Basic
accounting
concepts – Q&A
Peter Baskerville
Nowmaster Pty. Ltd.
Nowmaster helps industry experts and elearning developers to become
edupreneurs and to profit from their experience by establishing businesses that capture, develop and distribute human intellectual capital in the form of digital learning products for global learners. We are an incubator for entrepreneurs establishing education sector enterprises.
Published in Australia by Nowmaster PO Box 960 Spring Hill Queensland, 4000 www.nowmaster.com
©Peter Baskerville 2013
ISBN 978-0-9922949-0-8
The moral rights of the author have been asserted.
First published 2013
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means (electronic,
mechanical, photocopying, recording or otherwise), without the prior permission in writing of Nowmaster Pty. Ltd. Enquiries concerning reproduction outside the scope of the above should be sent to Nowmaster Pty Ltd. at the address above.
BASIC ACCOUNTING CONCEPTS –
Q&A
About the book and the author...vi
Introduction to accounting...1
What is accounting?...1
What is the difference between accounting and accountancy?...2
Where did accounting start?...4
What was accounting like before double-entry bookkeeping?...5
What is the difference between financial accounting and management accounting? ... 6
What is the purpose of accounting?...9
Role of accountants and bookkeepers...11
Why do we need accounting?...11
What is the difference between a bookkeeper and an accountant?...12
Why do we need accountants?...14
Accounting concepts and conventions...18
What are the accounting concepts and conventions?...18
What is the accounting entity assumption?...20
What is the going concern concept in accounting?...22
What is the revenue recognition principle?...23
What is the matching principle in accounting?...26
What is the time period assumption in accounting?...30
Types of account group classifications...33
The five account groups...33
What are assets in accounting?...33
Assets and the accounting equation...33
What are liabilities in accounting?...37
What is revenue in accounting?...43
What is the difference between revenue and income?...45
What are expenses in accounting?...48
What are expense classifications and functions in accounting?...50
What is the accounting difference between an expense and an investment?...52
What is the difference between capitalisation and expensing?...53
What is the difference between a cost and an expense in accounting?...54
What are overheads in accounting?...56
Double-entry bookkeeping with debits and credits...59
What is the double-entry bookkeeping system?...59
Why is double-entry bookkeeping such a big deal?...61
How is the accounting equation formed?...62
What are debits and credits in the bookkeeping system?...64
How do you apply debits and credits in bookkeeping?...66
How do you make sense of debits and credits in accounting?...68
How can I better understand debit and credit?...75
The accounting process...77
What is the accounting cycle?...77
What are the steps in the accounting process?...79
What are source documents in accounting?...80
What is the Chart of Accounts in accounting?...83
What are journals in accounting?...85
What is a ledger account in accounting?...87
What are subsidiary ledgers in accounting?...88
What is posting in accounting?...91
What is the general ledger in accounting?...93
What is a trial balance in accounting?...94
What is an audit trail in accounting?...96
What are end-of-period adjustments in accounting?...98
Accounting methods: cash vs accrual...101
What is cash accounting?...101
What is accrual accounting?...103
What are the advantages and disadvantages of Cash VS Accrual accounting?...105
If there were no tax benefits, would there be any advantages for accrualaccounting?...107
Financial transactions and special accounts...109
What are accruals in accounting?...109
What are prepaid expenses in accounting?...111
What is a contra account in accounting?...113
What is amortisation in accounting?...115
What is Cost of Goods Sold?...118
What are bad debts in accounting?...119
What are doubtful debts in accounting?...122
What is the difference between bad debts and doubtful debts in accounting?...124
What is a 10-column worksheet in accounting?...126
Financial statements and standards...129
How is IFRS different from GAAP?...129
Who are the stakeholders of a business?...129
What are financial statements in accounting?...131
How do you read and understand a Balance Sheet?...133
How do you read and understand the Income Statement?...137
What is the financial ratio analysis?...139
List of accounting terms and abbreviations...142
ABOUT THE BOOK AND THE AUTHOR
This e-book is a guide and reference resource for students of accounting (and its subsidiary, bookkeeping). In simple language, it explains the basic accounting concepts and why they are important in the process and application of
accounting/bookkeeping.
Basically, the mechanics of accounting is little more than adding and subtracting figures, and sometimes applying a percentage. So, it is not usually the maths of accounting that students find difficult to grasp. Rather, it is the WHY of
accounting.
This book compiles answers provided by Peter Baskerville to questions about the WHY of basic accounting. It is designed as a learning resource that users can ‘dip in and out of’ as they seek answers to specific questions, rather than as a book to be read sequentially from cover to cover. As a result, there is some necessary repetition to ensure answers to all questions are contained and comprehensive. Peter has taught bookkeeping and accounting for many years at a technical college, and has first-hand experience in helping students to understand basic accounting concepts.
Peter explains the background and first principles that underpin each concept. The answers are grouped and ordered according to the standard learning process in accounting, but their focus is on the WHY: why accounting and bookkeeping operate as they do.
Identify
and classify
financial
transaction
s
Summarise
transaction
s in
financial
reports
Send
financial
reports to
stakeholder
s
Stakeholde
rs decide
how to use
economic
resources
of
accounting
entity
INTRODUCTION TO ACCOUNTING WHAT IS ACCOUNTING?Accounting is a financial recording and reporting system (see Figure 1).
Accounting identifies and classifies financial transactions; it then summarises these financial transactions into financial reports. Financial reports communicate relevant financial information to interested persons called stakeholders. This information allows stakeholders to decide how to best use the economic resources of the accounting entity (that is, the business or enterprise).
Figure 1
The accounting system
DEFINITION OF ACCOUNTINGHere is a simple definition:
Accounting is a system that provides numeric information about the finances of an accounting entity.
Here is another definition:
Accounting is the systematic recording, reporting and analysis of the financial transactions of a business.
Yet another definition is as follows:
Accounting is a tool for recording, reporting and evaluating—in monetary terms—the transactions, events and situations that impact on an enterprise.
The American Accounting Association defines accounting as: the process of
identifying, measuring and communicating information to permit judgment and decision by users of accounts.
An even simpler definition is this: accounting is the language of business.
Key
FACTS
Accounting is a system that operates for as long as the accounting entity exists.
Accounting is interested only in the financial or monetary transactions of the accounting entity.
The first phase of accounting is to identify, collect, measure, classify and record financial transactions; a second phase is to calculate, summarise, report and evaluate financial information.
The intent of accounting is to communicate the financial information of the accounting entity to decision makers.
Accounting deals with maintaining and storing financial results.
Accounting is not an end in itself. It is not, like art in a museum, to be displayed as a ‘beautiful set of numbers’ (even if you hear businesspeople speaking this way). Accounting is primarily a means to an end. This means that accounting is a process.
Accounting provides the most relevant and reliable financial information possible so that the real work of an accounting entity (for example, a business) can be done. The real work is to make the best possible decisions about how to use the economic resources of the entity.
S
UMMARY
—
DEFINITION
OF
ACCOUNTING
Based on the above definitions and conclusions, accounting can be divided into two broad elements:
1. Accounting is an information process that identifies, classifies and summaries the financial events and transactions that impact on a business.
2. Accounting is a reporting system that communicates relevant financial information to interested person (stakeholders). This information allows stakeholders to assess performance, make decisions about and/or control the economic resources of a financial entity.
WHAT IS THE DIFFERENCE BETWEEN ACCOUNTING AND ACCOUNTANCY? Accounting is the action or process of keeping financial accounts. Accountancy describes the duties of an accountant, the person whose job is to keep, inspect and interpret financial accounts.
In relation to business, accountancy is, in effect, the total of all actions taken by a business to:
to produce reports that allow stakeholders (such as managers, investors, funders, owners) of the business to make informed decisions about the financial resources under their control.
The main reasons why a business has a vital interest in accountancy are listed in Figure 2.
Government complianceFinancial performanceComparisonBudgeting and controlFunding
Figure 2
Main reasons why a business is interested
in accountancy
Government compliance: Tax laws require a business to report to the government on its revenue and income. Accountancy
provides a process to meet this requirement.
Funding: Banks, investors and finance institutions require reports on the financial
performance and position of a business before they invest in, or loan funds to, that business. Accountancy provides these reports in the form of an Income Statement and a Balance Sheet. Financial performance: A prime function of management is to ensure that the business will endure. Accountancy provides a reporting mechanism (by way of an Income Statement) that details a business’s revenue, expenses and resulting profit. Managers can use this statement to make informed decisions to ensure the sustainability of the business.
Budgeting and control: Financial information provided by the accountancy system allows managers to prepare budgets that become a benchmark for performance and a means of controlling the finances under their control.
Comparison: Accountancy, because it is universally applied using accounting standards, allows businesses to be compared. This comparison
WHERE DID ACCOUNTING START?
The accounting system we use today had its beginning in systems used by merchants in Venice over 500 years ago.
HISTORY OF ACCOUNTING
Generally, historians agree that the Renaissance period began in what we now call Italy during the late 1200s AD. The Renaissance was well established by about 1450. It saw a huge increase in trade with some merchants becoming very wealthy. Some merchants lent money even to kings. This rapid increase in trade and wealth led to the development of early banking systems. The city–state of Venice went even further, developing an accounting system to record complex financial dealings.
Most accountants today regard the Franciscan friar and mathematician Luca Pacioli (1446–1517) as the ‘father of accounting’. Pacioli did not claim to have invented the accounting system as such, but he did present the system in a way that others could easily understand. Da Vinci, a colleague of Pacioli, helped Pacioli to illustrate his second most important manuscript, De divina proportione [Of divine proportions]. Da Vinci mentions Pacioli many times in his notes.
FIRST ACCOUNTING TEXTBOOK
Pacioli’s most important manuscript was the five-section book called (translated into English) The collected knowledge of arithmetic, geometry, proportion and
proportionality. The book was published in 1494, about the same time that
Columbus was said to have discovered America. This book by Pacioli was one of the earliest books printed on the Gutenberg press.
This is how is all started for Pacioli. Guidobaldoda Montefeltro (1472–1508), the wealthy Duke of Urbino, asked Pacioli to help him to manage his financial affairs. Pacioli did so, and was the first person to codify and publish the Venetian
accounting system. This accounting system is explained in one section (made up of 36 short chapters) of Pacioli’s five-section book (see above).
For the next century, The collected knowledge of arithmetic, geometry,
proportion and proportionality was the only accounting textbook available. Most
of the principles, processes and concepts described in this book have been adopted by accountants right up to today. These principles, processes and concepts include the:
accounting cycle
use of journals and ledgers
duality of financial transactions (that is, debits equalling credits, or ‘double-entry bookkeeping’)
formation of account groups: Assets (including Receivables and Inventories), Liabilities, Owner’s equity, Income/Revenue, and Expenses
year-end closing entries
the trial balance, which Pacioli believed should be used to prove a balanced ledger.
The system Pacioli described in his book has become known as the ‘double-entry accounting’ system.
WHAT WAS ACCOUNTING LIKE BEFORE DOUBLE-ENTRY BOOKKEEPING? Before Pacioli codified the double-entry bookkeeping system, accounting systems of a sort did exist in some societies. These systems are today described as
‘primitive accounting’. Some of these primitive accounting systems date back more than 7,000 years to the time of ancient Babylon, Assyria and Sumeria. Over time, these primitive accounting systems led to the invention of more
sophisticated numerical systems and the accounting principles in use today. In fact, it has been difficult for comparative philologists (people who study language) to identify exactly where numbering (and hence accounting) systems started and where they then separated into uniquely different fields.
EARLY METHODS OF COUNTING
The use of counting systems goes back to the dawn of intelligence among human beings. Ancient peoples in different parts of the world developed their own counting systems. Many used their fingers and toes to help them to count. Hence, the bases of many of these early counting systems were 5, 10 or 20.
For example, the ancient Mexicans used 20 as their number base. The Peruvians, who used knotted strings called quipus, had a decimal system (based on 10) as did the early Greeks. The Chinese, Tibetans and Hottentots used the concepts of ears and hands, respectively, to denote 2 and the forebears of the Brazilians generally counted by the joints of the fingers, and consequently counted in lots of 3.
Further developments in numbering systems, and hence accounting, included the use of:
• Pebbles and twigs: Apart from using body parts to help them count, some
people began using pebbles and twigs, where each item represented an animal or item of economic value.
• Bullae and tokens: The bullae were round or cylindrical-shaped clay objects,
either hollow or solid. They were used over 3,000 years ago to help keep track of shipped goods, or to calculate inventory. The variety of differently shaped tokens inserted inside the hollow bullae (or described in script on the outside surface of solid bullae) represented the items being accounted for.
• Clay tablets: Over time, the use of tokens and bullae evolved into depicting
symbols on clay surfaces. At first, sellers would imprint their tokens onto wet clay tablets as a form of recorded accounting. But not all tokens transferred
their imprint clearly onto wet clay. So, in time, some merchants began
drawing the token symbols on the clay tablets. This drawing of token symbols became the first documented accounting system in history.
• Abacus: The abacus was invented in ancient China. Its use later spread
throughout the world. The abacus consists of a wooden frame with wires threaded through strings of beads. Adding, subtracting, multiplying or dividing calculations were carried out by sliding the beads in certain ways across the wires. Merchants could not only perform complex calculations on their abacus this way, but also keep the results of these calculations on their abacus as a record of financial transactions.
WHAT IS THE DIFFERENCE BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING?
Financial accounting prepares a limited number of prescribed financial reports in accordance with statutory standards and the needs of external stakeholders. Financial accounting summarises the consequences of past decisions on the performance of the business as a whole.
Management accounting prepares an unlimited number of financial reports in accordance with business requirements and the needs of management.
Management accounting analyses the performance of units within the business by comparing results with pre-set budgets. Management accounting thus assists management in its future planning and control functions.
WHY DO WE HAVE TWO TYPES OF ACCOUNTING?
Business managers need accounting information to help them make sound decisions about the organisation. Investors look for business profits in the hope of dividends. Creditors and lenders watch an organisation’s ability to meet its financial obligations. Governmental agencies need information to ensure that the correct tax is collected and to regulate business activities. Brokers and business analysts use financial information to form an opinion on investment
recommendations. Employees chose successful companies that enhance their career prospects, and they often have bonuses or share options that are tied to enterprise performance. These examples are but a small sample of the sorts of people who are interested in the financial information of an organisation (that is, the organisation’s stakeholders). For simplicity in reporting, accountants group these stakeholders into two main user groups, as shown in Figure 3.
• government agencies • lenders and investors (owners) • creditors
• suppliers and customers • trade associations • society at large
External users
(not directly involved in daily activities of the
organisation)
• Board of Directors
• Chief Executive Officer /Chief Financial Officer
• entrepreneurs • vice-presidents • employees
• line managers (for example, business unit managers, plant and store managers)
Internal users
(directly involved in daily activities of the
organisation)
Figure 3
Two main user groups of accounting information
In general, accounting information and financial reports designed for external users are prepared in accordance with Financial Accounting Standards.
Managerial accounting, on the other hand, provides accounting information to internal users according to their specific needs. While the reporting styles for each branch of accounting are vastly different, the underlying objective is the same—to satisfy the information needs of the user.
FINANCIAL ACCOUNTING
Financial accounting focuses on producing a limited set of specific prescribed financial statements in accordance with generally accepted accounting principles (GAAP). The central outputs from financial accounting are audited financial statements. These financial statements include the Balance Sheet and Income Statement, which provide a ‘scorecard’ by which the overall past performance of a business can be judged by outsiders.
This branch of accounting targets those external stakeholders with an interest in the reporting enterprise, but who are not involved in the day-to-day operations of the business. The reports produced by this branch of accounting are used for so many different purposes that it is often called ‘general-purpose accounting’. In addition to the financial statements, external stakeholders also have access to financial reporting via press releases. These press releases are sent directly to investors and creditors or via the open communications of the internet.
The emphasis in financial accounting is on summaries of financial consequences of past activities and decisions. So, only summarised data is prepared which covers the entire organisation. The data prepared must be objective, precise and verifiable (usually by an outside auditor).
This style of reporting must follow the generally accepted accounting principles set by peak accounting bodies in conjunction with government agencies. The numbers used in financial accounting are historical in nature. While the figures in financial statements seem to be fixed and not able to be changed, they are actually based on estimates, judgments and assumptions. This is why financial statements usually include ‘Notes to the Accounts’. These notes (from
management) explain and help users to interpret the numerical information. A more specialised area of financial accounting is tax accounting.
MANAGEMENT ACCOUNTING
Management accounting deals with information that is not made public; the information is used for internal decision making only. These reports are far more detailed than those for financial accounting; they can cover performances and activities by departments, products, customers and employees. Management accounting is an accounting system that helps management to achieve the goals and objectives of the organisation. The emphasis is on the measurement,
analysis, communication and control of financial and non-financial information. Management accounting is primarily interested in helping the organisation’s department heads, division managers and supervisors to make better decisions about the daily operations of the business—in particular, those relating to planning and control decisions.
The essential data is conveyed in a wide variety of reports specifically targeted at those who direct and control the organisation. These reports help to promote more efficient and effective planning; they also help to organise resources, direct personnel and motivate staff, as well as being useful ‘tools’ in performance evaluation and operations control.
Unlike financial accounting, there are no external rules for management accounting. The emphasis in management accounting is on making decisions that affect the future. Results are compared with budgets, activity-based costing, financial planning or industry benchmarks. Reports are delivered frequently and in a timely way to meet the needs of management. Most reports are analytical, and emphasise variations in the key indicators that monitor the financial
performance of the business unit. A more specialised area of management accounting is cost accounting.
Table 1
Main differences between financial and management
accounting
accounting Number of financial
reports
Limited number— specifically Balance Sheet and Income Statement
Unlimited number—set by needs of management Rules governing preparation of financial reports Government-backed accounting
standards (that is, GAAP)
No rules
Financial reports Generally required Not required Financial reports primarily prepared for ... External stakeholders not involved in day-to-day operations of the entity
Internal stakeholders involved in day-to-day operations of the entity
Are financial reports made public? Yes No Financial information in reports contains ... Organisational summaries
Detailed performances and activities of the organisation’s business units, products, customers or employees Financial information in reports emphasises ... Objectivity, preciseness and is verifiable
Analytical aspects that identify variations in key performance indicators
Financial reports assist stakeholders with ... Evaluation, assessment and investment decisions
Planning, resource allocation and control decisions Frequency of financial report preparation Typically half-yearly and annually according to statutory requirements
Typically daily, weekly, monthly according to needs of management
Financial performance is compared with ...
Prior periods Pre-set budgets and industry benchmarks
Emphasis of financial performance Historical, being a consequence of past activities and decisions
Analytical, in making future decisions
A specialised area is …
Tax accounting Cost accounting
WHAT IS THE PURPOSE OF ACCOUNTING?
The purpose of accounting is to provide financial information about economic entities (for example, businesses) in the form of financial statements and other
reports. Financial statements allow internal and external stakeholders to evaluate the performance of the business and its management.
This evaluation permits stakeholders to make informed judgments and decisions about the entity and their engagement with the entity.
FINANCIAL STATEMENTS
Each stakeholder is interested in gaining knowledge about the financial position and performance of the enterprise or business. Financial statements provide this information and help stakeholders make economic decisions in relation to their involvement with the enterprise.
The accounting information system is designed to produce financial statements that fulfil the key purposes and objectives of accounting (see Table 2).
Table 2
Key purposes and objectives of accounting
To provide amanagement
information system (MIS) that …
Systematically records business transactions created from business activities (the record-keeping function)
Communicates to managers and other stakeholders financial information that identifies the profitability, viability and financial position of the business
Assists managers to make decisions and to control activities that protect the property of the business from unjustified and unwarranted use
Enables management to plan short- and long-term business activities by analysing historical financial information to predict future outcomes communicated via budgets and strategic plans
To enable
organisations to comply with the statutory requirements of governments and other institutions (e.g. stock exchanges)
• Compliance relates to providing financial information as a basis for taxation, corporate regulations,
industrial relations and environmental assessment
Financial statements prepared for external stakeholders give insights into the following:
• accountability of the managers: (that is, ask the following question: Have the
finances of the business been appropriately used to benefit the business rather than the personal interests of the managers?)
• capital position of the business: (that is, the amount of money distributed to
the owners and the amount of capital remaining to settle the debts of the business (loan funds, creditors))
• valuation of an business’s equity: (that is, to provide enough information for
• financial strength: (that is, the business’s ability to pays its current bills as they become due, the debt to equity ratio and interest cover)
• financial sustainability: (that is, its profitability, its return on investment or
ROLE OF ACCOUNTANTS AND BOOKKEEPERS WHY DO WE NEED ACCOUNTING?
Do you know what would happen if the accounting function were removed from the business and the economic system?
• A government would not have access to tax income from business. Taxes could, of course, still be raised in other ways, but they would be unlikely to be enough to provide the standard of community services we enjoy today. It is unlikely, too, that other tax methods would be as equitable (that is, with an entity’s ability to pay based on a percentage of profits). History records what has often happened in societies where taxes imposed on the people are not equitable.
• Investors would be ‘flying blind’ and would thus be likely to withhold vital capital needed for businesses to survive and grow. Banks, investors and finance institutions require verifiable and accurate reports on a business’s financial performance and position before they can trust it, invest in it or provide it with loan funds. Accountancy provides these reports in the form of an Income Statement and a Balance Sheet and makes transparent the financial
performance and position of a business and its management decisions. No accounting = no investment/trust = no capitalist
economy
• Business owners and managers could not track their current financial performance in an accurate and timely way. A key function of business management is to ensure that the business will endure. Accountancy
provides a reporting mechanism by way of an Income Statement that details the revenue, expenses and resulting profit that managers can use to make informed decisions to ensure the sustainability of the business.
No accounting = ill-informed decisions = poor use of resources and the failure of the business to survive
• Banks as the core component of the global financial system could not facilitate the means of economic exchange. Trade between entities would therefore eventually cease. Businesses would not offer credit, turning the efficiency of our current financial system back to the ‘dark ages’ of barter and localised subsistence living.
• Business and economic planners would have ‘no instruments with which to fly’. Financial information provided by the accountancy system allows managers to prepare budgets that become instruments, gauges and benchmarks of performance and a means of controlling the finances under their control.
No accounting = no ability to plan = end of economic growth and development
• An sw ere d b y c omp aring la st m on th
's e r th at fo th ith fit w ro p ing erat op pre vio us mon th n t o ed lay Disp • he P ro fit an d L
oss ac he y t d b ate cre ts en em Stat co un tin g em syst Is the business currently profitable? Does it continue to have the capacity to endure? Which way is
the profit trending?
• An sw ere d b y t he cash flo w fo re
cast fit ro P he g t ysin nal y a d b ce du pro and th s to ge han d c t an en em tat ss S Lo e he y t d b ate cre et he S ce Balan acco un tin g sy ste m
Can the business pay its bills as they fall due? Can the business
remain solvent into the near future and
avoid bankrupcy? • An sw ere d b y t he v alue o f t he o wn er’
s et he S ce alan e B f th n o ctio y se uit eq
What is the financial strength of the business? What is its
net worth and how much value has the business created for
the owners?
• Comparisons that promote productivity and improved performance—and that are the key drivers in maximising the use of the world’s limited resources—would disappear. Accountancy, because it is applied using international accounting standards, provides a means of comparing businesses. This comparison provides benchmarks by which under- or over-performance of a business can be judged relative to an industry average, previous periods or against the entire business world.
Furthermore, the three key reports produced by the accounting system provide answers to the fundamental questions that go to the heart of a business’s ability to survive (see Figure 4).
Figure 4
How the accounting system answers fundamental
questions about business viability
WHAT IS THE DIFFERENCE BETWEEN A BOOKKEEPER AND AN ACCOUNTANT?
Bookkeeping is a task-oriented function that routinely and systematically records an organisation’s day-to-day financial transactions.
Accounting is more results-oriented than bookkeeping. Accounting is involved more with interpreting and using financial information than in preparing it.
BOOKKEEPERS
Bookkeeping is generally the tedious, clerical and exacting role in the accounting system. Today bookkeepers use computer and accounting software to do much of this work.
The bookkeeper function is performed primarily by skilled clerical personnel who may or may not have any formal accounting training. They will, however, have a basic knowledge of the ‘double- entry system’, which ensures that financial transactions are recorded correctly.
Bookkeepers are required to classify transactions into the correct ledger
accounts as previously determined by the accountant and business owner. A final check in the bookkeeping process is called a ‘trial balance’. This summary
ensures that financial transactions have been correctly recorded. At this point, the bookkeeper usually hands the system over to the accountant who performs the second element of the accounting function: analysis and reporting.
ACCOUNTANTS
Quite often the terms bookkeeper and accountant are used interchangeably. Certainly, they both play a role in the accounting process. However, they each perform quite different functions.
Let’s revisit a definition of accounting to help us understand these differences:
Accounting consists of two key elements:
an information process that identifies, classifies and summarises the financial events that take place within an organisation
a reporting system that communicates relevant financial information to interested persons, which allows them to assess performance, make decisions and/or control the economic resources in the organisation.
As a rule, bookkeepers do only the first element described above. Accountants, who are trained and able to do both, generally do the second element. This is because accountants are uniquely specialised professionals whose time would be poorly invested in tasks that a computer—together with accounting software and a competent bookkeeper—could easily perform. So, accountants deal with the big picture. They set up the overall structure and design for both the financial information capture and the appropriate financial reporting functions.
KeyFACTS
• Accountants are responsible for reporting to governments and statutory requirements. These reports include the Statement of Financial Performance and the Statement of Financial Position. • Accountants also prepare reports and advise business managers in developing their businesss.
This advice may relate to:
– cash flow and profit forecasting
– auditing to check the accuracy of information – tax planning and lawful tax minimisation
– redesigning business accounting systems to ensure maximum efficiency.
Generally, accountants need to be highly qualified with a university degree plus membership of a peak accounting body that is maintained by the accountant’s continuous professional development.
WHY DO WE NEED ACCOUNTANTS?
People might seek the services of an accountant for many different reasons; these reasons may include:
to seek the advice of someone who is appropriately qualified in trying to understand and interpret the 70,000 or so pages of taxation law and then apply it to a business. Many people in business do not have the time or expertise to so that and are happy to pay for an accountant’s professional services to ensure that:
– the business complies with the law and avoids penalties, legal costs and potential criminal charges
– the business and related transactions are structured in a tax-effective way to ensure that tax is not overpaid. This might happen simply by getting the timing of payments and the signing of agreements in the wrong order. – business personnel spend their time doing what they do best, which is
building the business, not being involved in something where they have no specialised expertise
to help businesses fully understand the financial performance and position of their business on a continual basis. Qualified accountants have
significant experience in business and can help set up a specialised chart of accounts and a management information system that helps to identify under-performing aspects of the business. Their networks give them access to industry benchmarks which they can use to identify these areas of under-performance.
to enhance credibility when applying for bank loans and when seeking investment partners. Accountants give such external parties confidence, particularly if the accountant has prepared the financial statements
according to GAAP and gives assurances to that fact. Accountants can also ‘talk the language’ that financiers and investors speak. If the accountant is not at the negotiation table, there is a chance a business will not
effectively communicate its message and that its access to funds therefore is limited.
Of course, an accountant is not needed anymore to ‘keep the books’ of a
business. Modern computerised accounting systems allow many businesses to do their own bookkeeping. The vast majority of accountants are happy with this development because they can now spend so much more of their time giving clients the value-added advice and analysis that are really needed.
or many business owners and
managers, the accountant is
always their first appointed and
primary ongoing adviser in
business. Most owners and
managers will report that they have always
saved more money from their accountant’s
advice than they have ever paid for their
service.
F
What advice do you have for someone who is interested in working in the accounting field but not sure where to get started?
ase study: Wray Rives, qualified
accountant
C
Wray Rives is a qualified accountant and an active Quora participant. He may well wish to add to what is said below if contacted on Quora. This is what he says about becoming an accountant …
‘I studied accountancy at university as part of a degree in business and quickly saw its value in contributing to the success of my entrepreneurial dreams. I don’t have the temperament to be an accountant but I did see the value of financial/accounting skills for entrepreneurs in regard to financial modelling in business plans, structuring corporate/accounting entities, keeping your own books with computerised bookkeeping, understanding financial statements, adopting managerial accounting in regard to cash flow budgets, accessing finance options and conducting valuation analysis. See my
answer on this at: Which specialty within accounting is more beneficial to a
career in entrepreneurship—Tax or Audit? So, I didn't work directly in a
recognised accountancy field but I have embraced accountancy skills in all my entrepreneurial endeavours and in my advisory roles.
If you are interested in working in any of the specialised accounting fields, you must begin with an understanding of accounting/finance theory via a formal education. If you wish to eventually become a qualified accountant (rather than just acquire the accounting skills as I have) you will need to firstly complete an accounting or business or finance degree at a university and then complete additional specialised accounting studies as required by the professional accounting association that you may be required to join.
Check with the peak accounting body in your country in regard to their membership requirements before choosing your formal education pathway.’ SPECIALISED FIELDS OF ACCOUNTING
• Bookkeeping: This sub-set of accounting could be performed by a
para-professional who has completed formal vocational education (diploma or certificate level) at a college. Generally, a person does not need to have completed a degree or belong to one of the peak accounting bodies to work in bookkeeping. It would be necessary, though, to apply your formal
education to implanting and maintaining leading industry computerised accounting packages.
• Financial accounting jobs: People in these roles primarily prepare financial
reports for shareholders, government agencies/departments, stock
exchanges and corporate regulators; they must be a member of one of the peak accounting bodies. In Australia, these bodies are represented as CAs (Charted Accountants) and CPAs (Certified Practicing Accountants). This field requires current and complete knowledge of tax law and accounting
standards, provided through membership of a selected peak professional accounting body. Auditing is a specialised role in financial accounting that also requires membership of a peak accounting body.
• Management accounting: This field of accounting is primarily interested in
helping the organisation’s department heads, division managers and supervisors make better decisions about the day-to-day operations of the business and, in particular, those relating to planning and control decisions. The emphasis is on making decisions that affect the future, with results being compared with budgets, activity-based costing, financial planning or with industry benchmarks. These analytical reports emphasise variances in the key indicators that monitor the financial performance of the business unit. Experience counts significantly in getting jobs in this field but entry generally requires, as a minimum, a degree in accountancy/finance.
TYPES OF ACCOUNTING CAREER JOBS
So you are an accountant! Where might you seek a career in accounting?
Table 3
Opportunities for a career in accounting
Location Employer role Career benefits Requirements Public accounting firms Responsible for providing accounting services to individuals, businesses and government. The ‘big 4’ in this area are: PricewaterhouseCoop
Useful way to start an accounting career. Provides foundation
knowledge before moving into more specialised areas.
Candidates with a degree in
accounting/finance
Firms will generally assist employees in qualifying for peak body membership.
ers, Deloitte and Touché, KPMG, and Ernst & Young.
Government Responsible for
preparing budgets, tracking costs and analysing government initiatives.
Working at any level of government, prospects for advancement are generally good, due to the size of the organisation. The slow-paced, non-innovative, bureaucratic environment and politicised decision making are ‘downsides’. Preferred candidates generally have 5+ years of ‘big 4’ industry experience.
Corporations (of all sizes)
Responsible for preparing (or helping to prepare) financial statements, for tracking costs, for handling tax returns and for working on major transactions.
The work is more dynamic than government work, and career
prospects are good.
Preferred candidates will generally have industry experience and have
membership of a peak body.
Independent Responsible, as a self-employed accountant for creating one’s own business.
Benefits flow from good customer contact, independence and good financial returns; disadvantages when business is not so good.
Clients will often choose an
accountant who is a member of a peak body when perusing independent service providers.
Entrepreneurship Opts to pursue own entrepreneurial dreams, using accounting/finance skills only to build and manage a business outside of accounting. practice Prospects for becoming a valuable founding member of any business start-up team.
Formal qualifications and peak body membership are a distinct advantage but not critical.
S
UMMARY
—
BEING
AN
ACCOUNTANT
If you wish to work in any field of accountancy, start with a formal education. This should preferable be an accounting/finance degree at a university.
ACCOUNTING CONCEPTS AND CONVENTIONS
WHAT ARE THE ACCOUNTING CONCEPTS AND CONVENTIONS?
Accounting is based on generally accepted accounting principles (GAAP). These principles summarise the assumptions, practices, principles and concepts that provide the basis for measuring financial values and for reporting on the results of business activities.
Accounting concepts and conventions guide accountants when reporting on the financial performance and position of a business. Accounting principles and assumptions greatly influence the reported financial position and performance of a business.
WHY IS THERE A NEED FOR ACCOUNTING PRINCIPLES AND CONVENTIONS?
Accounting deals almost exclusively with numbers. Yet it is not purely a science of objective measurement or assessment. Accounting also involves a degree of subjective judgement because values are involved, and anyone in business will tell you that value is definitely ‘in the eye of the beholder’. What one
businessperson holds to be important, or values, another one won’t.
Either way, in order for the stakeholders of a business to make sound decisions, they need financial information that—as accurately as possible—reflects the ‘true and fair view’ of the financial performance and position of the business.
TOWARDS A ‘TRUE AND FAIR VIEW’
The concepts and conventions that accountants have adopted to guide the preparation of financial statements for a business help to support them in taking a ‘true and fair view’ approach. These concepts and conventions are sometimes called assumptions or principles.
Whatever we call them, or however they are grouped, it is important that these concepts and conventions be appropriately applied by those responsible for preparing the financial statements of a business. The concepts and conventions that need to be applied in this regard are listed in Figure 5. These key concepts explained in more detail in the text that follows.
Accounti ng entity assumpt ion Going concern concept Monetary measure ment assumpti on Time period conventi on Historic al cost convent ion Matchin g (or accruals ) principl e Realisat ion of income conventi on
Full disclosu re concept Material ity principl e Prudence (or conservat ism) principle Consiste ncy conventi on Dual aspect concept Objectiv ity concept Substan ce over form principl e
Figure 5
Accounting concepts and conventions
• Accounting entity assumption: The accounting entity assumption states that
the business is an entity (perceived to have its own existence) that is
separate from its owner. Therefore business records should be separated and kept distinct from the personal records of the business owner(s).
– This is also known as the economic entity concept or the separate business entity principle.
• Going concern concept: Accountants assume, unless there is evidence to the
contrary, that a company is not going broke and will continue to operate for an indefinite period of time or at least into the foreseeable future. This assumption allows businesses to spread (amortise) the cost of a fixed asset over its expected useful life.
• Monetary measurement assumption: Accountants do not account for items
unless they can be quantified in monetary terms (that is, money was
exchanged to acquire the item or a market exists that would be prepared to exchange money for it). A business may have other valuable resources (like workforce skills, business morale, market leadership, brand recognition, quality of management) but these do not get recorded in the financial statements because they cannot be quantified in monetary terms.
• Time period convention: This convention allows for the performance
evaluation of a going concern business to be broken up into specific period of time such as a month, a quarter or a year.
– This is also known as the accounting period convention.
– This short time period of assessment allows internal and external users to
adjust their strategy for the business. Also, using the time period assumption, the accountant and other users can compare like to like financial results over a similar period of time.
• Historical cost convention: This convention requires that the assets of a
business be recorded in the ledger accounts at the price paid to acquire them. No account is taken of the changing values of these assets in the marketplace.
• Matching principle or Accruals principle: This principle holds that expenses
should be ‘matched’ against revenues that they enabled, and should be recorded in the same period in which the revenue is earned. This approach is supported by the accrual accounting method. To do this, accountants need to prepare accruals at the end of each reporting period to take account of expenses incurred but for which there is no source document. These are part of the end-of-period adjustments.
• Realisation of income convention (revenue recognition): With this convention, accountants recognise financial transactions (and any profits arising from them) at the point of sale or at the transfer of legal ownership. This may be different from the point when cash actually changes hands.
• Full disclosure concept: The full disclosure concept requires that financial
statements provide sufficient information to help users of the information to make knowledgeable and informed decisions about the business.
• Materiality principle: Accountants only record events significant enough to
justify the usefulness of the information. Only items deemed significant for a given size of operation are recorded. Otherwise the accounts will be
burdened down with minute details.
• Prudence/Conservatism principle: The rule is to recognise revenue only when
it is reasonably certain of happening and recognise expenses as soon as they are incurred (whether paid or not). Accounting in this manner ensures that financial statements do not overstate the business’s financial position. As a rule, accounting chooses to err on the side of caution and to protect investors from acting on inflated or overly positive results.
• Consistency convention: According to this convention, transaction
classification and valuation methods should remain unchanged from one period to the next. This allows for more meaningful comparisons of financial performance between periods by the stakeholders.
• Dual aspect concept: The dual aspect concept is based on the accounting
equation:
Assets = Liabilities + Owners Equity
All transactions recorded in the accounts must keep this equation in balance. To do this, financial transactions are allocated both a debit side and a credit side of equal amounts.
• Objectivity concept: The objectivity concept states that transactions must be
recorded on the basis of objective evidence. This means that accounting records will initiate from a source document to ensure that the information recorded is based on fact and not on personal opinion.
• Substance over form principle: In accounting, real substance takes precedent
over legal form. This means that accountants consider the economic or accounting point of view rather than just the legal point of view when recording transactions. This helps to explain the difference between a legal entity and an accounting entity.
WHAT IS THE ACCOUNTING ENTITY ASSUMPTION?
It is important to understand the principle of keeping the personal financial affairs of the business owners separate from the businesses they operate. Applying the accounting entity assumption helps produce meaningful and relevant financial reports for decision makers.
An entity is something that is perceived, known or inferred to have its own separate existence.
For example, the law recognises people as legal entities because they have their own separate existence. Under the law, this status allows people to sue other legal entities and to also be sued by them.
The law in most countries of the world also recognises some persons or non-living things as legal entities. Registered companies are a good example: while they are non-persons and non-living, they are recognised legal entities. These non-person legal entities have the same rights and obligations under the law as an individual person.
However, not all non-person activities are recognised as legal entities. For example, a sole trader’s business (for example, a plumbing business) or a local social club (for example, a Darts Club) are not recognised as legal entities. This is because under the law they are not perceived to be separate and distinct from the owners or they have not been registered as a separate legal structure.
ACCOUNTING ENTITY
Accounting takes the concept of entity one step further than the law. In
accounting, every business (including sole traders) becomes its own accounting entity. So, while the law does not recognise the sole trading business as a
separate legal entity distinct from its owner/s, accounting does recognize the sole trader’s business as a separate accounting entity.
The accounting system records the financial affairs of each accounting entity separately, as shown in Figure 6.
Financial transactions are separated between: the business owner’s financial affairs
the financial affairs of the sole trading firm, which the owner may operate. Under the accounting entity assumption, a business entity, regardless of its legal status, is treated as being separate and distinct from the owners or managers of that business.
The owner of the firm
• shown in the accounting system as one 'accounting entity'
The firm itself
•shown in the accounting system as a separate and distinct 'accounting entity'
Figure 6
How the accounting system records the financial affairs
of each ‘accounting entity’
PURPOSE OF THE ACCOUNTING ENTITY ASSUMPTION
One of the key reasons for creating separate accounting entities is to enable the accounting system to provide more useful and relevant financial reports to assist decision making in relation to each specific ‘accounting entity’.
For example, if the owner’s financial affairs are separated from the financial affairs of the business, decision makers like financiers and managers can clearly assess the business' s financial performance, position and
sustainability.
WHAT IS THE GOING CONCERN CONCEPT IN ACCOUNTING?
One fundamental concept of the GAAP is the going concern concept. (The term
concern here means a business or enterprise. It started being used to mean a
business or enterprise in the early 1900s.) The going concern concept reflects the desire of stakeholders for realistic financial statements that accurately reflect the financial performance of a business over short and consecutive time periods. The going concern concept directs accountants to prepare financial statements on the assumption that the business is not about to go broke or be liquidated (that is, where the business closes and sells all assets for whatever price it can get). The opposite view to the going concern concept is that the business will cease trading shortly and that all the assets will be sold off within the current year.
ccountants adopt the going
concern concept so they can
prepare realistic financial
reports. Otherwise,
accountants would have to
write off all assets in the current period
including long-term assets that still have
an economic benefit for future periods.
A
So, unless there is significant evidence to the contrary, accountants base their valuations and their reporting of financial data on the assumption that the business will remain in existence for an indefinite period.
An indefinite period means the foreseeable future or long enough for the business to meet its objectives and to fulfil its commitments. It is important to note that the going concern concept does not imply or guarantee that the business is profitable or that it will remain so for the foreseeable future. In other words, the going concern concept assumes that when a business buys assets such as land, equipment and buildings, it does so with the intent that these assets will produce income over a number of years. The business does not purchase these assets with the intention to close operations soon after purchase and then resell them.
For example, let’s assume that a business recently purchased equipment costing $5,000, which had 5 years of productive/useful life. Under the going concern concept, the accountant would write off only 1 year’s value $1,000 (1/5th) this year, leaving $4,000 to be treated as a fixed asset with future economic value for the business.
IMPLICATIONS OF THE GOING CONCERN CONCEPT
The going concern concept has significant implications for the valuation of assets and the liabilities of a business. By applying the going concern concept,
accountants are able to value and include long-term assets in a Statement of Financial Position (Balance Sheet).
If the going concern assumption was not applied, the accountant would need to write these assets off as costs within the year of purchase. Applying the going concern concept also allows accountants to properly allocate transactions that overlap 2 or more consecutive years. As well, by applying the concept of a going concern, accountants can record assets at historical costs. Recording assets at historical cost means the accountant does not need to constantly assess the liquidated value of business assets when preparing the financial statements.
For example, partly completed manufactured goods like work in progress would have little value in a liquidation. However, under the going concern concept, work-in-process assets are recorded at their current costs, which would be significantly greater than the liquidated value.
GOING CONCERN IN COMPANY LAW
Another aspect of going concern affects the directors of companies. This is a slightly different concept to the going concern concept in accounting.
Corporation laws generally require directors of companies to declare that their business continues to be a going concern. In this context, it means that the directors believe that the business they manage is able to pay its bills as they become due. These directors are required to disclose to the shareholders in the Notes to the Financial Statements if there are any factors that may put in doubt the company’s status as a going concern.
WHAT IS THE REVENUE RECOGNITION PRINCIPLE?
The revenue recognition principle is a set of guidelines that helps accountants to identify when a revenue event has taken place and how to appropriately record cash exchanges before, during and after the revenue event. The revenue
recognition principle also helps to determine the accounting period in which the revenue is to be recorded.
BACKGROUND TO THE REVENUE RECOGNITION PRINCIPLE
The primary purpose of accounting is to provide the necessary information for sound economic decision making to take place. A key piece of that information is the calculation of net income (that is, revenues less expenses). The growth and size of the net income informs decision makers about the sustainability, financial strength and growth capacity of the business. Growth can be determined only by comparing net income results over a series of accounting periods made up of similar durations (that is, monthly, quarterly or yearly).
dentifying when revenue can be
legitimately recorded into the books
of the business, and the accounting
period that it should be recorded
against, are important considerations
for accountants and decision makers alike.
I
The revenue recognition principle guides accountants on how the revenue timing issues should be managed and treated in the financial statements. (Note: The
Revenues are realised when measurable cash or claims to cash (Accounts Receivable) are received in exchange for
goods or services.
Revenues are earned when such goods are transferred
and services have been provided (that is, when the revenue generation process
has been substantially completed or as soon as the customer has a legal right of ownership over the goods).
Revenues are considered realisable when the assets received in such an exchange are readily convertible to cash
or have a clear claim to cash.
term recognition means the moment when a financial transaction should be recorded in the bookkeeping system of a business.)
The rule underpinning the revenue recognition principle is that revenue should be recorded in the books of a business only when:
payment is assured (realisable) and measurable
revenue has been actually earned (final delivery and completion of work). These rules must be adhered to before an event can be recorded as revenue in the bookkeeping system of a business. Figure 7 summaries these principles.
Figure 7
Accounting rules for treatment of revenue
THE ISSUE WITH REVENUE RECOGNITION IN ACCOUNTINGLet’s look at the following situation to try and understand what the revenue recognition principle sets out to solve.
ase study: revenue recognition
principle and Blake’s Furniture
Store
C
Blake's Furniture Store issues a purchase order for 20 timber chairs @ $125 each in December and includes a check for $500 as a deposit. According to the agreement, the chairs are to be delivered in January with the remaining $2,000 to be paid in February.
This financial event takes place over three monthly accounting periods: December, January and February. So, the question is ... ‘In what month should the revenue be recorded (recognised) and how much should be recorded?’ The answer to this question is determined by the bookkeeping method being used by the business, and then applying the revenue recognition principle There are two bookkeeping methods: the cash accounting method and the accrual accounting method. Large corporations and for-profit companies must use the accrual accounting method while small businesses and associations can choose one or the other.
Using the cash accounting method to determine when revenue should be recognised is relatively easy because under the cash accounting method revenue is recognised (recorded) when the cash from the customer is actually received(that is, revenue recorded in the books of the business is $500 in December and $2,000 in February).
The accrual accounting method records the revenue in the month that it was earned, without regard to when cash is actually received. Under the accrual accounting method, revenue is earned when either the goods are delivered or the service has been performed/completed (revenue recorded in the books of the business is $2,500 in January).
(Note: The deposit in December is initially treated as a liability because the deposit money remains owing to the customer until the legal transfer of ownership of the chairs takes place in January with the delivery of the good.) TYPES OF TRANSACTION INVOLVING REVENUE
The revenue recognition principle impacts on the four primary ways that a business can earn revenue. These are illustrated in Figure 8.
Se lli ng in ve nto ry : Th
ese he d t t a sed gni reco re s a enue rev ate y onl mm t co bu le e sa th of int erp re ted a s t he d ate o f d eliv ery
. ice vo e in th om fr ken ta is ate e d Th or
cash rece ip
t. Providing services: These
revenues are recognised when the service is completed. It is common
practice to use the date on the invoice to determine the revenue
recognition (recording) date.
Granting permission to use business assets (e.g. interest
for borrowed/invested money, rent for use of fixed assets of business, and royalties for use
of intangible assets like patents): These revenues are
recognised at the
agreed/negotiated time intervals or as the assets are actually used.
Se lli ng a n a ss et oth er th
an xe e fi b ld cou ese Th : ry nto ve in
d uring f d d o se po dis re t a tha ets ass th e co ndu ct o f a b usi ness a
nd hen t d w nise cog re re es a enu rev he vo in he hen t r w ce o la p kes ta le sa ice nt. se een s b ha
Earning
revenue
Figure 8
Four primary ways that a business can earn revenue
S
UMMARY
—
REVENUE
RECOGNITION
PRINCIPLE
Revenues are realised when measurable cash or claims to cash (AccountsReceivable) are received in exchange for goods or services. Revenues are considered realisable when the assets received in such an exchange are readily convertible to cash, or have a clear claim to cash.
Revenues are earned when goods are transferred and services have been provided (that is, when the revenue generation process has been substantially completed, or as soon as the customer has a legal right of ownership over the goods).
WHAT IS THE MATCHING PRINCIPLE IN ACCOUNTING?
The matching principle is a fundamental accounting concept in the measurement of net income. The matching principle directs those preparing financial
statements to ensure that revenues and all their associated expenses are
recorded in the same accounting period. This is done to ensure that a net income is not distorted by time differences in billing and cash exchanges.
The matching principle is the basis on which the accrual accounting method of bookkeeping is built.
One key purpose of accounting is to provide the information needed for sound economic decision making. Sound economic decisions can be made only if a business is able to measure and report accurately on its profitability.
Profitability for a business directly determines the sustainability, financial strength and growth capacity of the business. Profitability is calculated as the amount remaining after revenue has been offset by all the expenses incurred in earning that revenue.
o, it is vitally important that
business decision makers
identify all the revenues earned
for an accounting period and
that these revenues are offset
by all the associated expenses incurred in
earning that revenue.
S
This requirement led to the development of the matching principle. The matching principle helps avoid the possibility of mis-stating the net income for a given period.
The choice of bookkeeping method impacts significantly on the matching principle. There are two methods of bookkeeping allowable under tax laws and accounting standards: the cash accounting method and the accrual accounting method.
THE MATCHING PRINCIPLE AND CASH ACCOUNTING
The cash accounting method does not apply the matching principle. This is because the cash accounting method is designed as a simpler bookkeeping system for use by small sole proprietor businesses or small associations primarily for tax purposes. The cash accounting method delays recording revenue and expenses until the cash actually exchanges (that is, the cash is received or paid). Under the cash accounting method, no regard is taken to the period in which the revenue was earned or the expense legally incurred.
THE MATCHING PRINCIPLE AND ACCRUAL ACCOUNTING
On the other hand, the accrual accounting method does adhere to the matching principle. The accrual accounting method also recognises revenue (revenue recognition principle) as soon as a product has been sold or a service has been performed, regardless of when the money is actually received by the business.
