Basic concept of accounting

DEPARTMENT OF MANAGEMENT DEPARTMENT OF MANAGEMENT

STUDIESSTUDIES EMBAEMBA Program Program

Course # E-506Course # E-506

Fundamentals of Fundamentals of AccountingAccounting

BASIC CONCEPTSBASIC CONCEPTS

Concept of AccountingConcept of Accounting:: Accounting is a service activity Accounting is a service activity designed to accumulate, designed to accumulate, measure, and communicate measure, and communicate economic information about economic information about organizations for decision organizations for decision making purposes. making purposes.

The American Accounting The American Accounting Association (AAA) has defined Association (AAA) has defined accounting as “accounting as “the process of the process of identifying, measuring, and identifying, measuring, and communicating economic communicating economic information to permit informed information to permit informed judgments and decisions by the judgments and decisions by the users of accounting informationusers of accounting information.”.”

THE ACCOUNTING THE ACCOUNTING EQUATIONEQUATION

ConceptConcept: : An algebraic equation that An algebraic equation that expresses the relationship between expresses the relationship between assetsassets

( resources), liabilities (obligations), ( resources), liabilities (obligations), and owners’ equity. The equation is and owners’ equity. The equation is expressed as under:expressed as under:

Assets = Assets = LiabilitiesLiabilities + + Owners’ Owners’ Equity.Equity.

Elements of EquationElements of Equation

Assets:Assets: Economic resources that Economic resources that are owned or controlled by an are owned or controlled by an enterprise as a result of past enterprise as a result of past transactions or events, and that are transactions or events, and that are expected to have future economic expected to have future economic benefits. benefits.

Elements of Equation Elements of Equation (continued)(continued)

Liabilities:Liabilities: Obligations of an Obligations of an enterprise to pay cash or other enterprise to pay cash or other economic resources in return for economic resources in return for past, current, or future benefits. past, current, or future benefits. They represent claims against They represent claims against assets. In equation form it can be assets. In equation form it can be expressed as:expressed as:

LiabilitiesLiabilities = Assets – = Assets – Owners’ Owners’ Equity.Equity.

Elements of Equation Elements of Equation (continued)(continued)

Owners’ EquityOwners’ Equity:: The ownership The ownership interest in the assets of an enterprise. interest in the assets of an enterprise. It represents the “net equity” of the It represents the “net equity” of the business which is the amount of net business which is the amount of net assets available after all obligations assets available after all obligations are satisfied. In equation form it can are satisfied. In equation form it can be expressed as:be expressed as:

Owners’ EquityOwners’ Equity = Assets – = Assets – Liabilities.Liabilities.

TRANSACTIONTRANSACTION

Concept of Transaction:Concept of Transaction: Exchanges of Exchanges of goods and services for money. Transactions goods and services for money. Transactions affect the assets, liabilities, owner’s equity, affect the assets, liabilities, owner’s equity, revenues, and expenses of an organization. revenues, and expenses of an organization. Transactions involve:Transactions involve:

Two partiesTwo parties Exchange of goods and servicesExchange of goods and services Value of exchanges is measurable in terms of Value of exchanges is measurable in terms of

moneymoney Transactions cause change to financial position of Transactions cause change to financial position of

an organization.an organization.

AssetsAssets

1. Cash1. Cash2. Accounts Receivable2. Accounts Receivable3. Notes Receivable3. Notes Receivable4. Merchandise Inventory4. Merchandise Inventory5. Supplies on Hand5. Supplies on Hand6. Prepaid Expenses6. Prepaid Expenses(a)(a) Prepaid rent Prepaid rent (b)(b) Prepaid wages/ salaryPrepaid wages/ salary(c)(c) Prepaid insurancePrepaid insurance

7. Equipment7. Equipment

8. Building8. Building

9. Land9. Land

LiabilitiesLiabilities

1. Accounts Payable1. Accounts Payable2. Notes Payable2. Notes Payable3. Other Payables3. Other Payables (a) Rent payable(a) Rent payable (b) Wages payable(b) Wages payable (c) Salaries payable(c) Salaries payable (d) Interest payable(d) Interest payable (e) Fees payable(e) Fees payable

Owner’s EquityOwner’s Equity

1. Owner’s Initial Capital1. Owner’s Initial Capital

2. Owner’s Additional Capital2. Owner’s Additional Capital

3. Net Income from business3. Net Income from business

Reasons of Equity Reasons of Equity IncreaseIncrease

1. Additional Investment1. Additional Investment

2. Revenue from sales or service 2. Revenue from sales or service renderingrendering

3. Net income from business3. Net income from business

Reasons of Equity Reasons of Equity DecreaseDecrease

1. Withdrawals1. Withdrawals

2. Expenses2. Expenses

3. Net loss from business3. Net loss from business

Definition of an AccountDefinition of an Account

An account is a tool of recording financial An account is a tool of recording financial transactionstransactions

of a business. An account has four of a business. An account has four elements. These are:elements. These are:

1.1. A title;A title;

2. A code number2. A code number

3. Two wings3. Two wings

4. A balance4. A balance

Types of AccountsTypes of Accounts

Accounts

PersonalAccounts

RealAccounts

NominalAccounts

Assets Liabilities Expenses Revenues

ACCOUNTING INFORMATION

The information generated through accounting

system can be categorized in two parts:Accounting Information

Statutory InformationNon- statutory

Information

Routine Non-routine

Statutory Information:Statutory Information: Information required Information required by law.

In other words, mandatory for all registered organizations. Income Statement and Balance

Sheet are statutory information.Non-statutory Information: Information that

all nonregistered organizations are not required to

provide is non-statutory information.

Routine information is generated after certain intervals. Examples of routine information are fund flow statement/cash flow statement, annual budget, performance reports, cost sheet etc.

Non-routine information is need-based information

generated by accounting system to help in solving

specific problem, e.g., marginal cost sheet, zero-based

budgeting etc.

USERS OF ACCOUNTING USERS OF ACCOUNTING INFORMATIONINFORMATION

Different users, for making their decisions require

accounting information. These users may be classified

as:1. Internal Users2. External Users:(a) External users with direct interest(b) External users with indirect interest

Users of Accounting Users of Accounting InformationInformation

Users of AccountingInformation

Internal Users External Users

External Users with

Direct Interest

External Users with

Indirect Interest

1. Internal users: Top, middle and bottom level of management executives are the internal users of

accounting information. They need it for making decisions. These usersare interested in the profitability, operational efficiency and financial soundness of the business. The top-level management is concerned with accounting information related to planning, the middle level is interested in

planning and controlling and the lower level with operational affairs.

2. External users: External users may have direct interest or indirect interest and again be classified as:(a) External users with direct interest: The existing

and the prospective creditors and investors have direct interest in the accounting information. The sources of information for

externalusers are financial statements and reports of Directors and

Auditors.Investors assess the financial soundness and net worth of the

business so that they may decide about buying, selling or holding

investment in the business. Creditors, such as banks, lenders, debenture

holders and financial institutions assess the risk involved in granting loans,

servicingof the existing loans to the business.

(b) External users with indirect interest: These users such as

department of company affairs, registrar of joint stock companies, sales tax and income tax authorities, labor

unions,prospective customers, creditors, stock exchange’s trade associations and others who are interested in the affairs of the business. They have to make their own decision on the basis of the financial reports of the business. First exam will be up to users of accounting information

BRANCHES OF ACCOUNTING

On the basis of information generated by accounting

system, there are three main branches of accounting:

(i) Financial accounting system(ii) Cost accounting system(iii) Management accounting system.

1. Financial Accounting (FA)FA deals with preparation of Final

Accounts/Financial Statements viz.(i) Income Statement to get previous year’s

result of business operation i.e., Profit/Loss. Income statement

is also termed as Profit & Loss Account (P & L A/c).

(ii) Balance Sheet (B/S) to get previous year’s financial position i.e., picture of Assets and Liabilities.

2. Cost Accounting (CA)Cost accounting deals with present informationi.e., determining unit cost at different levels (known as cost centers) of ongoing production. Cost accounting process includes:(i) Cost determination i.e. costing(ii) Cost analysis i.e. studying behavior of profit

with respect to cost and volume.(iii) Cost control i.e. comparison of actual cost

with predetermined cost/standard cost.

3. Management Accounting (MA)MA deals with all those information, which helps in decision-making process i.e. planning and

controllingfinancial activities. In an organization, MA is

common toboth FA and CA because all those information,which are generated by FA and CA system are

useful in decision-making process and comes under thepreview of MA system e.g.

CVP analysis and variance analysis of CA system also form part of MA system.

Fund Flow Statement (FFS) of FA system also form part of MA system. Because it presents the flow

of fund through business organization during financial year and is of great help in assessing fund position.

Apart from above information which are common to both FA system and CA system, there are some

information exclusively generated by management accountants e.g.

(i) Projected statements like:A- Projected income statement to estimate

coming year’s target profit.B- Projected balance sheet to estimate

coming year’s target financial position. (i.e. assets and liabilities).

C-Projected FFS/CFS to estimate coming year’s target fund/cash position.

(ii) Developing budget and budgetary control system for the purpose of budgeting.

(iii) Marginal costing techniques for short-term decision-making purposes.

Need for Accounting

Accounting helps in knowing:

1.What is the result of business operation after a certain interval i.e., profit/loss?

2. Financial health: Will the organization be able to meet commitments/obligations in the near future?

3. What is fund/cash position?4. What the organization owns i.e.,

assets to the organization.5. What the organization owes i.e.,

liabilities of the organization.and many more things, which help

in decision-making process. This creates need for accounting.

Accounting CycleAccounting Cycle

The sequential and related steps that are The sequential and related steps that are required to perform to complete the required to perform to complete the accounting process is known as accounting process is known as accounting cycle. The steps include:accounting cycle. The steps include:

1. Analyze transaction by examining 1. Analyze transaction by examining source documents.source documents.

2. Journalize transactions in the Journal2. Journalize transactions in the Journal

3. Post journal entries to the accounts in 3. Post journal entries to the accounts in the Ledger.the Ledger.

4. Take a trial balance of the accounts 4. Take a trial balance of the accounts to measure arithmetic accuracy to measure arithmetic accuracy

5. Prepare a Work Sheet.5. Prepare a Work Sheet.

6. Prepare financial statements: 6. Prepare financial statements:

(a) Income Statement; and (a) Income Statement; and

(b) Balance Sheet(b) Balance Sheet

7. Journalize and post adjusting 7. Journalize and post adjusting entries.entries.

8. Journalize and post closing entries.8. Journalize and post closing entries.

9. Take a post-closing trial balance. 9. Take a post-closing trial balance.