Chapter 1

The role of accounting

Purpose of Accounting

Provide business owners with financialinformation that will assist them in making more informed decisions about the activities of their firm but that does not guarantee the right decision will be made in all cases. Accounting information will hopefully improve the performance of the firm and its chance to attain success

Users of accounting information

Users are classified as different firms, organisations or individuals who may be interested in the accounting information produced by a particular business. The User should dictate what necessary information the accounting system will provide.

Eg Banks will want to know about current levels of debt (shown by Current and Non-Current Liabilities in the Balance Sheet) before agreeing to more finance.

Financial Data vs Financial Information

Financial Data is the raw facts and figures on which financial information will be based. For example, when a receipt is issued to a debtor who pays their account or when a receipt is received after a creditor is paid. The receipt is classified as the raw data. It is the original transaction that accounting information can be checked against in the future. For example balance of the bank account as recorded in the balance sheet can be checked, in part, against all the receipts issued over a month.

Financial Data vs Financial Information

Financial Information is the end result once all the data has been sorted, classified and summarised into useful categories that can be understood easily by the users.

For example, $500 received through EFTPOS from a customer is entered into the CRJ classified as a sale and sorted by date throughout the accounting period. In the Profit and Loss Statement all sales from the CRJ are summarised as cash sales. The P&L Statement is then used by the ATO and potential investors or future owners.

The end result is a more simplified system for all users.

Accounting Process Source Documents

Source Documents is the first step in the accounting process which provide both the evidence that a transaction has occurred on a particular date and the details of the transaction itself. Source documents can be electronic or paper based, with electronic version being printed for proof of evidence. If a transaction is not written down – IT DID NOT HAPPEN !

Accounting Process Recording

Recording involves sorting, classifying and summarising information from the source documents into a usable format for the firm. For example, processing all source documents which occurred within a predetermined time frame into appropriate journals and ledgers.

Accounting Process Reporting

Reporting involves the transfer of the information from the accounting records into the financial statements in a consistent manner so that the owner of the firm, as well as other users such as the tax department, are able to make logical, appropriate and timely decisions about the firm in question.

Accounting Process Advice

Advice is offered by an accountant after they have analysed the accounting reports. Advice is given to the owner of the firm and should include a range of options or recommendations appropriate to the initial aims and objectives. The accountant should also offer advice on the suitability of each option or recommendation.

Accounting Principles

These are generally accepted rules to which accountants and firms are governed. They provide consistent and accurate information between the large range of businesses and industries in Australia.

Accounting PrinciplesEntity

From an accounting perspective the firm is assumed to be separate from the owner and other firms, and the records should be kept on this basis. For example, if the owner decides to use personal assets for firm purposes or withdraw money from the firm for personal use then a transaction between the firm and the owner has occurred and must be recorded as such.

Accounting PrinciplesGoing Concern

Assumes that the life of the firm is to be continuous and that the records will be kept with this assumption in mind. For example, if a credit sale is made the sale (a debtor) is recorded in one period but the cash (from the debtor) will be recorded in another period. The sale is recorded with the assumption that the business will still be in operation in future to receive the cash.

Accounting PrinciplesReporting Period

This principle is strongly linked to the going concern principle. It is assumed that the firm is continuous so therefore, the life of the firm must be divided into periods of time of equal distance. This allows reports to be prepared and accounting records to be recorded in the time period in which the transaction occurred. It can be as short as required but must be no longer than one year to meet ATO requirements for reporting of financial information.

Accounting PrinciplesHistorical Cost

Assets should be recorded at their original cost or value as this amount can be easily verified by a source document. For example, a piece of machinery purchased for a manufacturing plant will be accompanied by a receipt (source document). Assets should not be recorded at current estimated value as this value is only realised if the asset is sold.

Accounting PrinciplesConservatism

Losses should be recorded when identified as being probable and profits should be recorded when certain that they will occur. This is to ensure that expenses and liabilities are not understated and that revenue and assets are not overstated. It is important to be cautious when estimating likely outcomes for accounting reports, especially when large financial decisions are being made.

Accounting PrinciplesConsistency

Accounting reports need to be recorded using the same methods so that accounting reports can be compared between accounting periods. If methods change it is hard to determine if the change in outcome is due to the change in method or a change in the firms situation. For example, if straight line method of depreciation is used for an asset, then the straight line method must be used over the entire life of the asset and therefore over each accounting period.

Accounting PrinciplesMonetary Unit

All items recorded and reported throughout the accounting process must be recorded in monetary terms. For example, in Australian dollars. For example, if a firm holds investments in a UK company and earns income from those investments, both the revenue (income) and the asset (initial investment amount) must be recorded in Australian dollars ($$$$), not British Pounds (££££).

Qualitative Characteristics

The International Framework for the Preparation and Presentation of Financial Reports sets out the broad concepts that underpin the preparation of financial reports and defines the items that will be included in each report.

Qualitative Characteristics Relevance

Reports should include all information that is useful for decision making and exclude information that is not. Information needs to be up to date and appropriate for the decision which is being made. It is closely linked to the Entity and Reporting Period principles. For example, if an owner decides to use a company car for his/her own use on weekends, then the cost of running that car needs to be appropriately proportioned across the week between company use and home use.

Qualitative Characteristics Reliability

Reports should contain information free from bias, which can then be relied upon for its accuracy. There should be no estimates. This characteristic is closely linked to Historical Cost and to Source Documents. Reliable information needs proof. For example, the cost of maintenance on a building as reported in the Profit and Loss Statement should be substantiated by invoices or cheque butts kept by the firm.

Qualitative Characteristics Comparability

Reports should be comparable within the one firm over time and between different firms over time. This is achieved through the use of consistent accounting procedures. If a procedure is changed this needs to be stated clearly in the accounting report so that the users of the information can make a more informed decision. For example, an asset is always been reported at Historical Cost but may need to be ‘written down’ in value after a major storm caused some damage. The new value is then substantiated in the Balance Sheet by a new valuation certificate issued by an insurance company. The depreciation method is unlikely to change.

Qualitative Characteristics Understandability

Reports need to be recorded in a way that it is easy for the user to comprehend their meaning. This can include graphs, charts and table displaying information within and between accounting periods, as well as the more traditional Profit and Loss Statements and Balance Sheets.

The Accounting Elements

The International Framework for the Preparation and Presentation of Financial Reports states that the following elements must be included in each Accounting Report:

Assets RevenueLiabilities ExpenseOwner’s Equity

The Accounting ElementsAssets

Resources controlled by the entity as a result of past events from which future economic benefits are expected to flow to the entity. It must meet the following criteria:

• Controlled as opposed to just owned eg. Ownership of a building but Control of debtors.

• Future Economic Benefit which is yet to be received eg. Stock will be sold and a future economic benefit will be reaped (income).

The Accounting Elements Liabilities

Present obligations of an entity as a result of past events, the settlement of which is expected to result in an outflow or sacrifice of economic benefits from the entity.

• Present Obligations to settle a debt via a contract with the lender means that the business is obliged to repay the debt eg. Creditors who have supplied raw materials.

• Expected result of an outflow of economic benefits eg. A future economic sacrifice of an outflow of cash or a job to be completed if the job has been prepaid by a customer.

The Accounting ElementsOwner’s Equity

Owner’s Equity is the residual interest in the assets of the entity after the deduction of its liabilities as reported in the Balance Sheet. It is what the owner has left over once all liabilities have been met by assets. It is also known as the amount that the business ‘owes’ to its ‘owner’ (Entity Principle).

The Accounting ElementsRevenue

Inflow of an economic benefit (or a saving of outflows) in the form of increases in assets (or decreases in liabilities) that increase the value of owner's equity except for capital contributions made by the owner. For example, good being sold (sales) which is an economic benefit, or an increase in discounts offered to creditors which is a form of a decrease in a liability.

The Accounting Elements Expenses

Outflows or consumption of economic benefits in the forms of decreases in assets (or increases in liabilities) that reduce owner’s equity except for drawings by the owner. Drawings is not included as it makes no difference to the firms ability to carry out its trading activities. For example, a stock loss is a form of a decrease in an asset whereas accrued advertising expenses are a form of an increase in liabilities. In both cases these expenses are a part of general trading activities.