Accounting Principles and Financial Reporting Standards
1. Qualitative Characteristics of Accounting Information
Fundamental Characteristics
- Relevance: Information can influence decisions.
- Faithful representation: Information is complete, neutral, and free from material error.
Enhancing Characteristics
- Comparability: Helps users compare information across periods and entities.
- Verifiability: Information can be checked and confirmed.
- Timeliness: Available before it loses usefulness.
- Understandability: Clear to users with reasonable business and accounting knowledge.
2. Accrual Basis vs. Cash Basis Accounting
Accrual Accounting
- Recognize transactions when they occur, not when cash is received or paid.
- Includes receivables, payables, accrued items, and prepaid items.
Cash Accounting
- Recognize transactions only when cash moves.
- No receivables or payables are recorded.
Key Concept
- Economic activity does not equal cash movement.
- Companies usually use accrual accounting because it better shows true performance.
3. The Accounting Equation
Assets = Liabilities + Owner’s Equity
Expanded Equation:
Assets = Liabilities + Capital + Income – Expenses – Drawings
Key Concept
- Every transaction affects two or more accounts.
- The equation must always stay balanced.
- This is the basis of double-entry accounting.
Funding Logic
Assets are funded by:
- Liabilities: Borrowed money.
- Equity: Owner investment and accumulated profits.
Nothing appears from nowhere.
4. Debit and Credit Rules
| Account Type | Increase | Decrease |
|---|---|---|
| Assets | Debit | Credit |
| Liabilities | Credit | Debit |
| Owner’s Equity | Credit | Debit |
| Income | Credit | Debit |
| Expenses | Debit | Credit |
| Drawings | Debit | Credit |
| Dividends | Debit | Credit |
Common Accounts
| Category | Examples |
|---|---|
| Assets | Cash, Accounts Receivable, Inventory, Equipment, Vehicles, Prepaid Insurance |
| Liabilities | Accounts Payable, Bank Loan, Wages Payable, Tax Payable, Unearned Revenue |
| Equity | Owner’s Capital |
| Income | Sales Revenue, Service Revenue, Interest Revenue |
| Expenses | Rent Expense, Salary Expense, Electricity Expense, Advertising Expense, Insurance Expense, Phone Expense |
Memory Tip
- DEA LER
- Dividends, Expenses, Assets increase with Debit
- Liabilities, Equity, Revenue increase with Credit
5. The General Journal
Each journal entry includes:
- Date
- Accounts affected
- Debit amount(s) listed first
- Credit amount(s) listed second
- Narration
Rules
- Debits must equal credits.
- Each transaction affects at least two accounts.
- The accounting equation stays balanced.
Basic Format
Date Account Dr XXX
Account Cr XXX
(Narration)6. General Ledger and T-Accounts
Each T-account has:
- Account title
- Debit side (left)
- Credit side (right)
Used to:
- Classify transactions by account.
- Calculate balances.
- Prepare trial balances and financial statements.
7. Adjusting Entries
Why They Are Needed
Under accrual accounting, cash timing may differ from recognition timing. Adjusting entries ensure:
- Income is recorded when earned.
- Expenses are recorded when incurred.
Important Rule
- Never adjust the Cash account during adjusting entries.
Types of Adjusting Entries
| Type | Meaning |
|---|---|
| Prepaid Expense | Paid before being used |
| Unearned Revenue | Cash received before revenue is earned |
| Accrued Expense | Incurred but not yet paid |
| Accrued Revenue | Earned but not yet received |
Two Main Groups
- Deferrals (Prepayments): Prepaid expenses and unearned revenue.
- Accruals (Unrecorded): Accrued expenses and accrued revenue.
8. Closing Entries
Why They Are Needed
- Financial statements are for a specific period.
- Temporary accounts should not keep accumulating forever.
Purpose
- Reset income and expense accounts to zero.
- Transfer profit or loss into owner’s capital.
Temporary Accounts
- Revenue
- Expenses
- Drawings
Permanent Accounts
- Assets
- Liabilities
- Owner’s Capital
Flow of Information
Income/Expenses → Profit and Loss Summary → Owner’s Capital
9. Financial Statements
The Balance Sheet
Also called the Statement of Financial Position.
Reports
- Assets
- Liabilities
- Equity
- At a specific point in time
Equation
Assets = Liabilities + Equity
Formats
- Narrative (Vertical): The preferred format.
- Account (Horizontal): Side-by-side layout.
Statement of Profit or Loss
Also called the Income Statement or Statement of Financial Performance.
Formula
Profit = Income – Expenses
Rules
- If Income > Expenses, it is a Profit.
- If Income < Expenses, it is a Loss.
Time Focus
Covers a specific period of time.
Statement of Changes in Equity
Shows the movement in equity, including:
- Opening capital
- Plus profit
- Minus drawings
- Closing capital
Formula
Closing Capital = Opening Capital + Profit – Drawings
10. Ratio Analysis
| Ratio | Formula | Meaning |
|---|---|---|
| Return on Assets (ROA) | Profit / Average Total Assets | Profit generated per dollar of assets |
| Profit Margin | Profit / Net Sales | Profit generated per dollar of sales |
| Current Ratio | Current Assets / Current Liabilities | Liquidity; rule of thumb is often 1.5:1 |
| Debt to Total Assets | Total Liabilities / Total Assets | Percentage of assets financed by creditors |
| Cash Debt Coverage | Net Cash from Operations / Average Total Liabilities | Ability to generate cash for long-term obligations |
Interpretation Tips
- Higher ROA: Generally better.
- Higher Profit Margin: Generally better.
- Higher Current Ratio: Better short-term liquidity.
- Higher Debt Ratio: Greater financial risk.
- Cash Debt Coverage: Below 0.2 may be concerning.
11. Manufacturing Costs
Three Classes of Manufacturing Costs
| Cost Type | Meaning | Examples |
|---|---|---|
| Direct Materials | Raw materials directly traceable to product | Flour, steel, timber |
| Direct Labour | Labour directly traceable to product | Bakers, furniture factory workers |
| Manufacturing Overhead | Indirect manufacturing costs | Indirect materials, indirect labour, factory depreciation, insurance, maintenance |
Key Concept
Manufacturing costs are the costs of converting raw materials into finished goods.
12. CVP Analysis
Main topics include contribution margin, break-even point, margin of safety, and target profit.
Core Formulas
- Contribution Margin: Sales – Variable Costs
- CM per Unit: Selling Price per Unit – Variable Cost per Unit
- Break-even Units: Fixed Costs / CM per Unit
- Break-even Sales: Fixed Costs / CM Ratio
- CM Ratio: Contribution Margin / Sales
- Target Profit (Units): (Fixed Costs + Target Profit) / CM per Unit
- Margin of Safety: Actual Sales – Break-even Sales
13. Professional Ethics
Five Fundamental Principles
| Principle | Meaning |
|---|---|
| Integrity | Be honest and straightforward |
| Objectivity | Avoid bias, conflict of interest, or undue influence |
| Competence and Due Care | Maintain skills and act diligently |
| Confidentiality | Protect information gained through professional work |
| Professional Behaviour | Comply with laws and avoid discrediting the profession |
14. Independence
Independence of Fact (In Mind)
A state of mind that allows professional judgment without improper influence.
Independence in Appearance
Avoid situations where a reasonable third party would think integrity, objectivity, or skepticism has been impaired.
15. Sustainability Reporting
Why Companies Report Sustainability
- Investor Demand: Provides a fuller picture of risks and opportunities.
- Reputation: Builds trust and protects brand image.
- Regulation: Increasing disclosure requirements globally.
- Risk Management: Highlights climate, supply chain, and social risks.
16. Scope 1, 2, and 3 Emissions
| Scope | Meaning | Memory Aid | Examples |
|---|---|---|---|
| Scope 1 | Direct emissions from owned/controlled sources | Burn | Company vehicles, factories |
| Scope 2 | Indirect emissions from purchased energy | Buy | Electricity used by office/facility |
| Scope 3 | All other indirect value chain emissions | Beyond | Supply chain, waste, employee commuting |