F5 ACCOUNTING

What is Accounting? 

Accounting is the process of identifying, measuring and communicating financial information about an entity to interested parties to assist in decision making. Users of Accounting The owner(s) of a business will need to assess the performance of the business the performance of the business and plan for the future. Various people and organizations may also have an interest in a business and will need information concerning its performance. Users of accounting are categorized into two categories; Internal and External Users. 

These users have different reasons for wanting financial information. Outlined in the box below are some examples of those reasons: 

HOMEWORK: Copy notes on "Advantages and Disadvantages" of (1) Sole Trader, (2) Partnership, (3) Company

ACTIVITIES:

1. Define accounting. 

2. Name the user of accounting who would be interested in the following information about a business. 

a) Is the business providing a return on investment

b) Has the business achieved the objectives that have been set? 

c) Can the business repay the money loaned to it when required? 

d) Can the business pay its bills? 

e) How is our business performing in comparison with this business?

 f) Are the correct amounts of income tax and VAT being paid? g) Are our jobs secure? 

3. Four friends have just graduated with accounting qualifications from the local institute. Jason specialized in cost and management accounting, Abinete specialised in financial accounting, Ine specialized in auditing and Eva has qualified as an accounting technician. They all gained jobs in their specialized accounting areas. 

4. Kiri Tama own Wakeke Electrical, a shop in Abaiang selling large electrical appliances such as washing machines, refrigerators, TVs and stereos. You are required to: State two people who would be interested in the financial statements prepared for Wakeke Electrical for the year ended 31 March 2021. Explain a reason for their interest.  

5. Alex Mitch wants to start a business. He has always been interested in becoming his own bos but he doesn’t understand what would be a suitable type of organization to be involved with. You are required to: Explain to Ales who receives the profit, and the advantages and disadvantages of the following: a) A sole trader b) A partnership 

ACCOUNTING ENTITY

Definition:  The separation of the economic affairs of a business from the owner's personal business.

Meaning:  Affairs of two or more businesses should not mix. Affairs of each business should be kept separate from one another. Example: Economic  affairs of your Mechanic shop should be kept separate from the affairs of 

Financial elements. There are 5 elements: 

• Assets • Liabilities • Equity • Income • Expenses 

ASSETS                                                                                                                                                                          Assets are all the resources that will provide future economic benefits to the business. 

To qualify as a business asset, an item must have all of these characteristics. 

Examples: 1. The truck is an asset because:                                                                                                                                                                                        - It has future economic benefit in that the business uses it to deliver goods to customers to boost the sales. Sales will result in economic benefit in the form of cash inflow.                                                                                                                                                                                                       -  It is under the present control of the business (the owner can stop others from using it).                                                                                             -  It arises from a past transaction because the business has bought the truck. 

2. Accounts receivable is an asset because:                                                                                                                                                                                      - It has future economic benefit because the business will eventually receive the cash from the customers who owe it.                                            -  It is under the present control of the business because no-one else is entitled to receive the cash from these customers.                                   - It arises from a past transaction because the business has already provided goods and sent out invoices to the customer. 12 

LIABILITIES

Liabilities are amounts owed by a business.                                                                                                                                                                     This means that, because of some transactions which has taken place in the past, a business has an obligation to either pay money or provide some goods or service in the future. The most common types of liabilities are accounts payable for goods that have been purchased previously, or services such as repairs that have been performed for the business, for which payment has not yet been made. Many businesses will also have bank loans and mortgages which have been taken out to buy land and buildings. Sometimes assets such as trucks maybe purchased on hire purchase and the amount owing for those are also liabilities.  

To be classified as a liability, an item MUST:                                                                                                                                                                                                            - require a future outflow of economic resources from the business                                                                                                                                     - be a present obligation of the business                                                                                                                                                                                     - arise from the past event. 

Sometimes a business will have an obligation to provide goods and services in the future. This usually occurs because a customer has paid in advance – for example, for a magazine subscription, some tuition, or for rent. In these cases, the amount of the liability is the cash received in advance. 

Examples: 

1. Accounts payable is a liability because:                                                                                                                                                                             - --   The business will have a future outflow of economic resources when it uses cash to pay the accounts.                                                                     - The business has a present obligation to pay the debt.                                                                                                                                                          - The obligation arises from a past transaction because the business has already received the goods or services. 

2. A mortgage is a liability because:                                                                                                                                                                                              The business will make a future economic sacrifice when it uses cash to repay the mortgage.                                                                                        The business has a present obligation to pay the debt.                                                                                                                                                          The obligation arises from a past transaction when the business borrowed the money to buy land and a building. 

Measuring Liabilities 

Liabilities are measured in the number of dollars that will be required to be paid to satisfy them. For example, if a business receives a power bill for $200, then the amount of the liability is $200. 

Equity 

The net worth of a business is called equity. (This is sometimes called proprietorship because the owner of a business is called the proprietor.) The equity of a business equals the assets of the business less its liabilities. 

Formula for calculating Equity:    EQUITY (Eq) = ASSETS (A) - LIABILITIES (L)

We can also write this equation as: Assets (A) = Liabilities (L) + Equity (Eq) 

Example: 

Brad runs Trendy Tours, and outdoor adventure business he has been in business for a short while and has the following business assets and liabilities as at 30 June 2020: 

Assets – Cash in the Bank $3,500, Accounts Receivable $2,000, Outdoor equipment (Cost) $18,500, Van (cost) $30,000. 

Liabilities-Accounts Payable $4,500, Bank Loan (Deal 30 June 2023) $20,000. 

Let’s calculate the Equity of Brad’s Business. First we must work out the totals of the assets and liabilities (remember monetary measurement). 

ACTIVITIES:

The statement of Financial Position 

The statement of financial position can be presented in two different formats. We call these the ‘T’ format and the vertical format. The ‘T’ format presents the statement in the same form as the accounting equation, A = L + Eq. 

Income, Expenses and Profit 

As we mentioned earlier, the statement of financial position is like a photograph of the business at an instant in time. Every transaction carried out by the business changes the statement of financial position. This means that all the amounts shown for assets, liabilities and equity will change. 

It is very important for users of the financial statements to know why the equity has changed. We will now examine the reasons for these changes. 

Changes in Equity The statement of financial position os Trendy Tourz that was prepared at 30 June 2020 was shown in the previous section. Equity consisted of Capital of $29,500. Below is the statement of financial position that was prepared a month later, on 31 July 2020. 

ACTIVITY

PROFIT

What is Profit? Profit is an increase in the net assets of a business that does not arise from contributions by the owner 

Profit is composed of two elements: Income and Expenses

PROFIT = INCOME - EXPENSES

INCOME

Income results from activities such as selling goods or performing services. Types of income include: fees from operating activities, sales of goods, interest earned on investments, a gain on the sale of property, plant and equipment, charging clients fees on overdue accounts, or receiving commission on the sale of goods. Subscriptions paid by the members of clubs are income. When a business earns income, equity increases. A formal definition of income is as follows: 

                          "Income is increases in economic benefits during the accounting period in the form of inflows of assets or                             decreases of liabilities that result in increases in equity, other than those relating to contributions from owners." 

Note that a contribution by the owner to the business is not income. Income is earned only through transactions with outside parties. 

Example: Tour fees charged by Trendy Tourz are income, because they result in an increase in equity due to an inflow of assets (either cash or accounts receivable) and are not contributed by Brad. 

Increase in equity  arises in two ways:                                                                                                                                                                                          • Contributions by the owner.                                                                                                                                                                                                       • Income earned through business operations. 

EXPENSES

Expenses are essentially the costs of producing the income. Examples of expenses include: paying wages, paying rent, writing off bad debts, a loss on the sale of property, plant and equipment, and depreciation. When a business incurs expenses, equity decreases. A formal definition of expenses is as follows: 

                      " Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets                     or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to owners. "

Note that a withdrawal (drawing) by the owner from the business is not an expense because it does not help the business to produce income. 

Example: Rent paid by Trendy Tourz is an expense because it results in a decrease in equity due to an outflow of cash (an asset) and is not a drawing by Brad. 

Decreases in equity thus arise in two ways:                                                                                                                                                                                 • drawings by the owner                                                                                                                                                                                                                • expenses incurred through business operations. 

CALCULATING PROFIT