Chapter 1

Introduction to Accounting

Definition of accounting

Accounting is a service activity, its function is to provide quantitative information primarily financial
in nature, about economic entities that is intended to be useful in making economic decision.

Purpose of Accounting

Accounting provides vital information regarding cost and earnings, profit and loss, liabilities and
assets for decision making, planning and controlling processes within a business.

The main objective of accounting is to record financial transactions in the books of accounts to
identify, measure and communicate economic information. Moreover, tax reporting agencies
require you to keep books at a minimum level that tracks income and expenditure.

The primary role of accounting is to maintain a systematic, accurate and complete record of all
financial transactions of a business. These records are the backbone of the accounting system.
Business owners should be able to retrieve and review the transactions whenever required.

Business owners need to plan how they allocate their limited resources including labor, machinery,
equipment and cash towards accomplishing the objectives of the business.

An important component of business management, budgeting and planning enable businesses to

plan ahead by anticipating the needs and resources. This helps in the coordination of different
segments of an organization.

Accounting assists in a range of decision-making process and help owners in developing policies to
increase the efficiency of business processes. Some examples of decisions based on accounting
information include the price to be charged for products and services, the resources needed to
make these products and services and financing and business opportunities

Using the accounting reports, business owners can determine how well a business is performing.
The financial reports are a reliable source of measuring the key performance indicators, so business
owners can compare themselves against their past performance as well as against the competitors.

The financial statements generated at the end of the accounting cycle reflect the financial condition
of a business at that time. It shows how much capital has been invested, how much funds the
business has used, the profit and loss and the number of assets and liabilities of a business.

A common reason for small business failure is the mismanagement of cash. Accounting helps in
determining the liquidity of a business which refers to the cash and other liquid resources at your
disposal to pay off financial commitments. The information reduces the risk of bankruptcy through
detection of bottlenecks.

Accounting helps business owners prepare historic financial records as well as financial projections
which can be used while applying for a loan or securing investment for the business.

By placing various checks across the organization, accounting helps in avoiding losses caused by
theft, fraud, errors, damage, obsolescence and mismanagement. The internal controls safeguard
the business assets and avoid long-term losses.

Law requires businesses to maintain an accurate financial record of their transactions and share the
reports with the shareholders, tax authorities and regulators. The financial statements and
information are also required for indirect and direct tax filing purposes.

Users of Accounting

The accounting process provides financial data for a broad range of individuals whose objectives in
studying the data vary widely.   Three primary users of accounting information were previously
identified, Internal users, External users, and Government/ IRS.  Each group uses accounting
information differently, and requires the information to be presented differently.

Internal Users

Accounting supplies managers and owners with significant financial data that is useful for decision
making. This type of accounting in generally referred to as managerial accounting.

 Some of the ways internal users employ accounting information include the following:

 Assessing how management has discharged its responsibility for protecting and managing the
company’s resources
 Shaping decisions about when to borrow or invest company resources
 Shaping decisions about expansion or downsizing

External Users

Typically called financial accounting, the record of a business’ financial history for use by  external
entities is used for many purposes.  The external users of accounting information fall into six groups;
each has different interests in the company and wants answers to unique questions. The groups and
some of their possible questions are:

 Owners and prospective owners. Has the company earned satisfactory income on its total
investment? Should an investment be made in this company? Should the present investment
be increased, decreased, or retained at the same level? Can the company install costly
pollution control equipment and still be profitable?
 Creditors and lenders. Should a loan be granted to the company? Will the company be able
to pay its debts as they become due?
 Employees and their unions. Does the company have the ability to pay increased wages? Is
the company financially able to provide long-term employment for its workforce?
 Customers. Does the company offer useful products at fair prices? Will the company survive
long enough to honor its product warranties?
 Governmental units. Is the company, such as a local public utility, charging a fair rate for its
services?
 General public. Is the company providing useful products and gainful employment for
citizens without causing serious environmental problems?

Some of the ways external users employ accounting information include the following:
  Stockholders have the right to know how a company is managing its investments
 Federal and State Governments require tax returns and other documents often prepared by
accountants
 Banks or lending institutions may use accounting information to guide decisions such as
whether to lend or how much to lend a business
 Investors will also use accounting information to guide investment decisions

Forms of Business Organization

These are the basic forms of business ownership:
1. Sole Proprietorship
A sole proprietorship is a business owned by only one person. It is easy to set-up and is the least
costly among all forms of ownership. The owner faces unlimited liability; meaning, the creditors of
the business may go after the personal assets of the owner if the business cannot pay them.
The sole proprietorship form is usually adopted by small business entities.
2. Partnership
A partnership is a business owned by two or more persons who contribute resources into the entity.
The partners divide the profits of the business among themselves.
In general partnerships, all partners have unlimited liability. In limited partnerships, creditors cannot
go after the personal assets of the limited partners.
3. Corporation
A corporation is a business organization that has a separate legal personality from its owners.
Ownership in a stock corporation is represented by shares of stock.
The owners (stockholders) enjoy limited liability but have limited involvement in the company's
operations. The board of directors, an elected group from the stockholders, controls the activities of
the corporation.

Activities in Business Organization

Financing Activities

Financing activities are transactions or business events that affect long-term liabilities and equity. In
other words, financing activities are transactions with creditors or investors used to fund either
company operations or expansions.

Financing activities show how a company funds its operations and expansions externally. Internal
financing is not included. For example, a company that pays for its own plant expansion doesn’t
need financing. Thus, no financing activities exist because equity and liability accounts are
unchanged by the expansion.

Both investors and creditors are interested to see how efficiently a business can use its existing cash
to fund operations and how effectively it can raise capital for upcoming projects. In a way, the
financing activities section of the cash flow statement indicates how liquid a company is.
Investing Activities

Investing activities is consist of buying and selling long-term assets and other investments. In other
words, this is the net amount of cash received and paid during an accounting period for long-term
assets and investments. You can think of these activities like the money a company uses to invest in
itself or the money it makes from its investments.

he two main activities that fall in the investing section are long-term assets and investments. Long-
term assets usually consist of fixed assets like vehicles, buildings, and machinery. When a company
purchases a new vehicle with cash, the cash outflows are listed in the investing section. Likewise, if a
company sells one of its vehicles, the cash proceeds are listed in this section as well.
Investments are a little more complicated than the long-term assets because it depends on the
source of the investment. For example, cash paid for short-term investments like trading
securities and cash equivalents are included in this section. Principle payments on third party notes
are also included. However, payments on a note payable from a customer that resulted in a sale are
typically listed in the operating activities section—not the investing. Likewise, FASB requires that all
interest payments and receipts be classified as operating activities.

Operating Activities

Operating activities consist of principle activities that a company performs to earn income.  In other
words, these are the primary business operations that a company performs to earn revenue. This is
what the company is in business to do.

These cash inflows and outflows from operating activities are reported on two different financial
statements.  First, they show up on the income statement and are used to compute net income.
Second, they are reported on the statement of cash flows. 

Double Entry

Double entry, a fundamental concept underlying present-day bookkeeping and accounting, states
that every financial transaction has equal and opposite effects in at least two different accounts. It is
used to satisfy the accounting equation:

Assets=Liabilities+Equity

The Basics of Double Entry

In the double-entry system, transactions are recorded in terms of debits and credits. Since a debit in
one account offsets a credit in another, the sum of all debits must equal the sum of all credits. The
double-entry system of bookkeeping standardizes the accounting process and improves the
accuracy of prepared financial statements, allowing for improved detection of errors.

Types of Accounts

Bookkeeping and accounting are ways of measuring, recording, and communicating a firm's
financial information. A business transaction is an economic event that is recorded for
accounting/bookkeeping purposes. In general terms, it is a business interaction between economic
entities, such as customers and businesses or vendors and businesses.
Under the systematic process of accounting, these interactions are generally classified into
accounts. There are five different types of accounts that all business transactions can be classified:

 Assets
 Liabilities
 Equities
 Revenue
 Expenses

Bookkeeping and accounting track changes in each account as a company continues operations.

Debits and Credits

Debits and credits are essential to the double entry system. In accounting, a debit refers to an entry
on the left side of an account ledger, and credit refers to an entry on the right side of an account
ledger. To be in balance, the total of debits and credits for a transaction must be equal. Debits do
not always equate to increases and credits do not always equate to decreases.

A debit may increase one account while decreasing another. For example, a debit increases asset
accounts but decreases liability and equity accounts, which supports the general accounting
equation of Assets = Liabilities + Equity. On the income statement, debits increase the balances in
expense and loss accounts, while credits decrease their balances. Debits decrease revenue and
gains account balances, while credits increase their balances.

The Double-Entry Accounting System

Double-entry bookkeeping was developed in the mercantile period of Europe to help rationalize
commercial transactions and make trade more efficient. It also helped merchants and bankers
understand their costs and profits. Some thinkers have argued that double-entry accounting was a
key calculative technology responsible for the birth of capitalism.

The accounting equation forms the foundation of the double-entry accounting and is a concise
representation of a concept that expands into the complex, expanded and multi-item display of
the balance sheet. The balance sheet is based on the double-entry accounting system where total
assets of a company are equal to the total of liabilities and shareholder equity.

Essentially, the representation equates all uses of capital (assets) to all sources of capital (where
debt capital leads to liabilities and equity capital leads to shareholders' equity). For a company
keeping accurate accounts, every single business transaction will be represented in at least of its
two accounts.

For instance, if a business takes a loan from a financial entity like a bank, the borrowed money will
raise the company's assets and the loan liability will also rise by an equivalent amount. If a business
buys raw material by paying cash, it will lead to an increase in the inventory (asset) while reducing
cash capital (another asset). Because there are two or more accounts affected by every transaction
carried out by a company, the accounting system is referred to as double-entry accounting.

This practice ensures that the accounting equation always remains balanced – that is, the left side
value of the equation will always match with the right side value.