Accounting: Definition and Nature

Definition of Accounting

• Accounting is a service activity that provides quantitative, primarily financial, information about economic entities.
• This information should be useful in making economic decisions.
• The American Accounting Association (AAA) defines accounting as the process of identifying, measuring, and communicating economic information for informed judgments and decisions.
• The American Institute of Certified Public Accountants (AICPA) defines it as the art of recording, classifying, and summarizing transactions and events of a financial character, and interpreting the results.

Nature of Accounting

• Accounting adheres to professional standards and ethics, similar to medicine, law, and engineering.
• It's a service activity that provides financial reports on the financial activities of economic entities, rather than selling goods.
• As an art and science, accounting aims to perform its service efficiently and effectively, using established techniques.
• Accounting is regulated by rules, principles, postulates, and theories, and follows a cause-and-effect relationship, demonstrated by the double-entry system.
• Every transaction has a double-effect, where if one account is debited, another is credited automatically.
• Accounting serves as a means of communication, conveying the results of business operations to interested parties.
• These parties include owners, lenders, investors, government, employees, and other agencies.
• It informs them about the economic status of a business and provides insights into its financial standing through reports.
• Bookkeeping records, as the initial stage of accounting, enable business owners to monitor their financial progress.

Users of Accounting Information

• Users of accounting information are classified as internal (management group) and external (financing and public groups).
• Internal users own, manage, and control the business, needing detailed accounting information for economic decisions.
• Internal financial reports are prepared for the efficient operation and control of the business.
• External users and their needs include:
• Investors: They need accounting information to assess investment risk and decide whether to buy, hold, or sell investments.
• Employees: Workers are interested in financial statements to determine employer stability, profitability, and evaluate remuneration, retirement benefits, and opportunities.
• Lenders: Financial statements help lenders determine if borrowers can repay loans and interest.
• Suppliers and Trade Creditors: They use financial statements to assess customer continuity and whether debts will be paid when due.
• Customers: Financial statements assess supplier continuity, ensuring availability of supplies.
• Government and Agencies: They use financial reports for statistics, income taxes, and regulatory policies.
• Public: Financial reports provide information on enterprise trends, developments, and range of activities.

Accounting Concepts and Principles

• Accounting practices adhere to guidelines encompassing conventions, rules, and procedures, known as generally accepted accounting principles (GAAP).

Accounting Concepts

• Entity Concept: Business and owners are separate entities, so their transactions should not be combined.
• Dual Aspect Concept: Every transaction has two effects such as capital and asset accounts.
• Periodicity Concept: An entity's life can be divided into time periods for reporting, with one year being standard for external reporting.
• Going Concern: Assumes the business will continue indefinitely, assets are not valued at forced sale prices.
• Money Measurement Concept: Records aspects of a business that can be expressed in monetary terms.
• Cost Concept: Records assets at their original purchase price.
  • Fixed assets are recorded at cost and reduced by depreciation.
  • Assets disappear from the balance sheet when fully depreciated and sold as scrap.
• Accrual Accounting: Recognizes transactions in the period they occur, regardless of when payment is received or expenses are earned.
• Matching Concept: Profit is important for business activities, revenue and related expenses are recorded in the same accounting period.

Basic Principles of Accounting

• Objectivity Principle: Financial statements should be unbiased and free from influence.
• Cost Principle/Historical Cost Principle: Assets are recorded at their original purchase price.
• Revenue Recognition Principle: Recognizes revenue when goods are delivered or services are performed.
• Expense Recognition Principle: Recognizes expenses when goods and services are used to produce revenue.
• Adequate Disclosure or Full Disclosure Principle: Requires all relevant information to be disclosed in financial statements.
• Materiality Principle: Concerned with information significant enough to affect evaluations and decisions, judged by size and nature of the item.
• Consistency Principle: Requires an entity to apply the same accounting methods consistently, with changes permitted if justifiable and disclosed.

Accounting Equation

• The accounting equation is the foundation of double-entry accounting, showing the relationship between assets, liabilities, and owner's equity.
• Assets = Liabilities + Owner’s Equity
• Assets are resources owned by the company, like cash, inventory, equipment, and accounts receivable.
• Liabilities are obligations to external parties, including loans, accounts payable, and other debts.
• Owner's Equity (or shareholders' equity/net assets) represents the owner's claim on the company's assets after deducting liabilities.
• The accounting equation should always balance, ensuring accurate accounting for resources.

Expanded Accounting Equation

• The expanded accounting equation provides a more detailed view of a company's financial position.
• Assets = Liabilities + Owner’s Equity + Revenues – Expenses – Drawings
• Revenues are earnings from primary activities, increasing equity.
• Expenses are costs incurred to generate revenues, decreasing equity.
• Drawings are owner withdrawals for personal use, decreasing equity.

The Five Major Accounts

• Assets- Resources controlled by the entity from past events that will create future economic benefits.
• Liabilities- Obligations a company needs to fulfill to other companies.
• Owner’s Equity- Claims of the owner in the business.
• Income- Money received in exchange for goods and service or through investing capital, also increases owner's equity.
• Expenses- Costs of operations to generate revenue.

Classification of Assets

• Assets are classified by convertibility into cash.
• Current Assets
  • Entity expects to realize the asset or intends to sell or consume it during the normal operating cycle.
  • Holds the asset primarily for trading.
  • Expects to realize the asset within 12 months after the reporting date.
  • The asset is cash or equivalent limited to settling a liability for at least 12 months after the reporting date.
  • Listed on the balance sheet in order of liquidity, the speed at which they can be turned into cash.
  • Included are:
    • Cash
    • Accounts Receivable
    • Notes Receivable
    • Inventories
    • Supplies
    • Prepaid Expenses
    • Accrued Income
    • Short term investments
• Non-Current Assets
  • Cannot easily be converted into cash and cash equivalents, also termed fixed assets, long-term assets, or hard assets.
    • Property, Plant and Equipment
    • Long Term Investment
    • Intangible assets

Classification of Liabilities

• Current Liabilities
  • Liabilities due within one year of the reporting date, for example: Accounts Payable, Utilities Payable, and Unearned Income.
• Non-Current Liabilities
  • Liabilities not due within one year. Example: Notes Payable, Loan Payable, and Mortgage Payable.
• Accounts under Current Liabilities
  • Accounts Payable
  • Notes Payable
  • Accrued Expenses
  • Unearned Income
• Non- Current Liabilities
  • Notes Payable
  • Mortgage Payable

Equity/ Owner’s Equity

• The portion of total assets fully owned by the business owner with account titles such as:
  • Capital
  • Drawing

Income

• This increases economic benefits during the accounting period in the form of inflows of cash or other assets to increase equity.
  • Service Revenue
  • Interest Income
    • The term "income" is used since earnings interest from bank deposits are not the main line of operation of the business
  • Sales
  • Professional Fees

Expense

• Expenses are decreases of economic benefits during accounting period in the form of outflows of assets or incidences of liabilities that result in decreases in equity, such as are:
  • Utilities Expense
  • Salaries Expense
  • Taxes, duties & licenses
  • Supplies Expense
  • Depreciation Expense
  • Doubtful Accounts Expense

Chart of Accounts

• It's a listing of the accounts used by companies in their financial records.
• It helps to identify where the money is coming from and where it's going.
• This is the foundation of the financial statements.

Accounting Cycle

• A set of steps that companies follow to track and manage their financial transactions.
  1. Identifying Transactions
  2. Journal Entries
  3. Posting to Ledger
  4. Trial Balance
  5. Adjusting Entries
  6. Adjusted Trial Balance
  7. Financial Statements
  8. Closing Entries
  9. Post-Closing Trial Balance
  10. Reversing Entries

Debits and Credits—The Double-Entry System

• States every financial transaction has equal and opposite effects in at least two different accounts
  1. Two Sides to Every Transaction
  2. Balancing the Books

Rules of Debit & Credit

• Increases in assets are recorded as debits; decreases are credits.
• Increases in liabilities and owner's equity are credits; decreases are debits.
• Increases in income are credits; decreases are debits.
• Increases in expenses are debits; decreases are credits.

Normal Balance of an Account

• The side (debit or credit) where increases to the account are recorded.
  • Assets: Debit
  • Liabilities: Credit
  • Equity: Credit
  • Revenue: Credit
  • Expenses: Debit

Types of Business

• Service Business
  • Offers professional skills, advice, and consultations.
    • Examples: barber shops, beauty parlors, repair shops, banks, accounting, and law firms.
• Merchandising Business
  • Buys wholesale and sells retail, also known as "buy and sell".
    • Examples: book stores, sari-sari stores, and hardware stores.
• Manufacturing Business
  • Buys raw materials and uses them in making a new product.
    • Examples: shoe manufacturing businesses, and car manufacturing plants