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More on Financial Accounting

ASSETS – FIXED, CURRENT and INTANGIBLE

In the example at the end of the previous section, we introduced the item ‘stock’ into the balance sheet. This is an example of an asset. To be regarded as an asset, something must fulfil these criteria:

It must be expected to have some future monetary value – so in the case of Jo’s stock material, it will have value in the future when it is turned into cards (or it could be sold on to another card maker)

It must be under the exclusive control of the business – if Jo uses cutting equipment from the Art department to make cards, then this is a resource used but not an asset in these terms.

The future benefit must be due to something that has already happened - in this case, material to make more cards has already been bought. Even if Jo has decided to buy some cutting equipment as soon as there is enough money in the business, it does not yet count as an asset. However as soon as she buys the equipment, even if she buys it on credit it does count – with a corresponding liability for the outstanding loan if it is a credit purchase.

It must be possible to quantify it in monetary terms – this is known as the Money Measurement Convention. Sometimes in big business, a value is put on such things as brand loyalty when trying to value a business for takeover, for example. However these estimates are fraught with difficulty.

Please view the Powerpoint Slides Assets.ppt which provide definitions of different types of assets.

Reading

You can read more about assets in Atrill and McClaney or your chosen textbook.

Activity

Draw up a list of assets which you could include on a balance sheet for your organisation, saying whether they are fixed or current , tangible or intangible. For the purposes of this exercise, imagine that your service is independent so that you do have exclusive control over the assets.

LIABILITIES – CURRENT AND LONG TERM (NON-CURRENT)

Liabilities are the other side of the coin to assets.

Please view the Powerpoint Slides Liabilities.ppt which provide definitions of liabilities.

Reading

You can read more about liabilities in Atrill and McClaney or your chosen textbook.

ACCOUNTING TERMS AND CONVENTIONS

Double Entry Bookkeeping, Debits and Credits

This is the method used to record the financial transactions of a business. Although it was devised in the 15thcentury, it is still the basis of computerised financial systems, so do not be misled by the term ‘bookkeeping’.

The principle of Double Entry Bookkeeping is that every financial transaction generates equal and opposite Debit (DR) and Credit (CR) entries (hence, ‘double entry’ – there are two entries for every transaction and ‘balancing the books’ – those entries are equal but opposite – that also explains the term ‘balance sheet’). But beware! The accounting definitions of debits and credits are not the same as everyday understanding of these terms.

The specific way accountants use the terms ‘debit’ and ‘ credit’ stems from what is sometimes called the Accountancy equation which is: Assets = Liabilities + Equity, where ‘Equity’ is the value invested and/ or built up in the business. (Obviously, this equation can be re-organised to Assets – Liabilities = Equity which means, in everyday terms, what you own less what you owe is the same as/equal to the value built up in the business).

When double-entry bookkeeping originated, the left-hand side of the equation (the Assets) was referred to as the debit side while the right-hand side (Liabilities and Equity) was called the credit side. Ever since then, accountants have confusingly referred to things that increase assets as ‘debits’ and things that increase liabilities as ‘credits’ – entirely the opposite of the ‘ common-sense’ understanding.

So when a business buys stock or equipment its assets (in this case, value of stock) increases so that is a debit (DR) which is matched by a fall in the bank balance recorded as a balancing credit (CR).

You may also come across the term ‘trial balance’, especially if you use a computerised system. This just means making sure that the books really do balance before they are ‘closed’ for the period in question. Originally this was literally transferring the balance into a new ledger for the new period or at least ‘ drawing a line’ under the entries for the old period so that no more entries could be added.

This is likely to be all you need to know about this subject. If you are a frequent user of a bookkeeping system then you will need training – or a good user manual – which will explain it in more depth.

Debtors and Creditors

This is something which often catches people out.

If you have money in the bank then you have an asset. Assets are usually indicated on accounts with a DR sign, as described above.

If you have a loan, or an overdraft, then this is a liability. These are indicated with a CR sign.

You will recall that negative amounts are often shown in brackets (). This can be true of any ‘contrary’ amount , so in a column of CRs any positive amount may been shown in brackets. This can happen where, for example, a refund has been made. You may therefore come across the terms ‘negative debit’ and ‘positive credit’ – but let us hope not!

A debtor is someone who owes you money.

A creditor is someone to whom you owe money.

But if you take a look at your bank statement, you will probably see that if you have £500 in your account at the end of the statement it will be shown with a ‘CR’ after it, whereas if you have borrowed money, the amount outstanding will be shown with ‘DR’ after it. This appears contrary to the statement above about debtors and creditors, and the definition of Debits and Credits. What you have to bear in mind is that the statement is being produced from the point of view of the bank. Therefore if there is money in your account, this is money which, in effect, the bank owes to you – a liability. This makes you a creditor of the bank and the balance is shown with a CR against the amount owed to you by the bank. On the other hand, if you have a bank loan then the bank is your creditor and the balance is shown with a DR next to it as from the bank’s point of view this is an asset which it will include as part of its total wealth.

Revenue and Capital

Income and Expenditure are often designated as either ‘ revenue’ or ‘capital’. Essentially, revenue expenditure is the ongoing day to day expenditure which accounts for spending on such things as salaries, consumables (like paper and printer cartridges), utility bills and, in manufacturing or retail, stock and materials. Capital expenditure – which is sometimes referred to as investment expenditure – is used for major items which then have a value as long-term assets such as buildings, and equipment or for other major projects such as a reorganisation. These may often be too big to fund from the day-to-day income of the business so they may be funded from loans (or in some circumstances grants) or from the accumulated profit (surplus) of previous years.

Sometimes it is possible to transfer funds from the revenue stream to the capital stream and vice-versa. An example might be that money has been saved with the intention of undertaking building renovations (Capital account) but it is decided instead to release that money to fund an additional member of staff for three years (Revenue account). Transferring money from capital to revenue may be more difficult if an organisation has been given or has borrowed money for a specific capital project. The funding body may not allow it to be used for revenue expenditure.

Do not confuse this use of ‘Capital’ with the use of the term to mean ‘source of funds’. The money that a business has at its disposal includes money that has been invested in it by shareholders and/or owners. This is referred to as ‘Capital’ or ‘ Equity’ to distinguish it from money which has been borrowed but which does not confer ownership rights (that is, Debt).

Conventions

There are a few more technical terms which you should be aware of as you may come across them when you are examining financial statements.

Historic Cost Convention

The value of assets shown on the balance sheet is based on their original cost and not their current value. This convention is not always appropriate. It is important to read the notes accompanying accounts to see what basis is being used to value assets.

Going Concern Convention

This is the assumption that the business will continue for the foreseeable future and that the assets are not being valued as they would be if they were about to be sold off. Assets are usually worth more to the business than their resale value.

Prudence Convention

Financial statements should err on the side of caution. This is not a convention which has been obviously applied more recently.

Stable Monetary Unit Convention

This is the assumption that the value of money will not change over time. As this is now not the case, it is often necessary to revalue assets to reflect current values of, for example, land.

Reading

For more information about all of this, see Atrill and McClaney or any other introductory text.

Remember

….to look at the financial reports from your university and see how they compare. One thing to notice is that the figures will probably be expresses in thousands of pounds, so look out for ‘000s or £’000 at the top of each column. You may also see the P & L referred to as ‘gains and losses’.