1. Types of Accounting
Accounting is a vast and dynamic profession and is constantly adapting itself to the specific and varying
needs of its users. Over the past few decades, accountancy has branched out into different types of
accounting to cater for the diversity of needs of its users.
Main types of accounting
are as follows:
1. Financial
2. Management
3. Governmental
4. Tax
5. Forensic
6. Project
7. Social
Financial Accounting, or financial reporting, is the process of producing information for external use
usually in the form of financial statements. Financial Statements reflect an entity's past performance
and current position based on a set of standards and guidelines known as GAAP (Generally Accepted
Accounting Principles). GAAP refers to the standard framework of guideline for financial accounting used
in any given jurisdiction. This generally includes accounting standards (e.g. International Financial
Reporting Standards), accounting conventions, and rules and regulations that accountants must follow
in the preparation of the financial statements.
Management Accounting produces information primarily for internal use by the company's
management. The information produced is generally more detailed than that produced for external use
to enable effective organization control and the fulfillment of the strategic aims and objectives of the
entity. Information may be in the form budgets and forecasts, enabling an enterprise to plan effectively
for its future or may include an assessment based on its past performance and results. The form and
content of any report produced in the process is purely upon management's discretion.
Cost accounting is a branch of management accounting and involves the application of various
techniques to monitor and control costs. Its application is more suited to manufacturing concerns.
Governmental Accounting, also known as public accounting or federal accounting, refers to the type of
accounting information system used in the public sector. This is a slight deviation from the financial
accounting system used in the private sector. The need to have a separate accounting system for the
public sector arises because of the different aims and objectives of the state owned and privately owned
institutions. Governmental accounting ensures the financial position and performance of the public
sector institutions are set in budgetary context since financial constraints are often a major concern of
many governments. Separate rules are followed in many jurisdictions to account for the transactions
and events of public entities.
Tax Accounting refers to accounting for the tax related matters. It is governed by the tax rules
prescribed by the tax laws of a jurisdiction. Often these rules are different from the rules that govern the
preparation of financial statements for public use (i.e. GAAP). Tax accountants therefore adjust the
financial statements prepared under financial accounting principles to account for the differences with
rules prescribed by the tax laws. Information is then used by tax professionals to estimate tax l iability of
a company and for tax planning purposes.
Forensic Accounting is the use of accounting, auditing and investigative techniques in cases of litigation
or disputes. Forensic accountants act as expert witnesses in courts of law in civil and criminal disputes
that require an assessment of the financial effects of a loss or the detection of a financial fraud.
Common litigations where forensic accountants are hired include insurance claims, personal injury
2. claims, suspected fraud and claims of professional negligence in a financial matter (e.g. business
valuation).
Project Accounting refers to the use of accounting system to track the financial progress of a project
through frequent financial reports. Project accounting is a vital component of project management. It is
a specialized branch of management accounting with a prime focus on ensuring the financial success of
company projects such as the launch of a new product. Project accounting can be a source of
competitive advantage for project-oriented businesses such as construction firms.
Social Accounting, also known as Corporate Social Responsibility Reporting and Sustainability
Accounting, refers to the process of reporting implications of an organization's activities on its ecological
and social environment. Social Accounting is primarily reported in the form of Environmental Reports
accompanying the annual reports of companies. Social Accounting is still in the early stages of
development and is considered to be a response to the growing environmental consciousness amongst
the public at large.
Definition - What are Financial
Statements?
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 th e
payments of interest and dividends.
View detailed explanation and Example of Cash Flow Statement
3. 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
Income Statement | Profit & Loss
Account
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.
Topic contents:
1. Definition
2. Example
3. Basis of preparation
4. Components
5. Purpose & Use
6. Template
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
Notes
2013 2012
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)
4. 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 isearned 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 incurredeven 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 elect ronic 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 pe riod minus any closing
inventory.
In case of a manufacturer however, cost of sales will also include production costs incurred in the manufacture of goods duri ng 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.
5. 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 t hat 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 administrat ion
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
6. Prior Period Comparatives
Prior period financial information is presented along side current period's financial results to facilitate comparison of per formance 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
Income Statement | Profit & Loss
Account
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.
Topic contents:
1. Definition
2. Example
3. Basis of preparation
4. Components
5. Purpose & Use
6. Template
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
7. Notes
2013 2012
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 isearned 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 incurredeven 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.
8. 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 wil l 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 t hat 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.
9. 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 per formance 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
Relationship between Financial
Statements
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.
10. 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);
11. The increase in net assets and equity arising from the issue of share capital as reported in the statement of changes in equi ty;
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 fixe d
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 activ ities)
Relationship between Financial
Statements
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.
12. Balance Sheet
Balance Sheet, or Statement of Financial Position, is directly related to the income statement, cash flow statement and statement of chang es
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);
13. 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 o f 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)
Relevance:
Information should be relevant to the decision making needs of the user. Information is relevant if it helps users of the fin ancial statements in
predicting future trends of the business (Predictive Value) or confirming or correcting any past predictions they have made (Confirmatory
Value). Same piece of information which assists users in confirming their past predictions may also be helpful in forming fut ure forecasts.
Example:
A company discloses an increase in Earnings Per Share (EPS) from $5 to $6 since the last reporting period. The information is relevant to
investors as it may assist them in confirming their past predictions regarding the profitability of the company and will also help them in
forecasting future trend in the earnings of the company.
Relevance is affected by the materiality of information contained in the financial statements because only material information influences the
economic decisions of its users.
Example:
A default by a customer who owes $1000 to a company having net assets of worth $10 million is not relevant to the decision making needs of
users of the financial statements.
However, if the amount of default is, say, $2 million, the information becomes relevant to the users as it may affect thei r view regarding the
financial performance and position of the company.
Reliability
Information is reliable if a user can depend upon it to be materially accurate and if it faithfully represents the information that it purports to
present. Significant misstatements or omissions in financial statements reduce the reliability of information contained in them.
14. Example:
A company is being sued for damages by a rival firm, settlement of which could threaten the financial stability of the company. Non-disclosure
of this information would render the financial statements unreliable for its users.
Reliability of financial information is enhanced by the use of following accounting concepts and principles:
Prudence
Preparation of financial statements requires the use of professional judgment in the adoption of accountancy policies and estimates.
Prudence requires that accountants should exercise a degree of caution in the adoption of policies and significant estimates such that the
assets and income of the entity are not overstated whereas liability and expenses are not under stated.
The rationale behind prudence is that a company should not recognize an asset at a value that is higher than the amount which is expected
to be recovered from its sale or use. Conversely, liabilities of an entity should not be presented below the amount that is likely to be paid in its
respect in the future.
There is an inherent risk that assets and income of an entity are more likely to be overstated than understated by the management whereas
liabilities and expenses are more likely to be understated. The risk arises from the fact that companies often benefit from b etter reported
profitability and lower gearing in the form of cheaper source of finance and higher share price. There is a risk that leverage offered in the
choice of accounting policies and estimates may result in bias in the preparation of the financial statements aimed at improv ing profitability
and financial position through the use of creative accounting techniques. Prudence concept helps to ensure that such bias is countered by
requiring the exercise of caution in arriving at estimates and the adoption of accounting policies.
Example:
Inventory is recorded at the lower of cost or net realizable value (NRV) rather than the expected selling price. This ensures profit on the sale
of inventory is only realized when the actual sale takes place.
However, prudence does not require management to deliberately overstate its liabilities and expenses or understate its assets and income.
The application of prudence should eliminate bias from financial statements but its application should not reduce the reliabi lity of the
information
Completeness
Reliability of information contained in the financial statements is achieved only if complete financial information is provided relevant to the
business and financial decision making needs of the users. Therefore, information must be complete in all material respects.
Incomplete information reduces not only the relevance of the financial statements, it also decreases its reliability since users will be basing
their decisions on information which only presents a partial view of the affairs of the entity.
1. Definition
Single Economic Entity Concept suggests that companies associated with each other through the virtue of common control operate as a
single economic unit and therefore the consolidated financial statements of a group of companies should reflect the essence o f such
arrangement.
2. Explanation
Consolidated financial statements of a group of companies must be prepared as if the entire group constitutes a single entity in order to avoid
the misrepresentation of the scale of group's activities.
It is therefore necessary to eliminate the effects of any inter-company transactions and balances during the consolidation of group accounts
such as the following:
Inter-company sales and purchases
Inter-company payables and receivables
Inter-company payments such as dividends, royalties & head office charges
Inter-company transactions must be eliminated as if the transactions had not occurred in the first place. Examples of adjustments that may
be required to eliminate the effects of inter-company transactions include:
Elimination of unrealized profit or loss on the sale of assets member companies of a group
Elimination of excess or deficit depreciation expense in respect of a fixed asset purchased from a member company at a price that
was higher or lower than the net book value of the asset in the books of the seller.
15. 3. Example
XYZ PLC is a company specializing in the manufacturing of fertilizers. At the start of the current accounting period, XYZ PLC acquired DEF
PLC, a chemicals producer.
Following is a summary of the financial results of the two companies during the year:
XYZ DEF
$m $m
Sales 120 50
Cost of Sales (60) (20)
Gross Profit 60 30
Operating Expenses (20) (10)
Net Profit 40 20
XYZ PLC purchased chemicals worth $20m from DEF PLC which it used in the manufacture of fertilizers sold during the year.
Consolidation of XYZ Group's financial results will require an adjustment in respect of the inter-company sale and purchase in order to
conform to the single entity principle.
Consolidated financial results of the two companies will be presented as follows:
XYZ Group
$m
Sales (120 + 50 - 20) 150
Cost of Sales (60 + 20 - 20) (60)
Gross Profit
90
Operating Expenses (20 + 10) (30)
Net Profit
60
Since XYZ Group, considered as a single entity, cannot sell and purchase to itself, the sales and purchases in the consolidated income
statement have been reduced by $20 m each in order to present the sales and purchases with external customers and suppliers.
If we ignore the single entity concept, XYZ Group's financial results will present sales of $170 m and cost of sales amounting $80 m.
Although the net profit of the group will be unaffected by the inter-company transaction, the size of the Group's operations will be
misrepresented due to the overstatement.
Money Measurement Concept in
Accounting
16. Definition
Money Measurement Concept in accounting, also known as Measurability Concept, means that only transactions and events that are
capable of being measured in monetary terms are recognized in the financial statements.
Explanation
All transactions and events recorded in the financial statements must be reduced to a unit of monetary currency. Where it is not possible to
assign a reliable monetary value to a transaction or event, it shall not be recorded in the financial statements.
However, any material transactions and events that are not recorded for failing to meet the measurability criteria might need be disclosed in
the supplementary notes of financial statements to assist the users in gaining a better understanding of the financial performance and
position of the entity.
Matching Principle & Concept
Matching Principle - topic contents
1. Definition
2. Explanation
3. Examples
4. Matching Vs Accruals Vs Cash Basis
5. MCQ
1. Definition
Matching Principle requires that expenses incurred by an organization must be charged to the income statement in the accounting period in
which the revenue, to which those expenses relate, is earned.
2. Explanation
Prior to the application of the matching principle, expenses were charged to the income statement in the accounting period in which they
were paid irrespective of whether they relate to the revenue earned during that period. This resulted in non recognition of e xpenses incurred
but not paid for during an accounting period (i.e. accrued expenses) and the charge to income statement of expenses paid in respect of
future periods (i.e. prepaid expenses). Application of matching principle results in the deferral of prepaid expenses in order to match them
with the revenue earned in future periods. Similarly, accrued expenses are charged in the income statement in which they are incurred to
match them with the current period's revenue.
A major development from the application of matching principle is the use of depreciation in the accounting for non-current assets.
Depreciation results in a systematic charge of the cost of a fixed asset to the income statement over several accounting periods spanning the
asset's useful life during which it is expected to generate economic benefits for the entity. Depreciation ensures that the cost of fixed assets
is not charged to the profit & loss at once but is 'matched' against economic benefits (revenue or cost savings) earned from the asset's use
over several accounting periods.
Matching principle therefore results in the presentation of a more balanced and consistent view of the financial performance of an
organization than would result from the use of cash basis of accounting.
Definition
Timeliness principle in accounting refers to the need for accounting information to be presented to the users in time to fulfill their d ecision
making needs.
Importance
Timeliness of accounting information is highly desirable since information that is presented timely is generally more relevant to users while
conversely, delay in provision of information tends to render it less relevant to the decision making needs of the users. Timeliness principle is
therefore closely related to the relevance principle.
17. Timeliness is important to protect the users of accounting information from basing their decisions on outdated information. Imagine the
problem that could arise if a company was to issue its financial statements to the public after 12 months of the accounting p eriod. The users
of the financial statements, such as potential investors, would probably find it hard to assess whether the present financial circumstances of
the company have changed drastically from those reflected in the financial statements.
Materiality
Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the
financial statements (IASB Framework).
Materiality therefore relates to the significance of transactions, balances and errors contained in the financial stat ements. Materiality defines
the threshold or cutoff point after which financial information becomes relevant to the decision making needs of the users. I nformation
contained in the financial statements must therefore be complete in all material respects in order for them to present a true and fair view of
the affairs of the entity.
Materiality is relative to the size and particular circumstances of individual companies.
Example - Size
A default by a customer who owes only $1000 to a company having net assets of worth $10 million is immaterial to the financial statements
of the company.
However, if the amount of default was, say, $2 million, the information would have been material to the financial statements omission of
which could cause users to make incorrect business decisions.
What is a Going Concern?
Going concern is one the fundamental assumptions in accounting on the basis of which financial statements are prepared. Finan cial
statements are prepared assuming that a business entity will continue to operate in the foreseeable future without the need or intention on
the part of management to liquidate the entity or to significantly curtail its operational activities. Therefore, it is assumed that the entity will
realize its assets and settle its obligations in the normal course of the business.
It is the responsibility of the management of a company to determine whether the going concern assumption is appropriate in t he preparation
of financial statements. If the going concern assumption is considered by the management to be invalid, the financial statements of the entity
would need to be prepared on break up basis. This means that assets will be recognized at amount which is expected to be real ized from its
sale (net of selling costs) rather than from its continuing use in the ordinary course of the business. Assets are valued for their individual
worth rather than their value as a combined unit. Liabilities shall be recognized at amounts that are likely to be settled.
What are possible indications of going concern problems?
Deteriorating liquidity position of a company not backed by sufficient financing arrangements.
High financial risk arising from increased gearing level rendering the company vulnerable to delays in payment of interest an d loan
principle.
Significant trading losses bieng incurred for several years. Profitability of a company is essential for its survival in the long term.
Aggressive growth strategy not backed by sufficient finance which ultimately leads to over trading.
Increasing level of short term borrowing and overdraft not supported by increase in business.
Inability of the company to maintain liquidity ratios as defined in the loan covenants.
Serious litigations faced by a company which does not have the financial strength to pay the possible settlement.
Inability of a company to develop a new range of commercially successful products. Innovation is often said to be the key to the long-term
stability of any company.
Bankruptcy of a major customer of the company.
Accruals Concept
Financial statements are prepared under the Accruals Concept 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, 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. Conversely, prepaid income must be not be shown as income in the accounting period in which it is received but inst ead
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.
18.
Expenses, on the other hand, must be recorded in the accounting period in which they are 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.
Conversely, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it mu st be
presented as such in the subsequent accounting periods in which the services in respect of the prepaid expense have been
performed.
Accruals basis of accounting ensures that expenses are "matched" with the revenue earned in an accounting period. Ac cruals
concept is therefore very similar to the matching principle.
Business Entity Concept
Financial accounting is based on the premise that the transactions and balances of a business entity are to be accounted for separately from
its owners. The business entity is therefore considered to be distinct from its owners for the purpose of accounting.
Therefore, any personal expenses incurred by owners of a business will not appear in the income statement of the entity. Simi larly, if any
personal expenses of owners are paid out of assets of the entity, it would be considered to be drawings for the purpose of accounting much
in the same way as cash drawings.
The business entity concept also explains why owners' equity appears on the liability side of a ba lance sheet (i.e. credit side). Share capital
contributed by a sole trader to his business, for instance, represents a form of liability (known as equity) of the 'business' that is owed to its
owner which is why it is presented on the credit side of the balance sheet.
1. Definition Realization concept in accounting, also known as revenue recognition principle, refers to the application of accruals
concept towards the recognition of revenue (income). Under this principle, revenue is recognized by the seller wh en it is earned
irrespective of whether cash from the transaction has been received or not. - See more at:
Dual Aspect Concept | Duality Principle
in Accounting
1. Definition
Dual Aspect Concept, also known as Duality Principle, is a fundamental convention of accounting that necessitates the recognition of all
aspects of an accounting transaction. Dual aspect concept is the underlying basis for double entry accounting system.
Contents:
1. Definition
2. Explanation
3. Example
2. Explanation
In a single entry system, only one aspect of a transaction is recognized. For instance, if a sale is made to a customer, only sales revenue will
be recorded. However, the other side of the transaction relating to the receipt of cash or the grant of credit to the custome r is not recognized.
Single entry accounting system has been superseded by double entry accounting. You may still find limited use of single entry accounting
system by individuals and small organizations that keep an informal record of receipts and payments.
Double entry accounting system is based on the duality principle and was devised to account for all aspects of a transaction. Under the
system, aspects of transactions are classified under two main types:
1. Debit
2. Credit
Debit is the portion of transaction that accounts for the increase in assets and expenses, and the decrease in liabilities, equity and income.
Credit is the portion of transaction that accounts for the increase in income, liabilities and equity, and the decrease in assets and expenses.
The classification of debit and credit effects is structured in such a way that for each debit there is a corresponding credi t and vice versa.
Hence, every transaction will have 'dual' effects (i.e. debit effects and credit effects).
The application of duality principle therefore ensures that all aspects of a transaction are accounted for in the financial statements.
19. 3. Example
Mr. A, who owns and operates a bookstore, has identified the following transactions for the month of January that need to be accounted for
in the monthly financial statements:
$
1. Payment of salary to staff 2,000
2. Sale of books for cash 5,000
3. Sales of books on credit 15,000
4. Receipts from credit customers 10,000
5. Purchase of books for cash 20,000
6. Utility expenses - unpaid 3,000
Under double entry system, the above transactions will be accounted for as follows:
Account Title Effect Debit Credit
$ $
1. Salary Expense Increase in expense 2,000
Cash at bank Decrease in assets
2,000
2. Cash in hand Increase in assets 5,000
Sales revenue Increase in income
5,000
3. Receivables Increase in assets 15,000
Sales revenue Decrease in income
15,000
4. Cash at bank Increase in asset 10,000
Receivables Decrease in asset
10,000
5. Purchases Increase in expense 20,000
Cash at bank Decrease in asset
20,000
6. Utility Expense Increase in expense 3,000
20. Accrued expenses Decrease in asset
3,000
Elements of the financial Statements
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 opera tions 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.
Office Building
Non-current
Provides space to employees for administering company affairs.
Vehicle
Non-current
Used in the transportation of company products and 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.
Equity is the residual interest in the assets of the entity after deducting all the liabilities (IASB Framework).
21. 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 e ntity. 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 entit y.
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 (Equ ity). 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
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 si mply 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
Expense
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 distri butions of profits rather than expense.
This is the significance of the latter part of the definition of expense.
22. 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
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 t iming
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 sy stem. 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.
What is a Trial Balance?
1. Purpose of Trial Balance
2. Example of Trial Balance
3. Limitations of Trial Balance
Trial Balance is a list of closing balances of ledger accounts on a certain date and is the first step towards the preparatio n of financial
statements. It is usually prepared at the end of an accounting period to assist in the drafting of financial statements. Ledg er balances are
segregated into debit balances and credit balances. Asset and expense accounts appear on the debit side o f the trial balance whereas
liabilities, capital and income accounts appear on the credit side. If all accounting entries are recorded correctly and all the ledger balances
are accurately extracted, the total of all debit balances appearing in the trial balance must equal to the sum of all credit balances.
Purpose of a Trial Balance
Trial Balance acts as the first step in the preparation of financial statements. It is a working paper that accountants use a s a basis
while preparing financial statements.
Trial balance ensures that for every debit entry recorded, a corresponding credit entry has been recorded in the books in accorda nce
with the double entry concept of accounting. If the totals of the trial balance do not agree, the differences may be investig ated and
resolved before financial statements are prepared. Rectifying basic accounting errors can be a much lengthy task after the fi nancial
statements have been prepared because of the changes that would be required to correct the financial statements.
Trial balance ensures that the account balances are accurately extracted from accounting ledgers.
Trail balance assists in the identification and rectification of errors.
Example
Following is an example of what a simple Trial Balance looks like:
ABC LTD
Trial Balance as at 31 December 2011
Account Title
Debit Credit
$ $
23. Share Capital
15,000
Furniture & Fixture 5,000
Building 10,000
Creditor
5,000
Debtors 3,000
Cash 2,000
Sales
10,000
Cost of sales 8,000
General and Administration Expense 2,000
Total 30,000 30,000
1. Title provided at the top shows the name of the entity and accounting period end for which the trial balance has been prepare d.
2. Account Title shows the name of the accounting ledgers from which the balances have been extracted.
3. Balances relating to assets and expenses are presented in the left column (debit side) whereas those relating to liabilities, income
and equity are shown on the right column (credit side).
4. The sum of all debit and credit balances are shown at the bottom of their respective columns.
Limitations of a trial balance
Trial Balance only confirms that the total of all debit balances match the total of all credit balances. Trial balance totals may agree in spite of
errors. An example would be an incorrect debit entry being offset by an equal credit entry. Likewise, a trial balance gives no proof that certain
transactions have not been recorded at all because in such case, both debit and credit sides of a transaction would be omitte d causing the
trial balance totals to still agree. Types of accounting errors and their effect on trial balance are more fully discussed in the section on
Suspense Accounts.
