Assignment

Basic Principles of Double Entry Accounting

Without any doubt accounting is ingrained in our society and it is also a vital part of the economic
system. So much so that even households cannot be managed efficiently without accounting
processes like recording revenues and expenses. If households do not keep a check on their
expenses and income it would be very likely that they would end up running short of money for their
daily usage. Accounting helps these households to keep a track on their financial capacity at all times
and hence this leads to better planning and a more safe and secure future for them. Let us assume
that a situation arises where a family’s main bread winner has been injured in an accident and
hence, he no longer can go to work. In this situation if the family would have used accounting
processes like identifying and recording, they would be able to figure out how much savings they
have in store and for how long they would be able to pay for their expenses. If suppose they realize
that they would only be able to pay for one month of their expenses from the savings this family
would rush to the bank and get a loan in order to pay for their expenses in the future. Hence this
shows that accounting helps one maintain records of cash flow and maintain a smooth life.
Accounting is a vital part of our economy as it helps the country to calculate its balance of payments
and current account balances. Its helps to analyze the performance of the economy as if the assets
of the economy are greater than its liabilities the economy would be in a safe position. If the
economy does not have enough foreign reserves (which are recorded through accounting process)
the government and central bank would take steps to increase foreign reserves so that the country’s
currency remains stable. Hence this reflects that accounting is a vital part of the economy as well.

Accounting mainly consists of three activities- it identifies, records and communicates economic
activities that take place in a business. Firstly, the business identifies the economic transactions that
take place for e.g. Selling goods, purchasing goods, paying the supplier etc. after identifying these
events the business records them in order to maintain a history of its financial transactions. Lastly
these events are communicated to the stakeholders of the business through accounting reports that
are also called financial statements. Communicating the information also consists of analyzing and
interpreting it through accounting ratios, graphs and charts so that the user can easily understand it
and make decisions. In a business accounting information is used by both internal and external
users. Internal users comprise of the managers and supervisors of different departments in the
business who want to know the current situation of the business, analyze it and make decisions
based on it for the future. Firstly finance department use the accounting information to answer
questions like is there enough cash to pay dividends to the shareholders or is there enough money
to pay back our suppliers etc. after answering these question with the help of accounting info the
finance department would make decisions that whether they have to increase dividend payment or
decrease it and how much loan they have to take keeping in view the financial situation of the
company. The marketing department also uses accounting information to make decisions on
whether to increase or decrease the prices of products in order to maximize profits. Moreover, the
marketing department would decide whether to increase advertising or decrease it based on what
accounting information they receive. The human resources department would use accounting info to
decide whether to increase salaries of the employees. They may also consider dismissing some staff
in order to reduce their expenses in times of recession. Lastly the top management can use the
accounting information to decide whether a product should be eliminated or not depending
whether it is profitable or not. It can also decide whether to introduce a new product if the cash
projections for it are positive. External users are those outside the company who use accounting
information to make efficient decisions. These users include investors who check whether the
company is making profits or losses. Based on this they decide whether to buy its shares sell its
shares or hold its shares. By using accounting info investors also get to know how much dividends
companies are paying and hence they look to invest in companies that pay high dividends. Suppliers
use accounting info to analyze the cash position of companies before deciding whether to sell them
goods for credit. Likewise, banks thoroughly examine accounting information of companies before
lending them money to ensure the reduction in the number of defaulters. Labor unions also use
accounting information to know whether the company has enough cash to increase the salaries and
perks of the employees. Tax authorities also use accounting info to check whether a company is
paying taxes and complying by its policies.

Bookkeeping and accounting are not the same thing rather bookkeeping is just a part of Accounting.
The Accounting process includes bookkeeping. Bookkeeping is just the recording of economic events
whereas Accounting is responsible for identifying, recording, interpreting, classifying, analyzing,
communicating and summarizing financial data.

One of the building blocks of accounting is ethics. Ethics are standards by which actions are judged
to be right or wrong. Accountants must abide by these ethics in order to ensure fair financial
reporting’s to keep the confidence of stakeholders intact. By reflecting ethical behavior accountants
and companies would be able to maintain the credibility of their financial reports and hence
stakeholders like investors would trust these reports and base their decisions upon them. To analyze
ethical issues firstly we will have to recognize with our own lenses whether ethics are being
compromise in the issue. Secondly, we will have to identify which groups are being affected because
of lack of ethical behavior. Lastly, we will have to choose another ethical alternative which would
have fewer negative impacts on the stakeholders being Affected previously. A general set of
standards have been developed named generally accepted accounting principles (GAAP). These rules
inform how to report economic events. Under GAAP two basic measurement principles are used the
historical cost principle and the fair value principle. Companies use one of these principles
depending upon which would lead to a more relevant information for the stakeholders and a more
faithful representation of the performance of the business. Historical cost principle suggests
recording Assets on cost and on the value for which they were acquired. So, if the value of land
appreciates the company would still record the asset at the amount for which it was bought. On the
other hand, fair value principle orders assets to be recorded at their fair value (the amount at which
the asset would be sold). The fair value principle is used mostly in cases where the Assets are
actively traded like investment securities. Otherwise it is believed that recording at cost is a more
faithful representation. Accounting assumptions also act as building blocks of accounting. These
assumptions are followed when preparing financial statements. Two essential assumptions are
monetary unit assumption and economic entity assumption. Monetary unit assumption dictates that
transactions that have a monetary value will only be recorded in the books. Other important events
like the health of the owner or a fire in the factory cant be expressed in money terms hence they
wouldn’t be recorded in the company’s books even though these events are quiet crucial for the
future of the company. The economic entity assumptions states that the activities of the entity
should be kept separate from the personal activities of the owner or any other entity. Hence a
company’s owner would record his expenses separate from the expenses of the company and his
personal liability distinct from the liability of his business or any other business. This assumption is
followed whether the business is a proprietorship, partnership or a corporation.

The four financial statements are the income statement, owners’ equity statement, balance sheet
and the statement of cash flows. The income statement includes revenues like sales or service
revenue. Secondly the cost of goods sold are subtracted from the revenue to find the gross profit.
Thirdly the expenses which include operating expenses (wages, rent and depreciation expense) and
other expenses like interest expense or loss on sale of equipment are subtracted from the gross
profit to find the net profit or net loss of the company. Overall, the income statement reflects the
revenues, expenses and profitability of the business. The owners’ equity statement reviews the
changes in owners’ equity along a period of time. Firstly, the starting or opening capital is
mentioned. Secondly the net income calculated from the income statement and investments are
added to the opening capital. Lastly drawings which are the owner’s transactions for his personal use
are subtracted from the opening capital to find the closing capital. This statement shows how the
opening capital balance changes during a period. The balance sheet illustrates the amount of Assets,
liabilities and capital at a particular date. Assets are stated first and comprise of fixed assets and
current assets. Fixed assets are those assets that have a useful life of more than one year like
property and equipment. Current assets are assets that have a useful life of less than one year and
can easily be converted into cash. These include Cash, inventory, prepaid expenses and accounts
receivable. Then liabilities are recorded which also consist of current and noncurrent liabilities.
Current liabilities are those which have to be paid back within one year like short term loan,
accounts payable and wages payable. Noncurrent liabilities are those that have to be paid after one
year like long term loans. Lastly the amount of ending capital that is calculated in the owner’s equity
statements is also stated. The total of liabilities and capital should be equal to the total assets for the
balance sheet to be correct. The cash flow statement shows the movement of cash (inflows) and
(outflows) during a period. This statement shows the cash flows from operating activities like cash
received from sales and cash payments of expenses. Its shows cash flows from investing activities
like the purchase of equipment. It also shows cash flows from financing activities like investments
and drawings by owner. After considering all cash movements the net increase or decrease in cash is
calculated. This statement is useful for the stakeholders to know from where the company is getting
and where it is using its most liquid asset-cash.

The recording process starts firstly by analyzing each transaction regarding which accounts it would
affect and what the effect would be. For example, if a business sells goods on credit for 10,000. After
analyzing this event the business would know that this transaction will increase the sales account
and increase the receivable account. So hence they would move on to the next step in the
accounting process which is entering this transaction in the journal. There are many kinds of journals
likes sakes journal, purchase journal etc. but the most common type of journal is the general journal
in which companies usually record their day to day transactions. Entering transactions in the journal
is a process known as journalizing. Each entry made in the general journal shows the date of the
transaction the accounts debited and credited and by what amount and a small explanation of the
transaction. So, for the example of transactions that was mentioned before its entry would include
debiting the receivable account and crediting the sales account by 10,000. The explanation of this
entry in the general journal would be (credit sales). The general journal has three main benefits.
Firstly, it’s a journal where all the transactions are recorded in the sequence they occur. Secondly
the entries fully highlight which accounts are affected. Lastly the debit and credit columns can be
matched to avoid any mistakes and ensure accuracy. After journalizing transaction comes the
process known as posting. Posting refers to the transfer of journal entries into specific accounts
known as ledgers. Ledgers show individual balances of each account and what changes take place in
that account during the period. The mostly used type of ledgers are the general ledgers which
consist of all asset, liability and capital accounts. The ledgers reveal balances in each account for
example the cash account would state the amount of cash left with the business, the receivable
account would show the amount still owed by customers etc. A ledger consists of columns for date,
explanation, reference, debit, credit and balance. the date of transaction is mentioned in the date
column in the ledger while a brief explanation is given in the explanation column like (sales on
credit). Depending on whether the account is debited or credited (in this case the sales account
would be credited) the ledger is filled and after debiting or crediting a balance is shown. The
reference column shows the page of the journal from which the transaction is posted. After posting
entries in ledgers the closing balances of the ledgers are recorded in the trial balance usually at the
end of the period. The trial balance hence shows the ending balance of all accounts at a given date.
A trial balance consists of two columns for debit and credit balances. The total debit and credit
balances are equated to see whether the accounting process till then has been error free. If the
debit and credit balances do not match the accountant would be sure that there must be some
mistake in journalizing or posting transactions hence, he would try to correct that. So, the trial
balance makes sure the recording process is completely accurate. The last stage of the recording
process involves making financial statements by using the balances in the trial balance.

Net income is and indicator of the profitability of a business and it is the money left with the
business after paying all its expenses. The net income is mostly reinvested in the business for the
purpose of expansion and growth. Net income is calculated by subtracting cost of goods sold and all
operating and other expenses from revenue.

The time period assumption states that the life of a business should be divided into equal time
periods in order to produce financial information which correctly reflects the financial situation of
the business at that point in time. The time period assumption helps accountants to better analyze
the performance of the business and whether or not it is achieving the aims and targets. Moreover,
it helps them decide in which area the business is lacking and how to overcome that downfall. The
time period assumption affects accountant’s analysis in a way that they look at business transactions
and their effects in terms of specific time periods and also compare current period performance with
previous period performance to get a better view of the businesses performance.

Accrual basis accounting provides more useful information than the cash basis accounting. This is
because it follows the revenue and expense recognition principle which states that revenue should
be recognized when service is given, and expense should be recognized when it is incurred. By using
this method revenue is matched with expenses as when service is given the expenses incurred to
give that service are also recorded simultaneously leading to correct information in the reports.
on the other hand, under cash accounting revenue is recorded when cash is received while expense
is recorded when cash is paid. However, this method leads to inaccurate financial information.
Suppose a business provides service but does not receive cash, while it has incurred expense and
paid for it. So, in its books according to cash basis accounting revenue would not be recorded while
expense would be recorded. As a result, the matching principle would not be followed. Moreover
cash basis accounting might overstate the performance of the business by recorded revenues after
cash is received but not recording the huge amounts of payables the business has hence overstating
profits and working capital. Meanwhile the accrual basis accounting records receivables and
payables and hence shows the real picture of a company’s performance.

A classified balance sheet is divided into two main parts. The first part consists of Assets which
include current assets, long term investments, property plant and equipment and intangible assets.
Currents assets are those assets which have a useful life of less than one year and can easily be
converted into cash. These include cash, inventory, receivables, prepaid expenses. Long term
investments include investments in bonds and securities and long-term notes receivable. Property
plant and equipment consists of assets that have useful lives more than one year and are used in the
operations of the business, like equipment and land. These assets are recorded in the balance sheet
on fair value hence accumulated depreciation (the total reduction in value of the asset due to wear
and tear) is subtracted from the cost of the property plant and equipment. Intangible assets are non-
physical assets that mostly include good will. The second section of the balance sheet which is called
liabilities and owners equity firstly consists of current liabilities. Current liabilities are debts of the
business which have to be paid within one year, these include trade payable, short term loan and
salaries payable. Secondly long-term liabilities are those obligations which have to be paid any time
after one year. It includes long term loan and delayed taxes. Lastly comes the owners’ equity which
includes the value of shares shareholders have bought and the retained earnings which is the net
income left after paying dividends.

The main purpose of financial reporting is to provide information that is useful for investors and
creditors. The two main qualities of useful information are relevance and faithful representation.
Accounting info would be relevant when it would aid investors and creditors to make decisions
based on it and it would provide them the info that interests them. Faithful representation means
that the accounting info truly reflects the actual performance of the business. This would be possible
if the information would be error free and unbiased. There are 4 main accounting assumptions.
Firstly, the going concern assumption that states that the business will keep on running in the
foreseeable future. Secondly the time period assumption states that the life of the business can be
split into small periods of quarters etc. thirdly the economic entity assumption stated that the
entries of a business should remain separate from its owner and other businesses. Lastly the
monetary unit assumption states that only things that have monetary value should be recorded.
Hence important info like bad health of owner won’t be recorded as it does not have any monetary
value. Accounting principles include revenue recognition principles which states that revenue should
be recorded when performance obligation is fulfilled and not when the money is paid. The expense
recognition principle states that expenses should be recorded when incurred and they should be
matched with revenues. Lastly the full disclosure principle stated that companies should reveal all
economic events occurred and nothing should be kept concealed. Presentation of accounting
information has cost constraints. Often it is quiet costly to provide accounting information hence
accountants look to weigh the extent of costs and benefits of revealing the information and look to
maximize benefits of the information for its users.

Fair value principle suggests that assets and liabilities should be recorded at selling price of the asset
and at amount settled for liability. This principle is not followed for all measurements because the
selling prices of all assets cannot be easy to figure out. Rather this principle is often applied when
recording certain types of assets like investment securities because its market price is readily
available. Moreover, fair value of an asset depends on its demand in the market so it can sometimes
happen that the fair value is extremely high due to high demand and sometimes it is low due to low
demand of that asset. Hence this would lead to fluctuating values of the asset hence not reflecting
correct factual information. Overall, it is believed that fair value provides relevance to the
information however for a more factual and faithful representation of accounting information the
historical cost method is used.