Chapter 2: Maintaining Financial Records

Question 1

Accounting for business transactions

Answer 1

Bookkeeping is the act of recording financial transactions wholly and accurately. A bookkeeper records the past activities of the business.

An accountant uses the information compiled to prepare the business’s financial statements.

The financial statements summarise information from business transactions that flow through the accounting system.

Question 2

Financial (source) documents

Answer 2

Financial documents record detailed information about each business transaction.

Sales, purchases, cash payments and receipts are business transactions. Their corresponding documents are the sales invoice, purchase invoices, cheque stubs and remittance advice, respectively.

Question 3

General ledgers

Answer 3

The general ledger contains all the individual ledger accounts used by a business.

Information from source documents is posted to the appropriate ledger accounts using double entries. The general ledger contains individual accounts for a business’s assets, liabilities, capital, income and expenses.

For example, the information on a sales invoice is posted into the Sales ledger and Cash or Trade Receivables account using double entries.

The individual ledger accounts within the general ledger are called T-accounts, as it is a graphical representation of a ledger account.

Using a computerised system, a business may input details of the source document, and an automated double entry is generated to the relevant ledger accounts.

Question 4

journals

Answer 4

For unusual transactions, error corrections and period-end adjustments, the transactions are manually recorded and classified into the general ledger accounts using journals.

The journal will have the following format:
Debit General Ledger account $
Credit General ledger accoutn $
Explanation of the journal entry posting

the closing balances of the ledger accounts would be used to cast a trial balance and produce financial statements

Question 5

Trial Balance

Answer 5

Each ledger account balance is closed off, and the account balance flows to the trial balance.

The trial balance is a list of all the ledger account balances. An accountant prepares the trial balance periodically, usually once during year-end.

If the information entered into the ledgers conforms to the fundamentals of double entry, the trial balance should have equal debit and credit balances. The trial balance is investigated to ensure no errors in recording the transactions.

Question 6

Financial Statements

Answer 6

Each ledger account balance in the trial balance is totalled and summarised into financial statement categories: Assets, Liabilities, Capital, Income or Expenses.

The Statement of Financial Position is an overview of a business’s assets, liabilities, and capital at the financial year-end.

The Statement of Profit or Loss summarises a business’s income and expenses during the financial year. The profit or loss is the net of the business’s income and expenses.

Question 7

Computerised Accounting Systems

In a computerised system, activities are categorised into three processes:

Answer 7

• INPUTS - inputs are data entered into the accounting system from the source documents
• PROCESSING - Data entered is posted into the relevant ledger accounts
• OUTPUT - Financial statements and other reports are produced for management use

Question 8

FEATURES OF A COMPUTERISED SYSTEM
use of computerised system is always assumed

Answer 8

• A typical accounting computerised system comprises several modules to operate different business functions such as sales, purchases, inventory, receivables and payables.
• Computerised information can be integrated with other management modules to update transaction trails. For example,
  - Sales invoices generated through the sales system are automatically posted into the receivables or cash ledger accounts. It can also update the inventory system to record its movement and reduce the quantity.
  8 - Details of purchase invoices are entered into the purchases system, and the relevant ledger accounts, such as the payables, inventory, and any other relevant general ledgers, are updated.
• Back-ups of the data in a computerised system are available in the event of lost files.
• A computerised system allows you to amend transaction details and keep a log of the changes.
• There is a reduced likelihood of errors and omissions as computer systems do not allow error data to be processed.
• Real-time comprehensive and accurate management reports can be generated cost-effectively.

Examples of output reports from a receivables ledger system include:
Sales invoice
Customer statement
Receivables ageing list
Sales analysis report

Examples of output reports from a payables ledger system include:
List of outstanding supplier balance
Purchases analysis report

Question 9

desktop vs cloud accounting systems

• a DESKTOP accounting (on-premise) software system is hosted on a computer’s HARD DRIVE. The software is initially installed on the business premise’s desktop and is maintained regularly.
  (accessible on desktop where software installed; single access. only one person can use software at a time; updates and backup need to be performed manually; one time fee until renewal; needs installation; security tied to the desktop.data can be lost is computer crashes or breaks)
• A CLOUD accounting software system is hosted, updated, and maintained ONLINE
  (internet connection; multiple users can use the software, even remotely; automatically updates and backups data to online server; monthly sub fee; no installation required; security depends on the cloud software system, usually with multiple layers of encryption

Question 10

importance of maintaining financial records.
A business should be able to provide documents to support the figures reported in its financial statements. Such documents include all source documents such as the sales and purchase invoices, receipts, cash records and bank statements.

Answer 10

Information on the source documents is entered into the business’s accounting system and processed into relevant general ledger accounts.

Financial records and information are maintained by a business to satisfy users of financial information. Users, both internal and external, are parties interested in the financial ongoings of the business.

Question 11

Internal Users of Financial Information.

Business planning by owners

Answer 11

Business planning is an internal reason for maintaining records. It involves the business owner looking ahead and creating a plan for the future of the business. To make business decisions, owners must have financial records ready to be analysed to produce an action plan.

Business planning considers actions such as expanding the business by investing in an additional shop, selling a new line of products, or purchasing a delivery vehicle to satisfy delivery orders.

For example, the decision to expand the business will require financial information such as cash flow and profits to determine if there is sufficient cash to pay all the liabilities in the future.
Businesses can also use information such as customer satisfaction surveys to support their decision to purchase a delivery vehicle or rely on an external courier company.
The owner may use the financial records to run the business on a day-to-day basis. The records will enable the owner to identify problems that need to be addressed, such as cash flow shortages or increasing costs.

Question 12

employees of the business

Answer 12

Employees are internal users of financial information as they require information regarding individual transactions to operate in their respective functions.

For example, a cashier may need information and confirmation of a payment receipt before issuing a petty cash voucher.
Employees may also be interested in the business’s financial position to determine its going concern and job stability.

Question 13

External users of financial information

Answer 13

External users of financial information rely on the financial statements the business produces annually as they do not usually have access to detailed and specific information about the business due to competitive and confidentiality reasons.
Tax authorities; regulatory bodies; business lenders; suppliers; investors; customers and the public

Question 14

Tax authorities

Answer 14

Sole Traders are required to maintain financial records mainly to pay taxes. This is a critical external reason to maintain financial records. Tax authorities may request further information and documents to verify the authenticity of figures in the financial statements.

Question 15

Regulatory bodies

Answer 15

The business’s local legislative bodies set the rules and regulations governing the preparation of financial statements. Different governments may have specific rules for preparing and keeping financial records.

For example, larger organisations may be required to prepare financial statements that are audited independently. Financial statements are crucial as investors and shareholders rely on their financial information to evaluate the company’s financial health and earnings potential.

Question 16

Business Lenders

Answer 16

Lenders like banks and other borrowers will need evidence of the business’s ability to repay its debt.

The Statement of Profit or Loss will show whether the business generates sufficient profits to cover its interest charges. The Statement of Financial Position will show that business assets could be used as security in the event of loan defaults.

Question 17

Suppliers

Answer 17

Like lenders, suppliers may need information regarding the business’s financial stability before offering to sell goods on credit, determining the credit term and the maximum purchases the business can make.

Question 18

Investors

Answer 18

Existing investors of a business will want to know its financial position to determine if it is making profits and keeping a healthy financial position.

Potential investors may wish for financial information before investing in the business.

Question 19

Customers and the Public

Answer 19

Financial information will interest business customers as they want to know if their supply of goods is guaranteed. This is especially relevant for customers who make purchases for goods to be consumed over time.

• For example, a business sells annual gym memberships payable at the start of the year. A customer who pays for the membership would evaluate the available financial information of the company and assess its going concern abilities.
  The public may also be interested in business information and how the business affects its local economy and its commitment to environmental sustainability.

Question 20

The Need for Accounting Standards

Accounting standards are rules and guidelines that govern the preparation of financial statements by providing the basis of accounting policies and principles.

Accounting standards guide the accounting profession on how to report information accurately and reliably, thus facilitating financial accountability to users of financial statements.

The International Accounting Standards (IASs) and International Financial Reporting Standards (IFRSs) are the primary accounting standards that provide the framework for best accounting practices.

The relevant standards applicable in FA2 include:

Answer 20

• IAS 1 Presentation of Financial Statements
• IAS 2 Inventories
• IAS 16 Property, Plant and Equipment
• IFRS 15 Revenue from contracts with customers
  IAS 37 Provisions, Contingent Liabilities and Contingent Assets
  The Conceptual Framework for Financial Reporting (Chapter 2, Section 3.2)

Question 21

The Conceptual Framework
Qualitative Characteristics of useful accounting information

Answer 21

The Conceptual Framework describes that preparing financial statements provides useful information to various users, including those discussed in Section 2.3 above.

For the accounting information to be useful, it should have these characteristics:
Relevance; Faithful representation; comparability; verifiability; timeliness; understandability

Question 22

Relevance

Answer 22

Information is relevant when it can influence the economic decisions made by users.

Information is also relevant if it can be used to confirm past historical trends and predictions and predict future conditions and direction.

For example, the amount and ageing of a receivable from a customer, and the customer’s repayment history, are relevant to deciding whether to make additional credit sales to that customer.

Question 23

Faithful Representation

Answer 23

Information should faithfully represent the transactions and events of the business. It should be:

• Complete: all transactions and balances have been recorded
• Neutral: unbiased and free from manipulation
• Free from error
  For example, if the closing balance in the Cash account is $420, it should mean that the business has cash of $420, not more or less.

Question 24

Comparability

Answer 24

Useful financial Information of a business can be compared to prior period information and different businesses in the same industry. Comparisons can be analysed to identify trends and similarities.

To achieve comparability, similar items must be treated consistently.

For example, the sales transactions recorded for April 20X2 should be for April 20X2 (not before or after) to be comparable to April 20X1.

Question 25

Verifiability

Answer 25

Verifiability means that the information can be supported by evidence. This usually means having supporting financial documentation or a means to count physical items (i.e. purchased goods or cash).

For example, petty cash held by a business is counted at the premises to ensure it agrees to the Petty Cash account balance in the general ledger.

Question 26

Timeliness

Answer 26

Timeliness means receiving up-to-date information in time for it to be useful. Generally, the older the information is, the less valuable it becomes.

For example, it is essential to know the up-to-date cash balance available before making a significant cash transaction.

Question 27

Understandability

Answer 27

Information needs to be of sufficient quality to enable users with a reasonable knowledge of business and accounting to understand its meaning.

Financial transactions should be classified and information presented clearly and concisely with limitations on jargon used.

This is especially important for users from non-finance backgrounds.

For example, it is essential to understand and distinguish between assets and expenses, even though they are both debit balances in the accounts.