Accounting Is Therefore a Process Consisting of the Following Three Activities

Accounting FAC1502

Bookkeeping involves the identification and recording of economic events only; therefore it is just one part of the accounting process.

Accounting can be defined as the orderly and systematic identification and recording of the monetary values of the economic transactions of an individual entrepreneur (person) or a business enterprise (entity or institution) the reporting on the results of these transactions, and the provision of financial information by submitting financial statements, which information is used as a basis for decision making. Accounting therefore include bookkeeping.

Accounting is therefore a process consisting of the following three activities:

-Identifying those events that are evidence of economic activity (transactions) relevant to the particular business or entity

-Recording the monetary value of the economic events (transactions) in order to provide a permanent history of the financial activities of a business. Recording involves keeping a chronological diary of measured events in an orderly and systematic manner and classifying and summarising economic events

-Communicating the recorded information to interested users. This information is communicated through the preparation and distribution of accounting reports, the most common of which are known as financial statements.

Golden rule 1: Accounting records transactions in order to provide useful information for decision making.

The nature of accounting: accounting is a specialised means of communication which is used to convey a specialised message about an entity’s finances. The recipient of this specialised message (the user of financial information) must understand it otherwise the information that is conveyed has no value. Accounting is therefore a language.

The common unit of measurement in accounting is money and in RSA, the currency is known as the Rand. All an entity’s transactions are converted into monetary values before being processed. Using money as the common denominator, however, gives rise to two important limitation:

-Not all events can be expressed in monetary terms

-The value of money is unstable and is influenced by many economic factors such as inflation.

Knowledge of accounting is needed on two levels:

-By the users of financial information, and

-By the prepares of financial information.

AFS – Annual Financial Statements

• The format for these is provided by IFRS (International Financial Reporting Standards)

GAAP – Generally Accepted Accounting Practices

IFRS – International Financial Reporting Standards – this foundation is a general framework and encompasses, in broad terms, accounting concepts, principles, methods and procedures collectively

The objective of creating accounting standards for particular issues (e.g. for the treatment of taxation in financial statements) is to limit the variety of available accounting practices, but without striving for strict uniformity or creating a set of rigid rules for all circumstances. The ultimate aim of accounting standards is to encourage widespread use of particular standards in financial reporting and to eliminate undesirable alternatives.

The requirements of the Companies Act and Schedule 4 thereto are taken into account in the preparation of GAAP (Companies Act, No 61 of 1973 as amended, sections 285A (a) and (b))

The function of accounting is to provide financial information to all interested parties on the results of the economic activities of a particular individual or institution (entity).

A person performs economic activities by working and earning a salary. The income from this salary is added to the assets of the person at the moment that person earns the income. The increased assets are now available for use by that person.

A trading entity purchases merchandise which is sold at a price higher than the purchase price plus other related costs. The difference between the purchase price and costs on the one hand, and the higher selling price on the other, is called a profit.

The financial results of economic activities therefore have two aspects:

-The value added to the net worth of a person or an entity during a particular period, and

-The accumulated net worth of that person or entity.

In terms of paragraph 10 of IAS (International Accounting Standards) (AC 101), a complete set of financial statements must consist of:

-A statement of financial position as at the end of the period;

-A statement of comprehensive income for the period;

-A statement of charges in equity for the period;

-A statement of cash flows for the period;

-Notes, comprising a summary of significant account policies and other explanatory information, and

-A statement of financial position as at the beginning of the earliest comparative period when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements.

An entity is an economic unit whose financial results are determined on its own.

Accounting reports on the financial results and position of an entity.

The accounting process treats an accounting entity as a unit independent of its owner. A business owned by a particular person in thus regarded as being separate from the business.

In the private sector, there are mainly four types of business organisations with profit motives which can be considered as individual entities:

-Sole traders (or sole proprietors);

-Partnerships;

-Close corporations;

-Companies

Organisations in the private sector with various objectives, without a profit motive are non-profit organisations.

The Framework sets out the directives and concepts that underlie the preparation and presentation of financial statements. The purpose of the framework is to assist (Framework 1)

-In the development of future accounting standards and the review of existing accounting standards;

-In promoting the harmonising of regulations, accounting standards and procedures relating to the presentation of financial statements, by providing a basis for reducing the number of alternative accounting treatments permitted by accounting standards;

-National standard-setting bodies in developing national accounting standards;

-Auditors in forming an opinion regarding whether financial statements are in line with international accounting standards, and;

-Users of financial statements in interpreting and evaluating the information disclosed in financial statements.

Planning decisions are sometimes very simple, for example in the case of routine activities, or are sometimes very complex, for example decisions regarding the financial strategy and planning of an entity for the next financial year.

Control decisions entail using financial information to evaluate the results of financial activities.

Users of financial information:

-Investors: these are the providers of capital. They are concerned with the risk involved in their investment and the return (interest or dividends) they will receive on their investment. They need information to decide whether they should invest (buy), hold or withdraw (sell) share.

-Employees: employees are interested in information about the stability and profitability of the business. They also want to know if the entity will be able to pay remuneration and retirement benefits, and whether there are any employment opportunities.

-Lenders: lenders need information to determine whether their loans and the interest on the loan will be paid on due dates.

-Suppliers and other trade creditors: these users need information that will assure them that amounts owed to them will be paid when due.

-Customers: they want to know if the business will continue to exist, especially when they are involved for a long time or when they are dependent on the entity.

-Government and their agencies: they are interested in the allocation of resources and therefore in the activities of the entity. They also need information in order to regulate the activities of entities, determine taxation policies and use the information as a basis for national income and similar statistics.

-Public: members of the public are affected in several ways. Entities often contribute to the local economy by employing people and supporting local suppliers.

Users of financial information can be subdivided into the following two categories:

-Internal users – for example, management and employees

-External users – for example, investors, creditors and government

According to paragraph 12 of the Framework, the objective of financial statements is to provide useful information about the financial performance, financial position and changes in financial position, which information is useful to a wide range of users in making economic decisions.

The financial results of an entity consist of economic activities which are measured in two ways: firstly, the financial performance for a particular period and, secondly, the financial position at a particular point in time.

The financial performance reflects the profit made or the loss incurred by the entity over a specific period of time. The financial performance is reported in a statement of comprehensive income.

A statement of comprehensive income reports the two elements of financial performance, i.e. revenue that was earned, and expenses that were incurred to earn the revenue.

The difference between the revenue and the expenses results in the profit of loss for that specific period.

Statement of changes in equity forms a link between the statement of comprehensive income (reflecting the profit/total comprehensive income for the year) and the statement of financial position (reflecting the capital or equity) of the entity.

The financial position reflects the net worth of the entity at a specific point in time. The financial position is reflected in a financial report that is known as a statement of financial position. The financial position of an entity is affected by:

-The economics resources it controls;

-Its financial structure;

-Its liquidity;

-Its solvency, and;

-Its capacity to adapt to changes in the environment in which it operates.

The first part of the statement of financial position reflects the assets of the entity, while the second part reflects the sources from which the assets were financed. Two main types of sources of finance are distinguished, namely equity and liabilities. The contribution by the owner is the equity which represents the interest of the owner(s) in the assets of the entity. Liabilities are the amounts owing to creditors, for purchases or services received which are to be paid for at a later stage, or financial institutions from which the entity borrowed money. Liabilities reflect the claim of creditors against the assets of the entity.

Golden rule 3: the following are elements of financial statements:

-Elements that measure the financial position: (ASSETS = EQUITY + LIABILIITY)

• (1) Assets
• (2) Liabilities
• (3) Equity

-Elements that measure profitability (profit or loss = increase or decrease in equity):

• (4) income
• (5) expenses

An asset is a resource controlled by the entity as result of past events and from which future economic benefits are expected to flow to the entity.

A liability is a present obligation of the 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 is the residual interest in the assets of the entity after deducting all its liabilities.

Cash equivalents are short-term investments that can easily be withdrawn (converted into cash) without any meaningful risk of changes in value.

Accounting can be divided according to the nature of information it provides, thus;

-Financial accounting

• Financial accounting deals primarily with the external users of financial information. External users are people and institutions who exist outside the entity and who are not directly involved in the management and day-to-day operations of the entity. Specific set of standards governing how transactions are recorded and reported for users.

-Management accounting

• Management accounting caters mainly for the internal users of financial information of the entity. These users may include the internal management and operational personnel of the entity, who requires a wide variety of financial information in order to manage the entity on a day-to-day basis. Less rule-based.

Golden rule 2: financial statements must reveal a fair presentation of the financial position, financial performance and cash flow of an entity.

The techniques used in the practice of accounting are based on conceptual and theoretical ideas. These ideas are generally known as accounting principles.

Accounting policy is a set of decisions about how the entity will handle the same type of transaction in order to achieve a consistent result.

Since an accounting policy represents an entity’s decisions about situations which could deal with in various ways, it has to disclose its accounting policy in its financial statements. For example, an entity has to indicate what basis it has used to deal with the depreciation of property, plant and equipment.

The underlying assumptions, namely that financial statements are prepared on the accrual basis and that the entity is a going concern.

Using the accrual basis means that the effects of transactions and other events are recorded when they occur, not when cash is received or paid (unless all the transactions of an entity are cash transactions).

Financial statements prepared on the accrual basis inform users of:

-Past transactions involving cash payments and receipts;

-Obligations to pay cash, and

-Resources that represent cash still to be received in the future.

Going concern basis – Entity assumes that they will be able to continue operating in the foreseeable future

• “Foreseeable future” = 12 months
• “continue operating” = able to realise assets and settle liabilities in the normal course of business
• I.e.: is your business going to continue trading? (Make money from buying and selling goods)
• Or: is your business going to close down

Qualitative characteristics

Fundamental Qualitative characteristics:

-Relevance

• Appropriate for the users to base their decisions on

-Faithful representation

• The information should represent what really happened, (i.e.: Relevant information should not be manipulated or omitted)

Further qualitative characteristics:

-Comparability

• Over time, within industries, similar businesses
• Different entities should disclose (present) similar transactions the same way

-Verifiability

• Different people (analyst, observers, finance experts) should come to the same conclusions if they looked at the same information

-Timeliness

• The longer it takes to provide the user with the information, the less useful the information will be

- Understandability

• The financial statements should be drawn up in such a way that average users can get value from the information and understand it
• It doesn’t mean that information should be omitted purely because it’s difficult to understand

Consistency-Theconsistency principlestates that, once you adopt anaccounting principleor method, continue to follow it consistently in futureaccountingperiods. Only change anaccounting principleor method if the new version in some way improves reported financial results.

Materiality - Themateriality principlestates that anaccountingstandard can be ignored if the net impact of doing so has such a small impact on the financial statements that a reader of the financial statements would not be misled.

Profit is frequently used as a measure of performance. It is also sometimes used as a measure for return on investment in the entity.

Income is increased in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.

Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletion of assets or increases in liabilities that result in decreases in equity other than those relating to distributions to equity participants.

Financial statements:

Statement of Profit or Loss and other Comprehensive Income

-Performance for the year

Statement of Financial Position

-Position at the end of the year

Statement of Changes in Equity

-Changes in ownership

-How much money belongs to the owners

Statement of Cash flows

-Shows the movement of cash

Statement of Profit or Loss and Other Comprehensive Income

Statement of Financial Position

Elements of the financial statements

-How do we categorise all the transactions and financial information?

• Statement of Profit or Loss and Other Comprehensive Income
• Income
• Expenses
• Statement of Financial Position
• Assets
• Liabilities
• Equity

The Financial Position

Financial position information

Where did the money come from to fund your business? These questions also answer the 2 main sources of financing.

-Did you get loans/finance/credit from banks or suppliers? (Which are liabilities)

-Did the owners contribute/invest money? (which is equity)

What did you do with the money that came in?

- Purchase machines to make your product? (Assets)

-Keep it in the bank? (Assets)

Accounting entity -Anaccounting entityis a business for which a separate set ofaccountingrecords is maintained. The organization should engage in clearly identifiable economic activities, control economic resources, and be segregated from the personal transactions of its officers, owners, and employees.

-Or we can say every entity for which separate financial records are kept in an accounting entity. It is extremely important to see the business as a separate entity from its owners because transactions entered into by the entity have to be dealt with from the point of view of the entity whose books are being done.

Financial position looks like Equity = Assets – Liabilities

The financial position of the entity is described in terms of assets and interests at a given time. They are reflected in a statement of financial position, which is essentially an accounting report on the financial position of an entity. The statement of financial position communicates relevant financial information to the owners, creditors and other interested parties.

Non-current assets are those resources of a more permanent nature which are essential in the process of earning income. Assets can therefore be classified as non-current when they:

-Where not acquired from the main purpose of resale;

-Are to be used in the business, and

-Have a life span of longer than twelve months.

• Examples of non-current assets:
• Land and building
• Furniture and equipment
• Vehicle
• Financial assets

Current assets are assets which have a short life-span, and continually change in the normal course of business. An asset shall be classified as current when it satisfies any of the following criteria: