Accounting I: Foundations and the Accounting Cycle
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The NIE Accounting syllabus covers financial accounting in grade 12 (accounting concepts, sole proprietorship, manufacturing businesses, not-for-profit organizations, incomplete records, and partnerships) and, in grade 13, Sri Lanka Accounting Standards, company accounts, ratio analysis, management accounting, cost-volume-profit analysis, and capital investment decisions (NIE, n.d.-a; Alkuppiya, n.d.).
What Is Accounting?
Accounting is the process of identifying, measuring, recording, summarizing, and communicating financial information to users. Users include owners, managers, lenders, employees, suppliers, customers, government and tax authorities, and the public. Financial accounting reports to external users; management accounting supports internal decisions (Wood & Sangster, 2018; Atrill & McLaney, 2019).
Accounting Concepts and Conventions
| Concept | Meaning |
|---|---|
| Business entity | The business is separate from its owner |
| Money measurement | Only items that can be measured in money are recorded |
| Going concern | The business will continue in the foreseeable future |
| Historical cost | Assets are recorded at their cost |
| Accrual (matching) | Income and expenses are recognized when earned or incurred, and matched to the period |
| Duality (double entry) | Every transaction has two equal effects |
| Prudence (conservatism) | Do not overstate profits or assets; provide for losses |
| Materiality | Only significant items need separate disclosure |
| Consistency | Use the same methods from period to period |
| Periodicity | Profit is measured for fixed periods |
The Conceptual Framework for Financial Reporting sets out the objective of general-purpose financial reporting and the qualitative characteristics of useful information: relevance and faithful representation, enhanced by comparability, verifiability, timeliness, and understandability (IFRS Foundation, 2018).
The Accounting Equation
Assets = Capital (equity) + Liabilities. Every transaction keeps the equation in balance. Profit increases capital; drawings decrease it.
Double Entry
Debit (left) and credit (right) entries record each transaction:
| Account type | Increases with | Decreases with |
|---|---|---|
| Assets | Debit | Credit |
| Expenses and losses | Debit | Credit |
| Liabilities | Credit | Debit |
| Capital (equity) | Credit | Debit |
| Income and gains | Credit | Debit |
The process: source documents (invoice, receipt, cheque) → books of original entry (journal, cash book, sales and purchases day books) → ledger accounts → trial balance → financial statements. A trial balance lists debit and credit balances; equal totals show arithmetical accuracy but do not guarantee that no errors exist.
Specific Records
- Cash book: records receipts and payments; a three-column cash book has columns for cash, bank, and discounts. Petty cash uses the imprest system.
- Bank reconciliation: reconciles the cash book with the bank statement (unpresented cheques, uncredited deposits, bank charges, direct debits, errors).
- Control accounts: the sales ledger control account and purchases ledger control account check the accuracy of the subsidiary ledgers.
- Errors and suspense accounts: errors of omission, commission, principle, original entry, compensating errors, and reversal of entries; correct with journal entries; use a suspense account for errors that cause trial balance differences.
- Returns, discounts, and VAT: sales and purchases returns; trade and cash discounts; value-added tax (VAT) is charged on supplies at the prevailing rate (which has changed over time, so check the current rate with the Inland Revenue Department).
Adjustments
- Accruals (expenses owed) and prepayments (paid in advance); accrued income and deferred income.
- Depreciation allocates the cost of a non-current asset over its useful life.
- Straight-line: (cost − residual value) ÷ useful life.
- Reducing balance: a fixed percentage of the carrying amount.
- Example: cost 500 000, residual value 50 000, life 5 years: straight-line depreciation = (500 000 − 50 000) ÷ 5 = 90 000 a year. Reducing balance at 20 percent: year 1 = 100 000; year 2 = 20% × (500 000 − 100 000) = 80 000.
- Bad debts (written off) and allowance for doubtful debts (a provision; only the change is charged to profit).
- Closing inventory valued at the lower of cost and net realizable value.
- Disposal of non-current assets: profit or loss = proceeds − carrying amount.
Common Mistakes
- Reversing debit and credit for liabilities and income.
- Forgetting that a provision's movement, not its total, is charged to the income statement.
- Not adjusting for accruals and prepayments.
- Mixing up cash discounts and trade discounts.
CHAPTER 4