The foundation of the accounting system

In order to provide reliable, consistent, and unbiased information to decision makers, accountants follow guidelines, or standards, known as generally accepted accounting principles (GAAP). These standards are principles that encompass the conventions, rules, and procedures necessary in determining acceptable accounting practices at particular time. Accountants use GAAP to create inform financial statements throughout an industry for comparison purposes. GAAP provide the basis for sound decision making. Two accounting statements form the foundation of the entire accounting system: balance sheet and the income statement. The information found in these statements is calculated using the accounting equation and the double-entry system. A third statement, the statement of cash flows, is frequently prepared to focus specifically on the information related to sources and uses of cash for the firm from its operating, investing, and financing activities.

The Accounting Equation

Four fundamental terms are involved in the accounting equation: assets, equities, liabilities, and owners’ equity.

An asset is anything of value owned or leased by a business. Cash, accounts receivable and notes receivable (amounts owed to the business through credit sales), land, buildings, supplies, and marketable securities are all assets.

An equity is a claim against the assts of a business. The two major classifications of individuals who have equity in a firm are creditors (liability holders) and owners.

A liability of a businessis anything owed to creditors – that is, the claims of form’s creditors. When the firm makes credit purchase for inventory, land, or machinery, the creditors’ claims are shown as accounts payable or notes payable. Wages and salaries owed to employees also represent liabilities (known as wages payable).

The owners’ equity represents theinvestment in the business made by owners of the firm and retained earnings that were not paid out in dividends. A strong owners; equity position often is used as evidence of a firm’s financial strength and stability.

Because equities, by definition, represent the total claims of both owners and creditors against assets, then assets must equal equities. The basic accounting equation states that assets are equal to liabilities plus owners’ equity. It reflects the financial position of any firm at any point in time. Since financing comes from either creditors or owners, the right side of the accounting equation also represents the financing structure of business.

The relationship expressed by the accounting equation is used to develop two primary accounting statements prepared by every business, large or small: the balance sheet and the income statement. These two statements reflect the current financial position of the firm and the most recent analysis of income, expenses, and profits for interested parties inside and outside the firm. They provide a fundamental basis for planning activities and are also used in attracting new investors, securing borrowing funds, and preparing tax returns.

FINANCIAL ANALYSIS

Financial statements provide the essential information to evaluate the liquidity of the organization – its ability to meet current obligations and needs by converting assets into cash; the firm’s profitability; and its overall financial health. The balance sheet and income statement provide an outline from which management can base its decisions. By interpreting the data provided in these financial statements, the appropriate information can be communicated to internal decision makers and to interested parties outside the organization.

The Balance Sheet

The balance sheet shows the financial position of a company as of particular date. It is similar to a photograph comparing firm’s assets with its liabilities and owners’ equity at a specific moment in time. Balance sheets must be prepared at regular intervals, since a firm’s managers and other internal parties are likely to request this information on a daily, weekly, or at least once-a-month basis. On the other hand, external users, such as stockholders or industry analysts, typically use this information less frequently, perhaps every quarter or once a year.

It is helpful to keep the accounting equation in mind as a diagram that is explained by the balance sheet. Listing the various assets on the balance sheets indicates sources of the firm’s strengths – where the money is coming from. These assets, showing in descending order of liquidity (convertibility to cash), represent the uses that management has made of available funds. On the other side of the equation, liabilities and owners’ equity indicate the sources of the firm’s assets. Liabilities reflect the claims of creditors – financial institution or bondholders that have made loans to the firm, suppliers that have provided goods and services on credit, and others to paid, such as federal, state, and local tax officials. Owners’ equity represents the owners’ (stockholders’, in the case of corporations) claims against the firm’s assets to the excess of all assets over liability.

Income Statement

While the balance sheet reflects the financial position of the firm at a specific point in time, the income statement is a flow statement that reveals the performance of the organization over a specific time period. Resembling a motion picture rather than a snapshot, the income statement is a financial record summarizing a firm’s financial performance in terms of revenues, and profits over a given time period.

The purpose of the income statement is to show the profitability of a firm during a period of time, usually a year, a quarter, or a month. In addition to reporting the profit or loss, it helps decision makers focus on overall revenuesand the costs involved in generating these revenues. Non-profit organizations use this statement to see if the organization’s revenues and contributions will cover costs involved in operating the firm. Finally, the income statement provides much of the basic data needed to calculate numerous ratios used by management in planning and controlling the organization.

The income statement (sometimes called a profit and loss – or P&L – statement) begins with total sales or revenue generating during a year, quarter, or month, and then deducts all of the costs related to producing this revenues. Once all costs – administrative and marketing expenses, costs involved in producing the product, interest, and taxes, for instance – have been subtracted, remaining net income may be distributed to the firm’s owners (stockholders, proprietors, or partners) or reinvested in the company as retained earnings. The final figure on the income statement – net income after taxes – is well known bottom line.

Statement of Cash Flows

In addition to the income statement and the balance sheet, many firms prepare a third accounting statement. Since 1987 all companies listed on organized stock exchanges have been required to prepare a statement of cash flows as part of their annual registration information. In addition, the major lenders often require it of all firms applying for business loans. As the name indicates, the statement of cash flows provides investors and creditors with relevant information about firm’s cash receipts and cash payments during an accounting period.

The fact that cash flow is the lifeblood of every organization is evidenced by the business failure rate. Of more than 60,000 businesses that failed during a recent year, three of every five blamed economic factors linked to cash flow for their demise. More recent studies of small-and medium- sized companies reveal that one firm in four ranks inability to control cash flow as the firm’s number one problem. Proponents of the statement of cash flows hope its preparation and scrutiny by effected parties will prevent financial disaster for otherwise profitable firms that are forced into bankruptcy due to lack of funds needed to continue day-to-day operations.

 

Basic Data

Transactions Receipts, invoices, and other source documents related to each transaction are assembled to justify making an entry in the firm’s accounting records.

Processing

Record Transactions are recorded in chronological order in books called journals. Brief explanations are given for each entry. Classify Journal entries are transferred, or posted, to individual accounts kept in a ledger. All entries involving cash are brought together in the ledger’s cash account; all entries involving sales are recorded in the ledger’s sales account. Summarize All accounts in the ledger are summarized at the end of the accounting period and financial statements are prepared from these account summaries.

Financial Statements

Balance Sheet

Income Statement

Statement of Cash Flows

BUDGETING

Although the financial statements focus on what has occurred in the past, they are the basis for planning in the future. A budget is a planning and control tool that reflects expected sales revenues, operating expenses, and cash receipts and outlays. It is the quantification of the firm’s plans for specified future period. Since it requires management to estimate expected sales, cash inflows and outflows, and costs, it serves as a financial blueprint. The budget becomes the standard against which actual performance can be compared.

Budget preparation is frequently time-consuming and involves many people from various departments of the firm. The complexity of the budgeting process varies with the size of and complexity of the company. Giant corporations tend to have more complex and sophisticated budgeting systems. Their budgets serve as a means of integrating the numerous divisions of the form in addition to serving as planning and control tools. But budgeting by both large and small firms is similar to household budgeting in that the purpose is to match income and expenses so as to accomplish objectives and correctly time cash inflows and outflows.

Since the accounting department is the organization’s financial nerve center, it provides much of the data used in budget development. The overall master, or operating, budget is actually a composite of numerous of sub-budgets for each of the departments of financial areas of the firm. These typically include the production budget, cash budget, capital expenditures budget, advertising budget, and sales budget.

Budgets usually are established on an annual basis, but may be divided monthly or quarterly for control purposes. Since some activities, such as the construction of new manufacturing facilities or long-term purchasing contracts, tend to involve activities extending over several years, longer-term budgets may be used in those cases.

(Based on: Kurtz D., Boone L., Boone and Kurtz Business)

III. Here is the abstract from current Cooperation agreement. Translate this abstract from English into Russian and be ready for its discussion on the basis of active vocabulary, key terms quiz, review and discussion questions.

ACCOUNTING

Without prejudice to its obligations under the Ship Management Agreement the Company B shall on a quarterly basis within one month from the end of each calendar quarter, for the first time not later than 31 April 2004, provide the other Parties with:

(a) an income and expenditure review, based on the invoiced income and expenditure incurred in respect of the Project compared to the budgeted income and expenditures. The Project 5 year budget is hereto attached in Exhibit 1;

(b) a cash flow overview, based on the actual receipt of funds and the actual payments made in respect of the Project.

PROFITS AND LOSSES

1. Subject to the terms and conditions herein provided the Parties agreed that the profit earned by the Vessel will be accumulated in the Company A, provided, however, that an amount equal to 10% of expenditures actually have been beard by the Company B for the financial year as per Cyprus taxation, provided, that the net profit after Cyprus taxes have been paid, should be transferred to the Company A.

2. Starting from the 1^st of July the Company B shall transfer in advance a part of profit to the Company A in amount of USD 200 000 per month within two weeks following to the said month. The balance of the actual quarterly profit, after deduction 10% of expenditures be allocated as a taxable profit of the Company B shall be transferred to the Company A within one month from the end of each calendar quarter. All losses under the Project incurred by the Company B shall be covered by the Company A.

3. Each JV Affiliate shall account to the Company A within 15 (fifteen) days from the end of a month in respect of any Other Income generated by it and shall pay the balance thereof after deduction of incidental expenses properly accounted for to the Company A by remittance to the Company A Bank Account within 15 (fifteen) days from rendering its accounting.

4. The Parties hereby agreed that saving on the dry docking provisions as set forward in Exhibit 1 shall be transferred to the Company A Bank Account effected after each dry docking period in accordance with principles stipulated herein.

5. The amounts due to and by any of the Parties to another in terms of herein
may be set off against one another, provided the quantum of such set-off
is agreed in writing by the Parties.