Introduction to Accounting

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Users of Accounting

Accountancy is the process of communicating financial information about a business entity

to users such as shareholders and managers (Elliot, Barry & Elliot, Jamie: Financial
accounting and reporting).

Accounting has been defined as:

the art of recording, classifying, and summarizing in a significant manner and in
terms of money, transactions and events which are, in part at least, of financial
character, and interpreting the results thereof.(AICPA)

Users of Accounting Information - Internal & External

Accounting information helps users to make better financial decisions. Users of financial
information may be both internal and external to the organization.

Internal users (Primary Users) of accounting information include the following:

Management: for analyzing the organization's performance and position and taking
appropriate measures to improve the company results.

Employees: for assessing company's profitability and its consequence on their

future remuneration and job security.

Owners: for analyzing the viability and profitability of their investment and
determining any future course of action.

Accounting information is presented to internal users usually in the form of management

accounts, budgets, forecasts and financial statements.

External users (Secondary Users) of accounting information include the following:

Creditors: for determining the credit worthiness of the organization. Terms of credit
are set by creditors according to the assessment of their customers' financial health.
Creditors include suppliers as well as lenders of finance such as banks.
 Tax Authourities: for determining the credibility of the tax returns filed on behalf of
the company.

Investors: for analyzing the feasibility of investing in the company. Investors want to
make sure they can earn a reasonable return on their investment before they commit any
financial resources to the company.

Customers: for assessing the financial position of its suppliers which is necessary
for them to maintain a stable source of supply in the long term.

Regulatory Authorities: for ensuring that the company's disclosure of accounting

information is in accordance with the rules and regulations set in order to protect the
interests of the stakeholders who rely on such information in forming their decisions.

External users are communicated accounting information usually in the form of financial
statements. The purpose of financial statements is to cater for the needs of such diverse
users of accounting information in order to assist them in making sound financial decisions.

Accountancy encompasses the recording, classification, and summarizing of transactions

and events in a manner that helps its users to assess the financial performance and
position of the entity. The process starts by first identifying transactions and events that
affect the financial position and performance of the company. Once transactions and events
are identified, they are recorded, classified and summarized in a manner that helps the user
of accounting information in determining the nature and effect of such transactions and
events.

Accounting is the process of recording and summarizing financial information in a useful

way

Accounting provides a basis for decisions through the process of recording, summarizing
and presenting historical and prospective information.

The recording part of accounting, often known as book-keeping and financial accounting, is
obviously crucial to ensure that those running a business have a formal record of business
transactions in order for them to know basic information such:

How much they owe to suppliers, tax authorities, banks, employees and others?

How much each customer owes the business?

 How much capital is invested by the owners in the business?

How profitable is the business?

Such information is necessary for a business to fulfill its legal obligations and asserting its
own legal rights. Without proper accounting, it would be very difficult for a business to
determine for example the exact amount (net of any discounts, VAT, etc.) it needs to pay a
certain supplier (who could be one of dozens of suppliers for that business) from whom they
may have made several purchases in last month alone. Organizations need to have a
reliable way of recording information relating to transactions and that is where accounting is
so vital.

Historical accounting information is summarized to produce financial statements. Financial

Statements provide an overview of financial activities of a business during a period (e.g.
income and expenses) as well as information relating to its financial position on a certain
date (e.g. the amount of cash and inventory). Financial Statements help owners in
assessing the performance and position of their business can guide their investment
decisions (e.g. whether they should invest more in the business, diversify or dispose their
investment).

Read: Purpose of financial statements

Maintaining accounting records and preparing financial statements is often a legal

responsibility for most businesses above a certain size.

Read: What are financial statements?

Accounting nowadays is no longer concerned only with historical information. Budgeting,

appraisal and analysis based on prospective information has become an important aspect
of management accounting.

Management accounting is concerned with providing information to managers for decisions,

planning and control of business. Examples of such information include:

Variance Analysis

Investment Appraisal

Relevant Cost Analysis

Limiting Factor Analysis

 Ratio Analysis

Accounting has evolved into different specialties to address the diverse information needs
of its users.
Definition

Financial Statements represent a formal record of the financial activities of an entity.

These are written reports that quantify the financial strength, performance and liquidity of a
company. Financial Statements reflect the financial effects of business transactions and
events on the entity.

Four Types of Financial Statements

The four main types of financial statements are:

1. Statement of Financial Position

Statement of Financial Position, also known as the Balance Sheet, presents the financial
position of an entity at a given date. It is comprised of the following three elements:

Assets: Something a business owns or controls (e.g. cash, inventory, plant and
machinery, etc)

Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc)

Equity: What the business owes to its owners. This represents the amount of capital
that remains in the business after its assets are used to pay off its outstanding liabilities.
Equity therefore represents the difference between the assets and liabilities.

View detailed explanation and Example of Statement of Financial Position

2. Income Statement

Income Statement, also known as the Profit and Loss Statement, reports the company's
financial performance in terms of net profit or loss over a specified period. Income
Statement is composed of the following two elements:

Income: What the business has earned over a period (e.g. sales revenue, dividend
income, etc)

Expense: The cost incurred by the business over a period (e.g. salaries and wages,
depreciation, rental charges, etc)

Net profit or loss is arrived by deducting expenses from income.

View detailed explanation and Example of Income Statement

3. Cash Flow Statement

Cash Flow Statement, presents the movement in cash and bank balances over a period.
The movement in cash flows is classified into the following segments:

Operating Activities: Represents the cash flow from primary activities of a business.

Investing Activities: Represents cash flow from the purchase and sale of assets other
than inventories (e.g. purchase of a factory plant)

Financing Activities: Represents cash flow generated or spent on raising and

repaying share capital and debt together with the payments of interest and dividends.

View detailed explanation and Example of Cash Flow Statement

4. Statement of Changes in Equity

Statement of Changes in Equity, also known as the Statement of Retained Earnings, details
the movement in owners' equity over a period. The movement in owners' equity is derived
from the following components:

Net Profit or loss during the period as reported in the income statement

Share capital issued or repaid during the period

Dividend payments

Gains or losses recognized directly in equity (e.g. revaluation surpluses)

Effects of a change in accounting policy or correction of accounting error

View detailed explanation and Example of Statement of Changes in Equity

Link between Financial Statements

The following diagram summarizes the link between financial statements.

Definition

Statement of Financial Position, also known as the Balance Sheet, presents the financial
position of an entity at a given date. It is comprised of three main components: Assets,
liabilities and equity.
Statement of Financial Position helps users of financial statements to assess the financial
soundness of an entity in terms of liquidity risk, financial risk, credit risk and business risk.

Example

Following is an illustrative example of a Statement of Financial Position prepared under the

format prescribed by IAS 1 Presentation of Financial Statements.

Statement of Financial Position as at 31st December 2013

2013 2012
Notes
USD USD
ASSETS

Non-current assets
Property, plant & equipment 9 130,000 120,000
Goodwill 10 30,000 30,000
Intangible assets 11 60,000 50,000
220,000 200,000

Current assets
Inventories 12 12,000 10,000
Trade receivables 13 25,000 30,000
Cash and cash equivalents 14 8,000 10,000
45,000 50,000
TOTAL ASSETS 265,000 250,000

EQUITY AND LIABILITIES

Equity
Share capital 4 100,000 100,000
Retained earnings 50,000 40,000
Revaluation reserve 5 15,000 10,000
Total equity 165,000 150,000

Non-current liabilities
Long term borrowings 6 35,000 50,000

Current liabilities
Trade and other payables 7 35,000 25,000
Short-term borrowings 8 10,000 8,000
Current portion of long-term borrowings 6 15,000 15,000
Current tax payable 9 5,000 2,000

Total current liabilities 65,000 50,000

Total liabilities 100,000 100,000
TATAL EQUITY AND LIABILITIES 265,000 250,000

You may download a free blank excel template of the statement of financial position. The
template is pre-linked with the cash flow statement and statement of changes in equity.

Classification of Components

Statement of financial position consists of the following key elements:

Assets

An asset is something that an entity owns or controls in order to derive economic benefits
from its use. Assets must be classified in the balance sheet as current or non-current
depending on the duration over which the reporting entity expects to derive economic
benefit from its use. An asset which will deliver economic benefits to the entity over the long
term is classified as non-current whereas those assets that are expected to be realized
within one year from the reporting date are classified as current assets.

Assets are also classified in the statement of financial position on the basis of their nature:

Tangible & intangible: Non-current assets with physical substance are classified as
property, plant and equipment whereas assets without any physical substance are classified
as intangible assets. Goodwill is a type of an intangible asset.

Inventories balance includes goods that are held for sale in the ordinary course of
the business. Inventories may include raw materials, finished goods and works in progress.

Trade receivables include the amounts that are recoverable from customers upon
credit sales. Trade receivables are presented in the statement of financial position after the
deduction of allowance for bad debts.

Cash and cash equivalents include cash in hand along with any short term
investments that are readily convertible into known amounts of cash.

Liabilities

A liability is an obligation that a business owes to someone and its settlement involves the
transfer of cash or other resources. Liabilities must be classified in the statement of financial
position as current or non-current depending on the duration over which the entity intends to
settle the liability. A liability which will be settled over the long term is classified as non-
current whereas those liabilities that are expected to be settled within one year from the
reporting date are classified as current liabilities.

Liabilities are also classified in the statement of financial position on the basis of their
nature:

Trade and other payables primarily include liabilities due to suppliers and contractors
for credit purchases. Sundry payables which are too insignificant to be presented separately
on the face of the balance sheet are also classified in this category.

Short term borrowings typically include bank overdrafts and short term bank loans
with a repayment schedule of less than 12 months.

Long-term borrowings comprise of loans which are to be repaid over a period that
exceeds one year. Current portion of long-term borrowings include the installments of long
term borrowings that are due within one year of the reporting date.

Current Tax Payable is usually presented as a separate line item in the statement of
financial position due to the materiality of the amount.

Equity

Equity is what the business owes to its owners. Equity is derived by deducting total liabilities
from the total assets. It therefore represents the residual interest in the business that
belongs to the owners.

Equity is usually presented in the statement of financial position under the following
categories:

Share capital represents the amount invested by the owners in the entity

Retained Earnings comprises the total net profit or loss retained in the business after
distribution to the owners in the form of dividends.

Revaluation Reserve contains the net surplus of any upward revaluation of property,
plant and equipment recognized directly in equity.

Rationale - Why the balance sheet always balances?

The balance sheet is structured in a manner that the total assets of an entity equal to the
sum of liabilities and equity. This may lead you to wonder as to why the balance sheet must
always be in equilibrium.

Assets of an entity may be financed from internal sources (i.e. share capital and profits) or
from external credit (e.g. bank loan, trade creditors, etc.). Since the total assets of a
business must be equal to the amount of capital invested by the owners (i.e. in the form of
share capital and profits not withdrawn) and any borrowings, the total assets of a business
must equal to the sum of equity and liabilities.

This leads us to the Accounting Equation: Assets = Liabilities + Equity

Purpose & Importance

Statement of financial position helps users of financial statements to assess the financial
health of an entity. When analyzed over several accounting periods, balance sheets may
assist in identifying underlying trends in the financial position of the entity. It is particularly
helpful in determining the state of the entity's liquidity risk, financial risk, credit risk and
business risk. When used in conjunction with other financial statements of the entity and the
financial statements of its competitors, balance sheet may help to identify relationships and
trends which are indicative of potential problems or areas for further improvement. Analysis
of the statement of financial position could therefore assist the users of financial statements
to predict the amount, timing and volatility of entity's future earnings.

Definition

Income Statement, also known as Profit & Loss Account, is a report of income, expenses
and the resulting profit or loss earned during an accounting period.

Example

Following is an illustrative example of an Income Statement prepared in accordance with

the format prescribed by IAS 1 Presentation of Financial Statements.

Income Statement for the Year Ended 31st December 2013

2013 2012
Notes
USD USD
Revenue 16 120,000 100,000
Cost of Sales 17 (65,000) (55,000)

Gross Profit 55,000 45,000

Other Income 18 17,000 12,000

Distribution Cost 19 (10,000) (8,000)
Administrative Expenses 20 (18,000) (16,000)
Other Expenses 21 (3,000) (2,000)
Finance Charges 22 (1,000) (1,000)

(15,000) (15,000)
Profit before tax 40,000 30,000

Income tax 23 (12,000) (9,000)

Net Profit 28,000 21,000

Basis of preparation

Income statement is prepared on the accruals basis of accounting.

This means that income (including revenue) is recognized when it is earned rather than
when receipts are realized (although in many instances income may be earned and
received in the same accounting period).

Conversely, expenses are recognized in the income statement when they are incurred
even if they are paid for in the previous or subsequent accounting periods.

Income statement does not report transactions with the owners of an entity.

Hence, dividends paid to ordinary shareholders are not presented as an expense in the
income statement and proceeds from the issuance of shares is not recognized as an
income. Transactions between the entity and its owners are accounted for separately in the
statement of changes in equity.

Components

Income statement comprises of the following main elements:

Revenue
Revenue includes income earned from the principal activities of an entity. So for example, in
case of a manufacturer of electronic appliances, revenue will comprise of the sales from
electronic appliance business. Conversely, if the same manufacturer earns interest on its
bank account, it shall not be classified as revenue but as other income.

Cost of Sales

Cost of sales represents the cost of goods sold or services rendered during an accounting
period.

Hence, for a retailer, cost of sales will be the sum of inventory at the start of the period and
purchases during the period minus any closing inventory.

In case of a manufacturer however, cost of sales will also include production costs incurred
in the manufacture of goods during a period such as the cost of direct labor, direct material
consumption, depreciation of plant and machinery and factory overheads, etc.

You may refer to the article on cost of sales for an explanation of its calculation.

Other Income

Other income consists of income earned from activities that are not related to the entity's
main business. For example, other income of an entity that manufactures electronic
appliances may include:

Gain on disposal of fixed assets

Interest income on bank deposits

Exchange gain on translation of a foreign currency bank account

Distribution Cost

Distribution cost includes expenses incurred in delivering goods from the business premises
to customers.

Administrative Expenses

Administrative expenses generally comprise of costs relating to the management and

support functions within an organization that are not directly involved in the production and
supply of goods and services offered by the entity.
Examples of administrative expenses include:

Salary cost of executive management

Legal and professional charges

Depreciation of head office building

Rent expense of offices used for administration and management purposes

Cost of functions / departments not directly involved in production such as finance

department, HR department and administration department

Other Expenses

This is essentially a residual category in which any expenses that are not suitably
classifiable elsewhere are included.

Finance Charges

Finance charges usually comprise of interest expense on loans and debentures.

The effect of present value adjustments of discounted provisions are also included in
finance charges (e.g. unwinding of discount on provision for decommissioning cost).

Income tax

Income tax expense recognized during a period is generally comprised of the following
three elements:

Current period's estimated tax charge

Prior period tax adjustments

Deferred tax expense

Prior Period Comparatives

Prior period financial information is presented along side current period's financial results to
facilitate comparison of performance over a period.

It is therefore important that prior period comparative figures presented in the income
statement relate to a similar period.
For example, if an organization is preparing income statement for the six months ending 31
December 2013, comparative figures of prior period should relate to the six months ending
31 December 2012.

Purpose & Use

Income Statement provides the basis for measuring performance of an entity over the
course of an accounting period.

Performance can be assessed from the income statement in terms of the following:

Change in sales revenue over the period and in comparison to industry growth

Change in gross profit margin, operating profit margin and net profit margin over the
period

Increase or decrease in net profit, operating profit and gross profit over the period

Comparison of the entity's profitability with other organizations operating in similar

industries or sectors

Income statement also forms the basis of important financial evaluation of an entity when it
is analyzed in conjunction with information contained in other financial statements such as:

Change in earnings per share over the period

Analysis of working capital in comparison to similar income statement elements (e.g.

the ratio of receivables reported in the balance sheet to the credit sales reported in the
income statement, i.e. debtor turnover ratio)

Analysis of interest cover and dividend cover ratios

Definition

Statement of Cash Flows, also known as Cash Flow Statement, presents the movement in
cash flows over the period as classified under operating, investing and financing activities.

Example

Following is an illustrative cash flow statement presented according to the indirect method
suggested in IAS 7 Statement of Cash Flows:
 ABC PLC
Statement of Cash Flows for the year ended 31 December 2013
2013 2012
Notes
USD USD

Cash flows from operating activities

Profit before tax 40,000 35,000

Adjustments for:
Depreciation 4 10,000 8,000
Amortization 4 8,000 7,500
Impairment losses 5 12,000 3,000
Bad debts written off 14 500 -
Interest expense 16 800 1,000
Gain on revaluation of investments (21,000) -
Interest income 15 (11,000) (9,500)
Dividend income (3,000) (2,500)
Gain on disposal of fixed assets (1,200) (1,850)

35,100 40,650

Working Capital Changes:

Movement in current assets:

(Increase) / Decrease in inventory (1,000) 550
Decrease in trade receivables 3,000 1,400

Movement in current liabilities:

Increase / (Decrease) in trade payables 2,500 (1,300)

Cash generated from operations 39,600 41,300

Dividend paid (8,000) (6,000)

Income tax paid (12,000) (10,000)

Net cash from operating activities (A) 19,600 25,300

Cash flows from investing activities

Capital expenditure 4 (100,000) (85,000)

Purchase of investments 11 (25,000) -
Dividend received 5,000 3,000
Interest received 3,500 1,000
Proceeds from disposal of fixed assets 18,000 5,500
Proceeds from disposal of investments 2,500 2,200

Net cash used in investing activities (B) (96,000) (73,300)

Cash flows from financing activities

Issuance of share capital 6 1000,000 -

Bank loan received - 100,000
Repayment of bank loan (100,000) -
Interest expense (3,600) (7,400)

Net cash from financing activities (C) 896,400 92,600

Net increase in cash & cash equivalents (A+B+C) 820,000 44,600

Cash and cash equivalents at start of the year 77,600 33,000
Cash and cash equivalents at end of the year 24 897,600 77,600

Basis of Preparation

Statement of Cash Flows presents the movement in cash and cash equivalents over the
period.

Cash and cash equivalents generally consist of the following:

Cash in hand

Cash at bank

Short term investments that are highly liquid and involve very low risk of change in
value (therefore usually excludes investments in equity instruments)

Bank overdrafts in cases where they comprise an integral element of the

organization's treasury management (e.g. where bank account is allowed to float between a
positive and negative balance (i.e. overdraft) as opposed to a bank overdraft facility
specifically negotiated for financing a shortfall in funds (in which case the related cash flows
will be classified under financing activities).

As income statement and balance sheet are prepared under the accruals basis of
accounting, it is necessary to adjust the amounts extracted from these financial statements
 (e.g. in respect of non cash expenses) in order to present only the movement in cash
inflows and outflows during a period.

All cash flows are classified under operating, investing and financing activities as discussed
below.

Operating Activities

Cash flow from operating activities presents the movement in cash during an accounting
period from the primary revenue generating activities of the entity.

For example, operating activities of a hotel will include cash inflows and outflows from the
hotel business (e.g. receipts from sales revenue, salaries paid during the year etc), but
interest income on a bank deposit shall not be classified as such (i.e. the hotel's interest
income shall be presented in investing activities).

Profit before tax as presented in the income statement could be used as a starting point to
calculate the cash flows from operating activities.

Following adjustments are required to be made to the profit before tax to arrive at the cash
flow from operations:

1. Elimination of non cash expenses (e.g. depreciation, amortization, impairment

losses, bad debts written off, etc)

2. Removal of expenses to be classified elsewhere in the cash flow statement (e.g.

interest expense should be classified under financing activities)

3. Elimination of non cash income (e.g. gain on revaluation of investments)

4. Removal of income to be presented elsewhere in the cash flow statement (e.g.

dividend income and interest income should be classified under investing activities unless
in case of for example an investment bank)

5. Working capital changes (e.g. an increase in trade receivables must be deducted to

arrive at sales revenue that actually resulted in cash inflow during the period)

Investing Activities

Cash flow from investing activities includes the movement in cash flow as a result of the
purchase and sale of assets other than those which the entity primarily trades in (e.g.
inventory). So for example, in case of a manufacturer of cars, proceeds from the sale of
factory plant shall be classified as cash flow from investing activities whereas the cash
inflow from the sale of cars shall be presented under the operating activities.

Cash flow from investing activities consists primarily of the following:

Cash outflow expended on the purchase of investments and fixed assets

Cash inflow from income from investments

Cash inflow from disposal of investments and fixed assets

Financing activities

Cash flow from financing activities includes the movement in cash flow resulting from the
following:

Proceeds from issuance of share capital, debentures & bank loans

Cash outflow expended on the cost of finance (i.e. dividends and interest expense)

Cash outflow on the repurchase of share capital and repayment of debentures &
loans

Purpose & Importance

Statement of cash flows provides important insights about the liquidity and solvency of a
company which are vital for survival and growth of any organization. It also enables analysts
to use the information about historic cash flows to form projections of future cash flows of an
entity (e.g. in NPV analysis) on which to base their economic decisions. By summarizing
key changes in financial position during a period, cash flow statement serves to highlight
priorities of management. For example, increase in capital expenditure and development
costs may indicate a higher increase in future revenue streams whereas a trend of
excessive investment in short term investments may suggest lack of viable long term
investment opportunities. Furthermore, comparison of the cash flows of different entities
may better reveal the relative quality of their earnings since cash flow information is more
objective as opposed to the financial performance reflected in income statement which is
susceptible to significant variations caused by the adoption of different accounting policies.

Definition
Statement of Changes in Equity, often referred to as Statement of Retained Earnings in
U.S. GAAP, details the change in owners' equity over an accounting period by presenting
the movement in reserves comprising the shareholders' equity.

Movement in shareholders' equity over an accounting period comprises the following

elements:

Net profit or loss during the accounting period attributable to shareholders

Increase or decrease in share capital reserves

Dividend payments to shareholders

Gains and losses recognized directly in equity

Effect of changes in accounting policies

Effect of correction of prior period error

Example

Following is an illustrative example of a Statement of Changes in Equity prepared according

to the format prescribed by IAS 1 Presentation of Financial Statements.

ABC Plc
Statement of changes in equity for the year ended 31st December 2012

Share Retained Revaluation Total

Capital Earnings Surplus Equity

USD USD USD USD

Balance at 1 January 2011 100,000 30,000 - 130,000

Changes in accounting policy - - - -

Correction of prior period error - - - -

Restated balance 100,000 30,000 - 130,000

Changes in equity for the year

2011
Issue of share capital - - - -
Income for the year - 25,000 - 25,000
Revaluation gain - - 10,000 10,000
Dividends - (15,000) - (15,000)

Balance at 31 December 2011 100,000 40,000 10,000 150,000

Changes in equity for the year

2012

Issue of share capital - - - -

Income for the year - 30,000 - 30,000
Revaluation gain - - 5,000 5,000
Dividends - (20,000) - (20,000)

Balance at 31 December 2012 100,000 50,000 15,000 165,000

Components

Following are the main elements of statement of changes in equity:

Opening Balance

This represents the balance of shareholders' equity reserves at the start of the comparative
reporting period as reflected in the prior period's statement of financial position. The
opening balance is unadjusted in respect of the correction of prior period errors rectified in
the current period and also the effect of changes in accounting policy implemented during
the year as these are presented separately in the statement of changes in equity (see
below).

Effect of Changes in Accounting Policies

Since changes in accounting policies are applied retrospectively, an adjustment is required

in stockholders' reserves at the start of the comparative reporting period to restate the
opening equity to the amount that would be arrived if the new accounting policy had always
been applied.

Effect of Correction of Prior Period Error

The effect of correction of prior period errors must be presented separately in the statement
of changes in equity as an adjustment to opening reserves. The effect of the corrections
may not be netted off against the opening balance of the equity reserves so that the
amounts presented in current period statement might be easily reconciled and traced from
prior period financial statements.

Restated Balance

This represents the equity attributable to stockholders at the start of the comparative period
after the adjustments in respect of changes in accounting policies and correction of prior
period errors as explained above.

Changes in Share Capital

Issue of further share capital during the period must be added in the statement of changes
in equity whereas redemption of shares must be deducted therefrom. The effects of issue
and redemption of shares must be presented separately for share capital reserve and share
premium reserve.

Dividends

Dividend payments issued or announced during the period must be deducted from
shareholder equity as they represent distribution of wealth attributable to stockholders.

Income / Loss for the period

This represents the profit or loss attributable to shareholders during the period as reported
in the income statement.

Changes in Revaluation Reserve

Revaluation gains and losses recognized during the period must be presented in the
statement of changes in equity to the extent that they are recognized outside the income
statement. Revaluation gains recognized in income statement due to reversal of previous
impairment losses however shall not be presented separately in the statement of changes
in equity as they would already be incorporated in the profit or loss for the period.

Other Gains & Losses

Any other gains and losses not recognized in the income statement may be presented in
the statement of changes in equity such as actuarial gains and losses arising from the
application of IAS 19 Employee Benefit.

Closing Balance
This represents the balance of shareholders' equity reserves at the end of the reporting
period as reflected in the statement of financial position.

Purpose & Importance

Statement of changes in equity helps users of financial statement to identify the factors that
cause a change in the owners' equity over the accounting periods. Whereas movement in
shareholder reserves can be observed from the balance sheet, statement of changes in
equity discloses significant information about equity reserves that is not presented
separately elsewhere in the financial statements which may be useful in understanding the
nature of change in equity reserves. Examples of such information include share capital
issue and redemption during the period, the effects of changes in accounting policies and
correction of prior period errors, gains and losses recognized outside income statement,
dividends declared and bonus shares issued during the period.

Explanation

Financial Statements reflect the effects of business transactions and events on the entity.
The different types of financial statements are not isolated from one another but are closely
related to one another as is illustrated in the following diagram.
Balance Sheet

Balance Sheet, or Statement of Financial Position, is directly related to the income

statement, cash flow statement and statement of changes in equity.
Assets, liabilities and equity balances reported in the Balance Sheet at the period end
consist of:

Balances at the start of the period;

The increase (or decrease) in net assets as a result of the net profit (or loss)
reported in the income statement;

The increase (or decrease) in net assets as a result of the net gains (or losses)
recognized outside the income statement and directly in the statement of changes in equity
(e.g. revaluation surplus);

The increase in net assets and equity arising from the issue of share capital as
reported in the statement of changes in equity;

The decrease in net assets and equity arising from the payment of dividends as
presented in the statement of changes in equity;

The change in composition of balances arising from inter balance sheet transactions
not included above (e.g. purchase of fixed assets, receipt of bank loan, etc).

Accruals and Prepayments

Receivables and Payables

Income Statement

Income Statement, or Profit and Loss Statement, is directly linked to balance sheet, cash
flow statement and statement of changes in equity.

The increase or decrease in net assets of an entity arising from the profit or loss reported in
the income statement is incorporated in the balances reported in the balance sheet at the
period end.

The profit and loss recognized in income statement is included in the cash flow statement
under the segment of cash flows from operation after adjustment of non-cash transactions.
Net profit or loss during the year is also presented in the statement of changes in equity.

Statement of Changes in Equity

Statement of Changes in Equity is directly related to balance sheet and income statement.
Statement of changes in equity shows the movement in equity reserves as reported in the
entity's balance sheet at the start of the period and the end of the period. The statement
therefore includes the change in equity reserves arising from share capital issues and
redemptions, the payments of dividends, net profit or loss reported in the income statement
along with any gains or losses recognized directly in equity (e.g. revaluation surplus).

Cash Flow Statement

Statement of Cash Flows is primarily linked to balance sheet as it explains the effects of
change in cash and cash equivalents balance at the beginning and end of the reporting
period in terms of the cash flow impact of changes in the components of balance sheet
including assets, liabilities and equity reserves.

Cash flow statement therefore reflects the increase or decrease in cash flow arising from:

Change in share capital reserves arising from share capital issues and redemption;

Change in retained earnings as a result of net profit or loss recognized in the income
statement (after adjusting non-cash items) and dividend payments;

Change in long term loans due to receipt or repayment of loans;

Working capital changes as reflected in the increase or decrease in net current

assets recognized in the balance sheet;

Change in non current assets due to receipts and payments upon the acquisitions
and disposals of assets (i.e. investing activities)

Accountancy assists users of financial statements to make better financial decisions.

It is important however to realize the limitations of accounting and financial reporting
when forming those decisions.

Different accounting policies and frameworks

Accounting frameworks such as IFRS allow the preparers of financial statements to

use accounting policies that most appropriately reflect the circumstances of their
entities.

Whereas a degree of flexibility is important in order to present reliable information of

a particular entity, the use of diverse set of accounting policies amongst different
entities impairs the level of comparability between financial statements.
The use of different accounting frameworks (e.g. IFRS, US GAAP) by entities
operating in different geographic areas also presents similar problems when
comparing their financial statements. The problem is being overcome by the growing
use of IFRS and the convergence process between leading accounting bodies to
arrive at a single set of global standards.

Accounting estimates

Accounting requires the use of estimates in the preparation of financial statements

where precise amounts cannot be established. Estimates are inherently subjective
and therefore lack precision as they involve the use of management's foresight in
determining values included in the financial statements. Where estimates are not
based on objective and verifiable information, they can reduce the reliability of
accounting information.

Professional judgment

The use of professional judgment by the preparers of financial statements is

important in applying accounting policies in a manner that is consistent with the
economic reality of an entity's transactions. However, differences in the interpretation
of the requirements of accounting standards and their application to practical
scenarios will always be inevitable. The greater the use of judgment involved, the
more subjective financial statements would tend to be.

Verifiability

Audit is the main mechanism that enables users to place trust on financial
statements. However, audit only provides 'reasonable' and not absolute assurance
on the truth and fairness of the financial statements which means that despite
carrying audit according to acceptable standards, certain material misstatements in
financial statements may yet remain undetected due to the inherent limitations of the
audit.

Use of historical cost

Historical cost is the most widely used basis of measurement of assets. Use of
historical cost presents various problems for the users of financial statements as it
fails to account for the change in price levels of assets over a period of time. This not
only reduces the relevance of accounting information by presenting assets at
amounts that may be far less than their realizable value but also fails to account for
the opportunity cost of utilizing those assets.

The effect of the use of historical cost basis is best explained by the use of an
example.

Company A purchased a plant for $100,000 on 1st January 2006 which had a useful
life of 10 years.

Company B purchased a similar plant for $200,000 on 31st December 2010.

Depreciation is charged on straight line basis.

At the end of the reporting period at 31st December 2010, the balance sheet of
Company B would show a fixed asset of $200,000 while A's financial statement
would show an asset of $50,000 (net of depreciation).

The scenario above presents an accounting anomaly. Even though the plant
presented in A's financial statements is capable of producing economic benefits
worth 50% of Company B's asset, it is carried at a historical cost equivalent of just
25% of its value.

Moreover, the depreciation charged in A's financial statements (i.e. $10,000 p.a.)
does not reflect the opportunity cost of the plant's use (i.e. $20,000 p.a.). As a result,
over the course of the asset's life, an amount of $100,000 would be charged as
depreciation in A's financial statements even though the cost of maintaining the
productive capacity of its asset would have notably increased. If Company A were to
distribute all profits as dividends, it will not have the resources sufficient to replace its
existing plant at the end of its useful life. Therefore, the use of historical cost may
result in reporting profits that are not sustainable in the long term.

Due to the disadvantages associated with the use of historical cost, some preparers
of financial statements use the revaluation model to account for long-term assets.
However, due to the limited market of various assets and the cost of regular
valuations required under revaluation model, it is not widely used in practice.
An interesting development in accounting is the use of 'capital maintenance' in the
determination of profit that is sustainable after taking into account the resources that
would be required to 'maintain' the productivity of operations. However, this
accounting basis is still in its early stages of development.

Measurability

Accounting only takes into account transactions that are capable of being measured
in monetary terms. Therefore, financial statements do not account for those
resources and transactions whose value cannot be reasonably assigned such as the
competence of workforce or goodwill.

Limited predictive value

Financial statements present an account of the past performance of an entity. They

offer limited insight into the future prospects of an enterprise and therefore lack
predictive value which is essential from the point of view of investors.

Fraud and error

Financial statements are susceptible to fraud and errors which can undermine the
overall credibility and reliability of information contained in them. Deliberate
manipulation of financial statements that is geared towards achieving predetermined
results (also known as 'window dressing') has been a unfortunate reality in the recent
past as has been popularized by major accounting disasters such as the Enron
Scandal.

Cost benefit compromise

Reliability of accounting information is relative to the cost of its production. At times,

the cost of producing reliable information outweighs the benefit expected to be
gained which explains why, in some instances, quality of accounting information
might be compromised.

Elements of the financial statements include Assets, Liabilities, Equity, Income &
Expenses. The first three elements relate to the statement of financial position
whereas the latter two relate to the income statement.

The first three elements relate to the statement of financial position while the latter
two relate to income statements.
 Assets
Definition

Asset is a resource controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity (IASB Framework).

Explanation

In simple words, asset is something which a business owns or controls to benefit

from its use in some way. It may be something which directly generates revenue for
the entity (e.g. a machine, inventory) or it may be something which supports the
primary operations of the organization (e.g. office building).

Classification

Assets may be classified into Current and Non-Current. The distinction is made on
the basis of time period in which the economic benefits from the asset will flow to the
entity.

Current Assets are ones that an entity expects to use within one-year time from the
reporting date.

Non Current Assets are those whose benefits are expected to last more than one
year from the reporting date.

Types and Examples

Following are the most common types of Assets and their Classification along with
the economic benefits derived from those assets.

Asset Classification Economic Benefit

Machine Non-current Used for the production of goods for sale to customer.

Provides space to employees for administering

Office Building Non-current
company affairs.

Used in the transportation of company products and

Vehicle Non-current
also for commuting.

Inventory Current Cash is generated from the sale of inventory.

Cash Current Cash!

 Receivables Current Will eventually result in inflow of cash.

Definition

In order for an asset to be recognized in the financial statements, it must the following
definition laid down in the IASB Framework:

Asset is a resource controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity (IASB Framework).

It is worth noting that the framework defines asset in terms of control rather than ownership.
While control is generally evidenced through ownership, this may not always be the case.
Therefore, an asset may be recognized in the financial statement of the entity even if
ownership of the asset belongs to someone else. For instance, if a machine is leased to a
company for the entire duration of its useful life, the machine may be recognized in its
Statement of Financial Position (Balance Sheet) since the entity has control over the
economic benefits that would be derived from the use of the asset. This illustrates the use
of Substance Over Form whereby the economic substance of the transaction takes
precedence over the legal aspects of a transaction in order to present a true and fair view.

Explanation

Since, by definition, an asset must be controlled by the entity in order for it to be recognized
in the financial statements, certain 'Assets' would not qualify for recognition. Consider a
highly dedicated workforce. Generally speaking, a hardworking and motivated workforce is
the most valuable asset of any successful company. But does an entity has control over its
workers? The answer is no, because an employee may quit an organization any day and
seek employment in a rival firm much to the detriment of the company. Therefore, such
'Assets' may not be recognized in the financial statements of a company.

Apart from meeting the above definition, the Framework has advised the following
recognition criteria that ought to be met before an asset is recognized in the financial
statements.

The inflow of economic benefits to entity is probable.

The cost/value can be measured reliably.

Recognition Criteria
With regard to the first criteria, it makes sense to only recognize an asset if the benefits
from its use or sale are likely.

The second test ensures that the financial statements present assets that can be measured
objectively. For instance, how does a person place value on something subjective such as
customer loyalty or a dedicated employee?

Definition

According to IASB Frmework liability is defined as follows:

A liability is a present obligation of the enterprise arising from past events, the
settlement of which is expected to result in an outflow from the enterprise of
resources embodying economic benefits (IASB Framework).

Explanation

In simple words, liability is an obligation of the entity to transfer cash or other resources to
another party.

Liability could for instance be a bank loan, which obligates the entity to pay loan
installments over the duration of the loan to the bank along with the associated interest cost.
Alternatively, an entity's liability could be a trade payable arising from the purchase of goods
from a supplier on credit.

Classification

Liabilities may be classified into Current and Non-Current. The distinction is made on the
basis of time period within which the liability is expected to be settled by the entity.

Current Liability is one which the entity expects to pay off within one year from the reporting
date.

Non-Current Liability is one which the entity expects to settle after one year from the
reporting date.

Types and examples

Following are examples the common types of liabilities along with their usual classifications.

Liability Classification

Long Term Bank Loan Non-current

Bank Overdraft current

Short Term Bank Loan current

Trade Payables current

Debenture Non-current

Tax Payble Current

It may be appropriate to break up a single liability into their current and non current portions.
For instance, a bank loan spanning two years and carrying 2 equal installments payable at
the end of each year would be classified half as current and half as non-current liability at
the inception of loan.

Definition

In order for a liability to be recognized in the financial statements, it must meet the following
definition provided by the framework:

A liability is a present obligation of the enterprise arising from past events, the
settlement of which is expected to result in an outflow from the enterprise of
resources embodying economic benefits (IASB Framework).

As is clear from the above definition, the obligation must be a present one, arising from past
events. In case of a bank loan for instance, the past event would be the receipt of loan
principal. The obligation to pay off the loan would be present from the day the entity
receives the loan principal (i.e. when an obligating event occurs). Conversely, a liability may
not be recognized in anticipation of a future obligation such a bank loan expected to be
taken in two year's time.

Explanation

The obligation to transfer economic benefits may not only be a legal one. Liability in respect
of a constructive obligation may also be recognized where an entity, on the basis of its past
practices, has a created a valid expectation in the minds of the concerned persons that it
will fulfill such obligations in the future. For example, if an oil exploration company has a
past practice of restoring oil rig sites after they are dismantled in spite of no legal obligation
to do so, and it advertises itself as an environment friendly organization, then this gives rise
to a constructive liability and must therefore be recognized in the financial statements of the
company. This is because a valid expectation has been created that the company will
restore oil rig sites in the future.

Recognition Criteria

Apart from satisfying the definition of liability, the framework has also advised the following
recognition criteria to be met before a liability could be shown on the face of a financial
statement:

The outflow of resources embodying economic benefits (such as cash) from the
entity is probable.

The cost / value of the obligation can be measured reliably.

With regard to the first test, it is logical to recognize a liability only if it is likely that the entity
will be required to settle it. The second test ensures that only liabilities that can be
objectively measured are recognized in the financial statements.

If an obligation meets the definition of a liability but fails to meet the recognition criteria, it is
classified as a contingent liability. Contingent liability is not presented as a liability in the
statement of financial position but is instead disclosed in the notes to the financial
statements.

Definition

Equity is the residual interest in the assets of the entity after deducting all the liabilities
(IASB Framework).

Explanation

Equity is what the owners of an entity have invested in an enterprise. It represents what the
business owes to its owners. It is also a reflection of the capital left in the business after
assets of the entity are used to pay off any outstanding liabilities.

Equity therefore includes share capital contributed by the shareholders along with any
profits or surpluses retained in the entity. This is what the owners take home in the event of
liquidation of the entity.

The Accounting Equation may further explain the meaning of equity:

Assets - Liabilities = Equity

This illustrates that equity is the owner's interest in the Net Assets of an entity.

Rearranging the above equation, we have

Assets = Equity + Liabilities

Assets of an entity have to be financed in some way. Either by debt (Liability) or by share
capital and retained profits (Equity). Hence, equity may be viewed as a type of liability an
entity has towards its owners in respect of the assets they financed.

Examples

Examples of Equity recognized in the financial statements include the following:

Ordinary Share Capital

Preference Share Capital (irredeemable)

Retained Earnings

Revaluation Surpluses

Definition

Income is increases in economic benefits during the accounting period in the form of inflows
or enhancements of assets or decreases of liabilities that result in increases in equity, other
than those relating to contributions from equity participants (IASB Framework).

Explanation

Income is therefore an increase in the net assets of the entity during an accounting period
except for such increases caused by the contributions from owners. The first part of the
definition is quite easy to understand as income must logically result in an increase in the
net assets (equity) of the entity such as by the inflow of cash or other assets. However, net
assets of an entity may increase simply by further capital investment by its owners even
though such increase in net assets cannot be regarded as income. This is the significance
of the latter part of the definition of income.

Types

There are two types of income:

 Sale Revenue: Income earned in the ordinary course of business activities of the
entity;

Gains: Income that does not arise from the core operations of the entity.

For instance, sale revenue of a business whose main aim is to sell biscuits is income
generated from selling biscuits. If the business sells one of its factory machines, income
from the transaction would be classified as a gain rather than sale revenue.

Examples

Following are common sources of incomes recognized in the financial statements:

Sale revenue generated from the sale of a commodity.

Interest received on a bank deposit.

Dividend earned on entity's investments.

Rentals received on property leased by the entity.

Gain on re-valuation of company assets.

Definition

Expenses are the 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 equity participants (IASB Framework).

Explanation

Expense is simply a decrease in the net assets of the entity over an accounting period
except for such decreases caused by the distributions to the owners. The first aspect of the
definition is quite easy to grasp as the incurring of an expense must reduce the net assets
of the company. For instance, payment of a company's utility bills reduces cash. However,
net assets of an entity may also decrease as a result of payment of dividends to
shareholders or drawings by owners of a business, both of which are distributions of profits
rather than expense. This is the significance of the latter part of the definition of expense.

Types

Following is a list of common types of expenses recognized in the financial statements:

 Salaries and wages

Utility expenses

Cost of goods sold

Administration expenses

Finance costs

Depreciation

Impairment losses

Accruals Principle

Expense is accounted for under the accruals principal whereby it is recognized for the
whole accounting period in full, irrespective of whether payments have been made or not.

As expense is an element of the income statement, it is calculated over the entire

accounting period (usually one year) unlike balance sheet items which are calculated
specifically for the year end date

Every transaction has two effects. For example, if someone transacts a purchase of a drink
from a local store, he pays cash to the shopkeeper and in return, he gets a bottle of dink.
This simple transaction has two effects from the perspective of both, the buyer as well as
the seller. The buyer's cash balance would decrease by the amount of the cost of purchase
while on the other hand he will acquire a bottle of drink. Conversely, the seller will be one
drink short though his cash balance would increase by the price of the drink.

Accounting attempts to record both effects of a transaction or event on the entity's financial
statements. This is the application of double entry concept. Without applying double entry
concept, accounting records would only reflect a partial view of the company's affairs.
Imagine if an entity purchased a machine during a year, but the accounting records do not
show whether the machine was purchased for cash or on credit. Perhaps the machine was
bought in exchange of another machine. Such information can only be gained from
accounting records if both effects of a transaction are accounted for.

Traditionally, the two effects of an accounting entry are known as Debit (Dr) and Credit (Cr).
Accounting system is based on the principal that for every Debit entry, there will always be
an equal Credit entry. This is known as the Duality Principal.
Debit entries are ones that account for the following effects:

Increase in assets

Increase in expense

Decrease in liability

Decrease in equity

Decrease in income

Credit entries are ones that account for the following effects:

Decrease in assets

Decrease in expense

Increase in liability

Increase in equity

Increase in income

Double Entry is recorded in a manner that the Accounting Equation is always in balance.

Assets - Liabilities = Capital

Any increase in expense (Dr) will be offset by a decrease in assets (Cr) or increase in
liability or equity (Cr) and vice-versa. Hence, the accounting equation will still be in
equilibrium

Examples of Double Entry

1. Purchase of machine by cash

Debit Machine Increase in Asset

Credit Cash Decrease in Asset

2. Payment of utility bills

Debit Utility Expense Increase in Expense

Credit Cash Decrease in Asset

3. Interest received on bank deposit account

Debit Cash Increase in Asset

Credit Finance Income Increase in Income

4. Receipt of bank loan principal

Debit Cash Increase in Asset

Credit Bank Loan Increase in Liability

5. Issue of ordinary shares for cash

Debit Cash Increase in Asset

Credit Share Capital Increase in Equity

What are debits and credits?

Debit and Credit are the respective sides of an account.

Debit refers to the left side of an account.

Credit refers to the right side of an account.

Explanation

In accounting, every account or statement (e.g. accounting ledger, trial balance, profit and
loss account, balance sheet) has 2 sides known as debit and credit.
In a typical accounting ledger (often referred to as a T-Account) the debit and credit sides
are split horizontally as shown below:

XYZ Receivable A/C

Date Particulars $ Date Particulars $

01-Dec-14 Sales 12,500 10-Dec-14 Discount allowed 500

10-Dec-14 Bank 12,000

12,500 12,500

Debit Side Credit Side

According to the dual aspect principle, each accounting entry is recorded in 2 equal debit
and credit portions. In other words, the total amount that will be recorded in the left side
(debit) of accounting ledgers will always equal to the total amount recorded on the right side
(credit).

For example, you may consider how the accounting entries have been recorded in the
Receivable A/C shown above.

The ledger has been debited on account of credit sales amounting $12,500 and (as can be
ascertained from the particulars) the same amount has been credited in the Sales A/C.
Similarly, the credit entries in the Receivable A/C relating to discount allowed and bank
receipts are matched with equal amounts recorded on the debit sides of Discount Allowed
A/C and Bank A/C respectively.

In case of any confusion, please refer Accounting for Sales section for more thorough
explanation of the accounting entries discussed above.

Now the question arises, how do we know what to record on the debit side of an
account and what to record on the credit side?

Accounting has specific rules regarding what should be debited and what should be
credited as summarized in the chart below:
 Debit Entries account for: Credit Entries account for:

Increase in assets Decrease in assets

Increase in expenses Decrease in expenses

Decrease in liabilities Increase in liabilities

Decrease in income Increase in income

Decrease in equity Increase in equity

Assets, expenses, liabilities, income & equity are the 5 elements of financial
statements. For explanation and examples of the various elements, please refer
elements of financial statements section.

As with accounting ledgers, all accounting statements are based on the rules of debit
and credit. For example, in a balance sheet, assets are reported on the debit side
whereas liabilities and equity are presented on the credit side. Although traditional
accounts and statements are presented in a T-Account format as above (which makes
understanding debits and credits a bit easier for beginners) many accounts and
statements nowadays are reported in a vertical format.

But fear not! As long as you master the rules of debit and credit, you shall have no
problem in understanding their application and presentation.

Example
Record the debit and credit entries of the following transactions:

a) Purchase of an office building for $1 million via funds transfer

b) Bonus payable to various employees amounting $5 million

c) Credit Sales during the period amounting $7 million

d) Issuance of ordinary shares at par for $10 million

a) Purchase of an office building

 Account $ Effect

Debit Office Building 1,000,000 Increase in Asset

Credit Bank 1,000,000 Decrease in Assets

b) Performance Bonus

Account $ Effect

Debit Salaries, wages and benefits 5,000,000 Increase in Expense

Credit Bonus Payable 5,000,000 Increase in Liabilities

c) Credit Sales

Account $ Effect

Debit Accounts Receivables 7,000,000 Increase in Asset

Credit Sales Revenue 7,000,000 Increase in Income

d) Issuance of ordinary shares

Account $ Effect

Debit Bank 10,000,000 Increase in Asset

Credit Share Capital 10,000,000 Increase in Equity

If you face any problem in understanding the double entries, please refer double entry
accounting section.
Accounting Entries are recorded in ledger accounts. Debit entries are made on the left side
of the ledger account whereas Credit entries are made to the right side. Ledger accounts
are maintained in respect of every component of the financial statements. Ledger accounts
may be divided into two main types: balance sheet ledger accounts and income statement
ledger accounts.

Balance Sheet Ledger Accounts

Balance Sheet ledger accounts are maintained in respect of each asset, liability and equity
component of the statement of financial position.

Following is an example of a receivable ledger account:

Receivable Account

Debit $ Credit $

Balance b/d 1 500 Cash 3 500

Sales 2 1,000 Balance c/d 4 1,000

1,500 1,500

Balance brought down is the opening balance is in respect of the receivable at the
start of the accounting period.

These are credit sales made during the period. Receivables account is debited
because it has the effect of increasing the receivable asset. The corresponding credit entry
is made to the Sales ledger account. The account in which the corresponding entry is made
is always shown next to the amount, which in this case is the Sales ledger.

This is the amount of cash received from the debtor. Receiving cash has the effect of
reducing the receivable asset and is therefore shown on the credit side. As it can seen, the
corresponding debit entry is made in the cash ledger.

This represents the balance due from the debtor at the end of the accounting period.
The figure has been arrived by subtracting the amount shown on the credit side from the
sum of amounts shown on the debit side. This accounting period's closing balance is being
carried forward as the opening balance of the next period.
Similar ledger accounts can be made for other balance sheet components such as
payables, inventory, equity capital, non current assets and so on.

Income Statement Ledger Accounts

Income statement ledger accounts are maintained in respect of incomes and expenditures.

Following is an example of electricity expense ledger:

Electricity Expense Account

Debit $ Credit $

Cash 1 1,000 Income Statement 2 1,000

1,000 1,000

This is the amount of cash paid against electricity bill. The expense ledger is being
debited to account for the increase in expense. The corresponding credit entry has been
made in the cash ledger.

This represents the amount of expense charged to the income statement. The
balance in the ledger has been recycled to the income statement which is being debited by
the same amount. Unlike balance sheet ledger accounts, there is no balance brought down
or carried forward. Instead, the income statement ledger is closed each accounting period
end with the balancing figure representing the charge to income statement.

Similar ledger accounts can be made for other income statement components.

Double entry is recorded in a manner that the accounting equation is always in balance:

Assets = Liabilities + Equity

Assets of an entity may be financed either by external borrowing (i.e. Liabilities) or from
internal sources of finance such as share capital and retained profits (i.e. Equity). Therefore,
assets of an entity will always equal to the sum of its liabilities and equity.

The accounting equation may be re-arranged as follows:

Assets - Liabilities = Equity

 We may test the Accounting Equation by incorporating the effects of several transactions to
see whether it still balances as theorized in the accountancy literature. For the purpose of
this test, we may classify accounting transaction into the following generic types:

1. Transactions that only affect Assets of the entity

2. Transactions that affect Assets and Liabilities of the entity

3. Transactions that affect Assets and Equity of the entity

4. Transactions that affect Liabilities and Equity of the entity

Note:

For all the examples on the next pages, it will be assumed that before any transaction,
Assets of ABC LTD are $10,000 while its Liabilities and Equity are $5,000 each.

Transactions that only affect Assets of the entity

These transactions result in an increase in one asset which is equally offset by a decrease
in another asset and vice versa.

Since Assets, and other components of the equation, will be the same as before the
transaction, the Accounting Equation will be in equilibrium.

Example 1

ABC LTD purchases a machine costing $1000 for cash.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $10,000* - Liabilities $5,000 = Equity $5,000

* Assets $10,000 = $10,000 Plus $1,000 (Machine) Less $1,000 (Cash)

Example 2

ABC LTD receives $500 cash from a receivable DEF LTD in respect of goods sold on credit.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $10,000* - Liabilities $5,000 = Equity $5,000

* Assets $10,000 = $10,000 Plus $500 (Cash) Less $500 (Trade Receivable)

Transactions that affect Assets and Liabilities of the entity

These transactions result in the increase in Assets and Liabilities of the entity
simultaneously. Conversely, the transactions may cause a decrease in both Assets and
Liabilities of the entity.

Any increase in the assets will be offset by an equal increase in liabilities and vice versa
causing the Accounting Equation to balance after the transactions are incorporated.

Example 1

ABC LTD receives $2,500 bank loan in cash.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $12,500* - Liabilities $7,500* = Equity $5,000

*Assets $12,500 = $10,000 Plus $2,500 (Cash)

*Liabilities $7,500 = $5,000 Plus $2,500 (Bank Loan)

Example 2

ABC LTD pays $500 cash to XYZ LTD for goods purchased on credit.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $9,500* - Liabilities $4,500* = Equity $5,000

*Assets $10,000 = $10,000 Less $500 (Cash)

*Liabilities $4,500 = $5,000 Less $500 (Trade Payable)

Transactions that affect Assets and Equity of the entity

These transactions result in the increase in Assets and Equity of the entity simultaneously.
Conversely, the transactions may cause a decrease in both Assets and Equity of the entity.

Any increase in the assets will be matched by an equal increase in equity and vice versa
causing the Accounting Equation to balance after the transactions are incorporated.

Example 1

ABC LTD issues share capital for $2,500 in cash.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $12,500* - Liabilities $5,000 = Equity $7,500*

*Assets $12,500 = $10,000 Plus $2,500 (Cash)

*Equity $7,500 = $5,000 Plus $2,500 (Share Capital)

Example 2

ABC LTD pays dividend of $500 in cash.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $9,500* - Liabilities $5,000 = Equity $4,500*

*Assets $9,500 = $10,000 Less $500 (Cash)

*Equity $4,500 = $5,000 Less $500 (Divident)

Accruals and Prepayments Accruals Basis of Accounting Financial statements are prepared under the
Accruals Basis of accounting which requires that income and expense must be recognized in the
accounting periods to which they relate rather than on cash basis. An exception to this general rule is the
cash flow statement whose main purpose is to present the cash flow effects of transaction during an
accounting period. Under accruals basis of accounting, an entity must account for the following types of
transactions: Accrued Income Accrued Expense Prepaid Income Prepaid Expense - See more at:
http://accounting-simplified.com/accrual-and-prepayments.html#sthash.st0nYlqJ.dpuf

Accrued Income

Accrued income is income which has been earned but not yet received. Income must be recorded in the
accounting period in which it is earned. Therefore, accrued income must be recognized in the accounting
period in which it arises rather than in the subsequent period in which it will be received. As income will be
credited to record the accrued income, a corresponding receivable must be created to account for the
debit side of the transaction. The accounting entry to record accrued income will therefore be as follows:
DebitIncome Receivable (Balance Sheet) CreditIncome (Income Statement)< !-- google_ad_client = "ca-
pub-1129664394225711"; /* Square Add Content */ google_ad_slot = "6833715182"; google_ad_width =
250; google_ad_height = 250; //-->Example ABC LTD receives interest of $10,000 on bank deposit for the
month of December 2010 on 3rd January 2011. ABC LTD has an accounting year end of 31st December
2010. ABC LTD will recognize interest income of $10,000 in the financial statements of year 2010 even
though it was received in the next accounting period as it relates to the current period. Following
accounting entry will need to be recorded to account for the interest income accrued: $$ DebitInterest
Income Receivable10,000 CreditInterest on Bank Deposit (Income)10,000 On the date of receipt of
interest (i.e. 3rd January of the next year) following accounting entry will need to be recorded in the
subsequent year: $$ DebitBank10,000 CreditInterest Income Receivable10,000 - See more at:
http://accounting-simplified.com/accrued-income.html#sthash.nmTLFgGP.dpuf

Accrued Expense
Accrued expense is expense which has been incurred but not yet paid. Expense must be recorded in the
accounting period in which it is incurred. Therefore, accrued expense must be recognized in the
accounting period in which it occurs rather than in the following period in which it will be paid. As expense
will be debited to record the accrued expense, a corresponding payable must be created to account for
the credit side of the transaction. The accounting entry to record accrued expense will therefore be as
follows: DebitExpense (Income Statement) CreditExpense Payable (Balance Sheet) Example ABC LTD
pays loan interest for the month of December 2010 of $10,000 on 3rd January 2011. ABC LTD has an
accounting year end of 31st December 2010. ABC LTD will recognize interest expense of $10,000 in the
financial statements of year 2010 even though it was paid in the next accounting period as it relates to the
current period. Following accounting entry will need to be recorded to account for the interest expense
accrued: $$ DebitInterest Expense10,000 CreditInterest Payable10,000 On the date of payment of
interest (i.e. 3rd January of the next year) following accounting entry will need to be recorded in the
subsequent year: $$ DebitInterest Payable10,000 CreditCash10,000 - See more at: http://accounting-
simplified.com/accrued-expense.html#sthash.Sf7eYqIB.dpuf

Prepaid Income

Prepaid income is revenue received in advance but which is not yet earned. Income must be recorded in
the accounting period in which it is earned. Therefore, prepaid income must be not be shown as income
in the accounting period in which it is received but instead it must be presented as such in the subsequent
accounting periods in which the services or obligations in respect of the prepaid income have been
performed. Entity should therefore recognize a liability in respect of income it has received in advance
until such time as the obligations or services that are due on its part in relation to the prepaid income have
been performed. Following accounting entry is required to account for the prepaid income:
DebitCash/Bank CreditPrepaid Income (Liability) Example ABC LTD receives advance rent from its tenant
of $10,000 on 31st December 2010 in respect of office rent for the following year. ABC LTD has an
accounting year end of 31st December 2010. ABC LTD will recognize a liability of $10,000 in the financial
statements of year 2010 in respect of the prepaid income to acknowledge its obligation to make the office
space available to the tenant in the following year. Following accounting entry will be recorded in the
books of ABC LTD in the year 2010: $$ DebitCash10,000 CreditPrepaid Rent Income (Liability)10,000
The prepaid income will be recognized as income in the next accounting period to which the rental
income relates. Following accounting entry will be recorded in the year 2011: $$ DebitPrepaid Rent
Income (Liability)10,000 CreditRent Income (Income Statement)10,000 - See more at: http://accounting-
simplified.com/prepaid-income.html#sthash.IvwepYaS.dpuf

Prepaid Expense Prepaid expense is expense paid in advance but which has not yet been incurred.
Expense must be recorded in the accounting period in which it is incurred. Therefore, prepaid expense
must be not be shown as expense in the accounting period in which it is paid but instead it must be
presented as such in the subsequent accounting periods in which the services in respect of the prepaid
expense have been performed. Entity should therefore recognize an asset in respect of expense it has
paid in advance until such time as the services that are due in relation to the prepaid expense have been
performed by the suppliers/contractors. Following accounting entry is required to account for the prepaid
expense: DebitPrepaid Expense (Asset) CreditCash < !-- google_ad_client = "ca-pub-
1129664394225711"; /* Square Add Content */ google_ad_slot = "6833715182"; google_ad_width = 250;
google_ad_height = 250; //-->Example ABC LTD pays advance rent to its landowner of $10,000 on 31st
December 2010 in respect of office rent for the following year. ABC LTD has an accounting year end of
31st December 2010. ABC LTD will recognize an asset of $10,000 in the financial statements of year
2010 in respect of the prepaid expense to recognize its right to use office space in the following year.
Following accounting entry will be recorded in the books of ABC LTD in the year 2010: - See more at:
http://accounting-simplified.com/prepaid-expense.html#sthash.MO5kgmd0.dpuf

$ $

Debit Prepaid Rent 10,000

Credit Cash 10,000

The prepaid expense will be recognized as expense in the next accounting period to which the rental
expense relates. Following accounting entry will be recorded in the year 2011:

$ $

Debit Rent Expense (Income Statement) 10,000

Credit Prepaid Rent 10,000

RECEIVABLES AND PAYABLES

What is accounts receivable? Accounts receivable is the balance owed to the entity by its customers in
respect of sale of goods and services on credit. Accounting for Receivables Credit Sale As credit sale
results in increase in the income (sale revenue) and assets (receivable) of the entity, assets must be
debited whereas income must be credited. In case of a credit sale, the following double entry is recorded:
DebitReceivable CreditSales Revenue (Income Statement) The double entry is same as in the case of a
cash sale, except that a different asset account is debited (i.e. receivable). When the receivable pays his
due, the receivable balance will have be reduced to nil. The following double entry is recorded: DebitCash
CreditRecievable - See more at: http://accounting-simplified.com/accounting-for-
receivables.html#sthash.ZhsQdEjl.dpuf

Sales Tax

When a credit sale involves the application of sales tax, the receivable balance includes the amount of
sales tax since it will be recovered from the customer. Sales is recorded net of sales tax because any
sales tax received on the sales will be returned to tax authorities and hence, does not form part of
income. Sales tax account is credited since this is the amount of tax payable that will be paid to tax
authorities. The accounting entry to record a credit sale involving sales tax will therefore be as follows:
DebitReceivable (Gross Amount) CreditSales (Net Amount) CreditSales Tax (Payable) (Net Amount)
Subsequent receipt of dues from the customer will result in the following double entry: When the
receivable pays his due, the receivable balance will have be reduced to nil. The following double entry is
recorded: DebitCash (Gross Amount) CreditReceivable (Gross Amount) Example Bike LTD sells a
mountain bike to XYZ for $115 on credit. Sales tax is 15%. As the sale of $115 includes an element of
sales tax, we need to first separate tax from the gross amount. Sales tax on the transaction may be
calculated as follows: Sales Tax: 115 x 15/115 = $15 Deducting sales tax from the gross sale revenue, we
may now arrive at the tax exclusive sale value: Tax Exclusive Sales: 115 - 15 = $100 This is the amount to
be recognized as sales in the income statement. The accounting entry will therefore be as follows: $$
DebitXYZ (Receivable)115 CreditSales100 CreditSales Tax (Payable)15 Upon receipt of the amount
receivable from XYZ, following double entry will be made: $$ DebitCash115 CreditXYZ (Receivable)115
The sales tax payable of $15 will stand until it is paid to the tax authorities. - See more at:
http://accounting-simplified.com/sales-tax-on-receivables.html#sthash.EwDyyt2z.dpuf

Sales Return

Sales returns, or returns inwards, are a normal part of business. Goods may be returned to supplier if
they carry defects or if they are not according to the specifications of the buyer. There is need to account
for sale returns as though no sale had occurred in the first place. Hence, the value of goods returned
must be deducted from the sale revenue. Where a sale was initially made on credit, the receivable
recognized must be reversed by the amount of sales returned. The following double entry must be
recorded upon sales returns: DebitSales Return (decrease in income) CreditReceivable (decrease in
asset) Example Bike LTD sells a mountain bike to XYZ for $100 on credit. XYZ later returns the bike to
Bike LTD due to a serious defect in the design of the bike. The initial sale will be recorded as follows: $$
DebitXYZ (receivable)100 CreditSales100 Upon the return of bike, the following double entry will be
passed: $$ DebitSales Return100 CreditXYZ (Receivable)100 No further entry will be required as the
receivable due from XYZ has been reversed - See more at: http://accounting-simplified.com/sales-
return.html#sthash.jfNnXBgy.dpuf

Discount Allowed

Discounts may be offered on sales of goods to attract buyers. Discounts may be classified into two types:
Trade Discounts: offered at the time of purchase for example when goods are purchased in bulk or to
retain loyal customers. Cash Discount: offered to customers as an incentive for timely payment of their
liabilities in respect of credit purchases. Trade Discount Trade discounts are generally ignored for
accounting purposes in that they are omitted from accounting records. Therefore, sales, along with any
receivables in the case of a credit sale, are recorded net of any trade discounts offered. Example Bike
LTD as part of its sales promotion campaign has offered to sell their bikes at a 10% discount on their
listed price of $100. Sale revenue and any accounts receivable will be recorded net of trade discount, i.e.
$90 per bike. Cash Discount Cash discounts result in the reduction of sales revenue earned during the
period. However, not all customers may qualify for the cash discount. It is therefore necessary to record
the initial sale and receivables at the gross amount (after deducting any trade discounts!) and
subsequently decreasing the sale revenue and accounts receivable by the amount of discount that is
actually allowed. Following double entry is required to record the cash discount: DebitDiscount Allowed
(income statement) CreditReceivable Debiting discount allowed ledger has the effect of reducing gross
sales revenue by the amount of cash discount allowed. Consequently, receivables are credited to reduce
their balance to the amount that is expected to be recovered from them, i.e. net of cash discount.
Example Bike LTD as part of its sales promotion campaign has offered to sell their bikes at a 10%
discount on their listed price of $100. If customers pay within 10 days from the date of purchase, they get
a further $5 cash discount. Bike LTD sells a bike to XYZ who pays within 10 days. Before we proceed with
the accounting entries, it is necessary to first distinguish between the two types of discounts being offered
by Bike LTD. The 10% discount is a trade discount and should therefore not appear in Bike LTD's
accounting records. The $5 discount is a cash discount and must be dealt with accordingly. The initial sale
of the bike will be recorded as follows: $$ DebitXYZ (receivable)90 CreditSales90 As XYZ qualifies for the
cash discount, the following double entry will be required to record the discount allowed: $$ DebitDiscount
Allowed (income statement)5 CreditXYZ (receivable)5 The above entries have resulted in sales of Bike
LTD being reduced to $85 (100-90-5). The receivable from XYZ has also been reduced to this amount
effectively. - See more at: http://accounting-simplified.com/discount-allowed.html#sthash.cQcXeoyf.dpuf

Bad Debts / Irrecoverable Debts An entity may not be able to recover its balances outstanding in respect
of certain receivables. In accountancy we refer to such receivables as Irrecoverable Debts or Bad Debts.
Bad debts could arise for a number of reasons such as customer going bankrupt, trade dispute or fraud.
Every time an entity realizes that it unlikely to recover its debt from a receivable, it must 'write off' the bad
debt from its books. This ensures that the entity's assets (i.e. receivables) are not stated above the
amount it can reasonably expect to recover which is in line with the concept of prudence. Accounting
entry required to write off a bad debt is as follows: DebitBad Debt Expense CreditReceivable The credit
entry reduces the receivable balance to nil as no amount is expected to be recovered from the receivable.
The debit entry has the effect of cancelling the impact on profit of the sales that were previously
recognized in the income statement. Example ABC LTD sells goods to DEF LTD for $500 on credit. ABC
LTD subsequently finds out that DEF LTD is being liquidated and therefore the prospects of recovering its
dues are very low. ABC LTD should write off the receivable from DEF LTD in view of the circumstances.
The double entry will be recorded as follows: $$ DebitBad Debt Expense500 CreditDEF LTD
(Receivable)500 Bad Debt Recovered Occasionally, a bad debt previously written off may subsequently
settle its debt in full or in part. In such case, it will be necessary to cancel the effect of bad debt expense
previously recognized up to the amount settlement. Example ABC LTD sells goods to DEF LTD for $500
on credit. ABC LTD subsequently finds out that DEF LTD is being liquidated and therefore the prospects
of recovering its dues are very low. ABC LTD therefore writes off the receivable from its books. However,
the administrator appointed to oversee the liquidation of DEF LTD instructs the company to pay $300 to
ABC LTD in full settlement of its dues. As $300 of the bad debt has been recovered, it is necessary to
cancel the effect of previously recognized bad debt expense up to this amount. The accounting entry will
therefore be as follows: $$ DebitCash300 CreditBad Debt Recovered (Income)300 - See more at:
http://accounting-simplified.com/accounting-for-bad-debts.html#sthash.Ny75gNaS.dpuf

Discount Recieved Discounts may be offered by suppliers on sales of goods to attract buyers. Discounts
may be classified into two types: Trade Discounts: offered at the time of purchase for example when
goods are purchased in bulk or to retain loyal customers. Cash Discount: offered to customers as an
incentive for timely payment of their liabilities in respect of credit purchases. Trade Discount Trade
discounts are generally ignored for accounting purposes in that they are omitted from accounting records.
Therefore, purchases, along with any payables in the case of a credit purchase, are recorded net of any
trade discounts offered. Example BMX LTD as part of its purchases promotion campaign has offered to
sell their bikes at a 10% discount on their listed price of $100. Purchases and payables in respect of BMX
LTD will be recorded net of trade discount, i.e. $90 per bike. Cash Discount Cash discounts result in the
reduction of purchase costs during the period and the amount payable in respect of those purchases.
However, not all purchases may qualify for the cash discount. It is therefore necessary to record the initial
purchase and accounts payable at the gross amount (after deducting any trade discounts though!) and
subsequently decreasing purchases and payables by the amount of discount that is actually received.
Following double entry is required to record the cash discount:

DebitPayable CreditDiscount Received (income statement) Crediting discount received has the effect of
reducing gross purchases by the amount of cash discount received. Consequently, payables are debited
to reduce their balance to the amount that is expected to be paid to them, i.e. net of cash discount.
Example BMX LTD as part of its purchases promotion campaign has offered to sell their bikes at a 10%
discount on their listed price of $100. If customers pay within 10 days from the date of purchase, they get
a further $5 cash discount. Bike LTD purchases a bike from BMX LTD and pays within 10 days of the date
of purchase. Before we proceed with the accounting entries, it is necessary to first distinguish between
the two types of discounts being offered by BMX LTD. The 10% discount is a trade discount and should
therefore not appear in Bike LTD's accounting records. The $5 discount is a cash discount and must be
dealt with accordingly. The initial purchase of the bike will be recorded as follows: $$ DebitPurchases (net
of trade discount)90 CreditBMX LTD (Payable) (net of trade discount)90 As Bike LTD qualifies for the
cash discount, the following double entry will be required to record the discount received: $$ DebitBMX
LTD (Payable)5 CreditDiscount Received (income statement)5 The above entries have resulted in
purchases of Bike LTD being reduced to $85 (100-90-5). The payable to BMX LTD has also been reduced
to this amount effectively. - See more at: http://accounting-simplified.com/discount-
received.html#sthash.mSpHKnd0.dpuf

Bank Reconciliation Bank reconciliation statement is a report which compares the bank balance as per
company's accounting records with the balance stated in the bank statement. It is normal for a company's
bank balance as per accounting records to differ from the balance as per bank statement due to timing
differences. Certain transactions are recorded by the entity that are updated in the bank's system after a
certain time lag. Likewise, some transactions are accounted for in the bank's financial system before the
company incorporates them into its own accounting system. Such timing differences appear as
reconciling items in the Bank Reconciliation Statement. The purpose of preparing a Bank Reconciliation
Statement is to detect any discrepancies between the accounting records of the entity and the bank
besides those due to normal timing differences. Such discrepancies might exist due to an error on the
part of the company or the bank. Importance of Bank Reconciliation Preparation of bank reconciliation
helps in the identification of errors in the accounting records of the company or the bank. Cash is the most
vulnerable asset of an entity. Bank reconciliations provide the necessary control mechanism to help
protect the valuable resource through uncovering irregularities such as unauthorized bank withdrawals.
However, in order for the control process to work effectively, it is necessary to segregate the duties of
persons responsible for accounting and authorizing of bank transactions and those responsible for
preparing and monitoring bank reconciliation statements. If the bank balance appearing in the accounting
records can be confirmed to be correct by comparing it with the bank statement balance, it provides
added comfort that the bank transactions have been recorded correctly in the company records. Monthly
preparation of bank reconciliation assists in the regular monitoring of cash flows of a business. Preparing
a Bank Reconciliation Statement Following is a sample Bank Reconciliation Statement: ABC LTD Bank
Reconciliation Statement as at 31 December 2011 Balance as per corrected Cash Book1xxx Add:
Unpresented Cheques2xxx Less: Deposits in Transit3(xxx) Errors in Bank Statement4(xxx) Balance as
per Bank Statementxxx 1. Balance as per corrected Cash Book: This is the starting point of a bank
reconciliation. Corrected bank balance is calculated by adjusting the cash book ledger balance for
transactions that are recorded by the bank but not by the entity as shown below: Balance as per Cash
Bookxxx Add: Direct Credits5xxx Interest on Deposit6xxx Less: Bank Charges7(xxx) Direct Debits8(xxx)
Standing Order9(xxx) Errors in Cash Book10(xxx) Balance as per corrected Cash Bookxxx - See more at:
http://accounting-simplified.com/financial/bank-reconciliation/#sthash.ZuyzsU8L.dpuf

Unpresented Cheques These represent cheques that have been issued by an entity to a customer or
another third party but which have not presented to the bank by the reconciliation date. Entity records the
payment in its cash book as soon as the cheque is issued to the person but the bank records the
transaction when it receives the cheque. This causes a timing difference in the recording of the payment.
As the bank would not have recorded the unpresented cheques, the balance appearing in bank statement
would be higher than the cash book balance which is why the amount of outstanding cheques is added to
the cash book balance in the bank reconciliation.

Deposits in Transit There may be a time lag between when a company deposits cash or cheque in its
account and when the bank credits it. Since the company records the increase in bank balance in its
accounting records as soon as the cash or cheque is deposited, the balance as per bank statement would
be lower than the balance as per cash book until the deposit is processed by the bank. Therefore, any
outstanding deposits must be subtracted from the balance as per cash book in the bank reconciliation
statement.

Errors in bank statement Errors or omissions by the bank can lead to a difference between the balance as
per bank statement and the balance as per cash book. For instance, bank may incorrectly record the
deposits or withdrawals of another account into the company's bank account. Likewise, a deposit or
withdrawal be erroneously recorded twice by the bank. Such discrepancies would cause the balance
shown in the bank statement to be higher or lower than cash book balance depending on the nature of
the error or the omission. The differences must be intimated to the bank for timely correction.

Direct Credits

Direct Credits or Direct Deposits are amounts deposited directly by someone into an account of the
company. The payer rather than the payee in this case initiate the deposit.

Direct Credits are useful where regular receipts are expected from known parties (such as rent, interest
on investment, royalties, etc) who can deposit the money without the involvement of the payee. The
deposit may be made through cash, cheque or a fund transfer. Bank records the amount received as
soon as the transfer through direct credit is made but the business entity records the amount when it
receives intimation by the bank through bank statement or otherwise. Therefore, the balance as per bank
statement may be higher than the balance as per cash book due to direct credits not yet accounted for by
the entity. The difference needs to be eliminated by adjusting the cash book of the company before the
preparation a bank reconciliation