Fundamental of Accounting

INTRODUCTION TO ACCOUNTING

NATURE AND PURPOSE OF ACCOUNTING

Accounting is the process of identifying, measuring, and communicating economic information to
permit informed judgment and decisions by users of information.
Emphasize is on the following:

 Identifying - in accounting, this is the process of recognition or non-recognition of

business activities as accountable events. Stated differently, this is the process, which
determines if an event has accounting relevance.
 Measuring - in accounting, this is the process of assigning monetary
amounts to the accountable events.
 Communicating - As we could notice with the above definitions, one main
similarity between the three is the impact of communication. In order to be
useful, accounting information should be communicated to the different decision
makers. Communicating accounting information is achieved by the presentation
of different financial statements.

OBJECTIVES OF ACCOUNTING
 Systematic recording of transactions - Basic objective of accounting is to
systematically record the financial aspects of business transactions i.e. book-keeping.
These recorded transactions are later on classified and summarized logically for the
preparation of financial statements and for their analysis and interpretation.
 Ascertainment of results of above recorded transactions - Accountant prepares
profit and loss account to know the results of business operations for a particular
period of time. If revenue exceeds expenses then it is said that business is running
profitably but if expenses exceed revenue then it can be said that business is running
under loss. The profit and loss account helps the management and different
stakeholders in taking rational decisions.
 Ascertainment of the financial position of the business - Businessman is not only
interested in knowing the results of the business in terms of profits or loss for a
particular period but is also anxious to know that what he owes (liability) to the
outsiders and what he owns (assets) on a certain date. To know this, accountant
prepares a financial position statement popularly known as Balance Sheet. The
balance sheet is a statement of assets and liabilities of the business at a particular
point of time and helps in ascertaining the financial health of the business.
 Providing information to the users for rational decision-making - Accounting like a
language of commerce communes the monetary results of a venture to a variety of
stakeholders by means of financial reports. Accounting aims to meet the information
needs of the decision-makers and helps them in rational decision-making.
 To know the solvency position: By preparing the balance sheet, management not only
reveals what is owned and owed by the enterprise, but also it gives the information
regarding concern's ability to meet its liabilities in the short run (liquidity position) and
also in the long- run (solvency position) as and when they fall due.

USERS OF ACCOUNTING INFORMATION AND THEIR NEEDS

1. Government – the government needs accounting information during its day-to-day

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operations. The government needs accounting information to assess the amount of tax
to be paid by a business or an individual; accounting information is needed when
determining the fees to be charged in acquiring a business permit or a mayor’s permit;
when the Securities and Exchange Commission determines the legality of the amount
of share capital subscribed, accounting information is used; when the government
deals with certain economic problems like inflation, still accounting information is
used.
2. Employees – if you are an employee working in the accounting, finance or sales
department, definitely, accounting information is essential. However, the use of
accounting information is not delimited to employee working under accounting related
departments. Employees need accounting information to know if the business could
provide the necessary benefits that is due to them. Through accounting information,
employees would not be in the dark with regards to the operations of the firm that they
are working for.
3. Suppliers and Other Trade Creditors – suppliers and trade creditors are providers of
merchandise on account to different business establishments. Some examples of
suppliers are Coca-Cola and Pepsi. Coca-Cola and Pepsi products that are sold to
different fast-food chains and supermarkets but are not paid in cash immediately. Before
extending credit to customers, Coca-Cola and Pepsi should look into the accounting
records of an entity to determine if they would sell their products on account or not.
4. Customers/Clients/Consumers - Customers need accounting information in order to
determine the continuity of a business, most especially when there is a long-term
engagement between the parties or if the customer is dependent on the enterprise. For
instance, students have to go to a financially stable school that could continue to
provide quality education until they graduate. Through accounting information,
customers could also check if prices that are being charged are reasonable. Students
could look into the financial statements of a school and determine if they are being
charged the right tuition fees.
5. Lenders - Lenders have similar needs as suppliers wherein they interested in
accounting information that enable them to determine the ability of a client to pay
their obligations and the interest attached when the loan becomes due. However, in
contrast to suppliers, lenders are providers of money (like banks or lending
institutions) while suppliers are providers of tangible goods.
6. Investors and Businessmen - Investors need accounting information in order to make
relevant decisions. Through accounting information, they could determine whether to
purchase stocks, sell stocks or hold the stock. Businesspersons could determine which
operations to continue or discontinue, which product line is profitable, and many more.
They need to know about the financial performance, position, and cash flows of a
business.
7. Public - All of us need accounting information. We want to know the status of the
economy, we want to know what is happening with our favorite fast food chains, we
want to know the status of retirement plants, families need to budget their money,
monitor receipts and disbursements, and many more.

ACCOUNTING EQUATION

The accounting equation, also called the basic accounting equation, forms the foundation for all
accounting systems. In fact, the entire double entry accounting concept is based on the basic
accounting equation. This simple equation illustrates two facts about a company: what it owns

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and what it owes.

The accounting equation equates a company's assets to its liabilities and equity. This shows all
company assets are acquired by either debt or equity financing. For example, when a company
is started, its assets are first purchased with either cash the company received from loans or
cash the company received from investors. Thus, all of the company's assets stem from either
creditors or investors i.e. liabilities and equity.

Here is the basic accounting equation.

As you can see, assets equal the sum of liabilities and owner's equity (Capital). This makes
sense when you think about it because liabilities and equity are essentially just sources of
funding for companies to purchase assets.

The equation is generally written with liabilities appearing before owner's equity because
creditors usually have to be repaid before investors in a bankruptcy. In this sense, the liabilities
are considered more current than the equity. This is consistent with financial reporting where
current assets and liabilities are always reported before long-term assets and liabilities.

This equation holds true for all business activities and transactions. Assets will always equal
liabilities and owner's equity. If assets increase, either liabilities or owner's equity must increase
to balance out the equation. The opposite is true if liabilities or equity increase.

Now that we have a basic understanding of the equation, let's take a look at each
accounting equation component starting with the assets.

Assets

An asset is a resource that is owned or controlled by the company to be used for future benefits.
Some assets are tangible like cash while others are theoretical or intangible like goodwill or
copyrights.

Another common asset is a receivable. This is a promise to be paid from another party.
Receivables arise when a company provides a service or sells a product to someone on credit.

All of these assets are resources that a company can use for future benefits. Here are some
common examples of assets:
 Cash
 Accounts Receivable
 Prepaid Expenses
 Vehicles
 Buildings

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 Goodwill
 Copyrights
 Patents

Liabilities
A liability, in its simplest terms, is an amount of money owed to another person or organization.
Said a different way, liabilities are creditors' claims on company assets because this is the
amount of assets creditors would own if the company liquidated.

A common form of liability is a payable. Payables are the opposite of receivables. When a
company purchases goods or services from other companies on credit, a payable is recorded to
show that the company promises to pay the other companies for their assets.

Here are some examples of some of the most common liabilities:

 Accounts payable
 Bank loans
 Lines of Credit
 Personal Loans
 Officer Loans
 Unearned income

Equity (Capital)
Equity represents the portion of company assets that shareholders or partners own. In other
words, the shareholders or partners own the remainder of assets once all of the liabilities are
paid off.

Owners can increase their ownership share by contributing money to the company or decrease
equity by withdrawing company funds. Likewise, revenues increase equity while expenses
decrease equity.

Here are some common equity accounts:

 Owner's Capital
 Owner's Withdrawals
 Revenues
 Expenses
 Common stock
 Paid-In Capital

Example

Let's take a look at the formation of a company to illustrate how the accounting equation works
in a business situation.

Ted is an entrepreneur who wants to start a company selling speakers for car stereo systems.
After saving up money for a year, Ted decides it is time to officially start his business. He forms
Speakers, Inc. and contributes $100,000 to the company in exchange for all of its newly issued
shares. This business transaction increases company cash and increases equity by the same

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amount.

After the company formation, Speakers, Inc. needs to buy some equipment for installing
speakers, so it purchases $20,000 of installation equipment from a manufacturer for cash. In
this case, Speakers, Inc. uses its cash to buy another asset, so the asset account is decreased
from the disbursement of cash and increased by the addition of installation equipment.

As you can see, all of these transactions always balance out the accounting equation. This is
one of the fundamental rules of accounting. The accounting equation can never be out of
balance. Assets will always equal liabilities and owner's equity.

PROFESSIONAL ETHICS

A professional accountant is required to comply with the following fundamental principles:

a. Integrity
A professional accountant should be straightforward and honest in all professional and business
relationships.

b. Objectivity
A professional accountant should not allow bias, conflict of interest or undue influence of
others to override professional or business judgments.

c. Professional Competence and Due Care

A professional accountant has a continuing duty to maintain professional knowledge and skill
at the level required to ensure that a client or employer receives competent professional service
based on current developments in practice, legislation and techniques. A professional
accountant should act diligently and in accordance with applicable technical and professional
standards when providing professional services.

d. Confidentiality

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A professional accountant should respect the confidentiality of information acquired because of

professional and business relationships and should not disclose any such information to third
parties without proper and specific authority unless there is a legal or professional right or
duty to disclose. Confidential information acquired as a result of professional and business
relationships should not be used for the personal advantage of the professional accountant or
third parties.

e. Professional Behaviour
A p r o f e s s i o n a l a c c o u n t a n t s h o u l d c o m p l y w i t h r e l e v a n t laws and
regulations and should avoid any action that discredits the profession.

ACCOUNTING CONCEPT/ PRINCIPLES

Accounting Concepts and Principles are a set of broad conventions that have been devised to
provide a basic framework for financial reporting. As financial reporting involves significant
professional judgments by accountants, these concepts and principles ensure that the users of
financial information are not mislead by the adoption of accounting policies and practices
that go against the spirit of the accountancy profession. Accountants must therefore actively
consider whether the accounting treatments adopted are consistent with the accounting
concepts and principles.
Accounting Principles includes:

Relevance:
Information should be relevant to the decision-making needs of the user. Information is relevant
if it helps users of the financial statements in predicting future trends of the business
(Predictive Value) or confirming or correcting any past predictions they have made
(Confirmatory Value). Same piece of information which assists users in confirming their past
predictions may also be helpful in forming future forecasts.

Reliability
Information is reliable if a user can depend upon it to be materially accurate and if it
faithfully represents the information that it purports to present. Significant misstatements
or omissions in financial statements reduce the reliability of information contained in
them.

Reliability of financial information is enhanced by the use of following accounting concepts

and principles:
1. Neutrality
2. Faithful Representation
3. Prudence
4. Completeness
5. Single Economic Entity Concept
Neutrality
Information contained in the financial statement attempting to present them in a favored light.
Information may be deliberately biased or systematically biased. Deliberate bias occurs where
circumstances and conditions cause management to intentionally misstate the financial
statements while systematic bias occurs where accounting systems have developed an inherent

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tendency of favoring one outcome over the other over time.

Faithful Representation
Information presented in the financial statements should faithfully represent the transaction
and events that occur during a period. Faithfull representation requires that transactions and
events should be accounted for in a manner that represents their true economic substance
rather than the mere legal form. This concept is known as Substance Over Form.

Substance over form requires that if substance of transaction differs from its legal form than
such transaction should be accounted for in accordance with its substance and economic
reality. The rationale behind this is that financial information contained in the financial
statements should represent the business essence of transactions and events not merely their
legal aspects in order to present a true and fair view.
Prudence
Preparation of financial statements requires the use of professional judgment in the adoption of
accountancy policies and estimates. Prudence requires that accountants should exercise a
degree of caution in the adoption of policies and significant estimates such that the assets and
income of the entity are not overstated whereas liability and expenses are not under stated.

Completeness
Reliability of information contained in the financial statements is achieved only if complete
financial information is provided relevant to the business and financial decision making needs
of the users.
Therefore, information must be complete in all material respects.

Money Measurement Concept in Accounting

Money Measurement Concept in accounting, also known as Measurability Concept, means that
only transactions and events that are capable of being measured in monetary terms are
recognized in the financial statements. Therefore all transactions and events recorded in the
financial statements must be reduced to a unit of monetary currency. Where it is not possible to
assign a reliable monetary value to a transaction or event, it shall not be recorded in the financial
statements.

Matching Principle & Concept

Matching Principle requires that expenses incurred by an organization must be charged to the
income statement in the accounting period in which the revenue, to which those expenses
relate, is earned.

Timeliness of Accounting Information

Refers to the need for accounting information to be presented to the users in time to fulfill their
decision making needs.

Timeliness of accounting information is highly desirable since information that is presented

timely is generally more relevant to users while conversely, delay in provision of information
tends to render
it less relevant to the decision making needs of the users. Timeliness principle is therefore
closely related to the relevance principle.

Timeliness is important to protect the users of accounting information from basing their
decisions on outdated information. Imagine the problem that could arise if a company was to

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issue its financial statements to the public after 12 months of the accounting period. The users
of the financial statements, such as potential investors, would probably find it hard to assess
whether the present financial circumstances of the company have changed drastically from
those reflected in the financial statements.

Substance Over Legal Form

Substance over form is an accounting concept which means that the economic substance of
transactions and events must be recorded in the financial statements rather than just their legal
form in order to present a true and fair view of the affairs of the entity.

Substance over form concept entails the use of judgment on the part of the preparers of the
financial statements in order for them to derive the business sense from the transactions and
events and to present them in a manner that best reflects their true essence. Whereas legal
aspects of transactions and events are of great importance, they may have to be disregarded at
times in order to provide more useful and relevant information to the users of financial
statements.

Comparability/Consistency
Financial statements of one accounting period must be comparable to another in order for the
users to derive meaningful conclusions about the trends in an entity's financial performance
and position
over time. Comparability of financial statements over different accounting periods can be
ensured by the application of similar accountancy policies over a period of time.

A change in the accounting policies of an entity may be required in order to improve the
reliability and relevance of financial statements. A change in the accounting policy may also
be imposed by changes in accountancy standards. In these circumstances, the nature and
circumstances leading to the change must be disclosed in the financial statements.

Understandability
Transactions and events must be accounted for and presented in the financial statements in a
manner that is easily understandable by a user who possesses a reasonable level of knowledge
of the business, economic activities and accounting in general provided that such a user is
willing to study the information with reasonable diligence.

Materiality
Information is material if its omission or misstatement could influence the economic decisions
of users taken on the basis of the financial statements (IASB Framework). Materiality therefore
relates to the significance of transactions, balances and errors contained in the financial
statements. Materiality defines the threshold or cutoff point after which financial information
becomes relevant to the decision making needs of the users. Information contained in the
financial statements must therefore be complete in all material respects in order for them to
present a true and fair view of the affairs of the entity.

Going Concern
Going concern is one the fundamental assumptions in accounting on the basis of which financial
statements are prepared. Financial statements are prepared assuming that a business entity will
continue to operate in the foreseeable future without the need or intention on the part of
management to liquidate the entity or to significantly curtail its operational activities. Therefore,

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it is assumed that the entity will realize its assets and settle its obligations in the normal course
of the business.
Accruals Concept
Financial statements are prepared under the Accruals Concept of accounting which requires that
income and expense must be recognized in the accounting periods to which they relate rather
than on cash basis. An exception to this general rule is the cash flow statement whose main
purpose is to present the cash flow effects of transaction during an accounting period.

Business Entity Concept

Financial accounting is based on the premise that the transactions and balances of a business
entity are to be accounted for separately from its owners. The business entity is therefore
considered to be distinct from its owners for the purpose of accounting.

Realization Concept (Revenue Recognition Principle)

In accounting, also known as revenue recognition principle, refers to the application of accruals
concept towards the recognition of revenue (income). Under this principle, revenue is
recognized by the seller when it is earned irrespective of whether cash from the transaction has
been received or not.

Dual Aspect Concept | Duality Principle in Accounting

Dual Aspect Concept, also known as Duality Principle, is a fundamental convention of
accounting that necessitates the recognition of all aspects of an accounting transaction. Dual
aspect concept is the underlying basis for double entry accounting system.
Double entry accounting system is based on the duality principle and was devised to account
for all aspects of a transaction. Under the system, aspects of transactions are classified under
two main types:
1. Debit
2. Credit
Debit is the portion of transaction that accounts for the increase in assets and expenses, and the
decrease in liabilities, equity and income.
Credit is the portion of transaction that accounts for the increase in income, liabilities and
equity, and the decrease in assets and expenses.

The classification of debit and credit effects is structured in such a way that for each debit there
is a corresponding credit and vice versa. Hence, every transaction will have 'dual' effects (i.e.
debit effects and credit effects).

The application of duality principle therefore ensures that all aspects of a transaction are
accounted for in the financial statements.

Example

Mr. A, who owns and operates a bookstore, has identified the following transactions for the
month of January that need to be accounted for in the monthly financial statements:

$
1. Payment of salary to staff 2,000
2. Sale of books for cash 5,000

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3. Sales of books on credit 15,000

4. Receipts from credit customers 10,000
5. Purchase of books for cash 20,000
6. Utility expenses - unpaid 3,000

Under double entry system, the above transactions will be accounted for as follows:

Account Title Effect Debit Credit

$ $

1. Salary Expense Increase in expense 2,000

Cash at bank Decrease in assets 2,000

2. Cash in hand Increase in assets 5,000

Sales revenue Increase in income 5,000

3. Receivables Increase in assets 15,000

Sales revenue Decrease in income 15,000

4. Cash at bank Increase in asset 10,000

Receivables Decrease in asset 10,000

5. Purchases Increase in expense 20,000

Cash at bank Decrease in asset 20,000

6. Utility Expense Increase in expense 3,000

Accrued expenses Decrease in asset 3,000

QUALITIES OF USEFUL ACCOUNTING INFORMATION

In order for accounting information to be useful, it must contain certain qualities and meet
certain standards. These qualities include:

1. Relevance
Relevance in accounting information is necessary for predictive and feedback value. If
investors cannot review accounting information for a company and assess its financial
worthiness, then the information is not relevant and fails the relevance test. If management
cannot review accounting information and use it to make decisions concerning business
operations, then the information fails the feedback test.

2. Timeliness
Timeliness is a quality subset of relevance. If you do not present accounting information in a
timely manner, its usefulness to investors and managers is diminished or completely
eliminated. The quality of timeliness requires both recording the financial transaction in the
appropriate accounting period and generating accounting reports as soon as all data are posted
so that issues with business operations are discovered before the problem grows.

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3. Reliability
If accounting information is not reliable, it cannot be used to make quality business decisions.
In order to meet GAAP standards for reliability, accounting information must be verifiable,
meaning you should be able to prove the authenticity and show a paper trail for every income
and expense entry recorded to the accounting general ledger. In order for accounting
information to be reliable, it must also be neutral, meaning only GAAP standards were used
when the accounting information was recorded; that is, the information was not recorded to
reflect better on the company’s financial performance.

4. Consistency
In order for accounting information to be useful in decision making, it must be recorded
consistently, meaning the same accounting treatment must be applied at all times to a given
type of accounting data. Recording the same monthly expense in different expense accounts
skews the expense categories and makes it harder to determine the actual expense in any one
category. Large- scale accounting changes, such as changing inventory method, also affect
consistency in accounting data. You should make every attempt to limit large-scale changes
altogether, and if they are necessary, implement them at the beginning of a new accounting
year.

5. Comparability
Comparability is a subset of consistency. If you cannot compare accounting information for one
period of time to another, then you cannot derive useful information in order to make
operational decisions. Without consistency, any comparison of accounting data is useless, as
the data compared will not have been created using the same methods or standards.

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