Principle of Accounting.pptx

Principle of Accounting
PRESENTED BY: ROBBIA GULNAR

Content
 Discuss the purpose of the cash flow, profit & loss and the balance sheet statements
 Explain the key terms use in accountancy
 Identify the thirteen accounting principles and how they each may be breached
 List the six accounting concepts
 Outline the purpose of the classification system and its benefits
 Identify the relevant journals and ledgers when posting standard transactions

What is accounting
Accounting is a process of three activities
◦ Identification
◦ Recording
◦ Communication

Objectives of Accounting
The goal of accounting is to ensure information provided to decision makers is useful. To be
useful information must be
◦ Relevance & Reliability
◦ Faithful representation
◦ Understandability
◦ Comparability
◦ Verifiability
◦ Timeliness

Financial Report
Financial
Statements
Statement of
financial
position
Statement of
Owner Equity
Statement of
Cash Flows
Statement of
profit or loss

Basic Accounting Equation
Liabilities
Owner
Equity
Assets

Balance Sheet
The Statement of financial position/balance sheet shows a business’s
assets, liabilities, and equity at a point in time.

Assets
Economic resources that are owned or controlled by an enterprise as a result of past
transactions or events, and that are expected to have future economic benefits.
They are things of value used in carrying out such activities as production, consumption, and
exchange.
Characterized as current and non-current

Liabilities
Liabilities: are claims against assets.
They are existing debts and obligations
Have a known:
◦ Amount, Date to be paid, Person to whom payment owed

Classification of terms for the Balance
Sheet
Classification of items into current and non-current sections helps assess
liquidity. There are three criteria for separating current from non-current assets:
◦ Time - How long before the asset is expected to be converted into cash?
◦ Intention - Is it intended to convert the asset into cash in the near future?
◦ Economic benefit - For how long will the asset continue to earn revenue for
the business?

Functional classification
Functional classification refers to the manner in which expenses are grouped in
the Profit and Loss statement. The expenses are classified according to the
function they perform and usually correspond to the cost centers of the firm.
The advantages of functional classification include-
◦ the opportunity to delegate responsibility, for instance, the sales manager is
responsible for the sales department expenses
◦ the capacity to compare one cost center with another, with that of similar
firms, to benchmarks or with targets set by the firm
◦ to set limits on spending for particular cost centers
◦ decisions may be made on the basis of information provided, such as
considering whether an increase in advertising leads to an increase in sales

The trial balance
At the end of the accounting period ledger accounts are closed off if they are
revenue or expense items, and balanced if assets, liabilities or owners equity
items.
There are two presentations of the trial balance: the pre-trial balance and the
post trial balance. The distinction between the two is easily seen when
preparing the '10 column worksheet', in a later slide slides. The post trial
balance occurs after balance day adjustments.

The trial Balance (Contd.)
The purpose of the trial balance is to compile all the ledger account totals and
balances in order to confirm the accuracy of the recording process. Assets and
expenses are listed in then debit column while revenue, liabilities and owners
equity items are shown in the credit column. Negative items are also shown.
Accumulated depreciation of non-current assets is shown on the credit side and
drawings are shown on the debit side of the trial balance.
It is possible for the trial balance to balance and yet be incorrect. Recording
errors will not necessarily be detected by carrying out a trial balance.

continued
Examples of errors not detected by a trial balance:
a complete entry has been omitted from the ledger
an amount has been placed in the wrong account. For example, $300 paid
wages should have been included as cleaning expense
a compensating error has been made. For instance, both sales and
purchases have been overstated by $100
a money amount has been listed incorrectly
debit and credit entries have been reversed. A debtor has paid us money,
yet debtors are incorrectly debited and bank wrongly credited

Preparation of Report
The cash report, the Profit and Loss statement, and the balance sheet are
regarded as 'position statements'. Position statements reflect:

Income Statement
An income statement communicates information about business’s
financial performance by summarizing revenues less expenses over
a period of time.
Income Statement Equation
Revenues-Expenses=Profit/Loss

What is accrual accounting
What Is Accrual Accounting? Also called accrual basis accounting, the accrual
accounting method requires that transactions be recorded at the time they
occur in agreement – not at the time when cash is actually received or spent.
Accrual Accounting (or Accrual Basis Accounting) for example.
◦ Depending on the size of your organization, and whether it is privately owned
or publicly traded, the accrual accounting method might be required by the
Generally Accepted Accounting Principles (GAAP).
◦ However, if you are just starting out, are not publicly traded, or have a
smaller-medium business, then it is up to you to decide which accounting
method will work best for you.

The Advantages of Accrual Accounting
1. It's Compliant With GAAP
◦ Even if you are not yet required to use the accrual accounting method, one solid argument for establishing this
practice in your business now is that it is the method required by the GAAP.
◦ As your company grows, you might eventually be required to switch over to accrual accounting in the future, so
already having this method in place and being accustomed to using it will put you at a significant advantage down the
road.
2. It's More Transparent
◦ Unlike the cash accounting method which only shows transactions as they happen – not as they're about to happen –
accrual accounting is much more transparent because it shows a business's accounts as they are about to be or truly
are, reflecting all of the money that will soon be coming in and all the payments that will soon be going out.
◦ As a result, the accrual accounting method provides business leaders with a much clearer picture of a company's
financial health at any given time.
3. It Simplifies Strategic Planning
◦ Since accrual accounting reflects certain future cash flow activities, it enables much better strategic planning.
◦ With this accounting method, business owners can quickly identify when a cash flow shortage might be on the
horizon or when a cash influx is coming. As a result, accrual accounting allows you to better plan ahead to prevent
crises as a result of unforeseen shortages and to be prepared to make the most of upcoming windfalls.

The Disadvantages of Accrual Accounting
1. It Can Be Challenging
◦ Cash accounting is straightforward: record expenses as they go out and record income as it comes in. Accrual accounting, on the other
hand, is not so straightforward. There are several rules that need to be followed and a consistent process must be established for defining
when and how to record certain types of expenses and income. Additionally, tax forms can be slightly more complicated to complete
when using the accrual accounting method.[2]
2. It Can Be Difficult to Switch to Accrual
◦ If you are already using a different accounting method in your business, switching over to the accrual method can be challenging. For
example, having cash flow issues can exacerbate this challenge. That being said, cash flow improvement and transparency are important
reasons why businesses should use the accrual method.
3. It Can Leave You Vulnerable to Fraud
◦ If you are handling your business's finances on your own or with a few back-office employees, the accrual accounting method can open
your business up to the potential for fraud. To safeguard your company from internal fraud and to ensure your financial statements are
always accurate, it's essential to have proper systems of control in place – especially, if you do not feel fully comfortable evaluating the
company's ledgers and understanding the accrual accounting method.

Transactions and Balances
Accounting consists of accounting transactions and balances. Transactions are
financial events such as issuing an invoice or receiving payment, whereas balances are
stores of value. This value can either be actual money, such as the bank balance, or the
estimated value of non-monetary things. As we progress through this course we will
explore what some of these things are.
Recall the example from the previous lesson about running a business that sells
oranges to a supermarket chain. You are going to use an interactive model to simulate
doing this, but first watch this video that explains the accounting analogy and how to
use the model.

What’s the Difference Between Cash Flow
and Revenue?
Revenue Cash Flow
Financial statement Income Statement Cash Flow Statement
What it measures The dollar amount of sales
the firm generates through
marketing or other
activities
The cash generated by
operating, investing, and
financing activities of the
firm
What it means Revenue must always
remain greater than
expenses for a healthy firm.
Cash flow must always
remain positive or the firm
does not have the money
to operate.
Accrual or cash accounting Revenue is reported on an
accrual basis. Sales have
been made that are not yet
paid for.
Cash flow is reported on a
cash basis. It is the cash
that moves into and out of
the firm.

Summary of Assets vs. Liabilities
Assets are the purchases an organization makes to improve their financial position
or assist in their operations. Liabilities are the amounts a company owes to external
entities.
Assets and liabilities are both taken into consideration to reflect the true financial
position of a company.
The assets of a company are also used to determine the credit scores of a company
among other factors.
Comparisons within different firms can also be done accurately with the balance
sheet that displays both the assets and liabilities.
Assets include land, buildings, plant and machinery, inventory and can all easily
depreciate in value. Liabilities include loans, debentures, accounts payables and can’t
depreciate.

Double-Entry Bookkeeping
When running the model you will now notice that every flow starts and ends in a
tank. This means that every accounting transaction "comes out" of one balance and
"goes into" another. This is a general principle of accounting called the principle of
double-entry bookkeeping. At the end of this lesson we will look at how this is linked
to debiting and crediting.
Another thing you may have noticed in the model is that every balance is initially
zero. This corresponds directly to the fact that when a business is created every
balance is zero. Every subsequent transaction in the business will fill one tank and
drain another.

Assets, Liabilities & Equity
Assets = Liabilities + Equity
A good way to think about the equation is to think that everything that a business owns (its
assets) it also owes (its liabilities and equity). The amounts owed are a combination of actual
legal debts to employees or suppliers, and the profit that a business has generated which from
an accounting perspective is owed back to the company's owners.
This equation is called the Fundamental Equation of Accounting. As we have seen using the
model, it is a simple result of double-entry bookkeeping and the initial value of zero for every
balance.

Capital Assets
The types of assets explored in previous topics were all current assets - i.e. assets generated
continuously by the business as part of its usual operations that it aims to convert into cash. And
similarly the accounting transactions were all continuous - businesses generate revenue, incur
costs, receive money and make payments on a day-to-day basis.
There is another class of asset called capital assets or fixed assets. These are things like
property, equipment and machinery. They are long-term assets (expected to last longer than a
year) and unlike current assets the business does not generate them continuously or expect to
convert them into cash. Instead it aims to benefit from using them over their expected lifetimes
before probably needing to replace or upgrade them.

Asset Definition
For a resource to meet the accounting requirements to qualify as an asset:
The resource must be owned or controlled by the business,
There must be an expectation that the business will benefit from the resource, and
The resource value must be measurable somehow.
These criteria are automatically satisfied for physical things purchased by the business like
inventory - the business owns them, it obviously plans to use them in its operations and the
asset value is the purchase price. In this topic we will also look at non-physical assets called
intangible assets where these criteria become harder to fulfil.

Current vs Fixed
A good example of the difference between fixed and current assets is laptop computers. For a
company such as Dell that sells laptops, the laptops that it holds as inventory for sale would be
classed as current assets. However, the laptops that it issues to its employees would be classed
as fixed assets because it does not aim to sell them and their expected lifetime is over a year.
This example demonstrates that it is not the nature of the item but rather its purpose and how
the business uses it that determine whether an asset is classed as fixed or current. The reason
the distinction is important is because the accounting treatment for each is different. Current
assets are converted into cash, whereas fixed assets are depreciated.

Depreciation
One problem is that it means that a business' financial results suffer in the year of purchase as
a result of buying new equipment, since it has to charge a $4m cost to its profit and loss
account. Senior management bonuses are often linked to the business' overall financial
performance, so this treatment could discourage management from upgrading and replacing the
machinery, even if the business needs it.
The other problem is that accrual accounting aims to reflect the operational reality. The
equipment will be used continuously over its lifetime, and so to reflect this accountants spread
the total cost of the fixed asset over the asset's expected lifetime. This technique is called
depreciation and the asset's expected lifetime is called the write-off period.
So in the example above, the simplest way to spread the cost is to divide $4m by 8 years,
resulting in a cost of $500,000 per year. Let's look at the accounting transactions for
depreciation.

Debt
Before looking at the pros and cons of equity funding, we are going to consider further types of debt
funding in addition to just payables and overdraft. The main type of debt funding is loans. There are
different considerations to take into account with loan funding - we are going to look at the main 3
which are the loan term, the loan cost and the concept of security.
A secured loan is one that uses a particular asset or assets as collateral in the event of the borrower
defaulting on the loan. A mortgage is an example of a secured loan - if you are unable to repay your
mortgage, the lender can take ownership of your property. The loan is said to be secured against the
property. Security reduces the lender's risk, and so secured loans are generally easier for a business to
obtain and have lower rates of interest compared to unsecured loans.
A bank overdraft on the other hand is a type of unsecured loan facility. It is unsecured because there
is no particular asset that the bank can take possession of in the event of the business being unable to
repay its overdraft. As we have already seen, the term loan facility means that interest is only charged
as the loan is used (i.e. when the balance is overdrawn), rather than a conventional loan where a sum
of money is borrowed up front and repaid in instalments over time.

Direct Costs
•A consulting business may categorise the
salaries of its consultants as direct costs and
the salaries of other staff such as finance and
HR staff as overheads.
•There are no hard and fast rules on direct vs
indirect costs, and different companies
within the same industries may do things
slightly differently. The more important thing
is to understand how costs fit into the
accounting framework, which is what we will
look at now.

Retail
In order to explore working capital and liquidity in any depth it is
necessary to look at how it works within an example industry. We are
going to consider the example of a retail business, since the business
model is fairly simple and everyone is aware of the industry by virtue of
being a consumer. The concepts we will introduce though are valid for
every industry.
A traditional retail business buys inventory or stock from its suppliers,
stores the products in its warehouses and on its shelves before
consumers purchase the items. Let's look at how these accounting
transactions work and explore the working capital cycle for a retail
business.

Principle of Accounting.pptx

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