CHAPTER 1

Question 1

Accounting

Answer 1

Accounting is the collection and recording of financial data, and the reporting, analysis and interpretation of financial information. The purpose of accounting is to provide to business owners financial information to assist decision-making about the activities of their firm.

Question 2

Financial data and information

Answer 2

Financial data is raw facts and figures upon which financial information is based and financial information is financial data that has been sorted, classified and summarised into a more useable and understandable form. The accounting system converts the data into information that is useful for decision making.

Question 3

Accounting process

Answer 3

Source documents (inputs stage)
Records (processing stage)
Reports (outputs stage)
Provides advice

Question 4

Transaction

Answer 4

An exchange of goods or services with another party.

Question 5

Source documents STAGE 1

Answer 5

Source documents are the paper or electronic documents that provide both the evidence that a transaction has occurred and the details of the transaction itself. Source documents provide the data on which the accounting information will be based. Common source documents include receipts, cheque butts, invoices and memos.

Question 6

Recording STAGE 2

Answer 6

Once the source documents have been collected, the data needs to be written down or noted in a more useable form, or ‘recorded’. Recording involves sorting, classifying and summarising the data contained in the source documents so that it is more useable. This is sometimes known as the ‘processing’ stage, where data becomes information. Common records include journals, ledgers and stock cards.

Question 7

Reporting STAGE 3

Answer 7

The ‘output’ stage of the accounting process involves taking the information generated by the accounting records and reporting that information to the owner of the business in an understandable form. Reporting involves the preparation of financial statements that communicate financial information to the owner so that decisions can be made. Three common reports include the cash flow statement, the income statement and a balance sheet.

Question 8

ADVICE STAGE 4

Answer 8

Armed with the information presented in the reports, the owner should be in a much better position to make informed decisions. However, the best course of action is sometimes unclear. Therefore, the accountant should be able to offer advice by making some suggestions about an appropriate course of action or at the very least presenting owners with a range of options from which they can choose from. The provision of advice is the accountants key function but this advice rests on the information generated by the first three stages of the accounting process.

Question 9

Accounting principles

Answer 9

The generally accepted rules that govern the way accounting information is generated.

Question 10

LIST ACCOUNTING PRINCIPLES

Answer 10

CHER@MCG
Consistency
Historical cost
Entity
Reporting period
Monetary unit
Conservatism 
Going concern

Question 11

Entity

Answer 11

The business is assumed to be separate from the owner and other businesses, and its records should be kept on this basis. If we are to asses the performance of the business itself, we must only include information relevant to that business. The owner may own a beach house but if this is not being used by the business, it must not be included as a business asset.

Question 12

Drawings and capital contributions

Answer 12

In practical terms, the Entity principle means that the business must have a separate bank account, and that it should only be used for business purposes. If the owner uses the business’s funds for personal purposes, this must be recorded in the business’s records as drawings.
In the same way, if the owner contributes personal assets to the business, then this should be recorded as a capital contribution from one entity (that is, the owner) to another entity (that is, the business).

Question 13

Contribution of non cash assets and the entity principle

agreed value

Answer 13

In the case of a contribution of non-cash assets, such as a vehicle, the Entity principle will have a further effect in terms of the way the asset is valued. Consider an asset, such as a vehicle, purchased by the owner but then contributed to the business. This asset cannot be valued at the original price paid by the owner, as it is the cost to the business, as a separate entity, that is important.
However, although the business and the owner are assumed to be separate accounting entities, there would be no source document to verify the ‘sale’ by the owner to the business as they are, in fact, one and the same. In this case, the asset would be recorded in the books of the business at an agreed value (determined at the time the asset is contributed to the business). This agreed value would then become the effective Historical Cost as far as the business is concerned.

Question 14

Going concern

Answer 14

The Going Concern principle assumes that the life of the business is continuous, and its records are kept on that basis. This principle is important because it allows as to record transactions that have an effect on the future. For instance, where a sale is made on credit terms, the cash will not have been received from the customer. By assuming that the business will continue trading indefinitely, the Going Concern principle allows as to record debtors (amounts owed to the business by credit customers) as an asset because at some stage in the future the business is likely to receive cash. The same applies to amounts the business owes to its creditors for its credit purchases, or to amounts the business has paid in advance for benefits it is yet to receive.

Question 15

Reporting period

Answer 15

The Reporting Period principle states that the life of the business most be divided into periods of time to allow reports to be prepared. This principle is inextricably linked to the idea that the business is a Going Concern. Because the life of the business is assumed to be continuous, it is necessary to divide that life into arbitrary periods so that profit can be determined. We cannot wait until the end of the firm’s life to calculate profit (because we are assuming that the end will never come) so we calculate profit for the month, or year A Reporting Period an be as short as the owner requires, but in most cases, to meet taxation requirements, is no longer than a year.

Question 16

Accrual Accounting

Answer 16

One possible consequence of dividing the life of the business is that at the end of a Reporting Period the business may still be waiting for some cash from debtors, or may not yet have paid for some expenses. These amounts are still included in the calculation of profit, as the revenue was earned (when the goods were sold) and the expense incurred (when the item was consumed) in the current reporting period. This method of calculating profit as revenues earned less expenses incurred in each Reporting Period is known as accrual accounting.

Question 17

Historical Cost

Answer 17

The Historical Cost principle states that a transaction should be recorded at its original cost or value, as this value is verifiable by reference to the source document. This principle applies particularly to assets, which must be recorded at their original purchase price. Any other valuation, such as resale value or replacement value, is subject to a certain amount of guesswork, and therefore Historical Cost is preferred. For instance, if land is bought for $300 000, and is later estimated to be worth $320 000, it should remain in the accounting records as $300 000 as the other price is only an estimate, and not verifiable. There are certain situations in which it is acceptable to use a valuation other than Historical Cost, but these situations will be covered in later chapters.

Question 18

Conservatism

Answer 18

The Conservatism principle states that losses should be recorded when probable but gains should be recorded only when certain, so that liabilities and expenses are not understated and assets and revenues are not overstated. This principle advocates a worst-case scenario approach to accounting. Where different valuations are possible, or it is impossible to avoid the use of an estimate, accountants should use whichever data gives the most cautious or ‘conservative’ assessment. This does not mean the records should deliberately represent a situation as worse than it actually is, but it does mean they should not represent the situation as better than it might turn out to be. From an accounting point of view it is better to be cautious and conservative than overly optimistic (and then get a rude shock when reality does not match expectations).

Question 19

Consistency

Answer 19

The Consistency principles states that accounting methods should be applied in a consistent manner from one period to the next, so that reports can be compared between periods. Without consistent accounting methods, it is difficult to tell whether changes in accounting reports are the result of changes in business performance, or simply changes in accounting procedures. This makes it difficult to compare reports from one period to the next. The amounts in the reports do not need to be the same, but the way they are calculated does.

Question 20

Monetary unit

Answer 20

The Monetary Unit principle states that all items must be recorded and reported in a common unit of measurement; that is, Australian dollars. This is one of the more obvious principles. It would make little sense to record the purchase of a motor vehicle as ‘1 Holden Commodore’ without attaching a valuation in dollars. To do so would make it impossible to aggregate total assets or make comparisons between periods or businesses. Similarly, recording loans in Australian dollars and stock in Japanese yen would make the information impossible to use.

Question 21

Qualitative Characterisitcs

Answer 21

The qualitative characteristics are basically the qualities we would like our accounting information to possess. The four qualitative characteristics of accounting reports are:
Relevance
Reliability
Comparability
Understandability.

Question 22

Relevance

Answer 22

Relevance states that reports should include all information that is useful for decision-making, and exclude information that is not. This information should be up-to-date, and appropriate to the decision at hand. The quality of Relevance guides us in what to include in our reports, and will be present if we follow the Entity and Reporting Period principles. For example, when preparing a Balance Sheet for a business, it is not relevant to include the personal assets of the owner, as these are not being used by the business to earn revenue, and thus are not useful for making decisions about future business activities. Similarly, the Income Statement should include only revenues and expenses from the current Reporting Period — last year’s wages, or next year’s sales figures will not help us to assess this year’s profit. The key is whether the information is useful for decision-making.

Question 23

Reliability

Answer 23

Reliability states that reports should contain information that is free from bias and error, and thus can be relied upon for its accuracy. The quality of Reliability means that in relation to the amounts we show in reports, we should avoid the use of estimates. Reliability will be assisted via the Historical Cost principle, because the best way to ensure that information is free from bias and error is to make sure it is verifiable by reference to a source document. Reliable information has proof to support its accuracy. For example, it should be possible to check the level of credit sales reported in the Income Statement against the invoices that documented the sales. This ensures there is no room for subjectivity or guesses.

Question 24

Understandability

Answer 24

Understandability states that reports should be presented in a manner that is simple to understand.
It is important to remember that the most basic function of accounting reports is to communicate information to the user; that is, sole traders and/or owners. Most small business owners are not accountants, so it is not sensible to present reports in a form that owners cannot understand. The characteristic of Understandability means it is easy for the user to comprehend the meaning of reports. For this reason, it may be more effective to present information in graphs, tables or charts, or simply in language that is free from accounting jargon.

Question 25

Comparability

Answer 25

Comparability states that reports should be comparable over time, and between different companies, through the use of consistent accounting procedures. One of the most basic uses of accounting reports is to compare performances of businesses and between periods. However, this will only be possible if consistent accounting methods have been used. Where accounting procedures are changed, this should be stated clearly (disclosed) in the reports, so that the users can make more informed assessments of what the reports are telling them

Question 26

5 elements of accounting

Answer 26

assets
liabilities
owner's equity
revenues
expenses

Question 27

Asset

Answer 27

A resource controlled by an entity, as a result of past events, from which future economic benefits are expected to flow to the entity.

Question 28

Liabilities

Answer 28

Liabilities are present obligations of the entity as a result of past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. This may seem like a lot of jargon, but broken into its components it is easier to understand.

Question 29

Owners Equity

Answer 29

Owner’s equity is the residual interest in the assets of the entity after the deduction of its liabilities. In effect, owner’s equity is what is left over for the owner once a firm has met all its liabilities. Given that the owner and the firm are considered to be separate entities, it can also be described as the amount the business ‘owes the owner’.

Question 30

Revenue

Answer 30

Revenues are inflows of economic benefits (or savings in outflows) in the form of increases in assets (or decreases in liabilities) that increase owner’s equity, except for capital contributions by the owner. Capital contributions are excluded because they occur not due to the activities of the business, but rather the actions of the owner.

Question 31

Expenses

Answer 31

Expenses are outflows or consumptions of economic benefits in the form of decreases in assets (or increases in liabilities) that reduce owner’s equity, except for drawings by the owner. Drawings is excluded because it doesn’t contribute to the firm’s ability to carry out its trading activities, and so does not affect its ability to earn revenue or profit.

Question 32

Outline three features of the accrual accounting system

Answer 32

Accrual accounting determines an accurate profit figure by offsetting the expenses incurred in a reporting period against the revenue earned in that same period of time. Expenses may be recognised as incurred, regardless of whether or not they have been paid. Revenues may be recognised as earned, regardless of whether or not they have been received. Balance day adjustments are recorded at the end of a period in order to ensure that the accounts reflect both revenue earned and expenses incurred. When these adjustments are recorded they also have an effect on the assets in the Balance Sheet (prepaid expenses, accrued revenues, accumulated depreciation) and current liabilities (accrued expenses, prepaid revenues). Thus, accrual accounting is a method that helps determine an accurate profit figure for each reporting period and an accurate Balance Sheet at the end of each period.