Accounting: Definition, Statements & Evolution

Definition and Nature of Accounting

• Accounting involves identifying, measuring, and communicating economic information for informed decision-making
• Financial transactions are recorded, classified, summarized, and their results interpreted, thus, accounting is an art

Financial Statements and Their Relationships

Income Statement

• Reports income and expenses over a specific period
• Determines profit or loss for a business

Statement of Changes in Equity

• Considers profit or loss from the income statement
• Details changes in owner's equity over a period

Statement of Financial Position (Balance Sheet)

• Reports the ending owner's equity, which comes from the Statement of Changes in Equity
• Shows a business's assets, liabilities, and equity at a specific date

Statement of Cash Flows

• Reports the net increase or decrease in cash over a period
• The ending cash balance aligns with the Balance Sheet

Evolution of Accounting

Primitive Accounting

• Earliest records date back to 8500 B.C. in Mesopotamia (modern Iraq)
• Clay tokens (cones, disks, spheres, and pellets) were used for transactions
• Tokens were sealed in clay balls (bullae) for record-keeping

Amatino Manucci

• Creator of the double-entry bookkeeping system
• Systematized balancing procedures for the General Ledger

Users of Accounting Information

External Users (Outside the Business)

• Include individuals or groups, like employees, customers, creditors/lenders, stockholders/investors, suppliers and trade creditors, and government agencies, with a financial interest but not involved in daily operations

Internal Users (Within the Business)

• Include individuals responsible for decision-making within the organization, such as the Board of Directors, Chief Executive Officers (CEO), Chief Financial Officers (CFO), Vice Presidents, Internal Auditors, Business Unit Managers, Plant Managers and Supervisors

Branches of Accounting

Bookkeeping

• Bookkeeping is a mechanical task involving the collection of financial data
• Transactions are recorded, classified, and then summarized in financial statements

Financial Accounting

• Centers on recording transactions and preparing financial reports
• Adheres to Generally Accepted Accounting Principles (GAAP)

Management Accounting

• Aids in decision-making, planning, and performance management
• Offers financial reports and control systems to support management

Cost Accounting

• Tracks, allocates, and controls costs related to production or services
• Assists businesses in planning and controlling operations

Financial Management

• Financial Management focuses on managing an organization's financial resources
• Financial Management ensures financial stability and growth for an organization

Functions of Financial Management

• Raising capital for operations and investments
• Managing daily cash flow to ensure smooth transactions
• Selecting the best investment projects to maximize returns
• Managing risk exposure to protect financial assets
• Developing ethical governance structures for business integrity

Key Accounting Formula

• The key accounting formula is: Assets = Liabilities + Owner's Equity
• This equation is the foundation of accounting, ensuring that financial records remain balanced

Financial Position

• A company's financial position is assessed through the Balance Sheet
• The Balance Sheet presents assets, liabilities, and owner's equity at a specific point in time

Elements of Financial Statements

Assets

• Assets are defined as a present economic resource controlled by an entity as a result of past events
• There are two types of assets, current assets and non-current assets

Current Assets

• Assets expected to be used or converted into cash within a year
• Examples: cash and equivalents, marketable securities, trade and other receivables, inventories, prepaid expenses

Non-Current Assets

• Long-term assets not easily converted into cash
• Examples: long-term investments, property, plant, and equipment (PPE), intangible assets (patents, trademarks, goodwill, etc.)

Liabilities

• Liabilities are a present obligation to transfer an economic resource due to past events
• Criteria for a Liability to Exist: There is an obligation that requires transferring an economic resource, and the obligation exists as a result of a past event
• There are two types of liabilities, current liabilities and non-current liabilities

Current Liabilities

• Liabilities expected to be settled within one year

Non-Current Liabilities

• Long-term obligations payable beyond one year

Owner's Equity

• Defined as the residual interest in an entity's assets after deducting liabilities
• Examples of Owner's Equity Accounts: Capital (Owner's Investment), Drawings (Owner's Withdrawals), Income Summary (Accumulated Profit or Loss)

Income (Revenue & Gains)

• Increases in assets or decreases in liabilities that increase equity, excluding owner contributions
• Revenue: Total money generated from selling goods or services
• Gain: Profit earned when an asset's market value exceeds its acquisition cost

Expenses

• Decreases in assets or increases in liabilities that reduce equity, excluding owner distributions

The Accounting Equation

• It ensures that every transaction is balanced in the financial statements

The Account & Double-Entry System

The Account

• The Account is a detailed record of the increases, decreases, and balance of financial elements, used in both the Balance Sheet and Income Statement
• The simplest form is called the T-account due to its shape

Double-Entry System

• Every transaction affects at least two accounts
• Debits and Credits Rule: Debit (Left side) increases Assets & Expenses, and decreases Liabilities & Equity; Credit (Right side) increases Liabilities, Equity & Revenue, and decreases Assets & Expenses
• Formula: Total Debits = Total Credits

Financial Statements Overview

Income Statement

• Shows income and expenses over a period, helping determine profit or loss

Statement of Changes in Equity

• Explains changes in owner's equity due to investments, withdrawals, or profits

Statement of Financial Position (Balance Sheet)

• Reports a company's financial position at a specific date

Statement of Cash Flows

• Reports cash inflows and outflows from operating, investing, and financing activities