Introduction of Accounting
Meaning
Accounting is the process of recording financial transactions pertaining to a business. The accounting process includes summarizing, analyzing, and reporting these transactions to oversight agencies, regulators, and tax collection entities.
Objectives and Nature of Accounting
Objectives of Accounting
The following are the main objectives of accounting
1. To maintain full and systematic records of business transactions
Accounting is the language of business transactions. Given the limitations of human memory, the main objective of accounting is to maintain ‘a full and systematic record of all business transactions.
2. To ascertain profit or loss of the business
Business is run to earn profits. Whether the business earned profit or incurred loss is ascertained by accounting by preparing Profit & Loss Account or Income Statement. A comparison of income and expenditure gives either profit or loss.
3. To depict financial position of the business
A businessman is also interested in ascertaining his financial position at the end of a given period. For this purpose, a position statement called Balance Sheet is prepared in which assets and liabilities are shown.
Just as a doctor will feel the pulse of his patient and know whether he is enjoying good health or not, in the same way by looking at the Balance Sheet one will know the financial health of an enterprise. If the assets exceed liabilities, it is financially healthy, i.e., solvent. In the other case, it would be insolvent, i.e., financially weak.
4. To provide accounting information to the interested parties
Apart from owner of the business enterprise, there are various parties who are interested in accounting information. These are bankers, creditors, tax authorities, prospective investors, researchers, etc. Hence, one of the objectives of accounting is to make the accounting information available to these interested parties to enable them to take sound and realistic decisions. The accounting information is made available to them in the form of annual report.
Nature of Accounting
We know Accounting is the systematic recording of financial transactions and presentation of the related information of the appropriate persons. The basic features of accounting are as follows:
1. Accounting is a process: A process refers to the method of performing any specific job step by step according to the objectives, or target. Accounting is identified as a process as it performs the specific task of collecting, processing and communicating financial information. In doing so, it follows some definite steps like collection of data recording, classification summarization, finalization and reporting.
2. Accounting is an art: Accounting is an art of recording, classifying, summarizing and finalizing the financial data. The word ‘art’ refers to the way of performing something. It is a behavioral knowledge involving certain creativity and skill that may help us to attain some specific objectives. Accounting is a systematic method consisting of definite techniques and its proper application requires applied skill and expertise. So, by nature accounting is an art.
3. Accounting is means and not an end: Accounting finds out the financial results and position of an entity and the same time, it communicates this information to its users. The users then take their own decisions on the basis of such information. So, it can be said that mere keeping of accounts can be the primary objective of any person or entity. On the other hand, the main objective may be identified as taking decisions on the basis of financial information supplied by accounting. Thus, accounting itself is not an objective, it helps attaining a specific objective. So it is said the accounting is ‘a means to an end’ and it is not ‘an end in itself.’
4. Accounting deals with financial information and transactions; Accounting records the financial transactions and date after classifying the same and finalizes their result for a definite period for conveying them to their users. So, from starting to the end, at every stage, accounting deals with financial information. Only financial information is its subject matter. It does not deal with non-monetary information of non-financial aspect.
5. Accounting is an information system: Accounting is recognized and characterized as a storehouse of information. As a service function, it collects processes and communicates financial information of any entity. This discipline of knowledge has been evolved out to meet the need of financial information required by different interested groups.
Users of Accounting
Internal users of Accounting information
Internal users are that individual who runs, manages and operates the daily activities of the inside area of an organization.
1. Owners and Stockholders.
2. Directors,
3. Managers,
4. Officers
5. Internal Departments.
6. Employees
7. Internal Auditor.
External users of accounting information are:
· Creditors
· Invstors
· Government
· Trading partners.
· Regulatory agencies.
· International standardization agencies.
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8 Users of Accounting
1. Owners:
The primary objective of accounting is to provide necessary information to the owners relating to their business. For example, the shareholders of a company are interested in the accounting information with a view to ascertaining the profitability and financial strength of the company.
2. Management:
In large business organizations there is a separation of the ownership and management functions. The managements of such concerns are more concerned with the accounting information because of their accountability to the owners for better performance of their concerns.
3. Creditors:
Trade creditors, debenture holders, bankers, and other lending institutions are interested in knowing the short-term as well as long-term position of the company. The financial statements provide the required information for ascertaining such position.
4. Regulatory Agencies:
Various governments and other agencies use accounting reports not only as a basis for tax assessment but also in evaluating how well various business concerns are operating under regulatory framework.
5. Government:
Governments all over the world are using financial statements for compiling statistics concerning business units, which, in turn help in compiling national accounts.
6. Potential Investors:
Investors use the information in accounting reports to a greater extent in order to determine the relative merits of various investment opportunities.
7. Employees:
Employees are interested in the earnings of the enterprise because their pay hike and payment of bonus depend on the size of profits earned.
8. Researchers:
The research scholars in their research in accounting theory as well as business affairs and practices also use accounting data. In addition, those with indirect concern about business enterprise include financial analysts and advisors, financial press and reporting, trade associations, labour unions, consumers, and public at large. Thus, the list of actual and potential users of accounting information is large.
Accounting concepts and conventions
ACCOUNTING CONCEPTS
Four important accounting concepts underpin the preparation of any set of accounts:
· Going Concern: Accountants assume, unless there is evidence to the contrary, that a company is not going broke. This has important implications for the valuation of assets and liabilities.
· Consistency: Transactions and valuation methods are treated the same way from year to year, or period to period. Users of accounts can, therefore, make more meaningful comparisons of financial performance from year to year. Where accounting policies are changed, companies are required to disclose this fact and explain the impact of any change.
· Prudence: Profits are not recognised until a sale has been completed. In addition, a cautious view is taken for future problems and costs of the business (the are “provided for” in the accounts” as soon as their is a reasonable chance that such costs will be incurred in the future.
· Matching (or “Accruals”): Income should be properly “matched” with the expenses of a given accounting period.
ACCOUNTING CONVENTIONS
The most commonly encountered convention is the “historical cost convention”. This requires transactions to be recorded at the price ruling at the time, and for assets to be valued at their original cost.
Under the “historical cost convention”, therefore, no account is taken of changing prices in the economy.
The other conventions you will encounter in a set of accounts can be summarised as follows:
· Monetary measurement: Accountants do not account for items unless they can be quantified in monetary terms. Items that are not accounted for (unless someone is prepared to pay something for them) include things like workforce skill, morale, market leadership, brand recognition, quality of management etc.
· Separate Entity: This convention seeks to ensure that private transactions and matters relating to the owners of a business are segregated from transactions that relate to the business.
· Realisation: With this convention, accounts recognise transactions (and any profits arising from them) at the point of sale or transfer of legal ownership – rather than just when cash actually changes hands. For example, a company that makes a sale to a customer can recognise that sale when the transaction is legal – at the point of contract. The actual payment due from the customer may not arise until several weeks (or months) later – if the customer has been granted some credit terms.
· Materiality: An important convention. As we can see from the application of accounting standards and accounting policies, the preparation of accounts involves a high degree of judgement. Where decisions are required about the appropriateness of a particular accounting judgement, the “materiality” convention suggests that this should only be an issue if the judgement is “significant” or “material” to a user of the accounts. The concept of “materiality” is an important issue for auditors of financial accounts.
Accounting Principles
The following is a list of the ten main accounting principles and guidelines together with a highly condensed explanation of each.
1. Economic Entity Assumption
The accountant keeps all of the business transactions of a sole proprietorship separate from the business owner’s personal transactions. For legal purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes they are considered to be two separate entities.
2. Monetary Unit Assumption
Economic activity is measured in U.S. dollars, and only transactions that can be expressed in U.S. dollars are recorded.
Because of this basic accounting principle, it is assumed that the dollar’s purchasing power has not changed over time. As a result accountants ignore the effect of inflation on recorded amounts. For example, dollars from a 1960 transaction are combined (or shown) with dollars from a 2018 transaction.
3. Time Period Assumption
This accounting principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short, distinct time intervals such as the five months ended May 31, 2018, or the 5 weeks ended May 1, 2018. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that period. For example, the property tax bill is received on December 15 of each year. On the income statement for the year ended December 31, 2017, the amount is known; but for the income statement for the three months ended March 31, 2018, the amount was not known and an estimate had to be used.
It is imperative that the time interval (or period of time) be shown in the heading of each income statement, statement of stockholders’ equity, and statement of cash flows. Labeling one of these financial statements with “December 31” is not good enough–the reader needs to know if the statement covers the one week ended December 31, 2018 the month ended December 31, 2018 the three months ended December 31, 2018 or the year ended December 31, 2018.
4. Cost Principle
From an accountant’s point of view, the term “cost” refers to the amount spent (cash or the cash equivalent) when an item was originally obtained, whether that purchase happened last year or thirty years ago. For this reason, the amounts shown on financial statements are referred to as historical cost amounts.
Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact, as a general rule, asset amounts are not adjusted to reflect any type of increase in value. Hence, an asset amount does not reflect the amount of money a company would receive if it were to sell the asset at today’s market value. (An exception is certain investments in stocks and bonds that are actively traded on a stock exchange.) If you want to know the current value of a company’s long-term assets, you will not get this information from a company’s financial statements–you need to look elsewhere, perhaps to a third-party appraiser.
5. Full Disclosure Principle
If certain information is important to an investor or lender using the financial statements, that information should be disclosed within the statement or in the notes to the statement. It is because of this basic accounting principle that numerous pages of “footnotes” are often attached to financial statements.
As an example, let’s say a company is named in a lawsuit that demands a significant amount of money. When the financial statements are prepared it is not clear whether the company will be able to defend itself or whether it might lose the lawsuit. As a result of these conditions and because of the full disclosure principle the lawsuit will be described in the notes to the financial statements.
A company usually lists its significant accounting policies as the first note to its financial statements.
6. Going Concern Principle
This accounting principle assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. If the company’s financial situation is such that the accountant believes the company will not be able to continue on, the accountant is required to disclose this assessment.
The going concern principle allows the company to defer some of its prepaid expenses until future accounting periods.
7. Matching Principle
This accounting principle requires companies to use the accrual basis of accounting. The matching principle requires that expenses be matched with revenues. For example, sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid). Wages to employees are reported as an expense in the week when the employees worked and not in the week when the employees are paid. If a company agrees to give its employees 1% of its 2018 revenues as a bonus on January 15, 2019, the company should report the bonus as an expense in 2018 and the amount unpaid at December 31, 2018 as a liability. (The expense is occurring as the sales are occurring.)
Because we cannot measure the future economic benefit of things such as advertisements (and thereby we cannot match the ad expense with related future revenues), the accountant charges the ad amount to expense in the period that the ad is run.
8. Revenue Recognition Principle
Under the accrual basis of accounting (as opposed to the cash basis of accounting), 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. Under this basic accounting principle, a company could earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in that month.
For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should recognize $1,000 of revenue as soon as its work is done—it does not matter whether the client pays the $1,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.
9. Materiality
Because of this basic accounting principle or guideline, an accountant might be allowed to violate another accounting principle if an amount is insignificant. Professional judgement is needed to decide whether an amount is insignificant or immaterial.
An example of an obviously immaterial item is the purchase of a $150 printer by a highly profitable multi-million dollar company. Because the printer will be used for five years, the matching principle directs the accountant to expense the cost over the five-year period. The materiality guideline allows this company to violate the matching principle and to expense the entire cost of $150 in the year it is purchased. The justification is that no one would consider it misleading if $150 is expensed in the first year instead of $30 being expensed in each of the five years that it is used.
Because of materiality, financial statements usually show amounts rounded to the nearest dollar, to the nearest thousand, or to the nearest million dollars depending on the size of the company.
10. Conservatism
If a situation arises where there are two acceptable alternatives for reporting an item, conservatism directs the accountant to choose the alternative that will result in less net income and/or less asset amount. Conservatism helps the accountant to “break a tie.” It does not direct accountants to be conservative. Accountants are expected to be unbiased and objective.
Book Keeping and Accounting
Book Keeping
Bookkeeping is the recording of financial transactions, and is part of the process of accounting in business. Transactions include purchases, sales, receipts, and payments by an individual person or an organization/corporation. There are several standard methods of bookkeeping, including the single-entry and double-entry bookkeeping systems. While these may be viewed as “real” bookkeeping, any process for recording financial transactions is a bookkeeping process.
Bookkeeping is the work of a bookkeeper (or book-keeper), who records the day-to-day financial transactions of a business. They usually write the daybooks (which contain records of sales, purchases, receipts, and payments), and document each financial transaction, whether cash or credit, into the correct daybook—that is, petty cash book, suppliers ledger, customer ledger, etc.—and the general ledger. Thereafter, an accountant can create financial reports from the information recorded by the bookkeeper.
Bookkeeping refers mainly to the record-keeping aspects of financial accounting, and involves preparing source documents for all transactions, operations, and other events of a business.
The bookkeeper brings the books to the trial balance stage: an accountant may prepare the income statement and balance sheet using the trial balance and ledgers prepared by the bookkeeper.
Book Keeping and Accounting
Recording of financial transactions in a proper manner related to the business operation of an entity is known as bookkeeping. Bookkeeping is the permanent recording of financial transactions in a proper manner in the books of accounts of an entity so that their financial effect on the business of entity can be seen. There is a difference between the two terms bookkeeping and accounting.
Book-keeping and accounting are different from each other. Bookkeeping is an important part of accounting.
Accounting is broader than book-keeping. Accounting includes a design of accounting systems which book-keepers use for the preparation of financial statements, audits, cost studies, income-tax statements, etc.
It also facilitates the interpretation of accounting information for both internal and external users for business decisions making. It requires skills and experience of an accountant.
There is a difference between the two terms bookkeeping and accounting, let us understand what is bookkeeping and accounting, their processes and difference between the two.
While doing Bookkeeping, we need to follow the basic accounting concepts and accounting conventions.
Bookkeeping is clerical in nature. Book-keeping is usually done by junior employees of the entity. Most of the entities nowadays use computers for bookkeeping rather than recording them manually. Accounting of an entity depends on its book-keeping system.
Book-keeping is the basis for accounting. It is because it is responsible for the proper recording of financial transactions. Whereas, Accounting involves classification, summarizing and reporting of financial transactions. It involves the preparation of source documents for all the financial transactions of the entity.
Bookkeeping
Process of Bookkeeping
1. Identifying financial transactions
2. Recording of financial transactions
3. Preparation of ledger accounts
4. Preparation of trial balance
Basic Accounting Terminologies
1. Accounts receivable (AR)
Accounts receivable (AR) definition: The amount of money owed by customers or clients to a business after goods or services have been delivered and/or used.
2. Accounting (ACCG)
Accounting (ACCG) definition: A systematic way of recording and reporting financial transactions for a business or organization.
3. Accounts payable (AP)
Accounts payable (AP) definition: The amount of money a company owes creditors (suppliers, etc.) in return for goods and/or services they have delivered.
4. Assets (fixed and current) (FA, CA)
Assets (fixed and current) definition: Current assets (CA) are those that will be converted to cash within one year. Typically, this could be cash, inventory or accounts receivable. Fixed assets (FA) are long-term and will likely provide benefits to a company for more than one year, such as a real estate, land or major machinery.
5. Asset classes
Asset class definition: An asset class is a group of securities that behaves similarly in the marketplace. The three main asset classes are equities or stocks, fixed income or bonds, and cash equivalents or money market instruments.
6. Balance sheet (BS)
Balance sheet (BS) definition: A financial report that summarizes a company’s assets (what it owns), liabilities (what it owes) and owner or shareholder equity ;at a given time.
7. Capital (CAP)
Capital (CAP) definition: A financial asset or the value of a financial asset, such as cash or goods. Working capital is calculated by taking your current assets subtracted from current liabilities—basically the money or assets an organization can put to work.
8. Cash flow (CF)
Cash flow (CF) definition: The revenue or expense expected to be generated through business activities (sales, manufacturing, etc.) over a period of time.
9. Certified public accountant (CPA)
Certified public accountant (CPA) definition: A designation given to an accountant who has passed a standardized CPA exam and met government-mandated work experience and educational requirements to become a CPA.
10. Cost of goods sold (COGS)
Cost of goods sold (COGS) definition: The direct expenses related to producing the goods sold by a business. The formula for calculating this will depend on what is being produced, but as an example this may include the cost of the raw materials (parts) and the amount of employee labor used in production.
11. Credit (CR)
Credit (CR) definition: An accounting entry that may either decrease assets or increase liabilities and equity on the company’s balance sheet, depending on the transaction. When using the double-entry accounting method there will be two recorded entries for every transaction: A credit and a debit.
12. Debit (DR)
Debit (DR) definition: An accounting entry where there is either an increase in assets or a decrease in liabilities on a company’s balance sheet.
13. Diversification
Diversification definition: The process of allocating or spreading capital investments into varied assets to avoid over-exposure to risk.
14. Enrolled agent (EA)
Enrolled agent (EA) definition: A tax professional who represents taxpayers in matters where they are dealing with the Internal Revenue Service (IRS).
15. Expenses (fixed, variable, accrued, operation) (FE, VE, AE, OE)
Expenses (FE, VE, AE, OE) definition: The fixed, variable, accrued or day-to-day costs that a business may incur through its operations.
· Fixed expenses (FE): payments like rent that will happen in a regularly scheduled cadence.
· Variable expenses (VE): expenses, like labor costs, that may change in a given time period.
· Accrued expense (AE): an incurred expense that hasn’t been paid yet.
· Operation expenses (OE): business expenditures not directly associated with the production of goods or services—for example, advertising costs, property taxes or insurance expenditures.
16. Equity and owner’s equity (OE)
Equity and owner’s equity (OE) definition: In the most general sense, equity is assets minus liabilities. An owner’s equity is typically explained in terms of the percentage of stock a person has ownership interest in the company. The owners of the stock are known as shareholders.
17. Insolvency
Insolvency definition: A state where an individual or organization can no longer meet financial obligations with lender(s) when their debts come due.
18. Generally accepted accounting principles (GAAP)
Generally accepted accounting principles (GAAP) definition:
A set of rules and guidelines developed by the accounting industry for companies to follow when reporting financial data. Following these rules is especially critical for all publicly traded companies.
19. General ledger (GL)
General ledger (GL) definition: A complete record of the financial transactions over the life of a company.
20. Trial balance
Trial balance definition: A business document in which all ledgers are compiled into debit and credit columns in order to ensure a company’s bookkeeping system is mathematically correct.
21. Liabilities (current and long-term) (CL, LTL)
Liabilities (current and long-term) definition: A company’s debts or financial obligations incurred during business operations. Current liabilities (CL) are those debts that are payable within a year, such as a debt to suppliers. Long-term liabilities (LTL) are typically payable over a period of time greater than one year. An example of a long-term liability would be a multi-year mortgage for office space.
22. Limited liability company (LLC)
Limited liability company (LLC) definition: An LLC is a corporate structure where members cannot be held accountable for the company’s debts or liabilities. This can shield business owners from losing their entire life savings if, for example, someone were to sue the company.
23. Net income (NI)
Net income (NI) definition: A company’s total earnings, also called net profit. Net income is calculated by subtracting total expenses from total revenues.
24. Present value (PV)
Present value (PV) definition: The current value of a future sum of money based on a specific rate of return. Present value helps us understand how receiving $100 now is worth more than receiving $100 a year from now, as money in hand now has the ability to be invested at a higher rate of return.
25. Profit and loss statement (P&L)
Profit and loss statement (P&L) definition: A financial statement that is used to summarize a company’s performance and financial position by reviewing revenues, costs and expenses during a specific period of time, such as quarterly or annually.
26. Return on investment (ROI)
Return on investment (ROI) definition: A measure used to evaluate the financial performance relative to the amount of money that was invested. The ROI is calculated by dividing the net profit by the cost of the investment. The result is often expressed as a percentage.
27. Individual retirement account (IRA, Roth IRA)
Individual retirement account (IRA) definition: IRAs are savings vehicles for retirement. A traditional IRA allows individuals to direct pre-tax dollars toward investments that can grow tax-deferred, meaning no capital gains or dividend income is taxed until it is withdrawn, and, in most cases, it’s tax deductible. Roth IRAs are not tax-deductible; however, eligible distributions are tax-free, so as the money grows, it is not subject to taxes upon with-drawls.
28. 401K & Roth 401K
401k & Roth 401k definition: A 401K is a savings vehicle that allows an employee to defer some of their compensation into an investment-based retirement account. The deferred money is usually not subject to tax until it is withdrawn; however, an employee with a Roth 401K can make contributions after taxes. Additionally, some employers chose to match the contributions made by their employees up to a certain percentage.
29. Subchapter S corporation (S-CORP)
Subchapter S corporation (S-CORP) definition: A form of corporation (that meets specific IRS requirements) and has the benefit of being taxed as a partnership versus being subject to the “double taxation” of dividends with public companies.
30. Bonds and coupons (B&C)
Bonds and coupons (B&C) definition: A bond is a form of debt investment and is considered a fixed income security. An investor, whether an individual, company, municipality or government, loans money to an entity with the promise of receiving their money back plus interest. The “coupon” is the annual interest rate paid on a bond.