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Lecture 1: Purpose of Accounting and the Accounting Equation

Definition

Accounting may be defined as a series of processes and techniques used to identify, measure and communicate economic information which users find helpful in making decisions.

Points to note about the above definition

1. Accounting is a process. It must identify, record, analyse and summarise economic events. Record: entering the transaction evidenced by some sort of source document into the accounting system. Analyse: grouping similar transactions together after the initial recording. Summarise: produce reports or financial statements at regular intervals i.e. reporting. Economic events: events that will have a measurable financial or cash flow impact on the enterprise. 2. Accounting is a communication device. Accounting is not an end in itself; it provides/comminicates valuable economic information to users of accounts (who are they?) to enable them to make informed judgements and decisions. This begs the following question: when is information communicated valuable? To answer this question, we need to know WHO is going to use the information and what TYPES OF DECISIONS will have to be made. If we know the decision under consideration, it will be possible to identify the particular information requirements.

M. Lamport/ MEF FM II/ Purpose of Accounting and A/c Equation

Users of information and their information requirements What decision? Has the company been employing its resources in the most effective way to maximise shareholder wealth? Has the company been a good corporate citizen? Are all our product lines profitable? How many units should we sell to break even? Should we invest in a new machine or undertake XYZ project? Make or buy decisions Buy, sell or hold shares? Will the company provide attractive remuneration, career path and retirement benefits? Is the business credit worthy and can it settle its debts as and when they fall due? Will interest and principal be repaid? What are the taxable profits of the company? Information requirements Profit for the whole enterprise Profit margins for individual products Costs absorbed in 1 unit of output Incremental future cashflows of a project and the cost of capital Sales by region Available resources (physical and intangible)

USERS Internal Owner-manager Directors/executives/functional managers

External Shareholders/ investors Employees

Suppliers

Overall profits of the enterprise Resources available Cash flow position of the enterprise

Lenders Tax authorities

M. Lamport/ MEF FM II/ Purpose of Accounting and A/c Equation

The link between users of accounting information and branches of accounting

The above tale shows that users of accounting can be grouped into internal users and external users. External users (shareholders, suppliers, lenders, customers) are interested in the profits, financial position and cash flow reported by the business. Financial Accounting is that branch of Accounting that produces general-purpose financial statements aimed at providing information about the financial position (the balance sheet) and performance of the enterprise (the profit and loss account and cash flow statement). Internal users (i.e management of all functions, production, marketing, administration, finance) are interested in obtaining relevant and timely information to assist them in their short term and long term decision making. Short-term decisions are based on the environment of today, and the physical, human and financial resources presently available to the firm. Long run or strategic decisions will commit the resources of the firm for a lengthy period of time and as such will have a profound effect on the firm's future financial position. Cost and Management accounting is that branch of accounting which is on the one hand concerned with ascertaining the cost of a product for stock valuation and profit measurement purposes and on the other provides relevant information to internal users to help them (i) make better short term and long term decisions (ii) effect control by comparing actual and planned outcomes. Relevance of information is at the heart of management accounting; if information is not relevant to the decision to be made, it has no value. The accounting equation

How does a business make money? Well, first of all to start a business one needs funds or capital. Capital comes from two broad sources: the owner's past savings (known as equity) and/or borrowings (known as debt capital or liabilities). To make money, the business will then have to use the funds have to acquire resources (known as assets e.g plant, motor vehicles, stock for resale, land). At any point in time, therefore, the following relationship (known as accounting equation) will hold: Sources of Funds = Resources (uses of funds) Equity + Debt (or liabilities) = Assets Equity = Assets - liabilities Assets are rights or access to future economic benefits controlled by an entity as a result of past transaction or events. Liabilities are the obligation of an entity to transfer economic benefits as a result of past events. Equity or ownership interest is the residual amount found by deducting all of the entity's liabilities from the entity's assets.

M. Lamport/ MEF FM II/ Purpose of Accounting and A/c Equation

How does equity change from one period to the next?

Increases in Equity: 1. 2. 3. 4. Injection of new capital Profit ( Revenue > Expenses) Revenue Revaluation surpluses Revenue increases the companys assets. Expenses are costs that are incurred in earning revenue. To earn revenue the company must make use of its assets. Therefore expenses are that part of the cost of the assets which have been consumed by the business to earn revenue. Decreases in Equity: 1. 2. 3. 4. Withdrawal of goods/stock/cash/other assets from the business for personal use. Loss (Revenue < Expenses) Expenses Revaluation deficits The Extended Accounting Equation Capital + ( Revenue - Expenses ) + Liabilities

Assets =

Rearranging: Assets + Expenses =

Capital + Revenue + Liabilities

Comprehensive question: Preparing Basic Financial Statements (i) (ii) (iii) (iv) (v) (vi) Required: Prepare the accounting equation. Prepare the income statement (profit and loss account) for the period. Prepare the balance sheet. Started business with capital of $5,000 cash obtained from personal savings. Borrowed $1,000 from the bank. Bought 300 units @ $5 per unit, 60% being paid in cash and 40% on credit. Bought van costing $2,000 cash. Interest of $100 is paid. Sold 200 units of stock at $8 per unit, 40% paid in cash and 60% on credit.

M. Lamport/ MEF FM II/ Purpose of Accounting and A/c Equation

M. Lamport/ MEF FM II/ Purpose of Accounting and A/c Equation