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Pre- master A&C - Samenvatting Financial Accounting 2
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Volledige samenvatting van Financial Accounting 2 pre- master A&C
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Summary: Financial Accounting 2Lecture 1
ACCOUNTING: THE LANGUAGE OF BUSINESS
Initially we are going to talk about accounting as a language of business. Our agenda is to talk about
the introduction, the IFRS framework and users of that accounting information and talk about the
qualitative characteristics of the framework before proceeding how the financial statements link
together and what is the basics accounting process we need to follow in order to put together those
financial statements and then look at some specific topic such as inventories, adjusting entries and
depreciation and creation profit in particular.
Business in general uses a cash pump entity. A ‘cash pump’ cycle = generic representation of the
activity of any business. In the figure below, the cash pump cycle is shown. The flow of cash is shown
by arrows pointing left (blue) and the flow of resources, goods or services by arrows pointing right
(red). Resources are obtained from the markets these are transformed into services and products
(value proportion and goods/services) that we sell to our customers from which we may or not may
receive cash at the moment of the sale. When we receive cash we use this cash in order to pay our
suppliers go out in the market buy new resources and start over with our business cycle. This is the
generic business model that one could use schematically in order to describe the function of any
business entity.
Figure: The generic business model is a ‘cash pump’ cycle
Within the model Accounting = information system that measures, processes and communicates
information about an economic entity. When we talk about accounting, two main streams are divided
financial accounting and managerial accounting. However our focus is on financial accounting, that has
to do with the external reporting of information to users of accounting information. Information that
is relevant for those users in order to make decisions whether they are going to invest or not in a
business entity. Therefore very important for a business entity in order to be in a position to attract
funds and finance themselves and therefore grow and further develop their product and services. It is
also a form for the management of any business entity to discharge there account ability to the owners
of the capital; the people that have put their money in the business in order to finance those
operations.
• Financial accounting: external disclosure, contains information for making an evaluating
decisions. Many users, with the shareholders as most important ones.
• Managerial accounting: internal disclosure, concerns about (financial) information provision
to the management of a company, with the intention of making decisions and controlling the
business process.
When we talk about users of financial information there are quite a view users with differences in
expectations and no hierarchy of users (but focus on shareholders) as you can see in the figure below.
Schematical owns potential users of that information disclosed in the financial statements. However
the IFRS and the border responsible for reaching the IFRS (the called IAB) is putting enfaces on creditors
and investors from those users. Basically indicating that if the needs of those primary users are service
than the needs of all other users are going to be service as well. Therefore mentioned primary users
by accounting information we talk about investors and creditors. Investors such as shareholders of a
business entity, investors that provide information to interest parties that may or may not be available
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,in the public domain that can be corporate together with all other public available information in order
to provide advice whether we should invest or not in a business. And of course when we talk about
creditors we refer to financial institutions that are lending us money and also suppliers that have
provided us with their inventories of merchandise to sell and we need to repay them in the short term.
Of course other users that are also particular interested is the management of the business and that is
focusing on every day running of the business and as mentioned earlier also discarded the
accountability to the information provided in the financial statements. And we talk about employers
such as work council and labor unions and other employees representatives. customers who are
interested into final products and services and would like to sequent notedly in the operations of the
business. And the competitors in the industry and also the government in the form of regulatory
agencies and tax authorities. And of course the general public. But as I mentioned before primary users
whose needs should be serviced are the investors and creditors and these are the main the main
individuals that should be serviced by the financial statements of a business entity and IFRS.
Figure: A set of financial accounting users
IFRS are financial guidelines and the number behind it describes a certain financial department. IFRS
is in Europe required adopted for listed companies since 2005, for small companies the IAS rules of the
Netherlands are applied
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,Example: The story of Costas, a young merchant in Venice.
Step 1: The family of Costas has endowed him with 120 gold ducats. Costas invests 100 ducats in the
venture and lent 900 ducats by a banker.
First create a statement of financial position or called balance sheet as shown below. On the left you
see the assets owned by the business of Costas and we make a distinction between the business entity
and the owner himself, where the business entity is completely separated from the owner. So basically
what is shown on the asset side is what is owned by the business. On the right hand side you see the
liabilities and the shareholders equity.
Table: VC Wealth account step 1
On this time Costas company has 1000 ducats in cash in his hand, this is financed by Costas his own
funds/entity/capital of 100 ducats and also by a bank loan of 900 ducats. You can see that Costas his
capital is also called the net worth of the business and this is equal to the difference between the total
assets minus the total liabilities. The balance sheet as we going to see later is described based on that
fundamental information that total assets equal total liabilities plus equity. Subsequently we going to
describe what assets, liabilities and equity are as the residual claim between the total assets and total
liabilities, that is also why we are calling it the net worth of the business.
Step 2: Subsequently Costas uses the funds available in the business (1000 ducats) to by a ship and to
outfit and staff it, load with cargo and merchandise. So there has been an exchange of one from of an
asset (cash) to another form of asset (equipment etc.) of the same value with no change in net worth.
Below the balance sheet is show after this second step. The business owns now cash in hand of 10
ducats, cash in hand of captain for future wages and operating expenses of 150 ducats, inventory of
food and supplies on board (these are supplies/items that the business have with the purpose to utilize
them itself) of 330 ducats, the inventory of merchandise to be traded (the purpose to be resold to
make profit/gain for the business) of 350 ducats and fixed assets in the form of ship and equipment of
160 ducats. On the right side nothing changed.
Table: Wealth account 2 after step 2
Step 3: Costas sells one half of his ‘shares’ to a friend for 500 ducats. Therefore he receives a premium
of this half of the shares of 500-50=450 or 100/2=450,however this money is not put back into the
business so nothing changes as far as the business is concerned, the net worth of the busines remains
the same. However the not recorded personal wealth increases with 20+500=520. This new step is
integrated into the balance sheet below.
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, Table: Wealth account of VC 3
Step 4: 4 years later, the expedition returns with 3 ships. They sold the merchandise for 10,008 ducats
and the ships for 300 ducats. In addition they grant the bonus to the crew of 1,000 ducats, they pay
salaries of 150 ducats, they pay interest of 418 ducats to the banker from which they took a loan. To
summarize these transactions this is put into the income statement as shown below. The income
statement is tracking the performance (gain of loss) of the business in one accounting period.
Unfortunately most students are confused between expenses and whether some items have to be
recognized as assets or not; an expense is created through the consumption of an asset so the using
up of an assets that’s going to be and expense, an expense is recognized the moment I start to using
up/consuming the resource. So since there are consuming items below in the table they are recognized
as expenses. Interest expense is a typical expense that all loans or debts bears, the additional costs a
business carries when getting a loan. Impairment expense is because the ship has lost value (net book
value of original ship after wear and tear). Looking at the income statement total revenues minus total
expenses gives us the net income, however this doesn’t mean we have in our pocket 7,900 euros.
Because accounting is, and in particular the financial statements of the income statement (the stages
of equity in the balance sheet) are based on accruals and defers on the principle of marching revenues
to expenses that they had to create those revenues for in that point in time. The fact that those
revenues where recognized has to do with us losing control of the item to the customer, however this
does not mean the customer already paid us. This is also the case at expenses, we can make an expense
but not paid it yet; like using water in December but paying the bill in January. Therefore revenues are
positive elements of the income statement and expenses negative elements.
Table: Report on the activity of the Venture Costas for the 4 years of its activity
Step 5: So the income statement tells us about revenues, expenses and our profit. However it does not
tell us about how much cash we have at this moment. This has to be stated in the ending cash balance
as shown in the table below. In this table cash inflows (11,308) minus cash outflows (- 2,4081) is
described. However this is more a flow of funds rather than a cash flow statement.
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