The following text was created as part of the university module “Financial accounting according to IFRS standards”. This work will introduce the financial reporting procedure as well as the legal framework and enable the reader to create (simple) financial statements on his/her own. Several examples and numerical figures as well as visual displays support the understanding. At the end, there is a summary about the balance sheet adjustments and a kind of FAQ (as part of the exam preparation). Please be aware that the international approaches are very similar to the German ones, but are not always the same.
This work is made from the notes taken during lectures and supplemented by additional information and pictures from secondary literature, namely “Financial Accounting – International financial reporting standards”, published by Pearson and written by Walter T. Harrison Jr. and Charles T. Horngreen. Additionally, some information from this book was visually displayed in self-made figures, diagrams and compilations. If an image is not marked otherwise, it's self-created.
Financial Accounting
The following text was created as part of the university module “financial accounting according to IFRS standards”. This work will introduce into the financial reporting procedure as well as into the legal framework and enable the reader to create (simple) financial statements by his/her own. Several examples and numerical figures support the understanding as well as visual displays. At the end a summary about the balance sheet adjustments as well as a kind of FAQ (as part of the exam preparation) is added. Be aware that the approaches are very similar to the German ones, but not always the same.
This work is made out of the notes from the lectures and supplemented by additional information and pictures out of the secondary literature “Financial Accounting – International financial reporting standards” published by Pearson and written by Walter T. Harrison Jr. and Charles T. Horngreen (ISBN-13: 978-0273777809). Additionally some information were visually displayed by self-made figures, diagrams and compilations. If an image is not marked differently, it's self-created.
Basics
Accounting has a great problem, the incomparability of information.
→ Transformation of information is necessary.
Accounting provides information by identifying, measuring, communicating, recording, classifying and summarizing of financial events and transactions.
Many groups in and outside the company are interested in truth and transparent financial accounting.
- Company itself for decision making, e.g., the use of scarce resources or prediction of opportunity costs.
- Employees want to know the financial situation of the company, so they can calculate with retirement benefits, employment opportunities and so on.
- Suppliers to evaluate the ability of the company to pay the supplied goods and interest in a long-term customer.
- State for taxes and regulations.
- Public for CSR, risk of pollution will lead to protest against this company.
- Consumers have long term involvements (e.g. warranties) and need to know the continuance of the company.
- Shareholders to evaluate the risk of giving money, determine whether to buy, hold or sell.
- Creditors to evaluate the risk of lending money and height of interest rates.
- As well as information intermediaries like rating agencies or financial analysts.
- Stakeholder are interested in company, but not necessary hold shares.
Differences between financial and management accounting.
- Financial accounting: communication to the outside.
- Following a general purpose, should give a generic overview, is highly regulated, once or twice a year, backward looking, providing information for buying, holding or selling shares.
- Management accounting: for internal use only, decision making.
- Specific purpose, detailed information, not regulated, made for every single decision, forward looking.
Business Activities.
- (1) Operating Activities.
- Daily processes (core values) for making money, depends what the company is.
- Primary activities to provide the customers with goods and services to generate cash.
- (2) Investing Activities.
- Purchase and sell of all goods that produce other goods.
- Buying something with the hope to receive more money back.
- (3) Financing Activities.
- Acquiring financial resources to engage in operating and investing activities.
- Raising of capital or debt, e.g., trading at stock exchange markets.
Financial accounting statements.
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- (1) Statement of comprehensive income (I/S). 1
- Comparison of company's revenue and expenses for a period.
- Separated in two statements (Income Statement and Statement of other Com-prehensive Income) (Last one is not necessary for the exam).
- (2) Statement of financial positions = Balance Sheet (B/S).
- Summary of all assets and source of capital, not for this period, contains information of all periods since the founding of the company.
- Information for investors to see the development of an company as well as the debt ratio.
- (3) Statement of cash flow (CF).
- Providing all transactions of a company, which are related to real flow of cash.
- Used to determine the cash on the bank account or the first position in the balance sheet.
- Shows the liquidity of a company.
- (4) Statement of changes in Equity (ΔEq.).
- Reveals the changes in Equity and is used to check the calculated worth in the balance sheet.
Structure of a balance sheet. 2
- Balance sheet is divided into two parts, use of funds on the left side, source of funds on the right.
- Assets = Liabilities + Equity.
- Sum of total assets has to be the same as sum of equity and liabilities.
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Components of retained earnings. 3
- Former value of retained earnings will be extended by the net income.
- Net income is calculated in the statement of the comprehensive income.
- Difference between revenues and expenses in one period.
- Sum of retained earnings and net income will be reduced by dividends to calculate the ending balance of retained earnings.
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Structure of a cash flow statement. 4
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- (I) Cash flow from operating activities.
- Net Income.
- Adjustment to reconcile net income to net cash provided by operating activities (given in exam).
- Net cash from operating activities.
- (II) Cash flow from investing activities.
- Acquisition of land.
- Sale of land.
- Net cash from investing activities.
- (III) Cash flow from financing activities.
- Issuance of shares.
- Payment of dividends.
- Net cash from financing activities.
- (IV) Total cash flow is the sum of all three cash flows.
Statement of changes in equity. 5
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- Beginning Equity.
- Issuance of share capital.
- Net income.
- Cash dividends.
- Ending Equity.
Why the financial statement is made.
- Investors and Creditors need information whether to buy, sell, hold shares or lend money.
- Decision Usefulness: Company has to reveal all information investors need for decision making.
- Information have to represent the real situation of the company and have to be relevant.
- Furthermore information has to be comparable, verifiable, understandable and accurate in time.
- Fundamental qualities of the information are relevance and faithful representation.
- Relevance: financial statement should reveal the actual value of the firm as well as a prognosis about the future value based on the goals and strategy.
- Faithful Representation: financial statement should contain complete, neutral and error-free information.
- Scope of the f/s: Should reveal as much information that a third party person is able to get a general overview about the company's financial situation.
- Goal of the f/s: Permission of decision making for actual as well as potential investors.
- Fundamental Characteristics of a f/s are Relevance and Reliability (Faithful Representation).
- Enhancin g Characteristics of f/s: Comparability, Verifiability, Timeliness, Understandability.
Relevance vs. Reliability.
- Relevant information contains every info may be having an influence on investors decision (degree of materiality); need to be revealed.
- Reliable information contains (i) every information may be having an influence on investors behavior, (ii) won't give a party any unfair advantage, (iii) is free from error, (iv) reflect economic reality and (v) uses a certain degree of caution when predicting company's development.
- Manager have to assess on reliability and relevance of any information, to avoid uncertainty and limit the power of managers three principles are set.
- (I) Avoiding specific accounting treatment.
- (II) Increasing disclosure (more information have to be revealed).
- (III) Control mechanism (external auditors have to proof the financial reports).
Organizing a business.
- Three basic forms of companies.
- (1) Proprietorship: One owner is personally liable.
- (2) Partnership: Two or more partners, only general partners are liable.
- (3) Corporation: Shareholders are owners and not personally liable.
→ In the exam only the f/s from a corporation will be asked.
Transactions and Double-entry system.
- Transactions are changes within the company, e.g., the change of cash and bought assets.
- Every transaction contains at least two information, necessary for the book-keeping.
→ The first information is always (or should be) clear, the second have to be thought about.
What is a credit and a debit?
- Answer to question above depends on the side of the Balance Sheet.
- A debit in assets mean an increase in worth, so a credit is an outflow of worth / a decrease.
- A debit in Liabilities or Equity means a decrease of worth, because of repaying a loan or losing equity.
- Example: Taking a bank loan increases the liabilities, so the “bank credit” is called credit.
- Simultaneous the amount of cash on the asset-side increases, called a debit.
- Important: Always think about the balance between sum of assets and sum of liabilities and equity; this sum must be kept even with the amount of credits and debits.
- Therefore: If there is a credit, there need to be a debit with the same value.
How to prepare a balance sheet starting with blank sheet of paper (Important Guideline).
- Companies will do a lot of transactions over the year, but every transaction is saved with date and sent to the accounting guys.
- 1st Step: Making a journal out of the list with transactions.
- 2nd Step: Turning the information from the journal into T-Accounts.
- 3rd Step: Arrange the single T-Accounts into the ledger.
- 4th Step: Turn information from ledger into a trial balance.
- 5th Step: With the information of the trial balance you can start calculating the net income in the I/S
- 6th Step: Closing the books for calculating retained earnings.
- 7th Step: Calculating the total changes in Equity.
- 8th Step: Start doing the Cash Flow Statement with all it's varies.
- 9th Step: Finally, the B/S is ready to be made.
Step One: The journal.
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- Example: Performing services on account leads to an increase in assets (account receivable), debit on asset's side.
- Furthermore this will lead to a increase in retained earnings (service revenue → increase in net income → increase in retained earnings), so a credit on equity's side.
- Analyze the given information and find out, what is the second (hidden) information and then decide what is a debit and what a credit.
- Always begin with the debit account!
- Normally the real capital volume is given (example above: Ser. Rev. in the height of $15k), so the capital will be inserted in the column debit / credit.
- If it is directly asked in the exam, only then you have to write a short explanation under Ser. Rev. about the transaction (“revenue on account for services”).
- Decreases in capital aren't wrote in brackets or with minus, just put into the right field (debit or credit).
Step Two: The T-Accounts.
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- Journal contains a huge amount of debits and credits for several accounts.
- This step means sorting the debits or credits by their accounts.
- Example: T2 and T5 both lead to an increase in cash (= debit), so they will be summarized in one T-Account.
- But: T2 is connected to a sale of land, and T5 to issuance of shares; This information will be kept in two different T-Accounts, so for the transactions 2 and 5 we turned 4 information into three T-Accounts.
- Important: Always begin with the debit side.
- After filling the T-Accounts, notice the balance on the bottom.
Step Three: The Ledger.
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- In the ledger you sort the T-Accounts by their side of the B/S.
- Don't forget to notice the Transaction number or date before the capital amount.
- Order the companion accounts close to each other (salary payable close to salary payable; building close to building depreciation expenses, close to accumulated building depreciation).
Step Four: The Trial Balance.
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- Now bring the single balances (not the T-Accounts anymore) into a nice order for the further steps.
- The account title on the left will contain the balance in the right order (decreases in assets not negative, just in credit, as well as decreases in L&E).
Step Six: Closing the Books. 6
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- Temporary accounts need to be “reset” for the next period.
- Writing the same amount as the total ending balance on the other side (debit or credit) closes the book.
- Because of doing this, you have to add the total ending balance of these accounts into the retained earnings account (on the “normal” side, expenses as debit, revenue as credit).
- With this you can calculate the retained earnings.
- Do not insert the new value of Retained Earnings in the trial balance! Use the old value.
Distinction between accrual and cash-flow accounting.
- Accrual accounting: When events occurring than the revenue will influence the net income.
- Cash based accounting: Only when cash is moving, events will influence net income.
- Accrual accounting is much better to measure the performance of companies.
When a Revenue is Recognized.
- Goods must change the owner; even if the goods are fully paid and left the seller, the goods only become property of the buyer if they arrive at his place.
→ Then the seller has realized a revenue.
- Only if the services are completely done the performer will realize revenue, even if the service was paid before performing.
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- Quote paper
- Mike G. (Author), 2016, Introduction into Financial Accounting according to IFRS, Munich, GRIN Verlag, https://www.grin.com/document/351180
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