Introduction to accounting

Introduction to accounting

Introduction

It is not easy to provide a concise definition of accounting since the word has a broad application within businesses and applications.

The American Accounting Association define accounting as follows:

"the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information!.

This definition is a good place to start. Let's look at the key words in the above definition:

- It suggests that accounting is about providing information to others. Accounting information is economic information - it relates to the financial or economic activities of the business or organisation.

- Accounting information needs to be identified and measured. This is done by way of a "set of accounts", based on a system of accounting known as double-entry bookkeeping. The accounting system identifies and records "accounting transactions".

- The "measurement" of accounting information is not a straight-forward process. it involves making judgements about the value of assets owned by a business or liabilities owed by a business. it is also about accurately measuring how much profit or loss has been made by a business in a particular period. As we will see, the measurement of accounting information often requires subjective judgement to come to a conclusion

- The definition identifies the need for accounting information to be communicated. The way in which this communication is achieved may vary. There are several forms of accounting communication (e.g. annual report and accounts, management accounting reports) each of which serve a slightly different purpose. The communication need is about understanding who needs the accounting information, and what they need to know!

Accounting information is communicated using "financial statements"

What is the purpose of financial statements?

There are two main purposes of financial statements:

(1) To report on the financial position of an entity (e.g. a business, an organisation);

(2) To show how the entity has performed (financially) over a particularly period of time (an "accounting period").

The most common measurement of "performance" is profit.

It is important to understand that financial statements can be historical or relate to the future.

Accountability

Accounting is about ACCOUNTABILTY

Most organisations are externally accountable in some way for their actions and activities. They will produce reports on their activities that will reflect their objectives and the people to whom they are accountable.

The table below provides examples of different types of organisations and how accountability is linked to their differing organisational objectives:

Organisation	Objectives	Accountable to (examples)
Private or public company (e.g. Barclays, Safaricom)	- Making of profit - Creation of wealth	- Shareholders - Other stakeholders (e.g. employees, customers, suppliers)
Charities (e.g.Ahadi Trust)	- Achievement of charitable aims - Maximise spending on activities	- Charity commissioners - Donors
Local Authorities (e.g Nakuru County)	- Provision of local services - Optimal allocation of spending budget	- Local electorate - Government departments
Public services (e.g. transport, health) (e.g. NHIF, Prison Service)	- Provision of public service (often required by law) - High quality and reliability of services	- Government ministers - Consumers
Quasi-governmental agencies (e.g. Kenya National Human Commission)	- Regulation or instigation of some public action - Coordination of public sector investments	- Government ministers - Consumers

All of the above organisations have a significant roles to play in society and have multiple stakeholders to whom they are accountable.

All require systems of financial management to enable them to produce accounting information.

How accounting information helps businesses be accountable

As we have said in our introductory definition, accounting is essentially an "information process" that serves several purposes:

- Providing a record of assets owned, amounts owed to others and monies invested;

- Providing reports showing the financial position of an organisation and the profitability of its operations

- Helps management actually manage the organisation

- Provides a way of measuring an organisation's effectiveness (and that of its separate parts and management)

- Helps stakeholders monitor an organisations activities and performance

- Enables potential investors or funders to evaluate an organisation and make decisions

There are many potential users of accounting Information, including shareholders, lenders, customers, suppliers, government departments (e.g. Inland Revenue), employees and their organisations, and society at large. Anyone with an interest in the performance and activities of an organisation is traditionally called a stakeholder.

For a business or organisation to communicate its results and position to stakeholders, it needs a language that is understood by all in common. Hence, accounting has come to be known as the "language of business"

There are two broad types of accounting information:

(1) Financial Accounts: geared toward external users of accounting information
(2) Management Accounts: aimed more at internal users of accounting information

Although there is a difference in the type of information presented in financial and management accounts, the underlying objective is the same - to satisfy the information needs of the user. These needs can be described in terms of the following overall information objectives:

Collection	Collection in money terms of information relating to transactions that have resulted from business operations
Recording and Classifying	Recording and classifying data into a permanent and logical form. This is usually referred to as "Book-keeping"
Summarising	Summarising data to produce statements and reports that will be useful to the various users of accounting information - both external and internal
Interpreting and Communicating	Interpreting and communicating the performance of the business to the management and its owners
Forecasting and Planning	Forecasting and planning for future operation of the business by providing management with evaluations of the viability of proposed operations. The key forecasting and planning tool is the "Budget"

The process by which accounting information is collected, reported, interpreted and actioned is called "Financial Management". Taking a commercial business as the most common organisational structure, the key objectives of financial management would be to:

(1) Create wealth for the business
(2) Generate cash, and
(3) Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources invested

In preparing accounting information, care should be taken to ensure that the information presents an accurate and true view of the business performance and position. To impose some order on what is a subjective task, accounting has adopted certain conventions and concepts which should be applied in preparing accounts.

For financial accounts, the regulation or control of what kind of information is prepared and presented goes much further. UK and international companies are required to comply with a wide range of Accounting Standards which define the way in which business transactions are disclosed and reported. These are applied by businesses through their Accounting Policies.

The main financial accounting statements

The purpose of financial accounting statements is mainly to show the financial position of a business at a particular point in time and to show how that business has performed over a specific period.

The three main financial accounting statements that help achieve this aim are:

(1) The profit and loss account (or income statement) for the reporting period

(2) A balance sheet for the business at the end of the reporting period

(3) A cash flow statement for the reporting period

A balance sheet shows at a particular point in time what resources are owned by a business ("assets") and what it owes to other parties ("liabilities"). It also shows how much has been invested in the business and what the sources of that investment finance were.

It is often helpful to think of a balance sheet as a "snap-shot" of the business - a picture of the financial position of the business at a specific point. Whilst this is a useful picture to have, every time an accounting transaction takes place, the "snap-shot" picture will have changed.

By contrast, the profit and loss account provides a perspective on a longer time-period. If the balance sheet is a "digital snap-shot" of the business, then think of the profit and loss account as the "DVD" of the business' activities. The story of what financial transactions took place in a particular period - and (most importantly) what the overall result of those transactions was.

Not surprisingly, the profit and loss account measures "profit".

What is profit?

Profit is the amount by which sales revenue (also known as "turnover" or "income") exceeds "expenses" (or "costs") for the period being measured.

Users of accounts

The financial accounts provide a wealth of information that is useful to various users of financial information, as summarised below:

User	Interest in / Use of Accounting Information
Investors	Investors are concerned about risk and return in relation to their investments. They require information to decide whether they should continue to invest in a business. They also need to be able to assess whether a business will be able to pay dividends, and to measure the performance of the business' management overall
Lenders	Banks and other financial institutions who lend money to a business require information that helps them determined whether loans and interest will be paid when due
Creditors	Suppliers and trade creditors require information that helps them understand and assess the short-term liquidity of a business. Is the business able to pay short-term debt when it falls due?
Customers & Debtors	Customers and trade debtors require information about the ability of the business to survive and prosper. As customers of the company's products, they have a long-term interest in the company's range of products and services. They may even be dependent on the business for certain products or services
Employees	Employees (and organisations that represent them - e.g. trade unions) require information about the stability and continuing profitability of the business. They are crucially interested in information about employment prospects and the maintenance of pension funding and retirement benefits. They are also likely to interested in the pay and benefits obtained by senior management!
Government	There are many government agencies and departments that are interested in accounting information. For example, the IR&CE needs information on business profitability in order to levy and collect Corporation Tax. Various regulatory agencies (e.g. the Competition Commission and the Environment Agency) need information to support decisions about takeovers and grants, for example.
Analysts	Investment analysts are an important user group - specifically for companies quoted on a stock exchange. They require very detailed financial and other information in order to analyse the competitive performance of a business and its sector. Much of this is provided by the detailed accounting disclosures that are required by the London Stock Exchange. However, additional accounting information is usually provided to analysts via formal company briefings and interviews.
General public	Interest groups, formed by various groups of individuals who have a specific interest in the activities and performance of businesses, will also require accounting information.

Accounting concepts and conventions

In drawing up accounting statements, whether they are external "financial accounts" or internally-focused "management accounts", a clear objective has to be that the accounts fairly reflect the true "substance" of the business and the results of its operation.

The theory of accounting has, therefore, developed the concept of a "true and fair view". The true and fair view is applied in ensuring and assessing whether accounts do indeed portray accurately the business' activities.

To support the application of the "true and fair view", accounting has adopted certain concepts and conventions which help to ensure that accounting information is presented accurately and consistently.

Accounting Conventions

The most commonly encountered convention is the "historical cost convention". This requires transactions to be recorded at the price ruling at the time, and for assets to be valued at their original cost.

Under the "historical cost convention", therefore, no account is taken of changing prices in the economy.

The other conventions you will encounter in a set of accounts can be summarised as follows:

Monetary measurement	Accountants do not account for items unless they can be quantified in monetary terms. Items that are not accounted for (unless someone is prepared to pay something for them) include things like workforce skill, morale, market leadership, brand recognition, quality of management etc.
Separate Entity	This convention seeks to ensure that private transactions and matters relating to the owners of a business are segregated from transactions that relate to the business.
Realisation	With this convention, accounts recognise transactions (and any profits arising from them) at the point of sale or transfer of legal ownership - rather than just when cash actually changes hands. For example, a company that makes a sale to a customer can recognise that sale when the transaction is legal - at the point of contract. The actual payment due from the customer may not arise until several weeks (or months) later - if the customer has been granted some credit terms.
Materiality	An important convention. As we can see from the application of accounting standards and accounting policies, the preparation of accounts involves a high degree of judgement. Where decisions are required about the appropriateness of a particular accounting judgement, the "materiality" convention suggests that this should only be an issue if the judgement is "significant" or "material" to a user of the accounts. The concept of "materiality" is an important issue for auditors of financial accounts.

Accounting Concepts

Four important accounting concepts underpin the preparation of any set of accounts:

Going Concern	Accountants assume, unless there is evidence to the contrary, that a company is not going broke. This has important implications for the valuation of assets and liabilities.
Consistency	Transactions and valuation methods are treated the same way from year to year, or period to period. Users of accounts can, therefore, make more meaningful comparisons of financial performance from year to year. Where accounting policies are changed, companies are required to disclose this fact and explain the impact of any change.
Prudence	Profits are not recognised until a sale has been completed. In addition, a cautious view is taken for future problems and costs of the business (the are "provided for" in the accounts" as soon as their is a reasonable chance that such costs will be incurred in the future.
Matching (or "Accruals")	Income should be properly "matched" with the expenses of a given accounting period.

Key Characteristics of Accounting Information

There is general agreement that, before it can be regarded as useful in satisfying the needs of various user groups, accounting information should satisfy the following criteria:

Criteria	What it means for the preparation of accounting information
Understandability	This implies the expression, with clarity, of accounting information in such a way that it will be understandable to users - who are generally assumed to have a reasonable knowledge of business and economic activities
Relevance	This implies that, to be useful, accounting information must assist a user to form, confirm or maybe revise a view - usually in the context of making a decision (e.g. should I invest, should I lend money to this business? Should I work for this business?)
Consistency	This implies consistent treatment of similar items and application of accounting policies
Comparability	This implies the ability for users to be able to compare similar companies in the same industry group and to make comparisons of performance over time. Much of the work that goes into setting accounting standards is based around the need for comparability.
Reliability	This implies that the accounting information that is presented is truthful, accurate, complete (nothing significant missed out) and capable of being verified (e.g. by a potential investor).
Objectivity	This implies that accounting information is prepared and reported in a "neutral" way. In other words, it is not biased towards a particular user group or vested interest

Key characteristics of accounting information

There is general agreement that, before it can be regarded as useful in satisfying the needs of various user groups, accounting information should satisfy the following criteria:
Understandability
This implies the expression, with clarity, of accounting information in such a way that it will be understandable to users - who are generally assumed to have a reasonable knowledge of business and economic activities

Relevance
This implies that, to be useful, accounting information must assist a user to form, confirm or maybe revise a view - usually in the context of making a decision (e.g. should I invest, should I lend money to this business? Should I work for this business?)
Consistency
This implies consistent treatment of similar items and application of accounting policies
Comparability
This implies the ability for users to be able to compare similar companies in the same industry group and to make comparisons of performance over time. Much of the work that goes into setting accounting standards is based around the need for comparability.
Reliability
This implies that the accounting information that is presented is truthful, accurate, complete (nothing significant missed out) and capable of being verified (e.g. by a potential investor).
Objectivity
This implies that accounting information is prepared and reported in a "neutral" way. In other words, it is not biased towards a particular user group or vested interest

Comparison of financial and management accounting

There are two broad types of accounting information:

• Financial Accounts: geared toward external users of accounting information

• Management Accounts: aimed more at internal users of accounting information

Although there is a difference in the type of information presented in financial and management accounts, the underlying objective is the same - to satisfy the information needs of the user.

Financial Accounts	Management Accounts
Financial accounts describe the performance of a business over a specific period and the state of affairs at the end of that period.  The specific period is often referred to as the "Trading Period" and is usually one year long.  The period-end date as the "Balance Sheet Date"	Management accounts are used to help management record, plan and control the activities of a business and to assist in the decision-making process.  They can be prepared for any period (for example, many retailers prepare daily management information on sales, margins and stock levels).
Companies that are incorporated under the Companies Act 1989 are required by law to prepare and publish financial accounts.  The level of detail required in these accounts reflects the size of the business with smaller companies being required to prepare only brief accounts.	There is no legal requirement to prepare management accounts, although few (if any) well-run businesses can survive without them.
The format of published financial accounts is determined by several different regulatory elements: ·   Company Law ·   Accounting Standards ·   Stock Exchange	There is no pre-determined format for management accounts.  They can be as detailed or brief as management wish.
Financial accounts concentrate on the business as a whole rather than analysing the component parts of the business.  For example, sales are aggregated to provide a figure for total sales rather than publish a detailed analysis of sales by product, market etc.	Management accounts can focus on specific areas of a business' activities.  For example, they can provide insights into performance of: ·   Products ·   Separate business locations (e.g. shops) ·   Departments / divisions
Most financial accounting information is of a monetary nature	Management accounts usually include a wide variety of non-financial information.  For example, management accounts often include analysis of: - Employees (number, costs, productivity etc.) - Sales volumes (units sold etc.) - Customer transactions (e.g. number of calls received into a call centre)
By definition, financial accounts present a historic perspective on the financial performance of the business	Management accounts largely focus on analysing historical performance.  However, they also usually include some forward-looking elements - e.g. a sales budget; cash-flow forecast.

BALANCE SHEET EQUATION

THE ACCOUNTING EQUATION/BALANCE SHEET EQUATION

http://youtu.be/_E1eGjOwYiU 

A business owns properties. These properties are called assets. The assets are the business resources that enable it to trade and carry out trading. They are financed or funded by the owners of the business who put in funds.

These funds, including assets that the owner may put is called capital. Other persons who are not owners of the firm may also finance assets. Funds from these sources are called liabilities.

The total assets must be equal to the total funding i.e. both from owners and non-owners. This is expressed inform of accounting equation which is stated as follows:

        ASSETS = LIABILITIES + CAPITAL

Each item in this equation is briefly explained below.

            Assets:

      An asset is a resource controlled by a business entity/firm as a result of past events for which economic   benefits are expected to flow to the firm.

An example is if a business sells goods on credit then it has an asset called a debtor. The past event is the sale on credit and the resource is a debtor. This debtor is expected to pay so that economic benefits will flow towards the firm i.e. in form of cash once the customers pays.

    Assets are classified into two main types:

i)        Non current assets (formerly called fixed assets).

ii)      Current assets.

Non current assets are acquired by the business to assist in earning revenues and not for resale. They are normally expected to be in business for a period of more than one year.

Major examples include:

§  Land and buildings

§  Plant and machinery

§  Fixtures, furniture, fittings and equipment

§  Motor vehicles

Current assets are not expected to last for more than one year.  They are in most cases directly related to the trading activities of the firm. Examples include:

§  Stock of goods – for purpose of selling.

§  Trade debtors/accounts receivables – owe the business amounts as a resort of trading.

§  Other debtors – owe the firm amounts other than for trading.

§  Cash at bank.

§  Cash in hand.

Liabilities:

These are obligations of a business as a result of past events settlement of which is expected to result to an economic outflow of amounts from the firm. An example is when a business buys goods on credit, then the firm has a liability called creditor. The past event is the credit purchase and the liability being the creditor the firm will pay cash to the creditor and therefore there is an out flow of cash from the business.

Liabilities are also classified into two main classes.

i)                    Non-current liabilities (or long term liabilities)

ii)                  Current liabilities.

Non-current liabilities are expected to last or be paid after one year.  This includes long-term loans from banks or other financial institutions.  Current liabilities last for a period of less than one year and therefore will be paid within one year. Major examples:

§  Trade creditors/

or accounts payable – owed amounts as a result of

                                         business buying goods on  credit.

§  Other creditors       - owed amounts for services supplied to the firm

  other than goods.

§  Bank overdraft      - amounts advanced by the bank for a short-term

  period.

Capital:

     This is the residual amount on the owner’s interest in the firm after deducting liabilities from the assets.

     The Accounting equation can be expressed in a simple report called the Balance Sheet.  The basic format is as follows:    

                                            Name

                                Balance sheet as at 31.12.                                         

                    Sh                    Sh                                                    Sh                        Sh

Capital                                     xx          Non Current Assets

                                                              Land & Buildings                          xx

Non Current Liabilities                        Plant & Machinery                                         xx

Loan                                                    xx          Fixtures, furniture & fittings                          xx

                                                          Motor vehicles                                               xx

Current liabilities                                                                                                       xx

Overdraft        xx                                 Current Assets

Creditors         xx                   xx             Stocks                              xx

                                                              Debtor’s                            xx

Capital and Liabilities                                    Cash at bank                     xx

                                                              Cash in hand                    xx                     xx  

                                               xx            Total assets                                             xx

                                             

The above format of the balance sheet is the horizontal format however currently the practice is to present the Balance Sheet using the vertical format which is shown below.

Name

Balance sheet as at 31.12.

Non Current Assets                       Sh                    Sh                    Sh

Land & Buildings                                                                xx

Plant & Machinery                                                              xx

Fixtures, furniture & fittings                                                            xx

Motors vehicles                                                                   xx

                                                                                            xx

Current Assets

Stocks/inventories                                       xx

Debtors/ trade receivables                           xx

Cash at bank                                                           xx

Cash in hand                                                           xx

Current Liabilities

Bank Overdraft                   xx

Creditors/trade payables      xx                    (xx)

Net Current Assets                                                              xx

Net assets                                                                            xx

                                                                                           

                                           

Capital                                                                             xx                   

Non Current Liabilities

Loan (from bank or other sources)                                      xx

                                                                                         xx

                                                                               

Please pay attention to the format. The Non Current assets are listed in order of permanence as shown i.e. from Land and Buildings to motor vehicles.  The Current Assets are listed in order of liquidity i.e. which asset is far from being converted into cash. Example ,stock is not yet sold, (i.e. not yet realised yet) then when it is sold we either get cash or a debtor (if sold on credit).  When the debtor pays then the debtor may pay by cheque (cash has to be banked) or cash.

The Current Liabilities are listed in order of payment i.e. which is due for payment first.  Bank overdraft is payable on demand by the bank, then followed by creditors.

Note that in the vertical format, current liabilities are deducted from current assets to give net current assets.  This is added to Non Current assets, which give us net assets.

Net assets should be the same as the total of Capital and Non Current Liabilities.