GRADUATE BUSINESS SCHOOL
FINANCIAL ACCOUNTING
MSCSM 1-04 MODULE
E. MARUFU
Contents
1UNIT ONE: FINANCIAL REPORTING AND THE ACCOUNTING CYCLE
1.1Objectives
1.2What is Accounting?
1.3Users of accounting information
1.4Branches of Accounting
1.5Forms of business entities
Sole proprietorship
Partnership
Company
Other forms of entities
1.6Separate entity concept
1.7Accounting equation
1.8Double entry system of accounting
1.9Books of Accounts
1.9.1Subsidiary books
1.9.2The Ledger
1.10Accounting entries in the ledger
1.11Trial balance
1.12Preparation and presentation of financial statements
1.13Summary of accounting cycle
1.14Questions
1.15References
2UNIT TWO: FINANCIAL REPORTING REGULATION
2.1Objectives
2.2Need for regulation of financial reporting
2.3Forces regulating financial reporting
2.3.1International Accounting Standards Board (IASB)
2.3.2Zimbabwe Accounting Practices Board (ZAPB)
2.3.3Statutory requirements
2.3.4Zimbabwe Stock Exchange (ZSE) requirements
2.3.5Generally accepted accounting practice (GAAP)
2.3.6Corporate governance framework
2.4Questions
2.5References
3UNIT THREE FINANCIAL REPORTING
3.1Objectives
3.2The objectiveof financial statements
The objective of financial statements is to provide information on:
The financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.
3.3Underlying assumptions
3.4Qualitative characteristics of financial statements
3.5The Elements of Financial Statements
3.5.1Definitions of the elements relating to financial position
3.5.2Definitions of the elements relating to performance
3.6Recognition of the Elements of Financial Statements
3.7Format for presenting financial statements
3.8Questions.
4UNIT FOUR: STATEMENT OF CASH FLOWS
4.1Objectives
4.2Objective of preparing a statement of cash flows
4.3Management need to control cash flow for the following reasons:
4.4Definitions of key terms
4.5Presentation of a statement of cash flows
4.5.1Operating activities
4.5.2Investing activities
4.5.3Financing activities
4.6Interest and dividends
4.7Taxes on income
4.8Non-cash transactions
4.9Format for presenting the statement of cash flows
4.10Drawbacks of statement of cash flows
4.11Questions
4.12References
5UNIT FIVE: FINANCIAL STATEMENT ANALYSIS
5.1Objectives
5.2Objective of financial statement analysis
5.3Standards of performance
5.3.1Internal Standards
5.3.2External Standards
5.4Financial ratio analysis
5.4.1Financial ratios
5.5Factors on which analysis and interpretation of financial ratios depend include:
5.6Financial ratio classification
5.6.1Profitability ratios
5.6.2Liquidity ratios
5.6.3Financial Leverage ratios
5.6.4Cash flow ratios
5.7Limitations of financial statement analysis
5.7.1Information problems
5.7.2Internal Comparison Problems
5.7.3External comparison problems
5.8Questions
5.9References
6UNIT SIX: FINANCIAL DISTRESS PREDICTION
6.1Objectives
6.2Financial distress prediction
6.3Indicators of financial distress
6.4Users of financial distress prediction models
6.5Financial distress models
6.5.1Univariate financial distress models
6.5.2Multivariate financial distress models
6.6Questions
1UNIT ONE:FINANCIAL REPORTING AND THE ACCOUNTING CYCLE
1.1Objectives
By the end of this unit you should be able to:
- Define accounting
- Identify users of accounting information and their information needs.
- Distinguish between financial accounting and management accounting.
- Explain the accounting cycle.
- Justify the use of accounting records in business.
1.2What is Accounting?
Of the several available definitions of ‘accounting’, the one developed by the American Accounting Association is perhaps the most comprehensive
Accounting is the process of identifying, measuring and communicating economic information about an entity to permit informed judgments and decisions by users of the information (Anthony et al, 1995)
Accounting is a financial information system and can be viewed as a link between an entity’s economic activities and the decision makers. As such it is a means by which we measure and describe the results of economic activities. Whether, one is managing a business, making an investment, an income tax return or paying a debt one is working with an accounting concept or accounting information.
1.3Users of accounting information
There are several users of accounting information .They are generally divided into two groups, the internal users and the external users.
Internal users require information for short term and long term planning and controlling routine operations, policy formulation and to ensure that the organization is properly managed.
External users use information in many ways such as making investment and lending decisions. Government agencies also require accounting information for economic planning and tax purposes. The following is a list of some users of accounting information. You are expected to show an understanding of their information needs.
Management
Investors: Shareholders/owners & lenders
Creditors/ suppliers
Debtors/customers
Government
The public/ Community
Financial analysts
Employees
1.4Branches of Accounting
Two major branches of accounting have evolved to meet the different information needs of the internal users and external users, that is, management accounting and financial accounting, respectively. The two branches of accounting have different objectives, as they provide information with which to make different decisions. All the information, however, comes from the same data base. The differences lie in the selection and presentation of the communicated information.
Financial accounting is concerned with providing economic information about an entity to external users. It makes available economic information about an entity by means of ‘general purpose’ financial statements, that is, the statement of financial position, statement of Profit or loss and other comprehensive income statement of changes in equity, statement of cash flows and notes to the financial statements. Such general purpose financial statements provide a report on management’s handling of the activities of the entity for a limited, already expired period. Accordingly, the information provided is a review of past financial performance and current financial position. The reports are prepared in accordance with certain external standards which are widely known as generally accepted accounting principles/practice (GAAP).
Management accounting is concerned with providing economic information about an entity to internal users. The information is used by management in the planning and control of the activities of the entity. The information is in the form of ‘specific purpose’ reports which are future oriented. Historical information is used only in so far as it is necessary and useful in planning and decision-making. Planning and decision-making are future oriented activities, not historical.
The major differences between financial accounting and management accounting are summarized in the table below:
Table 1.1 differences between financial accounting and management accounting
Financial accounting / Management accounting1. Provides economic information useful to external users / 1. Provides economic information useful to internal users
2.Generates general purpose financial statements / 2. Generates specific purpose statements and reports
3. Reports on financial effects of past events / 3. Set up for future oriented reports
4. Must conform to external standards / 4. Not subject to external standards
5. Uses objective data / 5. Uses subjective data.
1.5Forms of business entities
Business entities can be classified in terms of their form of ownership. The form of ownership has legal implications which affect economic decisions by stakeholders. The common forms of ownership encountered are sole proprietorships, partnerships, companies and non-profit organizations.
Sole proprietorship
A sole proprietorship is a business owned by one person who operates it for his own profit. At law, the business is not regarded as a separate legal entity, that is, there is no separation between the business and the owner. As a result, the business will cease to exist on the retirement or death of the owner. In addition, the sole proprietor has unlimited liability, which means that his total wealth, not merely the amount originally invested, can be taken to settle business debts. However, for accounting purposes, the business is regarded as a distinct entity separate from the owner.
Partnership
A partnership is a business owned by two or more people who operate it for profit. The law does not recognize a partnership as a separate legal entity. Accordingly, a partnership cannot enter into contracts in its own name, but must do so through the individuals who make up the partnership, and the partnership ceases to exist on the death, retirement, or admission of a partner. However, for accounting purposes, the partnership is regarded as a distinct entity separate from the owners.
Most partnerships are established by a written contract known as a partnership agreement/deed, although this is not obligatory. In a general partnership, all partners have unlimited liability. In a limited partnership, one or more partners can be designated as having limited liability, as long as at least one partner has unlimited liability. A limited partner is usually prohibited from being active in the management of the entity.
Company
A company, or a corporation, is a form of business entity that is created by law as a distinct legal person separate from the owners. Accordingly, it has the powers of an individual in that it can sue and be sued, make and be party to contracts and acquire property in its own name. It has a perpetual existence which is unaffected by changes in the membership of the company. It has limited liability, which means that the owners are only liable for the debts of the company up to the amount which they have agreed to contribute.
There are two types of companies, that is, a private limited company and a public limited company. A public limited company can offer its shares to members of the public, where as a private limited company cannot. A public limited company can be listed on the stock exchange where as a private limited company cannot.
Other forms of entities
Other forms of entities are co-operatives and non-profit organizations, such as charitable organizations and clubs.
1.6Separate entity concept
For accounting purposes, a business is treated as a distinct entity, or different persona separate from the owners who provided capital. This is known as the separate entity concept. Accordingly, every business for which separate financial records are kept is an accounting entity. It is important to see the business as a separate entity because transactions entered into by the business have to be dealt with from the point of view of the entity whose books are being done, not from the point of view of the owners. This implies that the organizations conduct their business as entities separate from their owners. Entity records can only reflect the owner’s interest as owner’s equity.
A company, by law, is a legal person separate from its owners, the ordinary shareholders. The separation in the financial statements of a company, as a business entity, from its shareholders is, therefore, supported in concept by legal reality. Although the partnership and sole proprietorship businesses are not legal persons, the separate entity concept is applied in accounting.
1.7Accounting equation
A fundamental rule in accounting, which flows from the separate entity concept, is that the assets of a business will always be equal to the sum of its liabilities plus its owners’ equity. This is known as the accounting equation, and the practice of financial accounting is based on it. The accounting equation shows the financial position of an entity at a particular point in time. It is reflected in the statement of financial position, which is essentially an accounting report on the financial position of an entity. The accounting equation is expressed as follows:
Assets =Equity + Liabilities
Where:
- Assets are resources controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity.
- Liabilities are present obligations of an entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
- Equity (or owners’ interest) is the net interest in the assets of the entity after deducting all its liabilities.
Changing the subject of the formula of the basic accounting equation gives the following outcomes:
Equity = Assets – Liabilities;
Liabilities = Assets – Equity.
1.8Double entry system of accounting
Each business transaction has a dual effect on the elements of the accounting equation. The dual effect of transactions on the elements of the accounting equation is the fundamental principle on which all entries in an accounting system are based, that is, the basis of the double entry system of accounting. In principle, it means that each transaction must be recorded in such a way that the accounting equation remains in balance. Accordingly, double entry is the system of accounting which reflects the fact that:
- Every financial transaction gives rise to two accounting entries;
- Each entry shows dual effect of the transaction on the accounting equation.
- Note: A transaction is an agreed upon transfer of value from one party to another which affects the amount, nature or composition of an entity’s assets, liabilities or equity.
1.9Books of Accounts
Books of accounts are classified into two categories namely subsidiary books and the ledger.
1.9.1Subsidiary books
Subsidiary books are those books where transactions are recorded as information is extracted from the source documents. These books are also referred to as books of prime entry, books of original entry or books of first entry.
Table 1.2 Subsidiary books
Subsidiary Book / use / Source documentCashbook / Cash transaction / Receipts, bank deposit slips, cheque counterfoils bank statements
2. Petty Cash book / Small cash payments / Petty cash voucher
3. Sales Journal / Credit sales / Sales invoice
4. Sales Returns Journal / Returns inwards/sales returns / Credit Note (C/N)
5. Purchases Journal / Credit purchases / Purchases invoice
6. Purchases Returns Journal / Returns outwards/ purchases returns / Credit Note (C/N)
7. General Journal / Any other transactions / Depends with nature of transaction: invoice, C/N
Subsidiary books are books in which entries are made prior to their posting to the divisions of the ledger. They are not part of double entry with the exception of the cash book. The purposes of subsidiary books are:
- To relieve the ledger of unnecessary detail by posting thereto only summarized data;
- To classify transactions and enable periodic totals to be posted to appropriate accounts in the ledger.
The subsidiary books commonly encountered are the cash book, purchases journal, sales journal, purchases returns journal, sales returns journal and general journal.
Cash book
This is the only subsidiary book which is part of double entry, as it is also a division of the ledger.
Petty cash book
Petty (small) cash payments are entered in this book to relieve the main cash book from congestion with minor payments which do not warrant the issuing of cheques. The imprest system is used in this book.
Purchases journal
Credit purchases are recorded in the purchases journal prior to posting to the suppliers’ personal accounts in the purchases ledger and the purchases account in the general ledger.
Sales journal
Credit sales are recorded in the sales journal prior to posting to the customers’ personal accounts in the sales ledger and the sales account in the general ledger.
Purchases returns journal
Returns to credit suppliers are recorded in this journal prior to posting to the suppliers’ personal accounts in the purchases ledger and the purchases returns account in the general ledger.
Sales returns journal
Returns from credit customers are recorded in this journal prior to posting to the customers’ personal accounts in the sales ledger and the sales returns account in the general ledger.
General journal
This journal is used for recording those transactions which cannot be recorded in the other subsidiary books. The typical uses of the general journal are to record:
- The sale, or purchase, of non-current assets on credit;
- The correction of errors;
- Opening entries, i.e. entries to open the books of the entity;
- Other transfers.
1.9.2The Ledger
It is the main book of accounts
All transactions entered in subsidiary books are posted to the ledger
Divisions of the ledger are:
- The cashbook
- Sales/debtor’s ledger
- Purchases/creditor’s ledger
- The General ledger
Table 1.3 Divisions of the Ledger
Ledger Section / ContentsCash book / Cash and bank accounts
Sales/Debtor’s ledger / Personal accounts of trade debtors
Purchases/Creditor’s ledger / Personal accounts of trade creditors
General ledger / Proprietary accounts, loan capital accounts, asset accounts, income accounts and expense accounts.
The ledger is divided into sections or divisions to meet the information needs of the entity as shown in the table above.
Cash book
The cash book is both a division of the ledger and a subsidiary book. It contains the cash account and bank account and is for recording all cash transactions.
Sales ledger
The sales ledger contains the personal accounts of credit customers.
Purchases ledger
The purchases ledger contains the personal accounts of credit suppliers.
General ledger
The general ledger contains the proprietary accounts (i.e. owner’s capital and drawings), loan capital accounts, asset accounts, income accounts and expense accounts.
1.10 Accounting entries in the ledger
An account is opened in the ledger for each asset, liability, item of expense, item of income and equity. The effects of business transactions are recorded in ledger accounts. An account is an accounting record in which all transactions relating to a specific item are recorded. A ledger is a collection of accounts in which the effects of the transactions entered into by the business are recorded. Each account appears on its own on a page in the ledger and is given a number known as a folio number. The double entry system of accounting divides each ledger page into two halves. The left-hand side of each page is called the debit side, while the right-hand side is called the credit side. The format of a ledger account is as follows:
DrName of accountCr
Date / Details / Folio / Amount / Date / Details / Folio / AmountA schematic representation of the double entry rules for assets, liabilities, equity, income and expenses is as follows:
DrAny asset accountCr
Increases / DecreasesDrAny liability accountCr
Decreases / IncreasesDrEquity accountCr
Decreases / IncreasesDrAny income accountCr
Decreases / IncreasesDrAny expense accountCr
Increases / Decreases1.11 Trial balance
Periodically, a trial balance is extracted from the ledger. A trial balance is a list of debit and credit balances of accounts extracted from the ledger on a specific date. It is prepared after all postings have been done. Since each debit entry in the ledger has a corresponding credit entry, and vice versa, the total of all debit balances should be equal to the total of all credit balances.
The reasons for preparing a trial balance are to:
- Test the arithmetical a ccuracy of the double entry system.
- Test whether double entry has been done
- Serve as the basis for the preparation of financial statements at the end of the accounting period.
Errors not revealed by a trial balance
These are errors which when made do not affect the balancing of a trial balance. These are errors of omission, errors of commission, errors of principle, compensating errors, errors of original entry and complete reversal of entries