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The academic 'accounting framework' definitions

Assets: probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

Liabilities: probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decrease of liabilities that result in increases in equity, other than those relating to contributions from equity participants. The definition of income encompasses both revenue and gains, and revenue arises in the course of ordinary activities of an enterprise and is referred to by different names, such as sales, fees, interest, dividends, royalties and rent.

Expenses are decreases in economic benefits during an accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. Thus the characteristics of expenses include the following:

1 sacrifices involved in carrying out the earnings process;

2 actual or expected cash outflows resulting from ordinary activities;

3 outflows reported gross.

Bookkeeping examples

The following example (Table 4.2) sets out how business transactions would be recorded under a system of double-entry bookkeeping.

TABLE 4.2 Record keeping for one day of trading

Record keeping for one day of trading

You'll either like or be confused by the 'simplicity' of the approach. Lecturing to Chartered Accountancy students years ago, I would estimate that 25 per cent understood first time what the routine was, 50 per cent would practise (it is a very practical subject) and 25 per cent would struggle for ever more, my joke being that this 25 per cent presumably worked in tax departments.

The end product is the balance sheet and P&L account (Table 4.3) -simple enough!

TABLE 4.3 Records for a period of trading for a manufacturer

Balance sheet

EBB

Cash

650

Sales 600

Costs (350)

Capital

650

Profit 250

Table 4.4 shows a more sophisticated example illustrating the capturing and classification of everyday business events for a business that makes aluminium window frames.

TABLE 4.4 Manufacturer starts with cash invested and buys machine and stock - put straight into cost of sales. Further materials for production are purchased on credit

Manufacturer starts with cash invested and buys machine and stock - put straight into cost of sales. Further materials for production are purchased on credit

Everyone learns in their own way, so do study this in detail if you wish, but Ed suggest that an executive review would be in order. The idea is to confirm to you the simplicity but robustness of bookkeeping, which leads to records of how a business has performed (the P&L account) and where the business stands (the balance sheet).

The business starts with a 50,000 investment of cash in exchange for the shareholders holding 50,000 shares. The company then spends money on a machine (a fixed asset) and materials (a cost of what will be sold, ie window frames).

More cash is spent on paying wages, renting premises and electricity (Table 4.5); for clarity, these are the only P&L costs incurred.

TABLE 4.5 Further sums are spent on production wages, rent and electricity for manufacturing

Further sums are spent on production wages, rent and electricity for manufacturing

Products are manufactured and sold (Table 4.6): 7,000 for cash, which goes straight into the bank, and 27,000 to debtors as receivable in the future.

TABLE 4.6 Products have been made and are sold for cash or on credit

Products have been made and are sold for cash or on credit

Finally, adjustments are made for the fact that all cost-of-sales materials were not consumed in the period and the machine is wearing out, or has been consumed in the period (Tables 4.7 and 4.8).

TABLE 4.7 Not all materials are used - there is stock left over

Not all materials are used - there is stock left over

TABLE 4.8 The machine is depreciated as it wears out

The machine is depreciated as it wears out

Note that the rent cost is split. The significance is to correctly cost the rental cost component of each item produced as opposed to the general office overhead costs. The strategic significance of this allocation is that you need to know the 'true' cost of products and separately the overhead burden. These relationships are explored further in Chapter 9. From a reporting viewpoint, the factory rent goes in cost of sales and the office rent is treated as a general expense.

The strategic significance of the sales split is that immediate cash allows immediate reinvestment in more materials or machinery, whereas the debtors require funding, in this case largely coming from the original 50,000. As long as the stock or inventory is not damaged and holds its value, for example there has not been a collapse in world aluminium prices, the 1,500 of asset value is carried forward at the period-end.

This asset then returns to manufacturing costs in the next period - stock to be consumed, this being an example of the accruals or matching concept.

The machine was purchased for cash and sits in the balance sheet as an asset; however, it is being used or consumed. If we did nothing, in due course there would a worthless asset in the balance sheet. An estimate is made of the expected useful life, in this case five years, thus on the basis of expected equal usage the cost charged to each period's P&L account is 5,000.

The summing of balances in a 'trial balance' to check that the debits and credits do indeed balance is now a foregone conclusion (Table 4.9). What we need is the split and analysing of the figures into the P&L and balance sheet.

TABLE 4.9 A trial balance

Account number

Db

Cr

1001 Fixed asset

25,000

1091 Fixed asset - accumulated depreciation

5,000

2001 Stock

1,500

2010 Debtor

27,000

2020 Bank

11,700

3010 Creditor

4,500

4001 Capital

50,000

5001 Sales

34,000

6001 Materials

16,000

6010 Wages

4,000

6091 Depreciation charge

5,000

7001 Rent

2,500

7008 Electricity

800

Totals

93,500

93,500

In this simplified example nearly all costs are related to cost of sales or cost of production. There is thus a fairly low gross profit (Table 4.10).

TABLE 4.10 The P&L account

Profit & Loss account for the period ended

Sales

34,000

Cost of sales

Materials consumed

16,000

Wages

4,000

Depreciation

5,000

Rent

2,000

Electricity

800

27,800

Gross profit

6,200

Overheads

Rent

500

Net profit

5,700

The balance sheet balances as it ought to (Table 4.11)! This is a mystery to some, who assume that we accountants balance by simply inserting the P&L account retained amount of 5,700. Indeed all other figures can be checked - audited. We can look at the bank statement, check a list of debtor and creditors, and count stock.

TABLE 4.11 The balance sheet - statement of financial position

Balance Sheet as at

Tangible fixed asset - cost -

25,000

accumulated depreciation

5,000

Fixed assets - net book amount

20,000

Current assets

Stock

1,500

Debtors

27,000

Bank

11,700

40,200

TABLE 4.11 continued

The balance sheet - statement of financial position

It is the end results, the P&L account and balance sheet, which are important to managers, and if the process of getting there seems rather heavy handed or tedious, do not worry - presumably you can leave the bookkeeping to the accountants or 'bean counters'.

There is no such thing as 'just a figure'

The above examples show the operation of bookkeeping. Presumably you do not have to do this mundane task yourself, but the point is that executives should be aware that transactions are recorded and the oft-heard quote 'Don't worry, it's just a figure' is not a very good answer to anyone enquiring about figures in a report, particularly figures for which they are responsible. Many accountants seem to forget the tenets of double-entry bookkeeping and the fact that they ought to be able to trace any figure back to source. Even in today's paperless businesses, the operation of bookkeeping and internal controls (see below) mean that all figures ought to be traceable.

In recent frauds in banks and the financial sector it is the apparent surprise of directors and executives that money has disappeared without their knowledge that is so unbelievable (there has to be at least one half of the accounting entry or the accounts are full of 'just figures' - the whole thing is a fraud).

 
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