Basic Accounting Concepts
Everything
you need to know about basic accounting concepts
Plain English
accounting targeting the basic accounting concepts that define accounting
Accounting is an ancient art indeed, with archaeological evidence identifying an accounting system being widely used in the Near East from about 8,000 BC to 3,000 BC. [1] In the 21st century, our accountants are proud to declare their accounting system as the “language of business”. Now that may well be the case, but the rest of us don’t quite understand why that language has to be so foreign and at times, so mysterious. This series looks to demystify the accounting definition and the basic accounting concepts to allow the users of accounting information, like entrepreneurs, to extract the maximum value from its outputs and processes.
Accounting is an ancient art indeed, with archaeological evidence identifying an accounting system being widely used in the Near East from about 8,000 BC to 3,000 BC. [1] In the 21st century, our accountants are proud to declare their accounting system as the “language of business”. Now that may well be the case, but the rest of us don’t quite understand why that language has to be so foreign and at times, so mysterious. This series looks to demystify the accounting definition and the basic accounting concepts to allow the users of accounting information, like entrepreneurs, to extract the maximum value from its outputs and processes.
Accounting for Entrepreneurs
This training session is targeted at non-accountants who have no intention of ever becoming an accountant. Whilst specifically developed for intending and practicing entrepreneurs, other non-financial managers and investors may also find the training session beneficial.
This training session assumes that you know nothing about accounting
but that you realise to be effective in your role, you need to
understand the accounting definition, what accounting does and where
it fits into your world. So, this session seeks to deliver the accounting
definition training from the users point of view.
Key Words – Accounting
Definitions
accounting,
bookkeeping, accountant, financial accounting, management accounting,financial
statements, entrepreneurs, financial information, accounting function, basic
accounting concepts, different branches of accounting, define
accounting, accounting concepts, accounting definitions.
Learning Outcomes
At the completion of
this training session, you will be able to:
1. Define the role, function and purpose of
accounting.
2. Explain the key benefits of the accounting
function for the entrepreneur
3. Explain the difference between a bookkeeper
and an accountant.
4. Describe the differences between the two main
branches of accounting
Introduction – Define Accounting
Whilst many things in life change, it appears
that some elements of accounting don’t. Take for instance the 500 year old
concept of ‘double entry bookkeeping’ that was first published and practiced in 1494
by a Venetian monk, Luca Pacioli. We still use his system today, in fact
accounting as an organized method for record-keeping has been around for almost
as long as the industries of trade and business. Many of the principles
established hundreds of years ago are still used as the basis for all our
accounting functions today. A comprehensive knol on The History
of Accounting Part I is provided by
Christine Errico and talks about this very issue.
This session is a foundation stone on which all future Basic
Accounting Concepts will be built (see Basic Accounting Concepts 2 – Debits
and Credits). It is essential
then, that you fully understand this session that covers the nature, purpose
and rationale of accounting. Now, entrepreneurs are by nature exceptional
readers of market changes and emerging opportunities but if they can also add a
workable understanding of accounting to their skill set they can become
exceptional exploiters of those opportunities as well. Unfortunately,
‘hard-nosed’ business acumen is not always an entrepreneur’s natural skill but
they can enhanced this acumen significantly with a full understanding of
accounting concepts and its processes.
This training session is divided into four (4) parts. Each part
provides the ideas, knowledge and skills necessary to answer the focus question
posed at the beginning. External links to definitions are provided where
appropriate. Each part is wrapped up by a summary. You are encouraged
to participate in the training by completing the activities set at the
conclusion of each part. A questionnaire has been prepared at the conclusion of
this session with answers provided at the end of this page. This
will help you gauge your degree of learning achieved in this training
session. Additional resources and a glossary are provided to add a greater
depth to your learning experience.
What you will need
§ It is advisable to open a blank page of your
word processor and save it as “Basic Accounting Concepts” or you could just use
a pen and note paper or write the activity outcomes into a
designated exercise book.
§
It is also advisable
to have a 2nd web browser or tab
open so that you can complete the research activities without exiting this
training session.
Session – Accounting Definition
PART 1 – What is accounting?
It depends. It depends on who you are asking.
For the accountant, it is one area of business activity that they use to derive
an income. A more professional way of putting that could be, that accounting is
an occupation that is engaged in the service of providing reliable and relevant
financial information that can be used by others to make informed decisions.
One ‘official’ definition of accounting is provided by TheAmerican Accounting
Association which defines
accounting as follows: “the process of identifying, measuring and
communicating economic information to permit informed judgements and decisions
by users of the information.”
For the rest of us, the definition and purpose of accounting
could be any one or a combination of the following:
1. Professors of
Accounting may call it “The language
of business.”
2. Economists may define it as the practical application of
economic theory in that it measures income and values assets.
3. Corporate managers may define it as a set of timely gauges that
helps them actually manage the organisation
4. Labor unions may see it as a monitor of an organisations
activities and performance, particularly in relation to the benefits secured by
employees Vs owners.
5. A Board of Directors
or a Chief Executive Officer (CEO) may see accounting as a data process and reporting system that
provide the information needed for sound financial or economic decision making
for their organisation.
6. Banks and other providers of loan funds may see it
as a process of providing reports showing the financial position of an
organisation in relation to the assets owned, amounts owed to others and monies
invested as well as the profitability of the
1.
organisation’s operations in
relation to repaying the loan with interest.
2.
Governments may
see it as a way of making organisations accountable to the general community by
way of taxation contributions and transparency in the outcomes from their
decision making.
3.
Potential
investors may see it as a method of evaluating an organisation’s
effectiveness in relation to industry benchmarks and the investor’s required
returns.
4.
Investors in
some failed enterprises may sadly call it a method of fooling some of the
people, some of the time with what has been dubbed ‘Creative Accounting’.
One final point to make here, is
that accounting is not an end in itself. It is not art to be hung in a museum
as a ‘beautiful
set of numbers’. Accounting is a means to an end
i.e. it provides the most relevant and reliable information possible to allow
for the real work to be done – the making of the best possible decisions.
Summary
– Define Accounting
We can see from these definitions
that accounting can be divided into two main elements:
§ an information process that identifies, classifies and
summarises the financial events that take place within an organisation and
§ 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.
Activity
1
§ Research the internet to find the website of an “accounting
association” based in your country.
§ Search the site to find their definition of accounting and
write it down.
§ Use underlying or coloring to identify the two main parts
identified in the summary definition above.
PART 2 – How does the accounting function benefit the
entrepreneur?
Success in any business needs a potent combination of both
innovative problem solving (value creation) and business acumen (value
maintenance and control). Accounting won’t help much with the former but it is
the central pillar on which business acumen is built. Entrepreneurs by nature
rely heavily on their innovative insights but the successful ones also know how
and when to apply business acumen in their decisions via the reality checks and
the more objective results provided by the accounting function.
Listed below are a few ways in which
the accounting function impacts on and/or benefits the entrepreneur:
1.
The most obvious one is the help in
preparing our financial records for tax assessment purposes. This is usually
annually for income tax but laws in some countries require more frequent
reporting due to value added taxes and employee withheld taxes. Depending on
your business structure and industry, you may also be required to provide your
financial information to government agencies or even some trade associations
under membership rules.
2.
Another common use of the accounting
function for entrepreneurs is in the preparation of financial forecasts. This
may be in the preparation of a business plan/proposal or when applying to a
funder for a loan or selling a share of the business to an investor/partner.
You must still tell the written and oral story of the business but by providing
your assumptions to an accountant, they can translate that story into a
language that is understood by all in common. Hence, accounting has come to be
known as the “language of business”
3.
It helps you calculate the break even for
your planned venture. This is a critical number for an entrepreneur to both
know and be able to reasonably defend to any interested stakeholder.
4.
The accounting function helps keep
you ‘in the game’. Entrepreneurs by nature live in the future because that’s
where they believe their reward will materialize, trouble is, the vast majority
of people want to be paid in the present. The accounting function with itscash flow modelling and
profit reporting can assist the entrepreneur in ensuring that they actually
make it to their future reward.
5.
It’s a reality check. Entrepreneurs
know that things change. They know that the real opportunity that emerges if
often times not the primary one that they set out to exploit. The accounting
function helps you to quickly pick the emerging winners and identify the
losers. Sure, entrepreneurs are very persistent people in any race but the
smart ones know when to ‘stop flogging a dead horse’ and climb aboard a winner
when the objective assessment shows that it is required.
6.
Once a new venture is trading, the
accounting function can help monitor important key indicators like gross profit margin which is the difference between your selling price and cost
of producing/buying the product. Your accountant can set you up with many other
key indicators which will become the instrument panel by which you guide and
direct your enterprise.
Summary
– Accounting benefit for entrepreneur
§ We have seen that accounting is an important function that
helps entrepreneurs in both establishing and managing their enterprises. It
helps with tax assessment, preparing financial forecasts, calculating your
breakeven, it keeps you in the game, it’s a reality check and can be used
to create an instrument panel to efficiently manage your new enterprise all the
way to success.
Activity
2
§ Research the internet to find the website of an accountant
in your area.
§ Search their site to find the list of services they provide.
§ Identify three that match the six outlined above and/or
identify one service from their site that is not mentioned above.
PART 3 – What is the difference between a
bookkeeper and an accountant?
We hear the two terms of bookkeeper and accountant used so
often and interchangeably when dealing with the finances aspects of a business.
The reality is that they are two quite distinct roles requiring two quite
distinct skill sets.
As mentioned in the summary of PART
1, the broad concept of accounting consists of two main elements.
1.
the information process that
identifies, classifies and summarises the financial events that take place
within an organisation and
2.
the 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.
Now, as a rule, bookkeepers only do
the first element whilst accountants, who could do both, generally stick with
the second. This is because accountants are uniquely specialised professionals
(read expensive) whose time would be poorly invested in tasks that a computer +
accounting software + a competent clerk could easily perform.
Bookkeeping is generally considered the tedious, clerical and exacting
role in the accounting function which is why it has been largely taken over by
computer processors with their inbuilt software systems. Bookkeeping is all
about the routine and systematic recording of the organisation’s financial
transactions, both incoming and outgoing, on a day-to-day basis. The bookkeeper
function today is performed primarily by skilled clerical personnel who may or
may not have had any formal accounting training because the role calls for
a more follow-the-instructions approach than a creative one.
Bookkeeping in large part is a task oriented function i.e it
records transactions
Bookkeepers need to classify
transactions into the correct compartment as previously determined by the
accountant and business owner. They must also have the basic knowledge of the
‘double entry system’ used in accounting to ensure that financial transactions
are recorded correctly. A final check in the process for this is called a ‘trial balance’ which
makes sure that the accounting system has been correctly followed. At this
point the bookkeeper usually hands the details over to the accountant who
performs the second element of the accounting function – reporting.
With a small amount of training on
one of the computerized accounting program on offer today, there is no reason
why an entrepreneur would not be able to be his/her own bookkeeper. This could
help initially with costs (accountants don’t come cheap) but more importantly
because it keeps the entrepreneur abreast of the up-to-the-minute changes and
development that are happening within their venture.
Accountants on
the other hand deal with the big picture or the overall structure and design of
both capturing the financial information and the appropriate reporting.
Accounting is more results oriented i.e. involved more with the interpretation
and use of accounting information than with its actual preparation.
Accountants work with entrepreneurs
initially to categorise all typical transaction types into groups that
they both believe will ultimately lead to meaningful reports for the
entrepreneur whilst also complying with government regulations. As mentioned
earlier, the bookkeeper is responsible for the accounting process up to the
trial balance stage. Now, whilst a correct ‘trial balance’ means that the
double entry accounting system has been correctly applied, it does not mean
that the transactions have been placed in their correct classification. The
accountant will conduct a scan of the entries, usually by viewing the detailed general ledger, to ensure that there are no irregularities. Having checked
that all is in order, the accountant then prepares the financial statements.
First priority is usually given to
the government and statutory
requirements involving the preparation of the
Profit & Loss Statement and the Balance Sheet, although depreciation
schedules and some end-of-period adjustments, called ‘accruals’, will first need to be completed. They then work to prepare
reports and give advice that assists the entrepreneur in the development of
their enterprise. These could be evaluating the efficiency of their operations,
resolving complex financial reporting issues, cash flow and profit forecasting,auditing to
check the accuracy of the information, tax planning and lawful tax minimisation
and redesigning the entrepreneur’s accounting systems to ensure maximum
efficiency.
Now unless you are prepared to
invest up to 6 years study to become a qualified accountant, the accounting
function will be beyond us. So, this is a key appointment in the founding
team for an entrepreneur and the best accountants add far more value than they
charge. This article on choosing
an accountant may help you find the right one.
Summary
– Accountant Vs Bookkeeper
§ The bookkeeper function generally performs the first element
of the accounting process being the identification, classifying and recording
of the financial transactions for an organisation. It is a daily task
orientated role that generally ends at the point of the ‘trial balance’.
§ The accountant function on the other hand is results
oriented, in that it is more focused on the interpretation of the financial
information which results in reports to governments and government agencies as
well as to the organisation’s management.
§ The two roles are vital parts of a whole and whilst they can
be combined into one role they are generally separated due to cost efficiencies
and lack of specialised technical skills.
Activity
3
·
Read the two descriptions of the
bookkeeper and the accountant detailed above.
·
Draw a matrix of 6 rows and 2
columns like the one shown.
·
Complete the matrix by comparing 5
aspects on which the bookkeeper and the accountant differ in their roles.
Bookkeeper
|
Accountant
|
1.
|
1.
|
2.
|
2.
|
3.
|
3.
|
4.
|
4.
|
5.
|
5.
|
PART 4 – What are the different branches of accounting?
For example, business managers need
accounting information to assist them in making sound decisions. Investors
watch the profits in the hope of ‘dividends’.Creditors and lenders are watchful of the organisation’s ability to
meet its financial obligations. Governmental agencies need information to
ensure the correct tax was 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. This a but a small sample of people that are
interested in the financial information of an organisation.
Now for reporting purposes,
accountants group these stakeholders into 2 main user group:
1.
External
users who are outside the organisation like Governmental agencies,
Lenders, Investors (Owners), Creditors, Suppliers, Customers, Trade
associations and society at large.
2.
Internal
users who are inside the organisation like a Board of directors,
Chief executive officer (CEO), entrepreneurs, Chief financial officer (CFO) ,
Vice presidents, employees and Line managers like Business unit managers, Plant
& Store managers.
Accounting information and financial
reports designed for external users is called Financial Accounting whereas
Managerial Accounting provides accounting information to internal users that is
most useful in the management of a company. Now whilst the reporting styles in
each branch are vastly different, the underlying objective is the same – to
satisfy the information needs of the user.
Financial
Accounting
Financial accounting is focused on
producing a limited set of specific prescribed financial statements in
accordance with generally accepted accounting principles. The central outputs
from financial accounting are audited financial statements such as
the balance sheet and income statement that provides a scorecard by which
a company’s overall past performance can be judged by outsiders.
This branch of accounting targets
those external stakeholders that have an interest in the reporting enterprise,
but that are not involved in the day-to-day operations. The reports produced by
this branch 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 that
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 summarized data is prepared, that covers the entire organization. The data
prepared must be objective, precise and be verifiable, usually by an outside ‘auditor’. This style of reporting must follow the generally accepted
accounting principles that are set by peak accounting bodies in conjunction
with government agencies. The numbers used in financial accounting are
historical in nature.
Now whilst appearing set in
stone, financial statements are actually based on estimates, judgments,
and assumptions. This is why financial statements usually include ‘notes to the
accounts’ which are the explanations from management that help explain and
interpret the numerical information. A more specialised area of financial
accounting is Tax Accounting.
Entrepreneurs rely heavily on the
specialist knowledge and skill of the accountant to perform this function but
entrepreneurs should still play a part in the process. Ideally they would scan
the detailed general ledger looking for anomalies, they would make sure their
stocktake was carried out and calculated according to their accountants
instructions, they would scan the financial reports looking for any numbers
that ‘didn’t seem right’. These should be discussed with the accountant before
the reports are sent because whilst accountants know all about accounting they
know a lot less about your business than you do.
Management
Accounting
Managerial accounting deals with
information that is not made public and is used for internal decision making
only. These reports are far more detailed than financial accounting and can
cover performances and activities by departments, products, customers, and
employees. It is an accounting system that helps management achieve the goals
and objectives of the organisation with an emphasis on the measurement,
analysis, communication and the control of financial and non-financial
information.
This branch of accounting is
primarily interested in assisting 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 the planning and control
decisions
.
The essential data is conveyed in a
wide variety of reports and is specifically targeted at those who direct and
control the organisation. These reports help to promote more efficient and
effective plan making, resources organizing, personnel directing, motivating
and performance evaluation, and operations control.
Unlike financial accounting, there
are no external rules governing management accounting. The emphasis in this
branch is on making decisions that affect the future with
results being compared to budgets, activity-based costing, financial
planning or to industry benchmarks. These reports are delivered frequently and
in a timely way according to the requirements of management. Most reports are
analytical in nature with a heavy emphasis on variances in the key indicators
that monitor the financial performance of the business unit. A more specialised
area of management accounting is Cost Accounting.
For the entrepreneur, the no.#1 most
critical management accounting report is the 13 week moving cashflow forecast.
Get your accountant to set this up for you using a spreadsheet program like
Microsoft Excel. You should learn to update it weekly and so manage the life
blood of your business – your cash. You should also identify the key performance indicatorsfor your business and have these monitored closely at
appropriate intervals. (i.e. Sales – daily, Expenses – monthly, Average unit
sale & average customer sale – weekly)
Summary
– different branches of accounting
§ There are many stakeholders who are interested in the
financial performance of an organisation. Each of these would prefer a
customised report detailing only their area of concern. Since this is not
feasible, accountants have created two branches of financial information
reporting:
·
financial accounting which prepares
highly regulated reports for external stakeholders who are not engaged in the
day to day operations of the organisation.
·
management accounting which provides
customised, appropriate and timely financial information to those internal
managers entrusted with the day to day operations of the organisation.
§ Both branches still uphold the underlying accounting
objective – to satisfy the information needs of the user.
Activity
4
§ Read the two descriptions of financial accounting and
management accounting detailed above.
§ Draw a matrix of 6 rows and 2 columns like the one
shown.
§ Complete the matrix by comparing 5 aspects on which
financial accounting and management accounting differ in their approaches.
Management Accounting
|
Financial Accounting
|
1.
|
1.
|
2.
|
2.
|
3.
|
3.
|
4.
|
4.
|
5.
|
5.
|
Additional Resources –
Accounting Definition
1 – For an overview of financial
accounting and some basic
accounting concepts see: The quick MBA accounting
2 – For an introduction to accounting and the accounting process see:
3 – For another series of lectures on the topic ‘Introduction to Accounting” see:
4 – For a glossary of accounting terms see:
5 – For another accounting start
point see:
Questionnaire – Accounting
Definition http://lvaccountingservices.blogspot.in/p/blog-page.html
On a separate piece of paper or on a
blank word processing document, write down your answers to the following
questions. Comparing these answers with those provided at the end of this page
will help you establish the extent to which the learning has taken place on
this session topic.
___________________________________________
Q1 –
A key purpose of accounting is to promote informed judgements and decisions by
users of the financial information
§ True
§ False
__________________________________________
Q2 –
If you could simplify accounting for an organisation into three steps it would
be (1) Identify the financial events (2) Classify and record the financial
events and (3) …………….. on the financial events of the organisation?
_________________________________________
Q3 –
Which one of the following is NOT a benefit for the entrepreneur from the
accounting process?
(A) It’s a reality check
(B) It helps calculate the tax
assessment
(C) It only has to report the good
results
(D) It helps monitor key indicators
_________________________________________
Q4 –
All bookkeepers can also perform the functions of an accountant.
§ True
§ False
_________________________________________
Q5 –
Bookkeepers are usually engaged in the accounting process up to the …………..
_________________________________________
Q6 –
Which one of the following is NOT a function usually performed by the
accountant?
(A) cash flow and profit forecasting
(B) recording the day to day
financial transactions
(C) resolving complex financial
reporting issues
(D) tax planning
________________________________________
Q7 –
There are two main branches of accounting. One is management accounting the
other is ………………….. accounting.
________________________________________
Q8 –
In reporting, Management accounting must comply with generally accepted
accounting principles.
§ True
§ False
________________________________________
Q9 –
Which one of the following is NOT a characteristic of management accounting?
(A) no external governing rules
(B) emphasis on decisions that
affect the future
(C) results are compared to budgets
(D) only a limited set of prescribed
reports compiled
_________________________________________
Q10 –
Which one of the following is NOT a characteristic of financial accounting?
(A) Reported frequently and as
required
(B) the data is objective and
usually verified
(C) the numbers are historic in
nature
(D) presents summarized data only
covering the entire organisation
Conclusion – Accounting
Definition
The key learnings from this training
session were:
1.
that accounting can be divided into
two elements regarding financial events within an organisation i.e.
recording and reporting.
2.
that there are many benefits for the
entrepreneur from the accounting function both in the establishment and the
operation of their venture.
3.
that bookkeepers generally control
the accounting process up to the trial balance before accountants take over to
prepare the financial statements and the management reports.
4.
that there are two main branches of
accounting (a) Financial accounting that prepares prescribed reports for
external stakeholders and (b) Management accounting that
prepares customized reports for those engaged directly in the management
of the organisation (internal).
Now, if you were able to complete
all set activities and achieved 100% correct answers on the questionnaire, then
congratulations your learning is complete and you are now ready to progress to
the next topic. If you answered a question incorrectly then review the session
part identified in the table below. Also, if you had difficulties
completing any of the activities, then it is recommended that you link to the
Additional Resources, as these may help you to complete them. If you have
further questions you could post a question to the website Ask the Accountant.
The key learning from this session
concerning the accounting definition, the role of bookkeeping
Vs accountant and the different branches of financial and management
accounting will provide the underpinning knowledge for the next learning
level, which deals with the
accounting equation.
