial data
3. Summarizing or processing the data in such a way that value of data is not lost
during conversion from data to information.
4. Communicating the information to users of financial information to help them
in making rational decisions.
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3.3 Accounting about what? - Understanding each element

As said in the definition of transactions, every time transaction happens, it affects one of
the FIVE elements. Let’s understand each element in some detail
Assets: These are the resources controlled (used) by the organization to run its
operations.
Assets can be divided into two classes based on their useful lives.
Asset with useful life of more than one year is called Non-Current Asset e.g.
Building, Machinery, office equipment, Motor vehicle, Land (also known as
Premises).
Asset with useful life up to one year is called Current Asset e.g. Stock (also
known as Inventory), Cash at bank, Cash in hand, Debtors
Expense: In simple words, cost of running an organization’s business is called

Expense. However, as we progress and acquire more knowledge about
different assets then we will know that expense is actually the value of the
resources which have expired or extinguished in a financial period.
Income: The net of everything organization earn and everything it incurs and/or bear is
called income.
Organizations can earn either directly by selling something which is a reason

of its operations e.g. by selling products they are manufacturing.
Organizations can also earn indirectly by other means e.g. by earning
interest on savings account with bank.
Liability: An obligation of the organization to pay back. In simple words it’s the debt.
Liabilities can be divided in two classes based on the time available to the
organization to pay it back.
 Liabilities due to be paid within next 12 months are called Current

Liabilities
 Liabilities not due to be paid within next 12 months are called Non-
Current Liabilities.
Capital: Amount invested in the organization by its owners.
STOP! Solve the following Questions

End of Chapter: Q1, Q2
End of Book:
S CAT T1 Practice Questions Kit:
T Page |11
CHAPTER
4 Users of Financial Information

Who they are and why they need information?
No business can operate on its own. In almost every business activity, organizations
have to interact with people and we also know that every activity involves decision
making.
And to decide people need information. Every person requires different sorts of
information depending on decision he is taking. But here we are not discussing all kinds
of information that users might demand or require instead we are focusing only on
financial information.
Financial information simply means any information related to money.
In order to understand their information needs we can classify these users of financial
information into groups.
Owners: are the ones at first place because of whom a certain organization exists.
They invest their personal resources to create an organization. They need
to know whether organization is on the right track and whether the
purpose of organization is being fulfilled or not. They take interest in the
financial performance and financial position of the company through
which they can understand how efficiently and effectively their funds are
being utilized. In some organizations owners are the ones who also run
the business and take active part in making business decisions. However,
in certain organizations, the role of managing the business is delegated to
another person or group of person named as managers.
Managers: are such personnel on whom owners pose trust and delegate majority of
their powers regarding running and managing the operations of the
organization and its business. Usually the owners are also the managers.
As they are duty bound to manage the business in such a way that not
only profits are maximized but also to ensure that the investment made by
the owners is also secured. As they are solely responsible for the
performance and status of the company they require information whether
organization’s assets are in good shape to support the cause and
objective of the organization. They also require information to decide
about the liabilities and how they will be paid out and when they fall due.
They are also under the duty to keep the expenses and income of the
business at such level that organization can sustain and grow.
Creditors: play important role in the life of organization as they provide goods and
services on credit basis i.e. without demanding immediate payment for
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CHAPTER
the goods and / or services provided. To decide about granting this credit
facility and to evaluate the expectation whether the money receivable will
be paid back or not they take interest in the financial position of the
business and the level of its liabilities towards others. If organization’s
financial position shows that it will be really difficult for the organization to
fulfill the liabilities on time then they should not be granting credit to the
organization and should insist for the business on cash basis.
Customers: As organizations buy goods and services from its suppliers, the same
way the people to whom organization supply goods and services are
called customers. Customers depend on organizations for the goods and
services they are buying. And as their businesses depend on the goods
and services they are buying, they are interested in financial information
to see whether they will have the interrupted supply of goods and
services. They never want to depend on such company which cannot
ensure proper and uninterrupted supply as agreed due to bad financial
position and performance.
Lenders: As the name suggest, they lend money to the business. They range from
banks, government to general public. Whenever, money is lent by the
organization, it is agreed that by what date the amount should be returned
and how much will be the amount. As lenders understand the risk of
lending money, they never want to give their hard earned money to the
wrong hands. For this they are interested whether organization holds
enough assets that it can pay back all the liabilities on time and whether
the managers are running the organization in a profitable way or not.
Sometimes, due to the risks involved, lenders ask for additional
conditions like organizations cannot take more loans until the amount is
returned. These conditions can extend to serious influence of lenders on
the organization’s financial policies and decisions.
Employees: depends on the employers heavily and they measure their own economic
status based on the financial position of the organization in which they are
working. As their lives are dependant every person wants to be a part of
such organization that is financially sound as it gives more job security.
Every insolvent organization leaves hundreds and thousands of workers
unemployed. That is why they are interested mostly in the profitability of
the business as profitable business can ensure their growth and
promotions. More profits mean more salaries and better life style.
Investors: always like to grow their wealth and want to invest in such organizations
where their investment is not only secure but also promise reasonable
returns on investments. To decide which organization is worthy of their
investment they need information about the existing assets of the
business and its operations. They take deep interest in what
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CHAPTER
organizations are producing and the market it is targeting and how many
customers it has. They like to know how the management will spend their
investment and how much profit will be shared with them afterwards.
Government: need information about the purpose of the organization and whether the
intended objectives and operations of the business are according to legal
and ethical rules and regulations. However, mostly they require financial
information about the organizations for tax purposes. They require
information about the profits earned by the business during a specific
period of time and whether the profits have been calculated properly and
correctly for computing tax liability. This is one of the many important
reasons why organizations prepare financial statements.
Competitors: mean other rival organizations operating under the same industrial
segment. Usually they include such organizations which are selling the
same product or service. In order to measure their own performance and
financial position they need information of other organizations of the same
size, with same operations under similar economic circumstances. It
helps organizations to set objectives and targets and to discover their
capabilities. The good financial position and financial performance of a
certain organization also suggests healthy market and gives indications to
other organizations to expand operations to such markets in which other
are organizations are flourishing.
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CHAPTER
2 Financial Accounting – Introduction
2
Financial
CHAPTER Accounting -
Introduction
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CHAPTER
Financial Accounting – Basics
Accounting has many types but in CAT – T1 we will be interested in Financial Accounting only.
The very foundation of financial accounting is very easy which is termed as accounting equation.
It is a very basic representation of business in mathematical form.
A new business starts when the owner invests something into it. At this very point it is
important to understand the difference between:
 The investment; and

 The form of investment (the resources)
Whenever owner invests something into the business it will be a resource in the hand of the
business. So we can say that the amount of investment will always be equal to the resources
available to the business. Now if we just name the investment of owner as Capital and resources
available to the business as Assets, the mathematical expression of this idea will be
Capital = Assets
However, as we already know that business transactions can be on credit basis also, it means
business can acquire its resources (assets) not just through its owner but also from people other
than owner. And if such resources are acquired on credit basis then it will give rise to an
obligation or a promise that value of the resource acquired will be paid back in future. This
promise to pay is called Liability.
So now business can acquire resources by raising its liabilities and not just relying on owner. And
thus the mathematical expression will become:
Capital + Liabilities = Assets
Remember, money vested in the business (by owner and third parties) will always be equal to
the resources in the business and that is why this equation which is known as accounting
equation will always be equal.
Let’s understand by working out a simple example that how this equation always stays equal.
Ms. Di started a business by investing $50,000 in the form of cash
Summary Accounting Equation

$
Cash ↑ Capital = Cash
Capital ↑ 50,000 = 50,000
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CHAPTER
Ms. Di opened a business bank account by transferring $20,000 from cash till to the bank
account

$
Bank ↑ Capital = Cash Bank
Cash ↓ 50,000 = 30,000 20,000
Ms. Di bought 2 machines for its business by paying in cash $15,000

$
Machinery ↑ Capital = Machinery Bank Cash
Cash ↓ 50,000 = 15,000 20,000 15,000
Ms. Di bought some inventory (stock) worth $5,000 on credit

$
Stock ↑ Capital Liabilities = Machinery Stock Bank Cash
Liabilities ↑ 50,000 5,000 = 15,000 5,000 20,000 15,000
Ms. Di bought more stock worth $2,000 paying through cheque

$
Stock ↑ Capital Liabilities = Machinery Stock Bank Cash
Bank ↓ 50,000 5,000 = 15,000 7,000 18,000 15,000
Ms. Di sold one of its machines for $7,000 on credit. It had cost the same when it was bought
[i.e. selling at no profit no loss]

$
Machinery ↓ Capital Liabilities = Machinery Stock Debtors Bank Cash
Debtors ↑ 50,000 5,000 = 8,000 7,000 7,000 18,000 15,000
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CHAPTER
Ms. Di made further investment in the business by putting $10,000 in cash till

$
Cash ↑ Capital Liabilities = Machinery Stock Debtor Bank Cash
Capital ↑ 60,000 5,000 = 8,000 7,000 7,000 18,000 25,000
Ms. Di paid some its liabilities by issuing a cheque amounting $2,000

$
Bank ↓ Capital Liabilities = Machinery Stock Debtor Bank Cash
Liabilities ↓ 60,000 3,000 = 8,000 7,000 7,000 16,000 25,000
And in similar fashion the transactions will be recorded and both sides of accounting equation
will ALWAYS stay balanced.
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CHAPTER
Appendix ///////////////////////////ATTENTION
Read at YOUR OWN RISK
Reading this appendix can cause serious confusion in understanding “T” accounts afterwards
One thing to remember is that every step is giving us the position of the company after the
transaction takes place. That is why the financial statement which provides the financial
information regarding the position of the company at any given time is called Statement of
Financial Position. In short, the accounting equation is in fact if arranged in a particular format
gives us the SoFP or Balance Sheet.
Drawing the very first financial statement – Statement of Financial Position [Balance Sheet]
Financial statement means a statement which is providing some sort of financial information
about the organization
Normally, every organization prepares 4 kinds of financial statements
1. Statement of financial position [also known as balance sheet]

2. Statement of comprehensive income [also known as income statement]
3. Statement of changes in equity
4. Statement of cash flows
Every financial statement serves some special information needs of users of financial statements
which we discuss later as we progress through the course.
As said earlier, we can present the position of the company by presenting the accounting
equation in a particular format. Following are the two possible variations of presenting the
financial position of the company.
Ms. Di
Statement of Financial Position as at ------
Capital
Capital 60,000 Non-Current Assets

Machinery 8,000
ASSETS
Current Assets
Liabilities 3,000 Stock 7,000
Liabilities
Debtors 7,000
Bank 16,000
Cash 25,000
Page |20

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CHAPTER

1 Understanding the role of Accounting in Business

Chapter # Title of Chapter Page #

1 Why study ACCOUNTING?

Though it is a narrow definition of business activity and is focusing just on profitability.

1.2 Understanding the relationship of business activity and

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2 Who runs businesses?

2.1 Types of organizations

1. Primary industrial sector

Another way of classifying the organization is by observing their scope of operations. If it

3 Business and role of Accounting

To make right decisions, organizations need accurate information.

Such information needs are fulfilled by Accounting.

3.2 Functions of Accounting

1. Identifying that business activity or transaction took place

3.3 Accounting about what? - Understanding each element

Expense: In simple words, cost of running an organization’s business is called

Organizations can earn either directly by selling something which is a reason

 Liabilities due to be paid within next 12 months are called Current

Capital: Amount invested in the organization by its owners.

STOP! Solve the following Questions

S CAT T1 Practice Questions Kit:

4 Users of Financial Information

Financial information simply means any information related to money.

Financial Accounting – Basics

 The investment; and

Capital + Liabilities = Assets

Ms. Di started a business by investing $50,000 in the form of cash

Summary Accounting Equation

Summary Accounting Equation

Ms. Di bought 2 machines for its business by paying in cash $15,000

Summary Accounting Equation

Ms. Di bought some inventory (stock) worth $5,000 on credit

Summary Accounting Equation

Ms. Di bought more stock worth $2,000 paying through cheque

Summary Accounting Equation

Summary Accounting Equation

Summary Accounting Equation

Ms. Di paid some its liabilities by issuing a cheque amounting $2,000

Summary Accounting Equation

Normally, every organization prepares 4 kinds of financial statements

1. Statement of financial position [also known as balance sheet]

Capital 60,000 Non-Current Assets

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