Accounting for managers

1
Accounting for managers

• An introduction to financial accounting
• doc. dr. Aljoa Valentincic

2
The Recording Process

• Accounting records
• Previously, we used a spreadsheet to record
  accounting events
• Each row represented one account
• Difficult to do this in practice
• Ledger-based accounting used instead
• source documents ? journal, ledger ? trial
  balance
• trial balance ? actual financial statements

3
General Ledger, Ledger Accounts

• An account record that summarises in monetary
  terms all transactions and events which affected
  a particular asset, liability or OE
• Original idea every page of the ledger assigned
  to each account
• General ledger (glavna knjiga) collection of
  account pages
• It has two important properties
• Its expandable as companys operations change,
  recordings of this must also change
• Detailed referencing system - chart of accounts
  (kontni nacrt)

4
T-Accounts, Debits and Credits

• All ledger accounts have a two-column format!
• Convention
• increases in asset accounts recorded in left-hand
  column
• increases in liabilities and owners equity
  accounts recorded in right-hand column
• This is a convention theres no other way to
  remember this but to memorise it.

5
The Balance Sheet and T-Accounts (1)

• Remember the basic accounting equation
• Assets (A) Equities (LOE)
• Assets increase on left-hand side (debit),
  decreases on right-hand side (credit)
• Liabilities and OE increases on right-hand side
  (credit), decreases in left-hand side (debit

6
The Balance Sheet and T-Accounts (2)

• Why are movements in equities accounts exactly
  the opposite of movements in assets accounts?
• Assets (A) Equities (LOE)
• Assume a company is just formed and is financed
  by 50 bank loan and 50 equity
• Remember Balances of all assets accounts must
  agree in total with balances of all equities
  accounts!
• equities liabilities owners equity

7
The Income Statement and T-Accounts

• Same convention applies to income statement
  accounts
• Essentially, there are only two income statement
  accounts
• Revenues increase OE and are therefore on RHS
  column of the revenue account
• Expenses decrease OE and are therefore on LHS of
  the expense account!

Corrections, adjustments and closing entries only!
8
The Journal and Journal Entry

• General ledger accounts by type, regardless of
  date
• Journal (dnevnik) accounts by time, regardless
  of type
• Journal entry
• at least two accounts are affected
• the amounts debited must equal the amounts
  credited, on an individual entry and after
  grouping together many transactions (e.g. total
  of a days sales)
• Each entry contains date of transaction,
  accounts affected and their code numbers, the
  effect of transaction on those accounts, by
  amount and direction (Dr., Cr.)
• debit left-hand side, credit right-hand side!

9
An Example of a Journal Entry

• Example of journal entry
• Sale on account of goods worth 5.000 EUR to Janko
• Receive payment from Metka for goods she bought
  30 days ago for 3.000 EUR

10
An Example of a Journal Entry

• Example of journal entry
• Sale on account of goods worth 5.000 EUR to Janko
• Receive payment from Metka for goods she bought
  30 days ago for 3.000 EUR

11
The Trial Balance

• Trial balance is a listing of balances in all
  general ledger accounts as of a particular day
• Entries in Dr. (LHS) column summed, entries in
  Cr. (RHS) column summed
• Difference
• Net debit balance (asset accounts) ? debit column
  of trial balance
• Net credit balance (L and OE accounts) ? credit
  column of trial balance
• Why do it? To check for errors in book-keeping
  but
• Of course if the totals agree, this is no
  guarantee the books are error-free!

12
Example of a Trial Balance

• These two must agree in total!

13
An Example Oblak, d.d.

• Jezikovna ola Oblak, d.d. (Language School Cloud
  plc)
• the company is already incorporated
• has done some business in Year 1
• we start with Year 2 ? we need history of Oblak,
  d.d.
• stored in Oblak, d.d., balance sheet at end of
  Year 1

14
Open New Accounts in the Ledger
Liabilities
Owners Equity
Assets
15
Open New Accounts in the Ledger
Liabilities
Owners Equity
Assets
16
We will now

• Go through a set of business transactions
• Record them in the journal
• Transfer these entries to appropriate ledger
  accounts
• Similar to the way things are done in reality

17
J1

• 1. The company wants to expand. Before buying new
  equipment it issues new shares to investors in
  mid-year 2 for 10.000 in cash and borrows 15.000
  from bank. The loan is one year and interest 12
  payable when loan matures.
• Journal entry J1
• Dr. Cash (Asset) 25.000
• Cr. Share capital (OE) 10.000
• Cr. Bank loan (Liabilities) 15.000

18
Liabilities
Owners Equity
Assets
19
J2

• 2. The company invests the cash raised in new
  equipment costing 25.000
• Journal entry J2
• Dr. Equipment (A) 25.000
• Cr. Cash (A-) 25.000

20
Liabilities
Owners Equity
Assets
21
J3

• 3. Company earns 80.000 in fee revenue for
  language courses during the year. Companies that
  sponsor students (35.000 of revenues) are granted
  a credit period of 30 days before the payment is
  due. Non-sponsored students (45.000) must pay in
  cash when they register for the course.
• Journal entry J3
• Dr. Accounts receivable(A) 35.000
• Dr. Cash (A) 45.000
• Cr. Revenue from tuition fees(OE) 80.000

22
Liabilities
Owners Equity
Assets
23
J4

• 4. The company buys 6.000 of supplies on account
  during year 2
• Journal entry J4
• Dr. Supplies inventory (A) 6.000
• Cr. Accounts payable (L) 6.000

24
Liabilities
Owners Equity
Assets
25
J5

• 5. Company receives 32.000 from other companies
  in payment of amounts owing for their employees
  tuition fees. Of this amount 6.000 relates to
  year 1 fees and 26.000 to year 2 fees.
• Journal entry J5
• Dr. Cash (A) 32.000
• Cr. Accounts receivable (A-) 32.000

26
Liabilities
Owners Equity
Assets
27
J6

• 6. The company pays 5.000 to suppliers. Of this
  amount 2.000 is in payment of year 1 credit
  purchases and 3.000 in payment of year 2 credit
  purchases.
• Journal entry J6
• Dr. Accounts payable (L-) 5.000
• Cr. Cash (A-) 5.000

28
Liabilities
Owners Equity
Assets
29
J7

• 7. Payments by the company for salaries in year 2
  amount to 47.000. Salaries are paid monthly and
  the final payment is 24 December.
• Journal entry J7
• Dr. Salary expense (OE-) 47.000
• Cr. Cash (A-) 47.000

30
Liabilities
Owners Equity
Assets
31
J8

• 8. The costs of telephone, electricity and water
  total 7.000 in year 2 and all bils are paid by
  the year-end.
• Journal entry J8
• Dr. Utilities expense (OE-) 7.000
• Cr. Cash (A-) 7.000

32
Liabilities
Owners Equity
Assets
33
J9

• 9. In September, the company launches a
  nine-month three-term language course, to tun
  from October Year 2 to end of June Year 3.
  Students have the option of paying for the whole
  course in advance at a discounted price. The
  company receives 18.000 by early October as
  advance payment for the course.
• Journal entry J9
• Dr. Cash (A) 18.000
• Cr. Unearned fee revenue (L) 18.000
• Unearned fee revenue why is this a liability?
• present obligation of Oblak, d.d., to students to
  provide future services
• arises from a past transaction (students have
  paid)
• it will involve sacrifice of assets (teachers,
  classrooms,) of known amount

34
Liabilities
Owners Equity
Assets
35
J10

• 10.At the beginning of November, the company
  invests 24.000 in short-term securities. This is
  cash which is surplus to its operating needs. The
  securities bear interest at an annual rate of
  10. Interest is receivable on maturity on 1 May
  year 3.
• Journal entry J10
• Dr. Short-term investment (A) 24.000
• Cr. Cash (A-) 24.000

36
Liabilities
Owners Equity
Assets
37

• Now
• Total the debit and credit side of each ledger
  account
• Determine the provisional balance of each account
• Transfer net debits to debit column of trial
  balance and net credits to credit column of trial
  balance

38
Liabilities
Owners Equity
Assets
39
Initial trial balance at 31 December Year
2Jezikovna ola Oblak, d.d.
40
To Finish Up the Recording Process

• Each of the transactions recorded so far was a
  consequence of interaction between Oblak, d.d.,
  and another entity (e.g. banks, employees,
  customers,)
• Accounting events - do not involve exchanges with
  parties outside the firm, but
• give rise to revenues and expenses
• cause changes in assets and liabilities
• We must adjust the accounts for these events -
  accrual adjustments

41
The Accrual Basis of Accounting

• Accrual basis of accounting recognition of
  accounting effect of a transaction or event when
  it occurs (may not be the same as when cash is
  paid/received)
• Rests on two basic guidelines or principles
• the decision when to recognise revenues (revenue
  realisation principle, also timing principle)
• costs of generating these revenues (i.e.,
  expenses) must be recognised at the same time
  (matching principle)
• Additionally going-concern assumption
• The aim is that a companys financial statements
  should reflect all transactions and events which
  have an economic impact on the company in a
  certain period.

42
Revenue Recognition

• Operating cycle of a company
• In principle, a firm might recognise revenue at
  any of these points, but
• IASB conditions to recognise revenue
• The company is expected to receive economic
  benefits from the transaction and
• It can measure reliably the revenues from the
  transaction and related costs AND
• It has transferred significant risks and rewards
  of ownership to the buyer
• Examples manufacturing, construction,
  shipbuilding, real estate

43
Revenue Recognition and Accounting Manipulations?

• A major source of accounting manipulations

44
Expense Recognition

• In principle, companies must match the costs
  incurred with the generation of recognised
  revenue
• But exact matching is often difficult ?
  approximations
• manufacturing companies would match production
  costs with units of goods sold, but
  non-production costs are often matched on a time
  basis
• note that what is in the selling costs bundle
  might include similar elements as manufacturing
  costs (e.g., depreciation)
• Also note that approximations open door for
  manipulation
• see Burgstahler and Dichev (1997) for public and
  Garrod, Ratej Pirkovc and Valentincic (2006) for
  private firms

45
Prudence Principle - Conservatism

• An expense recognised as soon as a liability is
  incurred or a potential loss sustained
• But revenues, gains, , are only recognised when
  they meet the criteria set before
• If prudence and matching principles conflict the
  precedence is usually given to prudence
• Despite recent moves away from conservative
  accounting, there is a strong market demand for
  this property of accounting

46
Accrual Adjustments

• We adjust the accounts produced from transactions
  with external parties for accounting events.
  Remember
• they do not involve exchanges with outside
  parties, but
• give rise to revenues and expenses
• cause changes in assets and liabilities
• Adjusting entries are of two types
• Passage-of-time adjustments
• Expiry-of-asset/liability adjustment

47
Passage-of-Time Adjustments (1)

• Borrowing
• Interest on debt outstanding (cost of borrowing)
  is incurred every day, but is usually paid at
  longer intervals (monthly, half-yearly,)
• The cost mounts up day by day and has to be
  accounted for
• Expense ? liability (e.g., Accrued unpaid
  interests)
• Lending
• Interest on loan is earned on a daily basis, but
  received only in intervals
• Revenue builds up day by day and has to be
  accounted for
• Revenue ? asset (e.g., Accrued interest
  receivable)

48
Passage-of-Time Adjustments (2)

• Example On 31st October year 5 company L lends
  company B 15.000 EUR for one year. Interest rate
  is 12 p.a. and will be received at the time of
  loan repayment.
• What does L register in year 5?
• On 31.10.
• Dr. Short-term investment (or loan receivable)
  (A) 15.000
• Cr. Cash (A-) 15.000
• On 31.12. - adjusting entry!!!
• Dr. Accrued interest receivable (A) 300
• Cr. Interest revenue (OE) 300

(2/12)1215.000300 EUR
49
Passage-of-Time Adjustments (3)

• What does L register in year 6?
• On 31.10.
• Dr. Cash (A) 15.000
• Cr. Short-term investment (A-) 15.000
• Dr. Cash (A) 1.800
• Cr. Interest revenue (OE) 1.500
• Cr. Accrued interest receivable (A-) 300
• Similar adjustments must be done for other
  time-based expenses (e.g., wages earned, but not
  paid).

1215.0001.800 EUR
50
Expiry-of-Asset/Liability Adjustments (1)

• Resources that yield benefits over several
  financial periods (e.g., equipment, prepaid rent,
  ) generate services in each of these periods and
  are consumed over their entire useful life
• In each period the services rendered have to be
  valued. Therefore
• asset ? expense
• similarly,
• liability ? revenue

51
Expiry-of-Asset/Liability Adjustments (2)

• Example In April year 8 company R rents (?gives
  them the right to occupy) a building to company T
  for one year, lease commences May 1st. Company T
  pays 24.000 in advance.
• What does R register in year 8?
• On 30. April Year 8
• Dr. Cash (A) 24.000
• Cr. Unearned rental revenue (L) 24.000
• Note NO revenue recognised by R in April, but
  we know today it has an obligation to provide
  future services.

52
Expiry-of-Asset/Liability Adjustments (3)

• What does R register in year 8?
• As company R renders services to company T
  from the 1st of May, it can recognise revenues.
• On 31. May Year 8 (adjusting entry)
• Dr. Unearned rental revenue (L-) 2.000
• Cr. Rental revenue (OE) 2.000
• On 30. June Year 8 (adjusting entry)
• Dr. Unearned rental revenue (L-) 2.000
• Cr. Rental revenue (OE) 2.000
• and so on...

53
Expiry-of-Asset/Liability Adjustments (4)

• What does R register in year 8 - alternative
  treatment
• 30. April Year 8
• Dr. Cash (A) 24.000
• Cr. Rental revenue (OE) 24.000
• 31. December Year 8(adjusting entry)
• Dr. Rental revenue (OE-) 8.000
• Cr. Unearned rental revenue (L) 8.000
• Alternative treatment
• record initial cash receipt as revenue and adjust
  the revenue account for the unexpired portion of
  liability
• record initial cash outlay as expense and adjust
  the expense account for the unexpired portion of
  asset

54
Expiry-of-Asset/Liability Adjustments (5)
Company R 30.4. Year 8 Dr. Cr. Dr.
Cash 24 Cr. Unearned revenue 24 31.12.
Year 8 (adj. Entry) Dr. Unearned revenue 16 Cr.
Rental revenue 16 30. 4. Year 9 Dr.
Unearned revenue 8 Cr. Rental revenue
8
Company T 30.4. Year 8 Dr. Cr. Dr. Prepaid
rent 24 Cr. Cash 24 31.12.
Year 8 (adj. Entry) Dr. Rent expense 16 Cr.
Prepaid rent 16 30. 4. Year 9 Dr. Rent
expense 8 Cr. Prepaid rent
8
55
From Trial Balance to Financial Statements

• Jezikovna ola Oblak, d.d., - trial balance at
  31. Dec. Year 2

56
Determine Provisional Balances (PBs) of Every
Ledger Account
Liabilities
Owners Equity
Assets
57
Adjusting Entry 1 (A1)

• 1.Interest on short-term securities the company
  acquired in early November of year 2 accrues at
  an annual rate of 10 or 200 a month, but company
  doesnt receive any interest until end of April
  year 3. Therefore it records the interest earned
  in November and December as a receivable.
• Journal entry A1
• Dr. Accrued interest receivable (A) 400
• Cr. Interest revenue (OE) 400

58
Entries in the Ledger
Liabilities
Owners Equity
Assets
59
A2

• 2. On inventory count on 31st of December the
  company that only 3.000 of 7.000 of supplies
  remain in stock. The company has therefore
  consumed 4.000 EUR worth of supplies. It records
  this as an expense.
• Journal entry A2
• Dr. Supplies expense (OE-) 4.000
• Cr. Supplies inventory (A-) 4.000

60
Liabilities
Owners Equity
Assets
61
A3

• 3. The company paid 16.000 EUR for two years
  rent of its premises at the start of year 1. Half
  of the asset Prepaid rent expired in year 1,
  now the remaining part has expired as well.
• Journal entry A3
• Dr. Rent expense (OE-) 8.000
• Cr. Prepaid rent (A-) 8.000

62
Liabilities
Owners Equity
Assets
63
A4

• 4. Year 2 depreciation of equipment it has bought
  in year 1 for 10.000 EUR. Additionally, it
  recognises the depreciation of equipment it
  bought in year 2 for 25.000 EUR. Both types have
  an expected life of 5 years and are consumed
  equally each year. Because it had bought the
  second equipment during year 2, it only charges
  one half on a yearly depreciation (mid-year
  convention).
• Journal entry A4
• Dr. Depreciation expense (OE-) 4.500
• Cr. Equipment (A-) 4.500

4.5002000(1/2)5000
64
Liabilities
Owners Equity
Assets
65
A5

• 5. The company borrowed 15.000 from the bank on
  July 1st year 2 for one year. By December 31st it
  has used the money for 6 months. The loan bears
  12 interest, payable on maturity. The company
  has incurred an expense and a liability for
  unpaid interest of 900 by end of year 2.
• Journal entry A5
• Dr. Interest expense (OE-) 900
• Cr. Accrued interest payable (L) 900

9006115.000
66
Liabilities
Owners Equity
Assets
67
A6

• 6. In early October year 2 the company received
  in advance 18.000 of tuition fees for a nine
  month language course. By end of December, the
  company has earned 3 months worth of fees -
  6.000 of the total liability of 18.000 of
  services it has to provide have expired
• Journal entry A6
• Dr. Unearned fee revenue (L-) 6.000
• Cr. Revenues from fees (OE) 6.000

68
Liabilities
Owners Equity
Assets
69
A7

• 7. The last salary payment date of year 2 was
  24th of December. The companys financial year
  does not end until the 31st. Employees earn their
  salaries also in this last week, so the company
  must accrue the cost of services they perform in
  that period. Its monthly wage bill is around
  4.000, so the company has to recognise an expense
  and a liability of EUR 1.000 salaries earned but
  not paid in the last week of year 2.
• Journal entry A7
• Dr. Salaries expense (OE-) 1.000
• Cr. Accrued salaries payable (L) 1.000

70
Liabilities
Owners Equity
Assets
71
Four Types of Adjustments Done

• asset ? expense (consumption of asset)
• depreciation, prepaid rent, supplies
• liability ? revenue (expiry of liability)
• revenue earned on prepaid tuition fees
• expense ? liability (passage-of-time adj.)
• interest and salaries incurred
• revenue ? asset (passage-of-time adj.)
• accrual of interest earned

72

• Now
• assume there are no errors any more
• determine the adjusted ending balances (EBs) in
  ledger accounts
• close the revenue and expense accounts

73
Liabilities
Owners Equity
Assets
74
Liabilities
Owners Equity
Assets
75
Calculate Closing Entries

• Calculate closing entries
• Year 2 revenue accounts (C1)
• Dr. Revenue from tuition fees 86.000
• Dr. Interest revenue 400
• Cr. Profit or loss in year 2 86.400
• (NEW BALANCE SHEET ACCOUNT!)
• Year 2 expenses accounts (C2)
• Dr. Profit or loss in year 2 72.400
• (NEW BALANCE SHEET ACCOUNT!)
• Cr. Salary expense 48.000
• Cr. Utilities expense 7.000
• Cr. Depreciation expense 4.500
• Cr. Supplies expense 4.000
• Cr. Rent expense 8.000
• Cr. Interest expense 900

76
Liabilities
Owners Equity
Assets
77
Liabilities
Owners Equity
Assets
78
Final Financial Statements Income Statement

• Jezikovna ola Oblak, d.d.
• Annual accounts for year 2
• Income statement for year 2 (1 January to 31
  December)

79
Final Financial Statements The BS

• Jezikovna ola Oblak, d.d.
• Annual accounts for year 2
• Balance sheet at 31 December year 2

80
Where Are We Going?

• Introduction / Balance sheet
• Income statement and link with balance sheet
• Recording process
• Accrual basis of accounting
• We now have covered all technicalities
• Can now proceed with some individual groups of
  accounts