Financial statements are prepared for a range of different business entities. 1.

Question

Financial statements are prepared for a range of different business entities.

1. Identify the different entities financial statements can be prepared for.

2. Identify the different financial statements and explain the type of information contained within each of the financial statements.

3. Explain the purpose of accounting information and how this purpose is linked to the needs of stakeholders involved with different entities.

Accounting information is guided by various principles, assumptions and qualitative characteristics.

1. Describe the process of generating accounting information.

2. dentify and describe the assumptions, qualitative characteristics and framework which guide the preparation of accounting information.

3. Explain why accountants have flexibility in accounting choices.

4. Explain how the assumptions and qualitative characteristics of accounting guide the choice of the following accounting methods.

- Revenue recognition

- Accounting for bad debts

Explanation / Answer

1. Financial statements can be prepared for any type of business entity. A business transaction is an economic event or condition that directly changes an entity’s financial condition or directly affects its results of Operations. Every business transaction should fit to the Accounting equation. The business entities can be broadly classified into four types.

Sole Proprietor – A sole proprietor business is owned by an individual. Advantages are like easy and low cost to organize. Disadvantages are Limited source of financial resources and unlimited liability.

Partnership – A Partnership is owned by two or more persons. Advantages are like more financial resources than a sole proprietor, additional management skills. Disadvantages are unlimited liability. There are various types of partnerships like General partnership, limited partnership, etc.

Company – The Company is set up as per the statute. Advantage is the ability to obtain large amount of resources by issuing shares. An accounting entity may be viewed as a set of assets and liabilities. It can be a small corporation or a large corporation.

Non-profit organizations – These are generally set up for a mission or cause. It can be a trust or charitable organization.

2. Basically financial statements are similar for every type of business entity. Broadly, financial statements consists of the Income statement, Balance sheet, Cash flow statements and statement of retained earnings. Depending on the size and nature of the business entities and the related GAAP rules, various statements are prepared.

Income statement – Income statement shows a company’s profitability during a specific period. The period of time could be one year, six months, three months, one month or any other time interval. The main components of the income statement are revenues, expenses, gains and losses.

Balance Sheet – Balance sheet shows a company’s financial position at the end of a specific date. Of the four basic financial statements, the balance sheet is the only statement which applies to single point in time. A company balance sheet has three parts: assets, liabilities and ownership equity.

Cash flow statement –

The cash flow statement reports the cash generated and used during the specified period.

Because the income statement is prepared under the accrual basis of accounting, the revenues reported may not have been collected. Similarly, the expenses reported on the income statement might not have been paid. You could review the balance sheet changes to determine the facts, but the cash flow statement already has integrated all that information.

The business people and investors utilize this important financial statement. It reports the cash generated and used in the following categories:

Statement of retained earnings - It is a financial statement prepared with the changes in retained earnings for a specific period in accordance with GAAP. It reconciles the beginning and ending retained earnings of the period. It is a part of another financial statement (balance sheet)

Retained Earnings (RE) = Opening (RE) + Net Income - Dividends paid to Shareholders

If net loss is more than beginning RE, then RE become negative, creating a deficit, The RE GL account is adjusted every time a journal entry is made to an income or expense account.

It is useful for management decisions like investing in growth opportunities, buying new machinery, or on more research and development

3. Purpose of financial statements are as follows:

The stakeholders are different in different type of business entities. In the case of sole proprietor, only the owner is the major stakeholder. When it comes to the partnership, the partners are the major stakeholders. However, if it is a large partnership, then even the vendors, banks, government agencies will be the stakeholders. Similar with the corporations.

In any type of business entity, Owners should have the proper financial statements to make the major business decisions. It can be for short term or long term. Whether the decision is for a business expansion or small investment or taking a loan or purchasing an asset or introduction of capital or withdrawing profit. A good financial statements will help the owners to take the right decision.

Employees to be motivated. They are the people who does all the work. They should be properly compensated. Talent to be retained. Only then the entity will be progressed.

Prospective investors should be confident on the performance and financial stability of the business. Financial statements shows the clear picture of these. It provides various information to calculate and evaluate the viability of the business.

Financial institutions like bank look the repaying capacity of the entity before giving any loan.

Government entities will be looking for the payment of various types of taxes like payroll, income tax, sales and use tax, property tax, etc. The entity is bound to be paid for all the taxes as regulated by the prevailing laws.

Vendors will check the credit worthiness of the company. To give a credit to any entity, vendors will see the turnover ratios and the profitability of the company.

Recording – Any business transaction should be recorded into the books of accounts. Under double entry system there will be a debit and credit for every business transaction. Making the journal entry is called Recording

Posting – After the journal entry is recorded, the transactions to be posted into the respective ledgers. There are various types of ledger like personal ledgers, subsidiary ledgers, etc. Each account will have a separate ledger.

Matching – The balances in each ledger will be transferred to the Trial balance. This checks the arithmetical accuracy of the transactions posted into the various ledgers

Preparing – From the balances in the trial balances various financial statements as discussed above will be prepared.

2. Accounting assumptions are as follows

Entity Unit Assumption –

The accountant keeps all of the business transactions of a Business Concern separate from the business owner's personal transactions.

Example: The best example here concerns that of the sole trader or one man business: in this situation you may have the sole trader taking money by way of 'drawings': money for his own personal use. Despite it being his business and apparently his money, there are still two aspects to the transaction: the business is 'giving' money and the individual is 'receiving' money. In contrast, there is no legal distinction between the sole trader and the business, and the sole trader is liable for all of the debts of the business

Going Concern Assumption –

Financial statements are prepared on the assumption that the entity is a going concern, meaning it will continue in operation for the foreseeable future and will be able to realize assets and discharge liabilities in the normal course of operations.

Monetary Unit Assumption –

The business entity unit should have one monetary unit to record its transactions

Time Period Assumption –

A fixed equal period of time ascertained to report the financial performance of an enterprise. Normally, these fixed equal periods may be of any length of time but periods of one year in length are the most commonly used. We can say that accounting period is a convenient way of dividing up the life of the business into smaller units of time to enable investors and other users of the financial statement to assess the financial performance.

Consistency -

Once a business has adopted one accounting method, it should use the same method for all subsequent events of the same character unless it has sound reason to change.

Accrual –

The business entity should recognize all the accrued expenses and revenue for a specific financial year.

3. The accounting should be done as per the GAAP and the underlying rules that govern a specific industry or business or market. The accountants will have the choice of using the basis of accounting, various principles and methods to record any business transaction. By using any method, the financial statements should present accurate and fair information for all its stakeholders.

4.

Revenue Recognition –

Revenues are recognized as soon as a product has been sold or a service has been performed, regardless of when the money is actually received. Record revenue when

a) Revenue is earned

b) Revenue is Realized or realizable

Accounting for Bad debts –

The term bad debts usually refer to accounts receivable (or trade accounts receivable) that will not be collected.

There are two methods of recording Bad debts: Direct Write off Method and Allowance Method

Under the direct write off method, a company does not anticipate bad debt expense. Rather, it waits until an account is actually written off as uncollectible before recording bad debt expense. This means its accounts receivable will be reported on the balance sheet at their full amounts—implying that all of the accounts receivable will be turning to cash.

The accounting profession prefers the allowance method over the direct write off method because the accounts receivable will be presented on the balance sheet with a reduction called the allowance for doubtful accounts. This means the net amount of the accounts receivable will be lower and closer to the amount that will actually be collected. Bad debt expense is reported at the time that the allowance for doubtful accounts is created and adjusted. Hence, the bad debt expense is reported closer to the time of the credit sale.

When the allowance method is used, the journal entry to Bad Debts Expense will include a credit to Allowance for Doubtful Accounts, a contra account and valuation account to the asset Accounts Receivable. The allowance method anticipates the losses and therefore requires the use of estimates.

Under the direct write-off method, the Allowance for Doubtful Accounts is not used. Rather, Bad Debts Expense will be debited when an account receivable is actually written off. The credit in this entry will be to the asset Accounts Receivable.

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