Introduction to Financial Accounting

1. Introduction to Financial Accounting

Accounting is the process of identifying, measuring and communicating economic information to assist users to make decisions.

• Financial accounting: periodic financial statements provided to external decision makers
• Management accounting: detailed plans and continuous performance report for internal decision makers

• Accrual accounting: an income statement reports revenues and expenses
• Cash accounting: A cash flow statement reports cash inflows and outflows (only occur when cash is paid or received)

Financial statements are presented information in financial accounting:

• Balance Sheet: It reports the financial position of an entity at a point of time

The relationship between assets, liabilities and equity is given by:

Assets = Liabilities + Equity

• Assets: resources which will benefit the company (i.e. cash, property, equipment  
• Liabilities: What the company owes
• Equity: What is left after liabilities are taken care of (i.e. net assets)

• Income Statement: Shows the result of business operations (financial performance) in a period of time. It gives a net profit based on revenues and expenses incurred during the period.
• Statement of Cash Flow: Statements of cash flows show the change of cash in an entity’s cash balance during a period of time. This is necessary since in accrual system only revenues and expenses are presented (revenues ≠ cash gained; expenses ≠ cash paid)

The cash flows are normally categorised into:

• Operating activities: main revenue producing activities
• Investing activities: acquisition and disposal of long term assets
• Financing activities: equity capital and borrowing

        Financial statement assumptions:

• Accrual basis:  Revenues and expenses are recognised at the time they occur
• Accounting entity:  The entity for which financial statements are prepared (e.g. company). Activities of the entity are separated from those of its owners/members
• Accounting period:  The life of business needs to be divided into discrete periods of equal time to evaluate financial performance and position. (e.g. monthly, quarterly, yearly)
• Monetary: Measure economic activity by a common denominator (AUD$). If there is a problem to use AUD as a measure of value for an item, that item can not be included in the balance sheet
• Historical cost: Assets are recorded at their original cost at purchase
• Going concern: Statements are prepared under the assumption that the organisation will continue operating in the foreseeable future, otherwise it is necessary to report the liquidation values of an organisation’s assets

1. Measuring & Evaluating Financial Position & Performance

• Balance sheet

A balance sheet presents information on an entity’s financial position at a point of time.

Assets = Liabilities + Equity

• Assets: Resources
• Liabilities: what the company owe
• Equity: what owners contributed (share capital^[1]), plus any profits that have accumulated (retained profits)

Notice: Not all assets & liabilities are reported on the balance sheet. To be reported on a balance sheet, assets and liabilities must (1) meet definition criteria and (2) meet recognition criteria.

• Assets

Definition: Assets are resources controlled by an entity as a result of past events from which future economic benefits are expected to flow to the entity.

Essential Characteristics:

1. Future economic benefit to generate net cash flows (e.g. cash, receivables, investments etc.)
2. Ownership and control, i.e. able to benefit from the assets and to deny access to others
3. Occurrence of past transactions or other past events (e.g. paid cash or credit)

       Recognition criteria:

1. It is probable that any future economic benefit with the item will flow to the entity.
2. A cost or value that can be measured with reliably

Assets are classified into two types

• Current assets: short term assets that are expect to be used or sold within the next 12 months
• Non-current assets: realise benefits over a longer period

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• Liabilities

Definition: Liabilities are present obligations of the entity arising from past events, the settlements of which is expected to result in an outflow from the entity of resources embodying economic benefits.

        Essential Characteristics:

1. A present obligation exists and the obligation involves settlement in the future.
2. The entity is obligated to sacrifice economic benefits to one or more other entities. (i.e. adverse financial consequences for the entity)
3. Past events: occurrence of past transactions

Liabilities also have 2 types:

• Current liabilities: the liabilities will be paid off within 12 months of the balance sheet date
• Non-current liabilities: the liabilities for at least next year.

• Equity

Definition: equity is the residual interest in the assets after deducting all of its liabilities.

(i.e. net profit)

Common components:

• Share capital
• Retained profits

       The expansion of the accounting equation:

[pic 1]

        [pic 2]

                                              [pic 3]

                                                 Where:   t    =    time t (at the ending period)

                                                                 t-1 =   time t-1 (at the beginning period)

                      Definitions:

• Share capital:  equity obtained through trading stock to shareholder for cash
• Retained profits:  net income is kept and not distributed as dividends to shareholders
• Revenue: income received from normal business activities
• Expense: outflow of cash to another company or person
• Dividend: portion of profit paid out to shareholders. This is NOT an expense.

• Working capital and Current ratio

• Working capital  =  CA(current assents) – CL(current liabilities)

Low or negative working capital is an indication of short-term financial difficulties