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Chapter 1 Introduction to Financial Accounting

The basic purpose of financial accounting is to produce useful info which is used

in many and varied ways. People use the info generated by financial accounting to improve their decision-making in allocating scarce resources.


Financial Accounting

Accounting is a process of identifying, measuring and communicating

economic information to allow informed decisions by the users of that information. Financial Accounting periodic financial statements to external decision makers

(investors, creditors) Financial accounting measures performance and position

Management accounting information for planning and performance reports

(internal decision makers)

Financial performance generating new resources from day-to-day operations over a period of time Financial position – the enterprise‟s set of financial resources and obligations at a

point in time Financial Statements reports describing financial performance and position

Notes part of the statements, adding explanations to numbers


The Social Setting of Financial Accounting

Financial accounting:


Helps stock market investors buy/sell/hold


Helps banks and lenders lend?


Helps mangers run enterprises (in addition to help from management acct)


Provides basic financial records for day-to-day mgmt, control, insurance and


fraud prevention Used by govt in monitoring actions of enterprises and in taxes, e.g. GST

Accounting is not a passive force within the social setting it tells us what is going on, and in doing so, affects decision making


The People Involved in Financial Accounting

Main Participants: Information users, information preparers, auditors

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User is someone who makes decisions on his own behalf, or on behalf of an org

User‟s main demand is for the credible periodic reporting of an enterprise‟s

financial position and performance Main groups of users: Owners, Potential Owners, Creditors and potential creditors, Managers, Employees, Regulators/govt, Financial and market analysts, Competitors, Accounting researchers, customers, miscellaneous third parties

Preparers (Decision Facilitators)

Main groups: Managers, Bookkeepers and clerks, Accountants

Auditors (Credibility Enhancers)

Auditors report on the credibility of the enterprise‟s financial statements, on

behalf of owners and others. Assists users by verifying financial statements have been prepared fairly

Internal and external auditors

Role is to scrutinise the preparation process

External auditors are appointed by the owners not allowed to be owner or

manager, ensuring that auditor is independent from company‟s – objectivity Accounting firms offer external auditing, advice on income tax, accounting, comp systems and many other financial and business topics

1.5 Accrual Accounting

Accrual accounting system, impact of transactions is recognised in the time

period the transactions and expenses occur, rather than when the cash is received or paid Revenue sales of goods or services

Expenses the costs of services or resources in the process of generating revenues

Accrual Accounting versus Cash Accounting

Cash accounting records revenues and expenses when the cash is received or

paid. Problem: timing of cash flow is in a different accounting period to the substance of transaction affected by interest rates, exchange rates, depreciation

Using Accrual Accounting to prepare financial statements

Include all the cash receipts and payments that have already happened; for

example, cash sale, cash payment for wages Incorporate future cash receipts and payments that should be expected, based on existing transactions

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Measure the value of incomplete transactions (amount of remaining loans can be recorded as an expense) Estimate figures when exact amounts are unknown (interest on loans) Make an economically meaningful overall assessment of awkward problems

1.6 The Key Financial Statements

Balance Sheet – shows an organisation‟s resources and claims on resources at a

particular point in time. Income Statement measures financial performance over a defined period

Cash Flow Statement shows the sources and uses of cash during the period

Retained Profits Note

Balance Sheet

Assets future economic benefits as a result of past transactions or other past

events needs to be measured in monetary terms Assets cash, accounts receivable, inventory, property

Liabilities future sacrifices of economic benefits that an organisation is

presently obliged to make to other organisations as a result of past events Liabilities goods on credit, bank loans, mortgages, long service leave, warranty

Liabilities accounts payable, wages payable, provision for employee

entitlements, long term loans Shareholder’s Equity excess of assets over liabilities share capital and retained

profits Shared capital amount that owners have directly invested into the company

Retained profits total cumulative amounts of profits that the company has retained in the business rather than distributed as dividends

Assets = Liabilities + Owners‟ Equity

Income Statement

Provides info on an organisation‟s profitability for a period of time

Previously called the profit and loss statement

Gross profit = Sales revenue cost of goods

Income statement Sales revenue, Costs of goods sold, Gross profit, Operating expense, profit before tax, profit after tax

Statement of cash flows

Shows the changes of cash during the period in one balance sheet accounting

Shows receipts and payments of cash

Revenues reported usually do not equal cash collected and expenses do not

equal cash paid, net profit is different from the change in cash for the period Individual transactions split into:


operating activities (G&S),

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investing activities (NCA/capital),
financing activities (equity and certain borrowings)
Relationships between the financial statements
The cash flow statement explains the change in cash in the balance sheet.
Net profit appears in income statement, also reflected in retained profits note.
Information use scenarios
Evaluation of CEO‟s performance by member of board of directors
Preparation of buy/sell/hold shares recommendations by financial analyst
Review of company‟s borrow status by bank lending officer
Development of supply contract with the company by a stationery supplier‟s

sales manager.

Demands on the quality of financial accounting information

Relevance useful, valuable, and timely manner

accordance with the GAAP, and that the resulting figures are appropriate to its

Reliability objective, undue error, not deliberately misleading

Materiality assessing whether omissions, misstatement of disclosure of info can

affect decisions. Judged by size of error compared to net profit, total assets. Time. GAAP (general accepted accounting principles) to assure accepted methods

are followed, auditor‟s opinion is that the statement have been prepared in

circumstances. Prudence controversial criterion that A, R, P should not be overstated and L, E,

Losses, should not be understated if there is uncertainty. Cautiousness Disclosure make clear to reader which acct methods was followed, provide

supplementary info on debts, share capital, commitments and other necessities in understanding statements Understandability reports should be prepared to regard to interests of users,

and making sure they have the ability to comprehend and contempt. Accounting practices Comparability financial statements should be prepared in a comparable way

so companies can determine their performance, as absolute sense is ambiguous Consistency Keeping same accounting methods Following GAAP, changes in method will be recorded, or record significant events that might have affected the trend.

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AASB (Australian Accounting Standards Board) Framework









Faithful representation (represents what really existed/happened)


Substance over form (substance and economic reality)


Neutrality (objectivity, freedom from bias)


Prudence (caution in estimates)

Completeness (material info not omitted, not misleading) Comparability


Tradeoffs among accounting principles

Prudence is a bias, interfering with neutrality and reliability

New AASB to conform with GAAP will mean lack of comparability with other

companies that didn‟t previously use this standard

For the sake of comparability, if other companies change acct methods, a comp has to decide whether to change or not

↑reliability or ↑costs, ↑time, ↓relevance

1.9 Financial Statement Assumptions

Accrual basis accrual accounting

Going concern organisation will continue operations as a going concern in the

foreseeable future Accounting equity separate and distinguishable from owner‟s personal equity

Accounting period discrete equal periods annual or half yearly or quarterly

Monetary Measured in common denominator AUD

Historical Cost

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Chapter 2 Measuring and Evaluating Financial Position and Performance


Introduction to the Balance Sheet


Contains 2 lists that have the same dollar total


Describe enterprise‟s financial position at a particular date


List 1: resources/assets

to be repaid, and any past accrual profits)

List 2: Liabilities (existing obligations to be paid in future), Shareholder‟s equity

(amounts received from owners, involve permanent financing but do not have


Assets = Liabilities + Owner’s Equity


Must have Company Name and “Balance Sheet as at DATE


2 styles side by side:






Useful Financial

Obligations to be

Useful Financial Resources





Obligations to be paid

Owner‟s Investment


Owner‟s Investment


Explanations of the three Balance Sheet Categories: Assets, Liabilities and Equity



Assets are resources controlled by the entity as a result of past events and from


which future economic benefits are expected to flow to the entity. Three essential characteristics future economic benefits, control by the entity,

occurrence of past transactions of past events Future economic benefits as assets are used to provide G&S for exchange,

aiming to generate net cash flows Control by entity relates to whether an entity can benefit from asset, and to deny or regulate access of others public good

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Occurrence of past transactions or other past events means that the transaction giving the entity control over benefits must have occurred Other assets may include happy employees or safe working environment However they do not count into balance sheet

  • - Cannot verify dollar cost

  • - Difficult to measure reliability how much more productive?

  • - Enterprise does not own employees – don‟t have economic control

Expenditure on market research not an asset impossible to calculate future benefits at date of expenditure. Current assets sold / used / collected within 1 year.


Liabilities are present obligations of the entity arising from past events, the

settlements of which are expected to result in an outflow from the entity of resources embodying economic benefits. Two essential characteristics A present obligation exists and involves settlement in the future via the sacrifice of future economic benefits.

  • - Legally enforceable contracts money borrowed, credit

  • - Imposed on entity e.g. tax payable, or damages awarded by courts

  • - Normal business transactions to maintain a good e.g. warranty

Adverse financial consequences for the entity, in that the entity is obliged to

sacrifice economic benefits to one or more entries Requirement of obligation means that liability occurs if enterprise has already received a benefit, e.g. received cash from bank


Equity is the owner‟s interest in the enterprise.

Can be direct contributions from shareholders/owners Can be derived from profit that are not collected e.g. dividends that have not been distributed

Assets represent pool of resources provided by all sources regardless of whether it is provided by owners or not. Book value of enterprise = residual or net concept of equity Book value is arithmetically valid idea, but does not tell very much. Impractical when companies go out of business, because equity (money returned to owners) will not simply be calculated by the difference between A and L. Shareholder‟s equity is generally based on historical transactions, and does not, except by coincidence, equal the current market value of business. Retained profits or retained earnings represent past accrual profit not yet given to owners.

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Earning profit means more assets (e.g. cash) or fewer liabilities, so profit is a source of assets

  • 2.3 Some preliminary analysis of the sound and light balance sheet

Soundly financed?

  • - Assets come from liabilities look at where assets come from

  • - Debt to equity ratio L/E Pay bills on time?

    • - Able to turn current assets to cash

    • - Look at current liabilities and cash

    • - Current assets current liabilities = ___ in working capital

    • - Working capital / current ratio CA/CL

Company‟s ability to sell inventory to pay for bills

  • - Quick ratio/ Acid test ratio Cash + AR / CL

  • - If less than 1, then that means company has to sell inventory to get pay L All ratios are only indicators

Should owners declare for dividend?

  • - By taking out dividend, decreasing retained profits, they decrease cash.

  • - This can create cash strain

  • - Most retained earnings are reinvested in land, equipment, inventories, so less cash Equipment / Depreciation:

    • - In calculating profit, accumulated depreciation counts as an expense

    • - Net book value of equipment = cost of equipment accumulated depreciation

    • - Accumulated depreciation is a negative asset

  • 2.4 A closer look at the balance sheet

Comparative balance sheets:

  • - Contains figures for 2 periods, to help users recognise changes.

  • - Recent on the left, closer to words

Remember to look for notes when studying financial statements Buildings (net) means the accumulated depreciation has been deducted Prepayments are prepaid expenses that have been paid for, for which the benefits have not been received. Intangible assets noncurrent assets that have no physical substance copyrights, patents, trademarks, brand names and good will. Accrued expenses relate to expenses that have been incurred during the year, but not yet paid wages, electricity bills Employee entitlements can be current or non-current

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Where do the figures come from?

Accounting is generally a historical measurement system

Assets are generally valued at what they cost when they were acquired

Liabilities are generally valued at what was promised when the obligation arose

Other terms/notes

Usually, accrued expenses and accounts payable is joint into payables account,

but will be separated in the notes Sometimes use different terms payables liabilities (no interest) and interest-

bearing liabilities (such as loans, which incur interest) Current tax liabilities estimate of the amount of income tax to be paid in next

financial year Deferred tax liabilities

  • - current profit > profit reported on tax return, liability for income tax is implied for later

  • - current profit < profit reported on tax return, deferred tax asset govt has to pay tax paid back Derivative financial instruments used to reduce exposure to foreign exchange and interest rate risks

2.5 Maintaining the accounting equation

Assets = Liabilities + Owner‟s Equity

Double entry system where accounting equation is always in balance


Managers and the Balance Sheet

Balance sheets are important, because outsiders read it.

Balance sheet reports what the organisation‟s position is at a point in time.

Shows assets that management has chosen to acquire

Provides useful picture of the state of organisation

Balance sheet does not state how management has performed in using assets to earn profit


The Income Statement

Might measure company‟s fin performance by closing it down, selling it, paying off liabilities and see whether money left was more than money owners put in

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But this is too drastic just to find out performances. Income statement uses accrual accounting to measure financial performance over a period of time, usually a year, 6 months, 3 months. Net profit for the period = Revenues Expenses


Increase in company‟s wealth arising from the provision of G/S Wealth increases due to increase in cash, promise for cash or pay with other forms of wealth, such as providing other assets, or forgiving debts Interests and dividends Test for revenue whether the good or services have been rendered (provided)


Expenses are the opposite of revenues

Decreases in company‟s wealth incurred in order to earn revenue

Wealth decreases due to costs of G/S, giving assets to customers, and wear and tear of long term assets 2 cases when goods are sold enterprise is better off because of revenue gained and enterprise is worse off because of cost of goods and services customer takes away Start with asset account of inventory of unsold goods, transferred to expense account of cost of goods sold Whether the firm makes profit depends on whether R > E. Separate account of Expenses with Revenue


Net profit = net inflow of wealth to the company during the period If net profit is negative = net outflow of wealth = loss Expenses include costs of earning revenue taxes (not including dividends), depreciation ...

The relationship of profit for the period to retained profits

Retained profits is the sum of past net profits since the firm began, minus

dividends declared (even if not yet paid) Through retained profits, balance sheet can be said to reflect everything that

happened from the beginning a historical information system Transactions with owners are taken out of RP, not an expense

Owners can be creditors too, if they are owed dividends, or if they lent the company money in addition to shares they bought

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  • 2.8 Connecting Balance Sheets and Income Statements




  • 2.9 A close look at the income statement

Income statement covers period in time not point in time Subsidiary is considered a controlled entity when parent company has the capacity to dominate decision-making Consolidation basically involves totalling revenues and expenses of parent entity and all the subsidiaries after eliminating any transactions between these entities When calculating retained profits, use profit AFTER tax.

  • 2.10 Capital Markets, Managers and Performance Evaluation

Importance placed on “bottom line” – profit figure and components

The Australian or the Australian Financial Review show announcements of

company‟s annual or half yearly profits.

Emphasis on profit never any data on non-financial performance, LT issues, or managerial efforts Announcement show sales, profits before and after tax (net), earnings per share (EPS), interim and financial dividends per share data (ff, p), present share price Per share data used by investors e.g. own n shares, so earn 0.355n $ Share market prices and profit announcements tend to end up moving in the same direction, so they are correlated Managers should be conversant about how his or her performance is measured in the income statement

  • 2.11 Capital Markets, Managers and Performance Evaluation

Public sector organisations are required to provide balance sheets that discloses the A,L, E of the govt department Also an income statement (before June 2001, was called operating statement) Accumulated surplus or deficit = retained profits for private companies Reserves

Income Statement

Emphasis on cost of services

Operating revenue is separate and deducted from operating expenses

After net cost of services are included, other revenues are included

Liabilities such as super is included in employee entitlements in addition to salaries

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When govt takes over liability, providing an appropriation, therefore recorded as revenue

The income statement enables users to identify:

  • - cost of services provided by the department during the year

  • - extent to which costs were covered by revenue

  • - source of revenue

  • - changes in resources controlled during the period as a result of operations

Chapter 2 Appendix Background: Sole Traders, Partnerships, Companies and Financing

A2.1 Four Kinds of Business Organisation

Two general kinds of equity:

  • - Directly contributed equity owners provide money or other assets to enterprise

  • - Indirectly contributed equity owners allowed profits to remain, to help earn

more profits in the future ... Types of owners depends on what type of business organisation

Sole Trader


One owner (the proprietor)

Cannot distinguish between the owner‟s direct contributions to the business and

Unincorporated does not legally exist separately from owner

the indirect contributions by retained profits – both lumped together as owner‟s capital Balance sheet:

Owner’s equity

Owner‟s capital



More than one owners


Not separate legal entities, and all partners are all personally responsible for

debts of partnership Since owner‟s personal assets can be claimed by business creditors, there is somewhat arbitrary distinction between business and personal affairs

Similar to sole trader, lumped together as owner‟s capital

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As with sole traders, partnerships are not legal entities, but are considered
separate entity from partners
Balance sheet:
Owner’s equity
Partner‟s capital:
Partner A
Partner B
Partner C
Total Capital
Legal entities under corporations law
Capital is divided into shares – owners = shareholders
Separate legal entities – can buy, sell, own assets, enter contracts and sue and
be sued
Limited liability in the event of failure – shareholders are not liable for debts once
shares have been paid for in full
Ease of transfer of ownership and increased borrowing powers
Shares can be sold freely, and transfer of ownership does not affect continuity of
Companies may issue debentures or unsecured notes.
Debenture – document that evidences an undertaking by comp to repay
particular amount at or before an agreed date, and to pay interest at an
agreed rate a specific intervals
Debt may be secured over floating charge or all assets, or specific charge over
certain assets
Public company can invite public to subscribe to their share capital by
prospectus (listed ones are on ASX)
Private companies (Pty Ltd) cannot invite public and has a limit on number of
shareholders (50) and other restrictions and transferability of shares.

Company: Forms of Share Capital

When shares are first issued, money received comes in as shared capital

Second time sold, money is not received by company but shareholder

Therefore, the millions of transactions on ASX that occur do not affect

company‟s financial statement

Several classes of shares:

Ordinary shares owners votes basically residual owners, deciding who will be

on the board of directors and managers Preference shares or otherwise special shares owners usually do not vote, but in return they have rights, such as receiving fixed dividend, or preference in asset distribution if company liquidates

Class A, Class B and other categorisations vague terms, because complexity of rights often prevents simple categorisation such as ordinary or preference

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Face of balance sheet or notes will list all kinds of shares, and specify rights Cash received is property of company owners have no right to get money back, except in specific circumstances

Company: Retained profits

Profits can be paid to owners in the form of dividend or retained within company.

Balance sheet:

Shareholder’s equity Share capital:


Class A Shares


Class B Shares


Total issued capita


Retained Profits


Total Shareholder‟s equity


Corporate Group

Groups of many companies

E.g. Woolworths, BHP Billiton, Commonwealth Bank

Balance sheet represent what group looks like as a consolidated economic entity, although there is no such legal entity

Looks like that of single company, with shareholder‟s equity section representing

equity of primary, parent, company in grouo

A2.2 Business Financing

Non - Current Liabilities (debts due more than a year in the future)

Mortgages and other debts extending several years

Owner‟s equity

Special loans from owners, LT tax estimates, estimated liabilities to be paid to

employees in the future

Sole trader and Partnership – owner‟s capital

Company shared capital received for each kind of share + retained profits (+ other items if legal or accounting complexities require them)

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Chapter 3 The Double Entry System


Transaction Analysis + 3.2 Transaction Analysis Extended















Set out:



Assets Cash, AR, Inventory, Land and Building, Equipment



Liabilities AP, Notes Payable, Wages Payable, LT Loans


Equity SC, R, E, Dividend


Recording Transactions: Double-entry Bookkeeping


System of debits and credits


Balancing Equation : A = L + SE





SC + Op.

A + E + D





↑D, ↓C


↑C, ↓D

Resources = Assets


Sources = Liabilities / Equity

Therefore sum of credits must = sum of debits

Transactions measured in terms of country‟s currency (AUD)

Recording transactions = entry

Records of transactions = journals / journal entries

Entries are transferred and summarised in accounts, which lie behind all amounts

and descriptions shown on balance sheet All accounts collected together = ledger accounts

Accountants makes a list of account balances from ledger to make sure Dr = Cr.

(this list is called the trial balance) All accounts put together = balance sheet

Each double entry record names one (or more) account that is debited, and

one (or more) that is credited Double entry records = journal entries each journal entry, sum Dr = sum Cr

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  • 3.4 More about Accounts

An account is a record of the dollar amounts comprising a particular A, L, E, R or Exp. Net effect of these amounts is debit or credit, and is called the accounts balance

  • 3.5 How Debits and Credits Work

Negative asset = contra asset has credit balance, e.g. accumulated depreciation

  • 3.6 Debits and Credits, Revenues and Expenses

Accounting accumulates information about activities Financial statements are prepared from the accounts that are produced as the information is accumulated Double entry recording system creates a set of accounts which is in balance (Dr = Cr) From these accounts are produced:

  • - The income statement

  • - A note to the accounts showing a statement of retained profits, the bottom line (ending retained profits), which transfers to

  • - The balance sheet, which summarises all accounts

  • 3.7 Arranging accounts on the balance sheet

Placement of CA, NCA, CL, NCL, E allows for calculation of meaningful ratios and other analysis Thus balance sheet is “classified” – because it is classified into meaningful categories Moving items around within Balance sheet is called reclassification Reclassification done by accountants whenever it is thought to improve informativeness of financial statement

Three examples of account classification

Current and Non-current portions of noncurrent liabilities

  • - Liabilities e.g. mortgages, bonds, debentures

  • - Thus accountants need to reclassify the amount to be paid on principal within the next year (to Current) and the residual to non current

  • - Interest owing but not paid is a separate liability

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Bank overdrafts

  • - E.g. bank overdraft of $500

  • - This means bank allowed company to remove $500 more cash from

account than there was in it, in effect, lending comp $500 Two ways of representing this:

  • - Other assets of $12400 minus bank overdraft of $500 = L & E of $11900

  • - Other assets of $12400 = L&E of $11900 + bank overdraft of $500 Negative amounts left as deductions

    • - Some negative amounts are left as deductions unlike the bank overdraft

    • - E.g. accumulated depreciation left as a negative deduction for asset

Three ways of representing this:

  • - Shown on RHS of balance sheet (before it was, and in some countries still is)

  • - Separate disclosure as a deduction on LHS of balance sheet, but since many types of assets and depreciation amounts can make sheet clustered

  • - Could be deducted from assets cost, so net book value of assets could be disclosed on balance sheet, but not the accumulated depreciation This method is becoming more popular, accompanied by note to fin statements, listing cost and accumulated depreciation amounts separately

3.9 Cash versus accrual accounting revisited

Accrual accounting

AR ↓, Cash ↑

Cash sale would increase by revenue and cash in that period

Credit sale will AR and R in that period

When the cash is paid,

Way accrual financial accounting info is assembled:

  • - Cash

  • - Credit transactions

  • - ST/LT adjustments are needed to prepare financial statements, unless the comp‟s accounting system is sophisticated enough to have already built them in

  • - Extensive narrative and supplementary disclosures (e.g. notes to financial statements)

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Example: Simone’s Jewellery Business

Difficulties of accrual accounting:

Accrual profit requires extra calculation more complex cause confusion as it

leaves more room for error than the simpler calculation Accrual profit differ from cash profit, differ from change in amount in bank

Accrual accounting can be a lot more complicated tax, rent, time ...


Public Sector Issues

During 1990s, all govt moved from cash based acct system to accrual based acct system

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Chapter 4 Record Keeping

4.1 The Importance of Good Records

Complete and accurate records provide observations and history of enterprise

The basis for extrapolations into the future

This is used by investors, managers to plan for future

Records cost money

Records provide:

Info for evaluating and rewarding performance

Basis of internal control over existence and quality of enterprise‟s assets

4.2 Financial Accounting’s Transactional Filter

Accounting is an info system to filter and summarise data.

Like newspaper, info system e.g. financial acct is limited.

Economically efficient to have 1 system organise data into information on behalf

of the various users E.g. of summarising and organising daily newspaper

Only report what sensors pick up as it seeks out data or filters data

Data bank: ledgers, journals (the books) and supporting records

Recording Classifying

= Bookkeeping

... Information = accounting or reporting

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Accounting reports are limited by the collected data

Transaction recorded

Not transaction routine accounting system ignores event

Two general kinds of transactions cash transactions or credit transactions

Non transactions natural disasters/ incidents, future delivery, land value ↑/↓

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Financial accounting transaction fundamental eco or legal characteristics:

  • - Exchange must involve exchange of G/S, $, legal promises, items of eco value

  • - Past exchange must have happened

  • - External exchange must be between entity and another party

Supplementary characteristics needed for accounting‟s record-keeping:

  • - Evidence must be some documentation paper/electronic

  • - Dollars must be measured in the currency relevant in country where transaction happens (AUD)

Following transaction characteristics define nature and value of fin acct info:

  • 1. Transactions linked to legal and economic concept of exchange (bounded by legal contract including $ transactions)

  • 2. Constitute large part of underlying rationale for historical cost basis of accounting, founded on accounting (history has to have happened)

  • 3. Characteristics of transaction provide basis on which records can be verified (audited) later as part of the process of ensuring info is credible

5 key points exchange, past exchange, external party, evidence, dollars

Adjustments/ adjusting journal entries in data bank when accountant is not satisfied with set of data and wishes to alter some event which is important RHS information deciding on adjustments, deciding on reporting format, making supplementary notes ...

4.3 Accounting’s ‘Books’ and Records

Accounting cycle

  • 1. Source documents

  • 2. Prepare journal entries

  • 3. Post to ledgers

  • 4. Prepare trial balance (collection of ledger accounts Dr = Cr)

  • 5. Prepare adjusting journal entries

  • 6. Prepare adjusted trial balance

  • 7. Prepare closing journal entries (close revenue, expenses and dividends to RP)

  • 8. Prepare post-closing trial balance

  • 9. Prepare financial statements

Source Documents and transactional style

Source documents show that transactions have occurred

Documents are kept so that the accounting records can be checked and verified to correct errors; permit auditing; used for disputes; support income tax claims and other legal action.

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Discounts after ordering: cheque will be less than amount owed Debit AP, Cr Cash discounts received (other revenue account)

Journal Entries

Record accounting transactions When business event is first recorded by acct system Basic transactional records are often called books of original entry A journal entry can list as many accounts as are needed to record transaction, but each journal entry must be recorded, so sum of debits equals sum of credits Dr left, Cr right Omit $ Traditional to write short explanation called narration below each entry as a memorandum of what the recorded transaction was about (not compulsory) Every journal entry must be dated and is usually numbered Posting reference is given to indicate the ledger account to which each journal entry is posted. Number obtained from company‟s chart of accounts. Enterprises with many transactions to record do not create separate entry for each transaction, but instead use special records for each routine kind of


e.g. sales journal, cash receipt journal, cash payment journal and

... purchases journal

Posting to ledgers

Ledgers are books or computer records that have a separate page or account

Trial Balance

code for each individual account referred in the books of original entry Where T accounts come in to illustrate simpler version of ledger accounts

General ledgers collection of all the A, L, E, R, Exp, summarising the entire

operations of business Subsidiary ledgers AR, AP – balance isn‟t based on Dr, Cr, but sum equal

amount in primary account in general ledger

Balanced journal entries > general ledger accounts > balanced balance sheet

There is always a little uncertainty on whether standard bookkeeping procedure

ensures that ledger adds up all Dr and Cr and makes sure they equal Therefore calculation is called trial balance

What to do when trial balance doesn‟t balance?

Re-add trial balance

Check posted journal entries to correct side of ledger accounts

Check that each ledger account is balanced correctly

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Check that each journal entry balances (Dr = Cr) Determine difference between Dr and Cr and look for account with that amount maybe left out ledger balance Difference / 2 and look for that amount means posted to wrong side of ledger account If difference is divisible by 9, maybe transposition error 21 instead of 12, 72 instead of 27 Sometimes trial balance cannot pick up error

Adjusting Entries

At end of each acct period, it is necessary to adjust Rev and Exp accounts

Splitting between accounting periods e.g. prepayments for insurance

Closing entries

Needed to facilitate preparation of financial statements

Needed to prepare accounting records to begin next period

Closing entries formally transfer the balances of the revenue and expense

accounts to a profit and loss summary, then to retained profits Closing entries also reset the rev and exp account balances to zero to being

records for the next accounting period P&L summary account to decreases everything to 0

Debit sales account to zero, credit expenses account

Debit profit and loss summary account

Then, to balance P&L account, clear it by debiting P&L

Credit retained profits

Post closing trial balance

Put together ledger accounts to see if Dr = Cr

Financial Statements

P&L summary account > Income statement

Post-closing trial balance > Balance sheet

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An Example: Northern Star Theatre Company

Source documents

General Journal

General Ledger

General Ledger trial balance

General Journal (with adjustments)

General Ledger General Ledger trial balance

Closing entries returning everything to 0, dr revenue, cr P&L

Financial statements Retained profits, income statement, balance sheet


Electronic Commerce

Electronic commerce (e-commerce) is a challenge to financial accounting and

internal control, because of the absence of “paper trail” that has traditionally

supported accounting records.

E.g. moving away from cash and cheque, but using lots of credit cards or

EFTPOS. Employees are being paid by deposits in personal bank accounts

Implications of e-commerce

  • - Needs to be compatibility between computing systems for proper recognition of accounting systems on both sides of transactions Trust in electronic media to make system work

  • - Tendency for records and payments to be speedier and separate from movements of product, means in-transit items can be a challenge to control

and reconcile

  • - Not only financial statements must be right, but also the underlying records – for business partners‟ enquiries to be answered reliably

Paradox: e-commerce works without paper but demands a good trail of evidence


Managers, Bookkeeping and Control (Importance of bookkeeping to managers)

Bookkeeping and its associated record keeping:

  • - Provide underlying data on which accounting info is built Decisions and evaluations may be constrained on nature of underlying data

  • - Provide data and systems used in meeting management‟s important responsibilities to safeguard assets and generally keep the business under control

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4.8 Public Sector Issues

The process of accounting also applies to public sector organisations

Accumulated funs = Public sector equity

Recurrent appropriation = govt revenue

User charges = revenue

Grants and subsidies = expense

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Chapter 5 Revenue and Expense Recognition in Accrual Accounting

5.1 Conceptual Foundation of Accrual Accounting

Revenues are inflows of economic resources from customers earned through

providing goods or services. Expenses are outflows of economic resources to employees, suppliers, taxation

authorities and others, resulting from business activities, to generate revenue and serve customers. Incurring expenses are the cost of earning revenues.

Net profit is the difference between revenues and expenses over time.

Net profit is the measure of success in generating more revenue and it costs to

do so. Features

Revenue and expenses refer to inflows and outflows of economic resources.

Involve phenomena that arise before or after cash changes hands, as well as the point of cash flows Net profit is dependent on how revenues and expenses are measured.

A conceptual system for accrual profit measurement

Need system that recognises revenue and expense before, at the same time

and after cash flows. Accrual method includes cash accounting


Revenue before cash collection form asset account (e.g. Accounts receivable)

Expense before cash payment form liability account (e.g. Accounts payable)

Unearned revenue liability

Expense after cash payment asset


Before cash

After cash







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5.2 Accrual Accounting Adjustments

Adjustments involved implementation of routine accruals, such as those

mentioned above Sophisticated accounting systems go beyond transactional records and

routinely include many adjustments Simpler systems make adjustments at year end in a special set of journals Many small companies don‟t bother until financial statements are needed

Follow double entry format:

  • - After each adjustments, A=L+E still balances

  • - Sum of credit = sum of debit

Adjusting journal entries purpose: augment transaction based figures, add story told by transactional records.

Objective of accrual accounting improve measurement of financial

performance and position Accrual > cash provides more complete record, more representative of

economic performance Four main types of routine adjustments:

  • - Expiration of assets (after prepayments)

  • - Unearned revenues

  • - Accrual of unrecorded expenses

  • - Accrual of unrecorded revenues

Expiration of assets

Prepayments assets that arise because an expenditure has been made, but

there is still value extending into the future Usually current assets

Arise whenever payment schedule for an expense does not match the company‟s financial period – e.g. insurance premiums where policy date doesn‟t match financial year

Prepaid expenses do not have market value, but they have economic value

because future resources will not have to be used E.g. insurance, advertisements




Prepayment Expense







Prepayment Expense






Prepayment Expense


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Unearned Revenues

Unearned Revenue future revenue where the cash has been received before

earning revenue (deposits) E.g. newspaper or magazine subscription companies, or airline, phone, membership



Unearned Revenue


Unearned Revenue


Sales Revenue


Accrual of unrecorded expenses

Involves determining which expenses have been incurred by the organisation

(but not paid in cash) during a particular time period Involves checking which invoices have been received from suppliers,

incorporating that info into accounting systems (e.g. AP), and making estimates for expenses for which invoices have not yet been received Accrued expenses

E.g. wage expense end of pay period and end of financial period occur on different days

Wages Expense


Accrued expense


Accrued expense




Accrual of unrecorded revenues

Accrued revenue

Occurs when a service has been provided but cash will not be received until the

following period Interest revenue, unbilled revenues, commissions earned

Accrued Revenue






Accrued Revenue


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Multicolumn Worksheets

Useful device to help prepare financial statements


Pre adjusted



Adjusted Trial


Balance sheet

Trial Balance








The Financial Period


As businesses run continuously, financial statements are prepared at specific

points or periods in time 2009 net profit is a measure of economic value added by the project during that

year IF there are 2 cash inflows 2008 and 2009:

  • - If 08 cash > 08 revenue, then unearned revenue will be set up

  • - If 08 cash < 08 revenue, then account received set up

Companies have initial choices about when the financial year begin and end.

Once they made their choice, reasons relating to habit, legal and tax rules force

them to stay with the choice Australia 30 June is most common

US, Canada, Singapore 31 December

UK, NZ, Japan 31 March

Possible in Australia to use substituted accounting period for taxation purposes


Introduction to Accounting for Inventory


Several different methods for controlling inventory

Most popular perpetual inventory control method (compared to periodic)

Under perpetual method, inventory is an asset

  • - Inventory bought debit inventory account

  • - Inventory sold debit cost of goods sold, credit inventory

  • - 2 entries are required for sales (revenue and cost of goods expense)

  • - Return of sales also require 2 entries



Contra Accounts


Just about every balance sheet account can be considered a control account

Amounts in accounts should be supported by detailed lists or subsidiary ledgers

Sometimes want to change account, and at the same time reluctant to.

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Worried that company might not be able to collect all money back from customers. Want to recognise bad debts. However that means crediting accounts receivable. But at the same, since we have not given up on collecting debts, we should not do that. Property and plan are being used up economically. Want to record depreciation expense. But do not want to change asset cost account, because costs are not changing, but rather economic value is being used.

Contra account set up to allow recognition of expense and related value

changes without changing control account Contra accounts have balances that are in opposite direction to those of the control account in which they are associated

Contra accounts only have meaning in conjunction with the control accounts to which they match.

Most common: accumulated depreciation (amortisation), doubtful debts receivable

Accumulated Depreciation (Amortisation)

Accumulate depreciation on fixed assets (e.g. buildings and equipments)

DR Depreciation Expense

CR Accumulated Depreciation Accumulated Depreciation relates to asset account of buildings

Showing both allows users to make rough guess on age of asset

Depreciation expense shows how much depreciated during that period

Accumulated depreciation shows total amount the buildings have depreciated

by Net book value = cost accumulated depreciation

Contra account is only meaningful in comparison to the cost. When the asset is

gone/sold, neither account is needed anymore. E.g. Truck bought at 50,000. Depreciates at 8,000 each year. Sold at end of 2nd

year for 37,000 Net book value of truck = 50,000 16,000 = 34,000

Journal Entry for selling truck:



Truck asset


Accumulated Depreciation


Revenue on sale of truck


When non-physical assets, e.g. goodwill, patents and trademarks are amortised, the accumulated amortisation account is used instead of accumulated depreciation

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5.6 Accounts Receivable and Contra Accounts

Accounts receivable when revenue is recognised but uncollected

DR accounts receivable, CR sales revenue

Such receivables are often called trade receivables

Valuation of accounts receivable

Receivables are valued on BS at lower of cost (original transaction value +

interest charges) or net realisable value (amount expected to be collected) If collectable amount < expected amount, receivable must be reduced to an

estimated collectable amount. This is done by subtracting an allowance for doubtful accounts from the

accounts receivable balance Estimated amount collectable = Trade receivables allowance for doubtful

debts Therefore allowance adjusts net value down to the lower of cost and current estimated collectable amount

Other receivables

2 other main types of receivables. If they are large, they are shown separately.

If they are not large, together, they‟re called “other debtors”

Notes receivable

  • - Supported by signed contract specifying payment schedule, interest rate

and often other legal details.

  • - Used for large or long term receivables, e.g. motor cars, house, appliances and loans by banks and finance comps Other receivables:

  • - Loans to employees, officers and shareholders, associated companies, tax Refunds Company is waiting for and other receivables not arising from revenue transactions.

  • - Accounted for and valued same as AR and notes receivable.

  • - Usually arise from peculiar circumstances, where company disclose reasons.

Allowance for doubtful debts

There is always a risk where customers will fail to pay

Therefore portion of debts will be doubtful and portion should be deducted from

revenue in determining profit for the period To recognise expense:

DR Bad Debts Expense CR Allowance for doubtful debts

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Reason for not deducting directly to keep balance between accounts receivable and list of individual accounts. Company may still try to collect on the accounts After pursuing non-paying customer for months, company may decide to write off account. Then:

DR Allowance for doubtful debts CR Accounts Receivable Allowance can be seen as a temporary holding account for amounts the company believes will not be collected, based on past experience and an assessment of outstanding accounts.

Another way of writing: Direct write off method DR Bad Debts Expense CR Accounts Receivable Used when company has few accounts receivable or when large account not

included in allowance suddenly goes bad Purposes of contra accounts are to provide useful information to the readers of

financial statements or to assist in accounting‟s internal control functions

5.8 Managers and Accrual Accounting Assumptions

Accrual accounting‟s purpose: to move beyond cash flows towards a broader

economic concept of profit and financial position.

Implications from a managers point of view:

  • - Fair evaluation of managerial performance

  • - Limitation accrual accounting, basing on history reflects on the past rather than looking into the future, as managers are inclined to do

  • - Only look at the resulted actions, not the reason why mangers initiated action

  • - Evidenced based accounting procedures for recognition of profit and expenses may not relate very well to economic concepts of earnings, or

manager‟s struggles to increase the value of their companies

  • - To managers seeking even handed evaluation of their performance, accounting may seem downwardly biased in its measures

  • - Criteria for revenue and expenses recognition is subjective some managers manipulate, some managers find it too loose and flexible

  • - The shorter the time period, the more mismatch the figures are between cash flow and accrual profit Accrual accounting has many advantages and is very widely used, but managers should not accept it uncritically

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5.9 Accrual Accounting in the public sector

Since 1995, local governments in Australia have been required to produce

Non-cash assets and depreciation

financial statements using accrual accounting Since 1994 NSW govt. 1999 all govt

Key differences with accrual accounting:

Value of receivables and payables

Liabilities (employee entitlements)

Changing value of financial assets and liabilities (exchange rate)

Cost and revenue of government activities

Cost of consuming assets expense (e.g. depreciation)

Value of goods and services received for free from other bodies (revenue)

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Chapter 5 Appendix Special Journals, Subsidiary Ledgers and Control Accounts

Business with small set of transactions initially recorded in general journal, then

posted to general ledger Complex business rather than info captured in 1 journal and posted to 1 ledger,

system of special journals, subsidiary ledgers used Special journals allow easy recording of the most common transactions

undertaken by a business Subsidiary ledgers present detailed analysis of info that is eventually transferred

to general ledger account Sales invoice >>> Journal Entries + Subsidiary ledger AR >>> General Ledger, Trial

Balance General ledger account called debtors or Accounts receivable

A5.1 Prime Entry Records: Special Journals

Special Journal :

Transaction Recorded:

Sales Purchases Cash receipts Cash payments

Credit sales of inventory Credit purchases of inventory All cash inflows (including cash sales) All cash outflows (including cash purchases)

Each entry represents a transaction that belongs to the same class as others in

the same journal Transactions not in special journal are recorded in general journal

Advantages of Special Journals:

  • - Recording efficiency

  • - Amounts posted from special journals to general ledger as totals, rather than individual journal entries

  • - More than one user can update accounting system, because it consists a number of related subsystems

  • - Nature of transaction eliminates need for narrations

  • - Info such as receipt or invoice number may be recorded for narrations

  • - Additional info can be added for convenience as it is available from source documents, e.g. discounts

A5.2 Subsidiary Ledgers and Control Accounts

Most common way of accommodating need for detailed records in the accounting system, without grossly expanding number of separate general ledger accounts

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Subsidiary ledger a set of ledger accounts that collectively represents a detailed analysis of one general ledger account classification Relevant account in general ledger is called the control account Accounts in subsidiary ledger can be periodically checked against total data and balance in control account

Examples of general ledger accounts that have subsidiary ledgers:

  • - Debtors/Accounts Receivable separate account for each debtor

  • - Creditors/Accounts payable separate account for each creditor

  • - Property, plant and equipment Asset Register separate for each piece

  • - Raw materials Inventory Separate records of each type of raw material

  • - Finished goods inventory Separate record of each type of finished good

Advantages for subsidiary accounts Check on accuracy (as subsidiary account and general account balances should =) Enable any desired amount of detail to be maintained to explain composition of selected general ledger account, without overloading general ledger

A5.3 Trade discount and Cash discount

Both Trade discount and cash discounts represents a reduction in the amount

that a customer ultimately pays a vendor for gods and services supplied Differ in the way they are recorded

Trade Discount

Trade discounts are a means of adjusting the actual price charged to a customer from a standard list price.

Usually determined by category of customer or normal volume of businesses

Manufacturer may sell at list price to general public, 40% off for retainers and 55%

off to wholesalers Most enterprises record only net amount of transaction

Effect of trade discount is merely to set an actual price for transaction

Cash Discount

Cash discounts are conditional adjustment after determining the actual selling

price at which the transaction takes place NOT a change in price of original sales transaction generally recorded as an additional transaction

Credit terms 2.5/10, n/30 2.5% deducted if money was paid within first 10 days, the net amount must be paid within the next 30 days

Discounts recorded as “Discounts allowed” (EXPENSE), or “Discounts Received”


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A5.4 Operation of Special Journals and Subsidiary Ledgers


Purpose of special journals is to eliminate need for such detailed recording in a

general journal and the general ledger Totals of special journals posted to control account, because CA only record

aggregates Sales journal updated everyday

Sales journal posted to AR, Sales revenue, COGS, Inventory

Subsidiary ledger may be established for each customer who buys on credit

Posting reference S1 indicates info comes from page S1 of sales journal

Tick in posting reference indicates that the amount has been posted to the

subsidiary ledger End of period total of subsidiary ledgers can be checked against balance of

AR control account. I.e. sum of balance in each debtor should = balance of AR control account


Purchases only used for recording the acquisition of goods, on credit, intended

Cash Receipts

for resale Source document purchase invoice from supplier, matched against delivery

docket and copy of official purchase order Even with discounts, the full amount owing is recorded

If discounts are received, then this is recorded in CPJ discount revenue, when

items are paid for Purchases journal updated every day for each creditor of each item of

inventory Credit transactions involving acquisition of fixed assets or items to be charged to

expense accounts, such as repairs, maintenance, printing and stationery, are often recorded in general journal.

Source document: evidence of cash receipt, list of cheques received or direct

deposit recorded on bank account statement Cash receipts journals are designed to meet specific needs of an enterprise

Most businesses include payments from debtors, possibly cash sales

Also sundry or miscellaneous column for cash receipts not otherwise identified by

specific column that represents a particular general ledger account E.g. proceeds from sale of fixed assets, refunds by creditors, new capital or

mortgage funding Discount expense column not sundry

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Cash Payments

Source documents: duplicate of cheque or cheque butt, statement and

invoices from creditors, receipt issued by recipient or payroll analysis certified as correct by responsible staff member Bank statement evidence of interest charged on any overdraft, together with

info about other bank charges and fees Minimise postings and provide analysis of payments, separate columns may be

provided to record entries affecting those ledger accounts frequently involved Sundry or miscellaneous column might be needed.

DO NOT POST total of sundry column

Desirable in all books of prime entry (journals) to provide reference to source

document for each entry Done by recording cheque number

In addition to postings to general ledger made at end of period, each individual item in the creditors column will be posted as a debit to the creditors account

A5.5 Role of General Journal and General Ledger

General journal used to record a number of important transactions:

Sales and purchase returns

Credit transactions other than those related to inventory, such as the purchase

of equipment Adjusting entries

Closing entries

Each entry in general journal is individually posted to appropriate account in

general ledger At the end of a period, all financial information will be posted to general ledger, either as an individual entry sourced from general journal (including sundry from special journal), or in aggregate from columns of various special journals

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Chapter 6 Financial Reporting Principles, Accounting Standards and Auditing

6.2 Accounting Principles and the use of Accounting Information

Doing accounting takes expert knowledge, considerable experience and

SAC 1 Definition of a Reporting Entity

continuous attention to new problems and solutions. Concepts and principles are important, as they form logical structure that

practising accountants use every day to consider problems to make recommendations GAAP (Generally Accepted Accounting Principles) applied differently for

different entities Rules, standards and usual practices that companies are expected to follow

when preparing financial statements Stock market crash of 1929 brought GAAP

AASB (Aust Accounting Standards Board)

IASB (International Accounting Standards Board)

AASB uses IASB as foundation, but includes more details applicable to Aust

environment SACS Statement of Accounting concepts

SAVS established for general concepts and principles to be used in preparing

financial statements

SAC 2 Objective of General Purpose Financial Reporting

SAC 3 Qualitative Characteristics of Financial Information

SAC 4 Definition and Recognition of the Elements of Financial Statements

Now, SAC 3 and SAC 4 is replaced with “Framework for Preparation and Presentation of Financial Statements”

FYI: Difficulties that face accounting and managers by GAAP

Difference in company structures e.g. ABC = not for profit, publicly owned.

Should ABC use same methods as other profit seeking organisations? Qantas / UNSW employees are not assets. But for sports team, such as Sydney

Swans millions are paid to have certain players on the team. Are they assets or expenses? Should they be amortised? Comparing movies‟ net profits – hard to measure profitability of certain movies e.g. star wars attracted many viewers when it was first released. However, due to its popularity, it continues to generate revenue, through video, dvd, toys,


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