Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

Fundamentals of Financial Accounting

Rafał Grabowski

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Dr Rafał Grabowski
 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

Contents
Introduction ........................................................................................................................................... 4
CHAPTER I Business Environment and Accounting ................................................................................. 5
I.1 Information as a Basis of Wise Decisions about Allocation of Resources ........................... 5
I.2 The General Concept of Accounting.................................................................................... 7
I.2.1 The Definition and Types of Accounting ............................................................................. 7
I.2.2 The Monetary Unit Assumption (Principle) ......................................................................... 9
I.2.3 The Balance Method ........................................................................................................... 9
I.2.4 The Entity Assumption (Principle) ..................................................................................... 12
I.3 Summary............................................................................................................................ 14
I.4 Exercises ............................................................................................................................ 15
CHAPTER II Balance Sheet: the Concept and Recognizing of Assets, Liabilities and Owners’ Equity ... 18
II.1 The General Concept of Financial Statements .................................................................. 18
II.2 The General Concept of a Balance Sheet .......................................................................... 19
II.3 Recognition Criteria of Assets ........................................................................................... 22
II.4 Recognition Criteria of Owners’ Equity and Liabilities ...................................................... 25
II.5 The Actual Layout of a Balance Sheet in Accordance with the Accounting Act ................ 27
II.6 Summary............................................................................................................................ 31
II.7 Exercises ............................................................................................................................ 31
CHAPTER III Business Transactions within the Accounting System (part I)........................................... 37
III.1 Business Transactions and Their Influence on the Financial Position of an Entity ........... 37
III.2 Measurement of business transactions ............................................................................ 41
III.3 Documentation of business transactions .......................................................................... 42
III.4 Recording of business transactions ................................................................................... 44
III.5 Summary............................................................................................................................ 57
III.6 Exercises ............................................................................................................................ 57
CHAPTER IV Profit and Loss Account ..................................................................................................... 68
IV.1 The General Concept of Profit (Loss), Revenues, and Expenses ....................................... 68
IV.2 Recognition and measurement of revenues and expenses .............................................. 71
IV.3 The Division of Income ...................................................................................................... 79
IV.4 Summary............................................................................................................................ 81
IV.5 Exercises ............................................................................................................................ 83
CHAPTER V Business Transactions within the Accounting System (part II) .......................................... 90
V.1 Recording Revenues and Expenses ................................................................................... 90
V.2 Transferring Revenues and Expenses to the “Net Profit (Loss)” Account ......................... 95

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Dr Rafał Grabowski
 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

V.3 Summary............................................................................................................................ 98
V.4 Exercises ............................................................................................................................ 98

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Dr Rafał Grabowski
 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

Introduction
This manual is designed for students who are starting to learn (study) accounting. It
contains a description of the key issues that are discussed during the course "Accounting".
However, it should be noted that the manual cannot be considered as an alternative to the
lectures - it may be treated only as an addition to the lectures. The manual describes the
theory. However, it also contains examples and exercises that are helpful in understanding
described issues.
This manual was written as a part of the project “Young Teachers Prepare a
Management Course in English” implemented at the Warsaw School of Economics.
Therefore, I offer thanks to all those who initiated and pursued this project.

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Dr Rafał Grabowski
 Projekt współfinansowany ze środków Unii Europejskiej w ramach Europejskiego Funduszu Społecznego

CHAPTER V
Business Transactions within the Accounting System
(part II)

V.1 Recording Revenues and Expenses

In order to explain rules of recording (entering) revenues and expenses in accounts it is
necessary to remind two aspects. Firstly, net profit (loss) is a part of owners’ equity.
Secondly, revenues result in increases of net profit, and expenses result in decreases in net
profit.
Since net profit (loss) is a part of owners’ equity we may say that all business
transactions that affect net profit (loss) should be entered (recorded) in accounts in the manner
that is appropriate for all other business transactions that affect owners’ equity. It means that
all revenues should be entered on the credit side of the profit (loss) account, because they
result in increases in owners’ equity. It means also that all expenses should be entered on the
debit side of the profit (loss) account, because they result in decreases in owners’ equity.

Exhibit V.1 The rules of entering increases and decreases in the profit (loss) account

Profit (loss) account

Debit (Dr) Credit (Cr)

- +
Expenses Revenues

In reality revenues and expenses are not entered directly in the profit (loss)
account. They are entered in separate accounts devoted to particular categories of revenues
and expenses. Thus we may say that revenues and expenses should be entered as it is shown
in the Exhibit V.2.

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Exhibit V.2 The rules of entering revenues and expenses

Accounts for revenues and expenses

Accounts used for the purpose of

Accounts used for the purpose of
recording expenses and their
recording revenues and their
changes
changes
Debit (Dr) Credit (Cr)
Debit (Dr) Credit (Cr)
Expenses
Revenues

As it is written in the Chapter III, every entity needs many accounts. We can open
(create) as many accounts as t is necessary. The division of accounts should be as detailed as
it is necessary to guarantee appropriate information for the preparation of financial statements
and the fulfilment of other entity’s obligations. Thus in the case of accounts devoted to
revenues and expenses we should create at least as many accounts as it is necessary to prepare
an income statement. At this stage we assume that the following division of accounts devoted
to revenues and expenses is appropriate:
1. the net revenues from sales account,
2. the operating expenses account,
3. the other operating revenues account,
4. the other operating expenses account,
5. the financial revenues account,
6. the financial expenses account,
7. the profit on extraordinary events account,
8. the loss on extraordinary events account.
This division is based on a simplified layout of the profit and loss account (income statement)
that was discussed in Chapter IV.
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In addition to the categories (revenues and expenses) specified above, net profit (loss)
is affected also by income tax. Since income tax result in decrease in net profit we may say
that it should be entered in accounts similarly to expenses. The appropriate manner of entering
income tax during a financial year is shown in Exhibit V.3.

Exhibit V.3 Entering income tax during financial year

Short-term liabilities –
Income Tax income tax

In order to illustrate how revenues and expenses are recorded in accounts let us
consider the following example.

Example V.1 Entering revenues and expenses during financial year

Mr. Bill Karavitis runs a company „Your House”. The core business of the company is
property management. The entity was established in 200A as a company providing a wide
range of services for owners in Warsaw.
At the end of the financial year 200A the company’s accounts showed the following
balances:
1. buildings – PLN 150 000,
2. truck – PLN 48 000 (initial value PLN 60 000, depreciation PLN 12 000),
3. cleaning supplies – PLN 9 800,
4. trade receivables – PLN 23 100,
5. cash in hand– PLN 7 500,
6. money in a bank – 15 200,
7. share capital – 219 400,
8. short term liabilities resulting from credits and loans – PLN 16 700,
9. trade payables – 3 500,
10. short-term liabilities resulting from income tax – PLN 2 000,
11. short-term liabilities resulting from payroll – PLN 12 000.

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During the financial year 200B the following business transactions were competed.
1. The company rendered cleaning services for a customer X. As a result of it:
a. employees used cleaning supplies – PLN 2 600,
b. Mr. Karavitis evaluated wages earned by employees – PLN 4 300,
c. Mr. Karavitis invoiced the customer X – PLN 21 500,
d. Mr. Karavitis paid wages by a bank transfer,
e. the customer X paid by a bank transfer for services.
2. The company rendered cleaning services for a customer Y. As a result of it:
a. employees used cleaning supplies – PLN 800,
b. Mr. Karavitis evaluated wages earned by employees – PLN 3 300,
c. Mr. Karavitis invoiced the customer Y – PLN 17 500,
d. Mr. Karavitis paid wages by a bank transfer,
e. the customer Y paid by for services by a bank transfer.
3. The company rendered cleaning services for a customer Z. As a result of it:
a. employees used cleaning supplies – PLN 1 600,
b. Mr. Karavitis evaluated wages earned by employees – PLN 5 300,
c. Mr. Karavitis invoiced the customer Z – PLN 9 500,
d. Mr. Karavitis paid wages by a bank transfer,
e. the customer Z paid for services by a bank transfer.
4. Mr. Karavitis acquired and used gasoline – PLN 2 200 (cash),
5. Mr. Karavitis repaid a loan – PLN 1 600 (including interest PLN 500),
6. Mr. Karavitis evaluated depreciation – PLN 12 000,
7. Mr. Karavitis evaluated his own salary – PLN 20 000,
8. someone stole cleaning supplies – PLN 700,
9. the insurance company paid by a bank transfer for the stolen supplies – PLN 550,
10. on behalf of the “Your House” company Mr. Karavitis made a donation to a charity –
PLN 700,
11. the bank paid accrued interest – PLN 150,
12. Mr. Karavitis assessed income tax – PLN 420.

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Required
1. Open accounts as at January 1, 200B.
2. Enter all business transactions that took place in the financial year 200B.
Answer
Assets, liabilities, and owners’ equity
Tangible assets – buildings Owners’ equity – share
and structures capital
OB 150 000 219 400 OB

Tangible assets – means of Short-term liabilities –

transport credits and loans
OB 60 000 12 000 (6 5) 1 100 16 700 OB

Tangible assets –
depreciation of means of Short-term liabilities –
transport trade payables
12 000 OB 3 500 OB

Short-term liabilities –
Inventories - materials taxes (income tax)
OB 9 800 2 600 (1a 2 000 OB
800 (2a 420 (12
1 600 (3a
700 (8

Short-term receivables – Short-term liabilities –

trade receivables payroll liabilities
OB 23 100 21 500 (1e 1d) 4 300 12 000 OB
1c) 21 500 17 500 (2e 2d) 3 300 4 300 (1b
2c) 17 500 16 500 (3e 3d) 5 300 3 300 (2b
3c) 16 500 5 300 (3b
20 000 (7

Short-term investments –
cash in hand
OB 7 500 2 200 (4

Short-term investments –
money at a bank
OB 15 200 4 300 (1d
1e) 21 500 3 300 (2d
2e) 17 500 5 300 (3d
3e) 16 500 1 600 (5
9) 550 700 (10
11) 150

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Revenues, expenses, and net profit (loss)

Operating expenses Net revenues from sales
1a) 2 600 21 500 (1c
2a) 800 17 500 (2c
3a) 1 600 16 500 (3c
1b) 4 300
2b) 3 300
3b) 5 300
4) 2 200
6) 12 000
7) 20 000

Other operating expenses Other operating revenues

10) 700

Financial expenses Financial revenues

5) 500 150 (11

Loss on extraordinary Profit on extraordinary

events events
8) 700 550 (9

Income Tax
12) 420

V.2 Transferring Revenues and Expenses to the “Net Profit

(Loss)” Account
In order to determine the value of net profit (loss) we have to transfer all revenues
and expenses to an account titled “net profit (loss)” and close accounts devoted to revenues
and expenses. Usually it is done at the end of financial year.

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Exhibit V.4 The simplified scheme of transferring revenues and expenses to the “Net
profit (loss)” account
Revenues, expenses, and net profit (loss)
Operating expenses Net profit (loss) Net revenues from sales

Other operating expenses Other operating revenues

Financial expenses Financial revenues

Loss on extraordinary Profit on extraordinary

events events

Income Tax

The “net profit (loss)” account determines the net profit (loss) by collecting all
expenses on the debit side and all revenues on the credit side. If the total debits exceed total
credits, it means that a company incurred a loss. If the total credits exceed total debits, it
means that a company earned a profit.
As a result of transferring all revenues and expenses to an account titled “net profit
(loss)”, all accounts devoted to revenues and expenses must begin and end each financial year
with zero balances.

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Example V.2 Transferring revenues and expenses to the “Net profit (loss)” account
To illustrate how revenues and expenses are transferred to the profit (loss) account we
will reconsider the accounts and the entries in them from the example V.1.

Revenues, expenses, and net profit (loss)

Operating expenses Net profit (loss) Net revenues from sales
1a) 2 600 52 100 (16 16) 52 100 55 500 (13 13) 55 500 21 500 (1c
2a) 800 17) 700 150 (14 17 500 (2c
3a) 1 600 18) 500 550 (15 16 500 (3c
1b) 4 300 19) 700
2b) 3 300 20 420
3b) 5 300 54 420 56 200
4) 2 200 CB 1 780
6) 12 000 56 200 56 200
7) 20 000

Other operating expenses Other operating revenues

10) 700 700 (17

Financial expenses Financial revenues

5) 500 500 (18 14) 150 150 (11

Loss on extraordinary Profit on extraordinary

events events
8) 700 700 (19 15) 550 550 (9

Income Tax
12) 420 420 (20

On the basis of these accounts and entries we may prepare a simplified profit and loss account
as follows.
200B
A. Net revenues from sales 55 500
B. Operating expenses 52 100
C. Gross profit (loss) on sales (A-B) 3 400
D. Other operating revenues 0,00
E. Other operating expenses 700
F. Profit (loss) on operating activities (C + D - E) 2 700
G. Financial revenues 150
H. Financial expenses 500
I. Profit (loss) on business activities (F + G – H) 2 350
J. Result on extraordinary events -150
K. Gross profit (loss) (I +/- J) 2 200
L. Income Tax 420
M Net profit (loss) 1 780

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V.3 Summary
In the chapter V we considered the rules of recording revenues and expenses as well as
rules of transferring them to the profit (loss) account. In general, we may say that all business
transactions that affect net profit (loss) should be entered (recorded) in accounts in the manner
that is appropriate for all other business transactions that affect owners’ equity. It means that
all revenues should be entered on the credit side, because they result in increases in owners’
equity. It means also that all expenses should be entered on the debit side, because they result
in decreases in owners’ equity.
At the end of the financial year all revenues, expenses, and income tax should be
transferred to the “net profit (loss)” account. If the total debits of this account exceed total
credits, it means that a company incurred a loss. If the total credits exceed total debits, it
means that a company earned a profit.

V.4 Exercises

Exercise V.1 Summary

Assume that we run a company X. as at 1 January 200B the company’s accounts
showed following closing balances.
No Description Balance
1. Intangible assets - software 5 000.00
2. Tangible assets – equipment 20 000.00
3. Tangible assets –buildings 340 500.00
4. Tangible assets – means of transportation 70 000.00
5. Property, plant, and equipment under construction - this category comprises
expenses related only to a new plant which is under construction on 1
January 200B. According to a plan, the plant should be completed and
usable at the end of the year 200B.
6. Inventories – merchandise (1 000 units * PLN 32) 32 000.00
7. Inventories – finished products (100 units * PLN 20) 2 000.00
8. Trade receivables 56 000.00
9. Cash in hand 19 900.00
10. Money in a bank 19 100.00
11. Shares intended for resale in 2 years 50 000.00
12. Short-term prepayments – include only rent paid in December 200A for the 12 000.00
period from January 200B – December 200B.
13. Share capital ....................................
14. Supplementary capital 35 000.00
15. Net profit (loss) for the financial year 200A (retained earnings) 78 000.00
16. Trade payables 22 000.00
17. Payables resulting from payroll for December 200A 9 500.00

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No Description Balance
18. Accruals – a value of electricity used in December 200A 200.00

In January 200B the following business transactions took place.

No Description
1. Owners invested PLN 100 000.00 in the company. Money was transferred to the company’s account.
2. The company completed services for PLN 9 000.00 on credit.
3. The company purchased office furniture for PLN 2 000.00; on credit (short-term).
4. The company acquired merchandise (100 units * PLN 32) on credit.
5. The company paid by a bank transfer trade payables PLN 2 000.00.
6. The company received PLN 2 800.00 from a client for the work completed in December [Link]
was transferred to the company’s checking account.
7. An employee withdrew of PLN 5 000.00 cash from the company’s checking account. Money was
withdrawn in order to buy office supplies.
8. The company received an invoice for electricity used in December 200A (PLN 200.00)
9. The company paid in advance PLN 1 900.00 for a computer program. Money was transferred from the
company’s checking account
10. The company sold 1 000 units of merchandise on credit. Unit price amounted to PLN 40.
11. The General Meeting of Shareholders approved the financial statements for the financial year 200A and
decide to distribute the profit in the form of dividends.
12. The company paid by a bank transfer insurance policy PLN 1 200.00. The policy period lasts from
January 200B to the end of December 200B.
13. The company paid by a bank transfer PLN 10 000.00 for services that were rendered on credit by the
supplier X to the company in the year 200A.
14. The company acquired on credit and used office supplies valued at PLN 500.00.
15. The company paid by a bank transfer the dividend.
16. The company provided services for PLN 12 500.00. A customer paid in cash.
17. The company received an invoice amounted to PLN 3 000.00 for construction of the new plant. The
amount is due on 15 February 200B.
18. The company paid by a bank transfer a credit instalment PLN 2 000.00 (interest included in instalment
amounted to PLN 200.00).
19. The company received dividend (as shareholder).
20. At the end of January 200B an accountant assessed the value of salaries for January 200B. The value
amounted to PLN 10 600.00 and should be paid in February 200B.
21. At the end of January 200B an accountant made an entry relating to the rent paid in advance in
December 200A.
22. At the end of January 200B an accountant made an entry relating to the insurance policy paid in advance
in 200B and
23. At the end of January 200B an accountant assessed the value of electricity used in January 200B: PLN
500.00.
24. At the end of January 200B an accountant assessed the value of income tax (tax rate: 20%).

Required:
1. Open accounts.
2. Enter all business transactions in the accounts.
3. Close the accounts.
4. Prepare a simplified balance sheet (without comparative information).
5. Prepare a simplified profit and loss account (without comparative information).
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31.01.200B
A. NON-CURRENT ASSETS
I. Intangible assets
II. Tangible assets
III. Long-term receivables
IV. Long-term investments
V. Long-term prepayments
B. CURRENT ASSETS
I. Inventories
II. Short-term receivables
III. Short-term investments
IV. Short-term prepayments
TOTAL ASSETS

31.01.200B
A. OWNERS’ EQUITY
I. Share capital
II. Called up share capital (-)
III. Own shares (-)
IV. Supplementary capital
V. Revaluation reserve
VI. Other reserves
VII. Retained earnings (losses)
VIII. Net profit (loss)
IX. Write-off on net profit during the financial year (-)
B. LIABILITIES AND PROVISIONS
I. Provisions (long term and short-term)
II. Long-term liabilities
III. Short-term liabilities
IV. Accruals
TOTAL LIABILITIES AND OWNERS’ EQUITY

January 200B
A. Net revenues from sales
B. Operating expenses
C. Gross profit (loss) on sales (A-B)
D. Other operating revenues
E. Other operating expenses
F. Profit (loss) on operating activities (C + D - E)
G. Financial revenues
H. Financial expenses
I. Profit (loss) on business activities (F + G – H)
J. Result on extraordinary events
K. Gross profit (loss) (I +/- J)
L. Income Tax
M Net profit (loss)

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