Fundamentals of accounting

Question 1

Bookkeeping is

Answer 1

the process of identifying and recording transactions and other financial events affecting an enterprise in a systematic way.

Question 2

Transactions

Answer 2

refer to the trading activities or buying and selling that every business needs to record.

Question 3

A financial event

Answer 3

could be any change in the value of a business, such as theft or damage to property, that also needs to be recorded.

Question 4

Accounting is

Answer 4

broader than bookkeeping and refers to the process of classifying, interpreting, summarising and reporting on transactions and other financial events. This is done in order to generate useful information from the many different types of purchases and sales that are individually recorded by bookkeepers.

Question 5

The responsibility of accountants is

Answer 5

to prepare reports that contain useful information for a range of decision makers and stakeholders inside and outside the business. Such reports need to give a complete answer to four crucial financial questions

Question 6

The four fundamental financial questions

Answer 6

Users of financial information, both inside and outside organisations, want answers from accountants to the following four fundamental financial questions:

Question 1: What does an enterprise own i.e. what are its assets?

Question 2: What does an enterprise owe i.e. what are its liabilities?

Question 3: How did the enterprise perform i.e. what is its profit or loss?

Question 4: How did the enterprise obtain and use cash i.e. what is its cash flow?

Question 7

Balance sheet

Answer 7

All the assets and liabilities of a business are summarised in a primary financial report called a balance sheet, also known as the statement of financial position. Such a report, as well as the underlying accounting records, give the answers for the first two fundamental accounting questions above.

Question 8

The difference between assets and liabilities

Answer 8

An asset is a resource with financial value that is owned by a business with the expectation that it will provide future financial benefit. A liability is a financial claim owing to lenders and suppliers of goods or services on credit.

Question 9

Overdraft

Answer 9

lets you borrow money through your current account by taking out more money than you have in the account – in other words you go “overdrawn”. There’s usually a charge for this. You can ask your bank for an overdraft – or they might just give you one – but don’t forget that an overdraft is a type of loan. An overdraft is when a bank balance is negative and the customer owes the bank a sum of money.

Question 10

A patent

Answer 10

, which is an exclusive right to make, use or sell an invention for a specified period, is a less common asset, a patent is classified as an intangible (non-physical) asset.

Question 11

Receivables or debtors

Answer 11

refers to the total money owed to a business by credit customers and is thus an asset.

Question 12

A mortgage

Answer 12

is a loan agreement secured on a business premise, for instance, in which the lender can take possession of the premise if the borrower fails to pay back the loan as agreed

Question 13

Payables or creditors

Answer 13

is the total money owed by a business to credit suppliers of goods or services.

Question 14

Income statement

Answer 14

The answer to the third fundamental question, ‘What is its profit or loss?’ is provided by the income statement, which is the second primary financial report. This report gives summary totals of all the income and expense items in a business that have been aggregated from the underlying double-entry accounting records. If total income (also known as revenue) is greater than total expenses then this positive difference is referred to as a profit. If total income is less than total costs, then this negative difference is referred to as a loss.

Question 15

What is the difference between the cash made or lost in a period and the profit or loss in the same period?

Answer 15

The amount of cash any business has made or lost in a period is simple to calculate. It is merely the difference in cash held at the beginning and the end of that period. If the cash position is greater at the end of the period than the beginning, then the business has generated a positive cash flow. If less, then the result will be a negative cash flow.

The profit or loss made in the same period is all income earned less all expenses incurred in generating that income. (It is important to recognise that ‘all income’ and ‘all expenses’ include cash as well as credit transactions.) If total income is greater than total expenses in a period, then a profit has been made regardless of whether a positive or negative cash flow has occurred. If less, a loss has been suffered irrespective again of whatever may have happened to the cash position of the enterprise.

Question 16

An important aspect of double-entry accounting is that income and expenses are recognised when they

Answer 16

occur (and not when cash is paid or received) and then reported in the financial period to which they relate.

Question 17

Cash is

Answer 17

just one asset of a business but is often described as the most important asset as it is the only one that can be used to pay debts at very short notice. Other assets, such as goods for sale or property, have to be sold first before any cash proceeds can be used to pay any debts owing.

Question 18

It is widely known that profit is the

Answer 18

difference between total income and total expenses in a business. What is less well-known is that the overall accounting value of a business is the difference between total assets and total liabilities as recorded in the balance sheet. This overall value is known as the net assets, net worth or capital of the business.

Question 19

Capital in accounting

Answer 19

Every enterprise starts with no money. It needs the owner to put in money to get the business going. Other assets, such as inventory (goods) to be sold to customers, are then bought for future financial benefit.

Businesses need to separate out the money put into the business by the owner from the liabilities it incurs, which need to be repaid. The money ‘owing’ to the owners is known as capital.

Question 20

Accounting records and the business entity concept

Answer 20

Some businesses, such as sole traders, have no separate legal existence from the owner or owners. All the debts of the business are their personal debts and, unlike a limited company, they have unlimited liability for honouring these debts. In spite of this they must always keep the accounting records of the business separate from their own personal affairs. This is known as the business entity concept and is as relevant to a small sole trader as it is to a multinational company.

Question 21

A principal purpose of double-entry accounting is to

Answer 21

prepare reports that contain useful information for a range of decision makers and stakeholders inside and outside the business.

Question 22

Financial accounting is

Answer 22

principally concerned with preparing financial reports for external users such as banks providing loans or tax authorities who want to know what tax is due from the business.

Question 23

Managerial accounting

Answer 23

These statements will also be of interest to managers of an organisation, but they will not be sufficient for managers’ information needs in the day-to-day running of an organisation. For this, much more detailed and more frequent accounting information is required. Providing such information and analysis is the function of management accounting. This area of accounting covers all areas of management decision making such as setting the price of a good for sale, deciding on the cost of a manufactured good or deciding what type of a budget best suits a business.
By contrast, outside users of financial information, such as loan providers and taxation officials, want summarised financial information that should be thoroughly checked before the business makes it available. For a sole trader, the smallest type of business, this checking process is done by the owner or, if the business is large enough, an internal employee or external accountant. Preparing financial statements for external users takes much time, experience and knowledge and, for larger private companies and all public companies, involves a detailed checking process by specially trained independent accountants known as auditors. The area of accounting that is targeted primarily at those outside of the business is called financial accounting.

Question 24

Using the same accounting records for all accounting purposes

Answer 24

It is important to note that the different routines of ‘management’ and ‘financial’ accounting do not mean that different accounting records must be kept. The same underlying accounting data is organised, summarised and communicated in different ways in order to meet different information needs.

Question 25

Chief purpose

Answer 25

F.A :The production of summarised financial statements by managers as a formal report of their management responsibility.

MA: The production of detailed and up to date informal reports by managers to decide and plan activities and to control the business.

Question 26

Viewpoint

Answer 26

FA: Gives information about past performance. Only available several months after period end.

MA: Gives comparative, up-to-date and forward-looking information about performance.

Question 27

Timing of information

Answer 27

FA: Normally annually, but depending on type of business may be every three or six months as well.

MA: Normally prepared on a monthly basis, but can sometimes be required at very short notice.

Question 28

Regulatory authority

Answer 28

FA: Financial statements need to be presented according to the requirements of government and the appropriate accounting regulators.

MA: Financial reports can be in any form needed.

Question 29

Accuracy level

Answer 29

FA: Need to be thoroughly checked in order to be as accurate as possible.

MA: Accuracy, while always important, may need to be compromised in order that information is up to date and relevant.

Question 30

Auditing requirement

Answer 30

FA: Required for certain enterprises such as public companies and larger registered charities.

MA: Not required

Question 31

Summary of Week 1

Answer 31

Bookkeeping is the process of recording financial transactions and financial events in a systematic way. Accounting is broader than bookkeeping and refers to the process of classifying, summarising, presenting and interpreting bookkeeping records. Users of financial information want answers to the following four fundamental financial questions:

Question 1: What does an enterprise own i.e. what are its assets?

Question 2: What does an enterprise owe i.e. what are its liabilities?

Question 3: How did the enterprise perform i.e. what is its profit or loss?

Question 4: How did the enterprise obtain and use cash i.e. what is its cash flow?

The principal financial statement that summarises the information contained in the accounting records is the balance sheet or statement of financial position. Every business also needs to keep track of its profit or loss and its cash inflows and outflows. Because of credit sales and purchases, a business can make a profit in an accounting period, normally a year, even though it loses cash in the same period.

A good system of financial record keeping allows all the information contained about an enterprise’s capital, assets (including cash), liabilities and profit or loss to be traced back, quickly and accurately, to original transactions and financial events.

The same system can be used for the purposes of financial and management accounting.

Question 32

Use of BODMAS and brackets

Answer 32

For this we use BODMAS, which give us the correct sequence of operations to follow so that we always get the right answer:

(B)rackets

(O)rder

(D)ivision

(M)ultiplication

(A)ddition

(S)ubtraction.

According to BODMAS, multiplication should always be done before addition,

Question 33

The memory function in a scientific calculator

Answer 33

The scientific calculator memory is particularly useful for more complex calculations in accounting. Such a calculator has a number of different memories of which the ‘M’ memory is the most commonly used in accounting calculations. Like most calculators, the ‘M’ memory is accessed using the M+ key. Only the most basic calculator is needed for this course but a scientific calculator should be strongly considered for any future study in accounting.

Question 34

Rounding

Answer 34

For most business and commercial purposes the degree of precision necessary when calculating is quite limited. While engineering can require accuracy to thousandths of a centimetre, for most other purposes tenths will do. When dealing with cash, the minimum legal tender in the UK is one penny, or £00.01, so unless there is a very special reason for doing otherwise, it is sufficient to calculate pounds to the second decimal place only.

However, if we use the calculator to divide £10 by 3, we obtain £3.3333333. Because it is usually only the first two decimal places we are worried about, we forget the rest of them and write the result to the nearest penny of £3.33.

This is a typical example of rounding, where we only look at the parts of the calculation significant for the purposes in hand.

Consider the following examples of rounding to two decimal places:

1.344 rounds to 1.34

2.546 rounds to 2.55

3.208 rounds to 3.21

4.722 rounds to 4.72

5.5555 rounds to 5.56

6.9966 rounds to 7.00

7.7754 rounds to 7.78

Rule of rounding

If the digit to round is below a 5, round down. If the digit is 5 or above, round up.

Question 35

Fractions

Answer 35

The top half of a fraction is called the numerator and the bottom half the denominator, i.e., in 4/16, 4 is the numerator and 16 is the denominator. We divide the numerator (the top figure) by the denominator (the bottom figure) to get the decimal form. If, for instance, you use your calculator to divide 4 by 16 you will get 0.25.

A fraction can have many different representations. For example, 4/16, 2/8, and 1/4 all represent the same fraction: one quarter or 0.25. It is customary to write a fraction in the lowest possible terms. That is, to reduce the numerator and denominator as far as possible so that, for example, one quarter is shown as 1/4 rather than 2/8 or 4/16.

If we have a fraction such as 26/39 we need to recognise that the fraction can be reduced by dividing both the denominator and the numerator by the largest number that goes into both exactly. In 26/39 this number is 13 so (26/13)/(39/13) equates to 2/3.

We can perform the basic numerical operations on fractions directly. For example, if we wish to multiply 3/4 by 2/9 then what we are trying to do is to take 3/4 of 2/9, so we form the new fraction:

3/4 x 2/9 =(3x2)/(4x9) = 6/36 or 1/6 in its simplest form.

In general, we multiply two fractions by forming a new fraction where the new numerator is the result of multiplying together the two numerators, and the new denominator is the result of multiplying together the two denominators.

Addition of fractions is more complicated than multiplication. This can be seen if we try to calculate the sum of 3/5 and 2/7. The first step is to represent each fraction as the ratio of a pair of numbers with the same denominator. For this example, we multiply the top and bottom of 3/5 by 7, and the top and bottom of 2/7 by 5. The fractions now look like 21/35 and 10/35 and both have the same denominator, which is 35. In this new form we just add the two numerators.

(3/5) + (2/7) = (21/35) + (10/35)

                    = (21 + 10)/35)

                    = 31/35

Question 36

VAT

Answer 36

(Value Added Tax – an indirect tax in the UK)

If the machine were quoted at the price including VAT (the gross price) and we wanted to calculate the price before VAT (the net price),For example, a restaurant bill is a total of £50.40 including a 12% service charge. The bill before the service charge was added would be:

£50.40 / 1.12 = £45.00

Question 37

Rules of negative numbers

Answer 37

The rules for using negative numbers can be summarised as follows:

Addition and subtraction

Adding a negative number is the same as subtracting a positive

50 + (-30) = 50 – 30 = 20

Subtracting a negative number is the same as adding a positive

50 – (-30) = 50 + 30 = 80

Multiplication and division

A positive number multiplied by a negative gives a negative

20 x -4 = -80

A positive number divided by a negative gives a negative

20 / -4 = -5

A negative number multiplied by a negative gives a positive

-20 x -4 = 80

A negative number divided by a negative gives a positive

-20 / -4 = 5

Question 38

An important note about the use of brackets

Answer 38

Always remember that while a single number in brackets means that it is negative, the rule of BODMAS means that brackets around an ‘operation’ between two numbers, positive or negative, means that this is the first operation that should be done. The answer for a series of operations in an example such as 12 + (- 8 – 2) would thus be 2 according to the rules of BODMAS and negative numbers. It should be also noted that if 12 + (- 8 – 2) was given as 12 + ( (8) – 2) the answer would still be 2 as (8) is just another way of showing -8.

Question 39

The relationship between numbers in the accounting equation

Answer 39

The accounting equation states that Assets (A) = Capital (C) + Liabilities (L). Such an equation, which can also be abbreviated as A = C + L, can be stated in financial terms for a particular business at a particular time:

£100,000 of Assets (A) = £80,000 of Capital (C) + £20,000 of Liabilities (L)

The accounting equation can be expressed in the different forms below, which are all correct for the example of our business with assets of £100,000:

A = C + L or £100,000 = £80,000 + £20,000 (accounting equation)

C + L = A or £80,000 + £20,000 = £100,000

C = A - L or £80,000 = £100,000 - £20,000

L = A - C or £20,000 = £100,000 - £80,000

A – L = C or £100,000 - £20,000 = £80,000

A – C = L or £100,000 - £80,000 = £20,000

Question 40

Manipulation of formulae

Answer 40

Manipulating or rearranging formulae involves the same process as manipulating or rearranging equations.

In the formula S = D / T, S is the subject of the formula. (This simply means that S stands on its own and is determined by the other parts of the formula. By convention the subject is always placed on the left-hand side of the equal sign, although S = D / T means the same as D / T = S)

To rearrange or manipulate an equation, the formula S = D / T can also be manipulated to make D or T the subject.

S = D / T

D / T = S (turning the formula around)

D = S x T (multiplying both sides of the formula by T)

Or, from D = S x T

D / S = T (dividing both sides of the formula by S)

T = D / S (turning the formula around)

Question 41

Summary of Week 2

Answer 41

A competent accountant should have the confidence and ability, both mentally and using a calculator, to be able to add, subtract, multiply, divide as well as use decimals, fractions and percentages. Completing tables of equivalencies is a good way of practising converting between percentages, decimals and fractions. All accountants should be able to manipulate simple equations and formulae. The most important equation in accounting is the accounting equation, which states that Assets (A) = Capital (C) + Liabilities (L).

Question 42

The business entity concept:

Answer 42

The business entity concept states that a business is separate from the owner(s) of the business.

Question 43

The accounting equation

Answer 43

The accounting equation, for any business, states: Assets = Capital + Liabilities.

Question 44

The duality concept:

Answer 44

The duality concept means that every transaction has two effects.

Question 45

The business entity concept

Answer 45

The business entity concept states that the business is separate from the owner(s) of the business. Therefore the accounting records for even the simplest business, the sole trader, must be kept separate from the personal affairs of the owner or owners.

There are basically three types of business entity:

sole trader
partnership
limited company.
The principles of double-entry accounting apply to all forms of business organisation, as well as not-for-profit organisations.

Question 46

The accounting equation

Answer 46

The financial position of a business is expressed in the statement of financial position, which is more commonly called the balance sheet. The financial position of a business is represented by:

assets (what the business owns)
liabilities (what the business owes)
owner’s capital (the monetary value of the owner’s investment in the business).

Assets = Capital + Liabilities

The left arm of the scales contains assets. This is balanced by the right arm of the scales, which contains capital and liabilities.

Figure 1 Assets equal capital and liabilities
The accounting equation should be kept in balance at all times i.e. the assets on the left side of the equal sign should always be the same as the sum of the capital and liabilities on the right-hand side.

Question 47

The duality principle in practice

Answer 47

Whether a business does one transaction or a thousand, the same results of the accounting equation and the duality principle are achieved.

Each transaction will have two effects in order that the accounting equation is kept in balance.
Assets or liabilities can further be broken down into the type of asset or liability that is affected.
For each transaction, as well as for the overall effect of a number of transactions, the figure for capital will reflect the accounting equation: A = C + L.

Question 48

T–accounts

Answer 48

are more correctly known as ‘ledger accounts’ as they were originally recorded in a ledger, the old name for a book. Under this system every transaction has two separate and distinct aspects, so two separate T-accounts are involved in each transaction. Monetary values recorded in these T-accounts are recorded either on the left-hand side, known as the debit side, or on the right-hand side known as the credit side. The value of the debits should always equal the values of the credits.

Separate T-accounts are needed for each type of asset and liability and also for capital. At least two accounts are needed to record each transaction.

These T-accounts are recorded in the general ledger (also known as the nominal ledger).

Question 49

The difference between debit and credit and debtors and creditors

Answer 49

The term debit has nothing to do with debtors, the amount owing to a business by its credit customers. A debit in a T-account simply means that it is recorded on the left side of such an account. The term credit has nothing to do with creditors, the amount owing to a business by its credit suppliers. A credit in a T-account simply means that it is recorded on the right side of such an account.

Question 50

For every transaction you need to follow three steps:

Answer 50

Step 1: Identify the two accounts affected.

Step 2: Decide the effect on each account. Perhaps one account is increasing and one is decreasing, or both accounts are increasing, or decreasing. (This ensures that that accounting equation A = C + L is always kept in balance after every transaction.)

Step 3: Record the entries.

If a transaction increases an asset account, then the value of this increase must be recorded on the debit or left side of the asset account. If, however, a transaction decreases an asset account, then the value of this decrease must be recorded on the credit or right side of the asset account. The converse of these rules applies to liability accounts and the capital account. These rules are summarised below and should be memorised.

Question 51

Why do you think the rules of double entry must be memorised?

Answer 51

These rules of double-entry accounting must be memorised as they form the basis of further work in this course as well any further study you do in accounting. The best way to remember them and to see how they work is to work through the following example and activity, so that double entry slowly becomes second nature to you.

Question 52

The reason why your bank account says your positive bank balance is a credit

Answer 52

When you have money in the bank, the bank statement shows that your account has a credit balance. This is because when the bank receives money from you they credit your account in their books as your deposit is a liability to them. If you tell them to pay your money to someone else (perhaps a mortgage payment or a mobile phone bill) the bank will have effectively given the money back to you and so the bank will debit your account. According to the same rules of double entry, if you have your own bank account, your deposit will be an asset in your books and thus a debit in your bank account. Any payment from this asset account will thus be a credit entry to show that the asset has decreased in value. Always remember that the bank’s records are a mirror image of your own as your deposit is a liability to them but an asset to you.

Question 53

In order to prevent errors and to make sure that all transactions are properly recorded as debits and credits in the correct T-accounts

Answer 53

a checking procedure takes place at the end of each accounting period. This is known as preparing a trial balance

Question 54

A trial balance

Answer 54

is thus a list of all the debit and credit balances in the general ledger accounts. If all the individual double entries have been correctly carried out, the total of the debit balances should always equal the total of the credit balances in the trial balance. A further important purpose of the trial balance is that it forms the basis for the preparation of the balance sheet.

If the total of the debit balances do not equal the total of the credit balance then there is a mistake somewhere, which needs to be investigated and corrected.

In order to prepare a trial balance at any time, it is necessary to determine the balance on each account. This process is known as ‘balancing off’ the general ledger accounts. The trial balance can then be prepared by listing each closing balance from the general ledger accounts as either a debit or a credit balance.

From the trial balance it can be seen that the total of debit balances equals the total of credit balances. This demonstrates that for every transaction the basic principle of double-entry accounting has been followed – ‘for every debit there is a credit’.

Question 55

Balance sheets

Answer 55

Although it may be acceptable to prepare a balance sheet with assets on one side and capital and liabilities on the other (known as the horizontal format) it is more conventional to show assets at the top and capital and liabilities at the bottom (known as the vertical format).

Balance sheets are commonly prepared in a vertical format of the accounting equation. This gives the owners clear information about the assets of the business, the liabilities of the business (the amount it owes) and the capital or owner’s interest in the business. The balance sheet is normally produced at the end of each trading or financial year and is a snapshot of the financial position of the business on the last day of the financial year.

Question 56

(Non-current assets

Answer 56

refer to assets that are typically held in a business for longer than a year.

Question 57

Current assets

Answer 57

are assets that are typically held for less than a year.

Question 58

non-current liabilities

Answer 58

refer to liabilities that are typically held in a business for longer than a year.

Question 59

Current liabilities

Answer 59

are liabilities that are typically held for less than a year.)

Question 60

The capital of a business is

Answer 60

the value of the investment in the business by the owner(s)

Question 61

The expanded accounting equation

Answer 61

Assets = Liabilities + Capital + (Revenue – Expenses)

Question 62

Summary of Week 4

Answer 62

If (a) all the double entries for every transaction and financial event are correctly recorded in the relevant T-accounts and (b) all the relevant T-accounts are correctly balanced off, then a correct trial balance can be prepared. The trial balance shows the double-entry rule that ‘for every debit there is a credit’.

The balances from the trial balance can be used to prepare the balance sheet. Balance sheets are commonly prepared in a vertical format of the accounting equation. The accounting equation can be expanded to Assets = Liabilities + Capital + (Revenue – Expenses) to reflect the fact that an increase in profit means an increase in capital