# Comprehensive Study Notes: Accounting Concepts and Frameworks --- ## Conceptual Framework for Financial Reporting ### Key Benefits of a Conceptual Framework 1. **Communication**: Facilitates better communication between standard-setting bodies and stakeholders. 2. **Cost Efficiency**: Promotes economical development of accounting standards. 3. **Logical Foundation**: Provides a structured basis for developing specific accounting standards. --- ## General Purpose Financial Statements & Reporting Entities ### General Purpose Financial Statements - **Definition**: Financial statements designed to provide information useful for a wide range of users. - **Governance**: Governed by the conceptual framework. ### Reporting Entity - **Definition**: An entity required or electing to prepare financial statements, which may or may not be a legal entity. - **Structure**: - Could be a single entity, part of an entity, or multiple entities. --- ## Objectives of General Purpose Financial Reporting ### Primary Goal - **Purpose**: To provide financial information about the reporting entity that is useful for existing and potential investors, lenders, and other creditors in decision-making. --- ## Qualitative Characteristics of Financial Information ### Fundamental Characteristics 1. **Relevance**: - **Definition**: Information must have predictive value and confirmatory value (feedback value). - **Materiality**: Information is material if omitting or misstating it could influence decisions made by users. For instance, a $1,000 error in a small business's financial report might be material, but the same error in a multinational corporation's report may not be. 2. **Faithful Representation**: - **Definition**: Information must accurately represent what it purports to represent. - **Key Qualities**: - **Completeness**: All necessary information is included. - **Neutrality**: Free from bias. - **Free from Error**: As accurate as possible. Many students confuse faithful representation with perfection. Faithful representation does not mean error-free but rather that the information is reliable and unbiased. 3. **Prudence**: - **Definition**: Exercise caution under uncertainty to avoid overstating assets/income or understating liabilities/expenses. ### Balancing Relevance and Faithful Representation - **Trade-offs**: Sometimes, a balance is required between relevance and faithful representation. If one characteristic is severely lacking, the information should not be provided. ### Enhancing Qualitative Characteristics 1. **Comparability**: Enables users to compare financial information across periods and entities. 2. **Verifiability**: Independent observers should be able to verify the information. 3. **Timeliness**: Information must be available in time for decision-making. 4. **Understandability**: Information should be clear and accessible to users. --- ## Elements of Financial Accounting ### Five Essential Elements 1. **Assets**: Resources controlled by the entity, resulting from past events, expected to bring future economic benefits. 2. **Liabilities**: Present obligations to transfer economic resources due to past events. 3. **Equity**: Residual interest in assets after liabilities are deducted. - **Formula**: $Equity = Assets - Liabilities$ 4. **Income**: Increases in assets or reductions in liabilities that result in equity increases (excluding contributions from equity holders). 5. **Expenses**: Decreases in assets or increases in liabilities that result in equity reductions (excluding distributions to equity holders). --- ## Recognition and Measurement of Financial Elements ### Recognition Criteria For an element to be recognized in financial statements: 1. It must meet the definition of an asset or liability. 2. It must be relevant and provide a faithful representation. 3. It must be measurable with sufficient reliability. ### Measurement Bases - **Historical Cost**: Original purchase price. - **Current Value**: - **Fair Value**: Market price. - **Value in Use**: Present value of future cash flows from the asset. - **Fulfillment Value**: Cost to settle a liability. - **Current Cost**: Replacement cost. The IASB supports using multiple measurement bases to suit different asset/liability types, ensuring the selection reflects qualitative characteristics and the cost-benefit constraint. --- ## Accounting Equation ### Basic Accounting Equation $$Assets = Liabilities + Owners' Equity$$ ### Extended Accounting Equation $$Assets + Expenses = Liabilities + Owners' Equity + Revenue$$ Where: - $A$ = Assets - $E$ = Expenses - $L$ = Liabilities - $OE$ = Owners' Equity - $R$ = Revenue --- ## Double Entry System ### Key Principles 1. **Debit (Dr)**: Always on the left side of an account. 2. **Credit (Cr)**: Always on the right side of an account. 3. **Golden Rule**: For every debit, there must be an equal and corresponding credit. ### Normal Balance of Accounts - **Assets**: Debit increases, Credit decreases. - **Liabilities**: Credit increases, Debit decreases. - **Owner’s Equity**: Credit increases, Debit decreases. - **Revenue**: Credit increases, Debit decreases. - **Expenses**: Debit increases, Credit decreases. --- ## Accounting Process ### Steps in the Accounting Cycle 1. **Source Documents**: Identify and record transactions (e.g., invoices, receipts). 2. **Journal Entries**: Record transactions in the journal. 3. **Posting to Ledger**: Transfer journal entries to ledger accounts. 4. **Trial Balance**: Ensure total debits equal total credits. 5. **Balance Day Adjustments**: Adjust for prepaid expenses, accrued expenses, unearned revenue, and accrued revenue. 6. **Adjusted Trial Balance**: Update trial balance after adjustments. 7. **Prepare Financial Statements**: Create the income statement, balance sheet, and cash flow statement. 8. **Closing Entries**: - Debit income accounts and credit the Income Summary account. - Credit expense accounts and debit the Income Summary account. - Debit the Income Summary account and credit Retained Earnings. - Debit dividends account and credit Retained Earnings. Example of Closing Entries: - Debit Sales $10,000 - Credit Expenses $6,000 - Final Transfer: Debit Income Summary $4,000 and credit Retained Earnings $4,000. --- ## Inventory Management ### Definition of Inventories (NZ IAS 2 Para 6) Inventories are assets that are: 1. Held for sale in the ordinary course of business. 2. In the process of production for sale. 3. Materials or supplies to be consumed in production or service rendering. ### Inventory Systems 1. **Periodic Inventory System**: - Updates inventory only after a physical count at specific intervals. - **COGS Formula**: $$COGS = Opening Inventory + Purchases - Closing Inventory$$ 2. **Perpetual Inventory System**: - Continuously updates inventory records for each purchase and sale. - **Accounts Used**: - Inventory (Asset) - Freight Inwards (Expense) - Cost of Goods Sold (Expense) - Sales (Income) - Sales Returns and Allowances (Contra-Sales) Example Transaction in Perpetual System: - Purchased Inventory (10 units at $100 each, GST exclusive): $$Dr \ Inventory \ 1,000 \quad Dr \ GST \ 150 \quad Cr \ Accounts \ Payable \ 1,150$$ --- ## Key Takeaways - The conceptual framework ensures consistency and reliability in financial reporting. - Qualitative characteristics like relevance and faithful representation are essential for useful financial information. - The accounting equation forms the foundation of all financial transactions. - Inventory systems differ in how they track and update inventory records. - The double-entry system ensures accuracy and balance in accounting records. Practice journal entries and trial balance preparation to strengthen your understanding of the accounting cycle.