Accounting is a framework of
concepts, procedures, and methods which are implemented
to prepare the financial information needed to the
stockholders and to help accounting information user in
making decision.
The main objectives of
accounting systems are:
1Provide
the necessary information needed by the management to tackle
the business organization decisions.
2Produce
financial statements to inform owner (s) of the business
about the financial position and the results of operating
the business for a specific period of time.
1.2
Financial Statements
1.2 Financial Statements
The Accounting system aims at
producing a set of financial statements.
These statements are:
-Balance sheet
(financial position).
-Income statement.
-Cash flow statement
-Statement of stockholder
or owners equity.
1.3
A Starting Point: Statement of
Financial Position
Among Assets
Liabilities before owner's equity
Owner's equity
separated into
Total assets
1.3 A Starting Point: Statement of
Financial Position
All three financial statements
contain important information, but each includes
different information. For that reason, it is important to
understand all three financial statements and how they
relate to each other.
A logical starting point for
understanding financial statements is the statement of
financial position; also
called the balance sheet. The purpose of this
statement is to demonstrate where the company stands, in
financial terms, at specific point in time. As we will see
later in this chapter, the other financial statement relates
to the statement of financial position and show how
important aspects of a company's financial position change
over time. Beginning with the statement of financial
position also allows us to understand certain basic
accounting principles and terminologies that are important
for understanding all financial statement.
Every business prepares a balance
sheet at the end of the yearand many companies prepare one at the end of each month,
week, or even day. It consists of a listing of the
assets, the liabilities, and the owners' equity of a
business. The date is important, as the financial
position of a business may change quickly. Table 1.1 shows
the financial position of Summit Company on December 31,
2004.
Table 1.1: Summit company
Summit Company Balance Sheet
December 31.2004
Assets
Liabilities & Owners' Equity
Cash
$22,500
Liabilities:
Notes: Receivable
$10,000
Notes Payable
$41,000
Accounts: Receivable
$60,500
Accounts Payable
36,000
Supplies
$2,000
Salaries Payable
3,000
$80,000
Land
$100,000
Owners' equity:
Capital stock
150.000
Office Equipment
$15,000
Retained Earnings
70,000
220,000
Total
$300,000
Total
$300,000
Let us
briefly describe several features of this balance sheet.
First, the heading communicates three things: (1) the name
of the business, (2) the name of the financial statement,
and (3) the date. The
body of the balance sheet also consists of three distinct
sections: assets, liabilities, and owners' equity.
Notice that cash
is listed first among the assets, followed by notes
receivable, accounts receivable, supplies, and any other
assets that will soon be converted into cash or used up in
business operations, Following these relatively " Liquid"
assets are the more "permanent" assets, such as land,
buildings and equipment.
Liabilities
are shown before owner's equity.
Liabilities are debts owed by the company to be paid
within a specific period of time to the creditors Each major
type of liability ( such as notes payable, accounts payables
and payable ) is listed separately, followed by a figure
for total liabilities.
Owners'
equity is separated into two parts: capital stock and
retained earning.
Capital stock represents the amount that owners originally
paid into the company to become owners. It consists of
individual shares and owner has a set number of shares.
Notice in this illustration that capital stock totals
$150,000. This means that the assigned value of the shares
held by the owners multiplied by the number of shares equals
$150,000. For example assuming an assigned volume of $10 per
share, there would be 15,000 shares ($10 X 15,000 = $
150,000).
Alternatively,
the assigned value might be $5 per share, in which case
there would be 30,000 shares ($5 X 30,000= $ 150,000). The
retained earning part of owners' equity is simply the
accumulated earning of previous years that remain within the
enterprise. Retained earnings are considered part of the
equity of the owners and serves to enhance their investment
in the business.
Finally
notice that the amount of total assets ($300,000) is equal
to the total amount of liabilities and owners' equity (also
$300,000). This
relationship always exists-in fact, the equality of these
totals is why this financial statement frequently called a
balance sheet.
1.4
The Concept of the Business
Entity
1.4 The Concept of the Business
Entity
Generally
accepted accounting principles (GAAP),
require that a set of financial statements describe the
affairs of a specific business entity. This concept is
called the entity principle.
A
business entity is an economic unit that engages in
identifiable business activities.
For accounting purposes, the business entity is regarded as
separate from the personal activities of its owners. For
example, Summit Company is a business organization operating
as a travel agency. Its owners may have personal bank
accounts, homes and even other businesses. These items are
not involved in the operation of the travel agency and
should not appear in Summit's financial statement.
If
the owners were to merge their personal activities with the
transactions of the business,
the resulting financial statement would fail to describe
clearly the financial activities of the business
organization. Distinguishing business from personal
activities of the owners my require judgment by the
accountant.
1.5
Assets
1.5 Assets
Assets are
economic resources that are owned by a business and expected
to benefit future operations.
In most cases, the benefit to the future operations becomes
the form of positive future cash flows. The positive future
cash flows may come directly as the asset is converted
into cash (collection of a receivable) or indirectly as the
asset is used in operating the business to create other
assets that result in positive future cash flows (building
and land used to manufacture a product for sale). Assets
may have definite physical forms such as buildings,
machinery, or an inventory of merchandise. On the other
hand, some assets exist not in physical or tangible form,
but the form of valuable legal claims or rights; examples
are amounts due from customers, investment in government
bonds, and patent rights.
One of the
most basic and at the
same time most controversial problems in accounting is
determining the dollar amount for the various assets of a
business. At present, generally accepted accounting
principles call for the valuation of many assets in balance
sheet at cost rather than at their current value. The
specific accounting principles supporting cost as the basis
for asset valuation are discussed below.
1.6
The Cost Principle
Exceptions
In reading a balance sheet
1.6
The Cost Principle
Assets such
as land buildings, merchandise and equipment are typical of
the many economic resources that are required in producing
revenue for the business.
The prevailing accounting view is that such assets should be
present at their cost. When we say that an asset is shown in
the balance sheet at its historical cost, we mean the
original amount the business entity to acquire the asset.
This amount may be different from the asset's market value.
For example,
let us assume that a business buys a tract of land for use
as a building site, paying $100,000 in cash. The amount to
be entered in the accounting records for the asset will be
the cost of $100,000 if we assume a booming real estate
market, a fair estimate of the market value of the land 10
years later might be $ 250.000. Although the market
price or economic value of the land has raised greatly, the
accounting amount as shown in the accounting records and in
the balance sheet would continue unchanged at the cost of
$100.000. This policy of accounting for many assets at
their cost is often referred to as the cost principle of
accounting.
Exceptions to
the cost principle are found in some of the most liquid
assets (i.e., asset that
are expected to become cash soon). Amount receivable from
customers is generally included in the balance sheet at
their net realizable value, which is an amount that
approximates the cash that will be received when the
receivable is collected. Similarly certain investments in
other enterprises are included in the balance sheet at their
current market value if management's plan includes
conversion into cash in the near future.
In
reading a balance sheet, it is important to keep in mind
that the dollar amounts listed for most assets do not
indicate the prices at which the assets could be or the
prices at which they could be replaced.
A frequently misunderstood feature of a balance sheet is
that it does not show how much the business currently is
worth.
1.7
The Going Concern Assumption
1.7
The Going Concern Assumption
Why don't
accountants change the recorded amount to correspond with
changing market prices for these properties? One reason
is that assets like land and buildings are being used to
house the business and were acquired for use and not for
resale: in fact, these assets usually cannot be sold without
disrupting the business. The balance sheet of a business is
prepared on the assumption that the business is a continuing
enterprise, or a going concern. Consequently, the present
estimated prices which assets like land and buildings could
be sold are of less importance than if these properties were
intended for sale. These are frequently among the
largest dollar amount of a company's assets determining that
enterprise is going concern may require judgment by the
accountant.
1.8
The Objectivity Principle
1.8
The Objectivity Principle
Another
reason for using cost rather than current market values in
accounting for most assets is the need for a definite,
factual basis for valuation.
The cost of land, buildings, and other assets purchased for
cash can be rather definitely determined. Accountants use
the term objective to describe asset valuation that are
factual and can be verified by independent experts. For
example, if land is shown on the balance sheet at any cost a
Certified public Accountant, who performed an audit of the
business would be able to find objective evidence the land
was actually measured at the incurred in acquiring it. On
the other hand, estimated market values for assets such as
buildings and specialized machinery are not factual and
objective. Market values are constantly changing and
estimates of the prices at which assets could be sold are
largely a matter of judgment.
At the date an
asset is acquired, the cost and market value usually the
same. With the passage of time, however, the current market
value of assets is likely to differ considerably from the
cost recorded in the owners' accounting records.
1.9
The Stable – Dollar Assumption
Accountants in Egypt
After much research
1.9
The Stable – Dollar Assumption
A limitation
of measuring assets at historical cost is that the value of
the monetary unit or dollar is not always stable.Inflation is a term used to describe the situation where
the value of the monetary unit decreases; meaning that it
will purchase less than it did previously. Deflation, on
other hand is the opposite situation in which the value of
the monetary unit increases, meaning that it will purchase
more than it did previously. Typically, countries like
the United States have experienced inflation rather than
deflation. When inflation becomes severe, historical cost
amounts for assets lose their relevance as a basis for
making business decisions. For this reason, some
consideration has been given to the use of balance sheets
that would show assets at current appraised values or at
replacement costs rather at historical cost.
Accountants
in Egypt, by adhering to
the cost basis of accounting, are implying that the LE is
a stable unit of measurement, as the gallon, the acre or
the mile. The cost principle and the stable-dollar
assumption work very well in periods of stable prices but
are less satisfactory under conditions of rapid inflation.
For example, if a company bought land 20 years ago for
$100,000 purchased a second similar tract of land today for
$500,000. The total cost of land shown by the accounting
records would be $600,000. This treatment ignores the
fact that dollars spent 30 years ago had greater purchasing
power than today's dollar. Thus the $600,000 total for
the cost of land is a mixture of two "sizes" of dollars with
different purchasing power.
After much
research into this
problem, the Financial Accounting Stand Board (FASB) is
required on basis that large corporations annually disclose
financial data adjusted for the effects of inflation.
But after several years of experimentation, The FASB
concluded that costs of developing this information exceeded
its usefulness. At the present time, this disclosure is
optional, as judged appropriate by the accountant who
prepares the financial statements.
1.10
Liabilities
1.10
Liabilities
Liabilities
are debts.They
represent negative future cash flow for the enterprise.The person or organization to whom the debt is owed is a
creditor. All businesses have liabilities even the
largest and most successful companies often purchase
merchandise supplies, and services on account. The
liabilities arising from such purchases are called accounts
payable. Many businesses borrow money to finance expansion
or the purchase of high-cost assets. When obtaining a loan
the borrower usually must sign a formal note payable. A note
payable is a written promise to repay the amount owed by a
particular date and usually for the payment of interest as
well.
1.11
Owners' Equity
1.11
Owners' Equity
Owners' equity
represents the owners' claim on the assets of business.
Because creditors' claims have legal priority over those of
the owners, equity is a residual amount. If you are the
owner of a business, you are entitled to assets that are
left after the claims of creditors have been satisfied in
full. Therefore, owners' equity is always equal to total
assets minus total liabilities. For example, using the data
from the illustrated balance sheet of Summit Travel Agency,
as shown in Table 1.2:
Table
1.2: Balance sheet of Summit Travel Agency
Summit has total
assets of ……………………….
$300.000
And total
liabilities of ………………………………….
( 80.000)
Therefore, the
owners' equity must be…………..
$220.000
Owners' equity
does not represent a specific claim to cash or any other
particular asset. Rather, it is the owners overall financial
interest in the entire company.
1.12
Increases in Owners' Equity
Decreases in
Owners' Equity
1.12
Increases in Owners' Equity
The owners'
equity in a business comes from two sources:
-Investments of cash
or other assets owners
-Earning from profitable
operation of the business.
Decreases in
Owners' Equity
Decreases in
owner's equity also are caused in two ways:
-Payments of cash
or transfers of other assets owners
Losses
from unprofitable operation of the business