Introduction. What is a business?

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1 1 Introduction to accounting By the end of this chapter you should be able to: define and classify businesses define accounting as a business activity state the main purpose of accounting list the qualities that help to fulfill the purpose describe the needs of various users define and give examples of key concepts in accounting state and explain key principles that guide accounting practice. Concept map accounting a key business function users purpose definition qualities principles key terms Introduction study of accounting Many people become interested in the profession of accounting because they believe that accountants make a lot of money for themselves and other people. Successful accountants can indeed help others make a lot of money. This may happen because accounting is about gathering financial data using either a manual or computerised system, processing data and communicating the resulting information to users. This information is then used as a basis for making successful business decisions, not only about current activities, but also future plans. To become a successful accountant, your study of accounting begins with an introduction to 1. The language of accounting. 2. Why one prepares accounting records for different users. 3. The principles which guide the accounting process. What is a business? A business can be described as any activity engaged in by one or more persons for the purpose of providing goods and/or services. Profit making is usually the main intention of all businesses but there are organisations whose focus is on meeting the needs of its members other than a share of profit. 1

2 ITQ1 1. What is a business? 2. What are two ways to classify businesses? Ways of classifying businesses The following are two main ways of classifying businesses by the way capital is raised or ownership by main activities undertaken. Ownership sole trader partnership unlimited liability corporation limited liability company shareholder cooperatives ITQ2 List four types of business classified according to ownership. retailers inventory/stock manufacturers service providers trading organisations ITQ3 List four types of business classified according to activities. non-trading organisations One way to distinguish a business is to consider who owns the business. When one person or a group of persons acting as one person owns the business it is called a sole trader. The business belongs to the sole trader who enjoys all the profits and bears all the risks or possible losses. If he/she dies or chooses to leave, the business often closes or it is no longer considered the same business. In contrast, if two or more persons agree to own and operate a business, it is called a partnership. Partners share in the profits and losses of the business according to an agreement, which may be oral but is often written out clearly. In the eyes of the law, both the sole trader business and the partnership are considered inseparable from their owner/s. The actions and debts of the business are the direct responsibility of the owner/s. This is called unlimited liability. A third type of business organisation is the corporation or limited liability company. This may be owned by as few as two persons and as many as thousands of persons; each of whom paid a given sum for parts or shares in the business. Each owner is called a shareholder and is entitled to a share of the profits of the business and also has to bear any eventual loss of share vaue. Legally, the shareholder is separate from the business organisation and has limited liability for the actions and debts of the organisation which is treated as a legal person in its own right. Cooperatives are similarly owned by a number of members who have combined to provide goods and services to themselves. Members buy shares regularly and are the main customers of the organisation. They too have limited liability for the actions and debts of the cooperative. Activities Another way to classify businesses is to look at their main activities. A retailer buys and sells already-completed goods called inventory or stock. Other businesses manufacture goods from several kinds of raw materials or components before selling them in a partly-finished or fully-finished state to other firms. Many manufacturers are large-scale producers but there are small, local manufacturing businesses such as seamstresses and caterers. There are businesses which supply services to individuals and other businesses. These include banks, insurance companies, repair shops, garages, private schools and photocopy shops. Whether they are retailers, manufacturers or service providers, these businesses are all trading organisations. A few organisations have not been set up to trade. Their focus is on meeting the needs of members. They may carry out activities which involve buying or selling to raise funds to support their goals. Trading is not their main activity and they are referred to as non-trading organisations. You may be a member of a youth society or sports club: these are non-trading concerns. 2

3 Definition of accounting accounting Whatever the type of ownership or activity, a business needs to set up an efficient accounting system to keep records of its financial activities. The business s stakeholders need to know what it owns, what it owes and whether or not it is meeting its goals, e.g. making a profit. Accounting provides the major service of gathering financial information of a business and communicating this information to users. Accounting is therefore defined as the process of recording, interpreting and reporting financial information or transactions in the form of financial statements. Users of accounting information In the business world, there are various groups of users of accounting information. The main users of accounting information are as follows: ITQ4 List any four categories of users of accounting information and explain one need each category has. Managers Accounting records assist management to operate organisations efficiently and profitably and also to plan for the future. Owners and potential investors They use information to determine whether or not the business is making a profit, meeting its obligations, increasing the value of its assets and remaining a thriving business. Banks, creditors and other lenders Apart from the financing provided by the owners, this group usually provides additional financing. They are interested in whether or not the business can pay interest on loans, meet its day-to-day expenses, pay for supplies and be able to repay long-term debts. Employees This group is interested in the performance of the business. They need to know that their jobs are secure and that they will be paid wages and salaries and other benefits on time. Government There are many reasons why government is interested in accounting information. This information assists in the levying of taxes, as well as helping to make decisions on granting financial assistance to businesses. Other businesses This group needs to know how their competitors are performing in order to make a comparison and also provide information to implement future policies. Accounting information influences the decisions made by both the individual and society as a whole. The purpose of accounting Decision-makers are also interested in having information about the financial affairs of a business. The main purpose of accounting therefore is the provision of information for decision-making in the world of business. ITQ5 List at least four qualities of good accounting information. Qualities of good accounting information Accounting information provided to users must possess certain qualities in order for it to fulfill its purpose. These qualities are: Clarity or understanding Accounting information should be presented in such a way that the user can easily understand it. To this end, standard formats and layouts are used. Relevance Accounting information should be relevant to the needs of the variety of users. Accuracy or reliability Accounting information must be based on fact as far as possible, not opinion, and data should be correct and unbiased. Estimates should be backed up by some research. Comparability Accounting information prepared consistently and in accordance with guiding principles can be used to compare annual performance results of a business or the performance of similar businesses. 3

4 Guiding principles principle of separate entity principle of prudence principle of consistency principles of matching and accrual Accounting procedures can be carried out in a number of ways and therefore the accountant is guided by a number of principles, assumptions or constraints. 1. The accountant regards the business as a clearly defined, separate, active body or entity possessing its own value and making its own decisions as to what are its objectives and actions. This means that even the owner/s is to be regarded as external: a lender of funds to the business. This rule of accounting is called the principle of separate entity. 2. The accountant will be prudent or conservative. This means that the accountant will be cautious about declaring that a profit or gain was made but will anticipate and help the business provide for losses. 3. The accountant will be consistent. This means that the accountant will follow chosen policies every time reports are prepared unless there is good reason to change. 4. The accountant will report on profits/losses and the value of assets and liabilities after having matched revenue and profits with the costs and losses incurred in earning them. To do this, revenue and costs are accrued, i.e. reported as they are earned or incurred, not as money is received or paid. Other important conventions include PRINCIPLES Periodicity Money measurement Double entry Going concern Cost BRIEF EXPLANATION The preparation of reports for clearly stated periods of time, usually the length of one calendar year (12 months) or parts of a year. Only business features that can be reported in money terms will be included in the accounting statements. Business activities usually mean that something is received and something is given and therefore the accounts must show this double effect. The business is reported on as if it is able to carry out its business and complete its jobs. Reports are not adjusted as if the enterprise is going out of business. If the business is to be closed down, the accountant would be working under different assumptions. The business generally reports the value of its assets and liabilities at original cost except where accounting rules indicate the need for a different method of valuation. Key terms in accounting transaction money value ITQ6 What is a transaction? What are two types of transactions? To meet the need to communicate with users, businesses have developed a language: the terms used in accounting. Two important terms are transaction and account. A transaction is a description of a business activity involving an exchange of things with money value. Transactions either contribute towards achieving the firm s profits, e.g. sale of goods, or help to change the business s financial position, such as additional capital received from owners. Transactions are twofold by nature, because they involve the giving and receiving of monetary value. They provide much of the data to be recorded in the accounting records. Accounting transactions are basically of two types. 1. Cash transactions where cash or cheques are paid for an item immediately. 4

5 ITQ7 What is an account? List three classes of accounts. debtors creditors account ITQ8 ALICE stands for the five types of accounts. List and give one example of each. 2. Credit transactions where no cash is paid immediately but an agreement exists that the debt will be paid at a later date. Credit transactions give rise to debtors (money is owed to the firm) and creditors (the firm owes money for goods and services). An account is a brief history of the business s exchanges with a person or entity. For example, Mr Smith, a customer, will have his own account showing sales made to him and payments made by him. Accounts can be categorised into three different classes or five different types. The three classes of accounts are: 1. Real accounts accounts in which information about assets is recorded, e.g. property, machinery and stocks. 2. Nominal accounts accounts that record the expenses and revenues of the firm, e.g. sales, purchases. 3. Personal accounts accounts in the name of individuals or firms as well as the private accounts of the owner, e.g. Capital, Drawings. The five types of accounts are 1. Assets (A) e.g. motor vehicle 2. Liabilities (L) e.g. loan from bank 3. Income (I) e.g. commissions earned 4. Capital (C) e.g. shares 5. Expenses (E) e.g. rent This table gives more details about these and other important terms. TYPE DESCRIPTION EXAMPLES Ledger The book in which records or accounts are kept. The ledger may be sub-divided to hold the different classes of accounts, e.g. personal accounts for debtors are found in the sales or debtors ledger. Asset: Current Asset: Fixed Liability: Current Assets can be classified in relation to how quickly they can be turned into an easily disposable form. These are purchased because they help the firm to produce profits over several accounting periods. A current liability represents a debt or amount owed to a firm or individual which must be paid within 12 months of its creation. 1. Cash in hand or in cash register. 2. Cash at bank for safe-keeping and safe use. 3. Accounts receivable (trade debtors) are individuals and firms to whom goods and services were supplied on credit. 4. Expense debtors are individuals and firms who have been paid beforehand to supply services to the firm. They owe for prepaid expenses. 5. Revenue debtors are individuals and firms who have been supplied with services but have not yet paid the firm. This is uncollected revenue or revenue receivable. 6. Inventory (stock) describes all kinds of goods which businesses need to operate. Land, buildings, factory buildings (called plant), machinery, equipment, furniture, fixtures (shelves, lighting), motor vehicles. 1. Accounts payable (trade creditors) are individuals or firms who have provided the business with goods on credit but have not yet been paid. 2. Expense creditors are individuals or firms who have provided the business with services on credit but remain unpaid. 3. Revenue creditors are individuals or firms who have paid beforehand for the provision of goods and services. 4. Other creditors, e.g. bank overdraft, where the firm s bankers allow it to withdraw more money than it has put into the account (other examples include a short-term loan, advances). 5

6 TYPE DESCRIPTION EXAMPLES Liability: Long-term Expense Income/ revenue Capital or equity A long-term liability represents a debt or amount owed to a firm or individual but the period for repayment is longer than one year. Outflows of assets, e.g. cash, debtors arising from the effort to earn revenues. Inflows of assets, e.g. cash, debtors arising from the firm s delivery of goods or services to others. The value put into the business by the owner/s in the form of assets. Bank loans, loans from individuals, loan type agreements, e.g. debentures, mortgages. Rent, wages, salaries, advertising, transport, utilities, purchase of inventories, office supplies. Sale of inventories, earnings from rent, commission. Many businesses begin with a combination of cash and other assets which are used to, for example, start up a business or buy shares in a business. Permanency and liquidity Assets and liabilities are also classified as either permanent of liquid. Liquidity refers to how easily the asset or liability can be expressed as cash. Cash on the firm s premises or in easily accessible bank accounts are the most liquid assets. Land and buildings acquired for long-term use are described as the most permanent or least liquid assets. The liability with the longest credit period is said to be more permanent than bank overdraft or trade creditors. Conclusion You have been introduced so far to users and the purpose of accounting as well as some significant terms used in accounting. Decision-makers need to understand information provided in accounting formats and develop an ability to make effective use of such information. 1. A business is any activity engaged in by one or more persons where goods and services are provided with the specific intention of making a profit. 2. Three ways of classifying businesses are by ownership pattern, by main activities and by size. 3. Accounting is a system of measuring, interpreting and reporting financial information so that owners, managers and other interested persons can make decisions. 4. The main purpose of an accounting system is the provision of information for decision-making. 5. To fulfill its purpose, accounting information should be presented clearly, be relevant, be accurate and allow comparisons. 6. The users of accounting information differ according to their information needs. The main users are owners, banks, employees, government and competitors. 7. Accountants use concepts or principles to guide decision-making in their work. The main principles are the principle of separate entity, the principle of prudence, the principle of consistency and the concepts of matching and accruals. 6

7 8. Other principles to be understood include periodicity, money measurement, dual aspect, going concern and the cost principle. 9. Accounting has its own language and key terms must be clearly understood. Key terms include cash transaction, credit transaction, real account, nominal account, personal account, ledger, asset, liability, income, capital, expense. ITQ1 ITQ2 ITQ3 ITQ4 ITQ5 ITQ6 ITQ7 ITQ8 a. Any activity engaged in by one or more persons for the purpose of providing goods and/or services at a profit. b. A business can be classified according to the sources of capital i.e. type of ownership OR by the activities it undertakes. Four types of businesses according to owners are: sole traders, partnerships, corporations, cooperatives. Four types of business according to activities are: retailers, manufacturers, service providers, non-profit organisations. Any four of the following are users of accounting information: managers, owners, investors, employees, lenders, other businesses, government agencies. Four qualities are: clarity, relevance, accuracy, comparability. A transaction is a description of a business activity involving an exchange of things with money value. Two types are cash and credit transactions. An account is a record, explanation or history of transactions. Three classes are: real, nominal and personal. ALICE stands for asset e.g. Building, liability e.g. Loan, income e.g. Commissions earned, capital e.g. Shares, and expense accounts e.g. Wages. Multiple choice questions 1. The study of Principles of Accounts does not focus on a. rules for recording transactions in business organisations b. rules for choosing the material to be recorded or not c. rules for organising, controlling and managing an organisation d. rules that set out the format of reports to managers 2. All of the following can be used to classify businesses EXCEPT a. accounting system used b. number of owners c. size of operation d. activities undertaken 3. Which of the following is INCORRECT? Users use accounting information for a. planning b. defrauding c. controlling d. deciding 4. Which of the following statements is CORRECT? a. accounting is the recording of information in sequential steps b. accounting is a process of gathering and communicating financial information c. accounting is the exchange of goods and services d. accounting is checking the accuracy of recorded financial information 7

8 5. The main purpose of accounting is to a. record transactions on paper b. record transactions using accepted formats c. record transactions and employ accountants d. record transactions to provide information to users 6. Great marketing skills are not recorded as an asset in business. Which principle of accounting underlies this treatment? a. money measurement b. going concern c. prudence d. separate entity 7. The accountant is expected to do all of the following EXCEPT a. interpret accounting information b. be prudent in declaring profits c. share the business s information with competitors d. match expenses with revenues 8. Which of the following is a class of accounts? a. real b. income c. inventory d. shares 9. The difference between a current liability and a long-term liability is a. the purpose for which it was acquired b. the length of time for repayment c. one is a source of funds for the business d. banks can only allow the firm long-term liabilities Examination-style questions 1. Match the terms on the left with the descriptions on the right a. Manufacturer 1. Buys completed goods and sells them to customers. b. Partnership 2. Resources owned for productive purposes. c. Asset 3. A time division for which reports of operations and results are prepared. d. Profit 4. A form of business ownership comprising two or more persons who share responsibility and liability. e. Business entity 5. Buys and converts material into finished goods for resale. f. Retailer 6. A specific body for which accounting information is recorded and reported. g. Financial period 7. A principle that cautions against the premature reporting of profits and the late recognition of losses. h. Prudence 8. The main purpose of business activity is to create this. 8

9 2. Four qualities that result in good accounting information have been identified: clarity (CL), accuracy (A), relevance (R), and comparability (CO). Listed below are statements that expand one s understanding of these qualities. Match these statements with the appropriate qualities by entering the appropriate letters in the blanks to the left. 1. The user wants information that is timely. 2. The information should be backed up by source documents. 3. The information gives an unbiased picture of the firm. 4. The user wants to be able to make choices after reading the accounts. 5. The information is presented in standard ways. 3. Match the numbered terms on the left with the descriptions on the right 1. Prudence a. The unchanging use of the policies decided upon 2. Consistency b. The assumption that the firm is continuing to operate 3. Accrual c. The firm is operating apart from its owner/s 4. Going concern d. Account for the least favourable effect on income 5. Separate entity e. Take into account all expenses and all revenues of a period 6. Periodicity f. Every transaction results in a giving and a receiving of value 7. Money measurement g. Account for transactions in terms of the relevant currency 8. Double entry h. The time for which reporting is done usually one year 4. Classify the following items into the categories: fixed assets, current assets, current liabilities, long-term liabilities, expense and revenue. Debtor Cash in hand 5-yr bank loan Building Inventory Creditor Money owed for short period to the business Money owed for short period by the business Motor vehicle Equipment Cash at bank Land 9