Basics of Accounting-Introduction

What Is Accounting?

Accounting is the process of recording financial transactions pertaining to a business. The accounting
process includes summarizing, analyzing, and reporting these transactions to oversight agencies,
regulators, and tax collection entities. The financial statements used in accounting are a concise
summary of financial transactions over an accounting period, summarizing a company's operations,
financial position, and cash flows. Usually, accounting is understood as the Language of Business
(The Language of Financial Decisions).

Types of Accounting

1. Financial Accounting

Financial accounting refers to the processes used to generate interim and annual financial statements.
The results of all financial transactions that occur during an accounting period are summarized into
the balance sheet, income statement, and cash flow statement. The financial statements of most
companies are audited annually by an external CPA firm. For some, such as publicly traded
companies, audits are a legal requirement. However, lenders also typically require the results of an
external audit annually as part of their debt covenants. Therefore, most companies will have annual
audits for one reason or another.

2. Managerial Accounting

Managerial accounting uses much of the same data as financial accounting, but it organizes and utilizes
information in different ways. Namely, in managerial accounting, an accountant generates monthly or
quarterly reports that a business's management team can use to make decisions about how the business
operates. Managerial accounting also encompasses many other facets of accounting, including
budgeting, forecasting, and various financial analysis tools. Essentially, any information that may be
useful to management falls underneath this umbrella.

3. Cost Accounting

Just as managerial accounting helps businesses make decisions about management, cost accounting
helps businesses make decisions about costing. Essentially, cost accounting considers all of the costs
related to producing a product. Analysts, managers, business owners and accountants use this
information to determine what their products should cost. In cost accounting, money is cast as an
economic factor in production, whereas in financial accounting, money is considered to be a measure
of a company's economic performance.

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Basic Elements of Accounting

What is an Account?

The term "account" is used often in this tutorial. Thus, we need to understand what it is before we proceed.
In accounting, an account is a descriptive storage unit used to collect and store information of similar nature.

For example, "Cash".

Cash is an account that stores all transactions that involve cash receipts and cash payments. All cash receipts
are recorded as increases in "Cash" and all payments are recorded as deductions in the same account.

Another example, “Building". Suppose a company acquires a building and pays in cash. That transaction
would be recorded in the "Building" account for the acquisition of the building and a reduction in the "Cash"
account for the payment made.

Classification of Accounts

1. Personal Accounts

Accounts which are related with accounts of individuals, firms, companies are known as personal accounts.
The personal accounts may further be classified into three categories:

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I) Natural Personal Accounts: Accounts of individuals relating to

natural persons.
II) Artificial Personal Accounts: Accounts of Companies, Institutions.
III) Representative Personal Accounts: Accounts w/c represent some person such as
insurance account

Assets
Assets refer to resources owned and controlled by the entity as a result of past transactions and events, from
which future economic benefits are expected to flow to the entity. In simple terms, assets are properties or
rights owned by the business. They may be classified as current or non-current.

A. Current assets – Assets are considered current if they are held for the purpose of being traded, expected
to be realized or consumed within twelve months after the end of the period or its normal operating cycle
(whichever is longer), or if it is cash. Examples of current asset accounts are:

1. Cash and Cash Equivalents – bills, coins, funds for current purposes, checks, cash in bank, etc.
2. Receivables – Accounts Receivable (receivable from customers), Notes Receivable (receivables
supported by promissory notes), Rent Receivable, Interest Receivable, Due from Employees (or
Advances to Employees), and other claims
• Allowance for Doubtful Accounts – This is a valuation account which shows the estimated
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uncollectible amount of accounts receivable. It is a contra-asset account and is presented as a

deduction to the related asset – accounts receivable.
3. Inventories – assets held for sale in the ordinary course of business
4. Prepaid expenses – expenses paid in advance, such as, Prepaid Rent, Prepaid Insurance, Prepaid
Advertising, and Office Supplies

B. Non-current assets – Assets that do not meet the criteria to be classified as current. Hence, they are long-
term in nature – useful for a period longer that 12 months or the company's normal operating cycle. Examples
of non-current asset accounts include:

1. Long-term investments – investments for long-term purposes such as investment in stocks, bonds,
and properties; and funds set up for long-term purposes
2. Land – land area owned for business operations (not for sale)
3. Building – such as office building, factory, warehouse, or store
4. Equipment – Machinery, Furniture and Fixtures (shelves, tables, chairs, etc.), Office Equipment,
Computer Equipment, Delivery Equipment, and others
• Accumulated Depreciation – This is a valuation account which represents the decrease in value of
a fixed asset due to continued use, wear & tear, passage of time, and obsolescence. It is a contra-asset
account and is presented as a deduction to the related fixed asset.
5. Intangibles – long-term assets with no physical substance, such as goodwill, patent, copyright,
trademark, etc.
6. Other long-term assets

Liabilities
Liabilities are economic obligations or payables of the business.

Company assets come from 2 major sources – borrowings from lenders or creditors, and contributions by the
owners. The first refers to liabilities; the second to capital.

Liabilities represent claims by other parties aside from the owners against the assets of a company.

Like assets, liabilities may be classified as either current or non-current.

A. Current liabilities – A liability is considered current if it is due within 12 months after the end of the
balance sheet date. In other words, they are expected to be paid in the next year.

If the company's normal operating cycle is longer than 12 months, a liability is considered current if it is due
within the operating cycle.

Current liabilities include:

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1. Trade and other payables – such as Accounts Payable, Notes Payable, Interest Payable, Rent Payable,
Accrued Expenses, etc.
2. Current provisions – estimated short-term liabilities that are probable and can be measured reliably
3. Short-term borrowings – financing arrangements, credit arrangements or loans that are short-term in
nature
4. Current-portion of a long-term liability – the portion of a long-term borrowing that is currently due.
Example: For long-term loans that are to be paid in annual installments, the portion to be paid next
year is considered current liability; the rest, non-current.
5. Current tax liabilities – taxes for the period and are currently payable

B. Non-current liabilities – Liabilities are considered non-current if they are not currently payable, i.e. they
are not due within the next 12 months after the end of the accounting period or the company's normal
operating cycle, whichever is shorter.

In other words, non-current liabilities are those that do not meet the criteria to be considered current. Hah!
Make sense? Non-current liabilities include:

1. Long-term notes, bonds, and mortgage payables;

2. Deferred tax liabilities; and
3. Other long-term obligations

Capital
Also known as net assets or equity, capital refers to what is left to the owners after all liabilities are settled.
Simply stated, capital is equal to total assets minus total liabilities. Capital is affected by the following:

1. Initial and additional contributions of owner/s (investments),

2. Withdrawals made by owner/s (dividends for corporations),
3. Income, and
4. Expenses.

Owner contributions and income increase capital. Withdrawals and expenses decrease it.

The terms used to refer to a company's capital portion varies according to the form of ownership. In a sole
proprietorship business, the capital is called Owner's Equity or Owner's Capital; in partnerships, it is called
Partners' Equity or Partners' Capital; and in corporations, Stockholders' Equity.

In addition to the three elements mentioned above, there are two items that are also considered as key
elements in accounting. They are income and expense. Nonetheless, these items are ultimately included as
part of capital.

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Income
Income refers to an increase in economic benefit during the accounting period in the form of an increase in
asset or a decrease in liability that results in increase in equity, other than contribution from owners.

Income encompasses revenues and gains.

Revenues refer to the amounts earned from the company’s ordinary course of business such as professional
fees or service revenue for service companies and sales for merchandising and manufacturing concerns.

Gains come from other activities, such as gain on sale of equipment, gain on sale of short-term investments,
and other gains.

Income is measured every period and is ultimately included in the capital account. Examples of income
accounts are: Service Revenue, Professional Fees, Rent Income, Commission Income, Interest Income,
Royalty Income, and Sales.

Expense
Expenses are decreases in economic benefit during the accounting period in the form of a decrease in asset
or an increase in liability that result in decrease in equity, other than distribution to owners.

Expenses include ordinary expenses such as Cost of Sales, Advertising Expense, Rent Expense, Salaries
Expense, Income Tax, Repairs Expense, etc.; and losses such as Loss from Fire, Typhoon Loss, and Loss
from Theft. Like income, expenses are also measured every period and then closed as part of capital.

Net income refers to all income minus all expenses.

Drawings
Drawings refer to the act of withdrawing cash or assets from the company by the owner(s) for personal use. Drawings
can occur by withdrawing cash from a business account, but can also include anything that is considered a
business asset, such as products or equipment that is removed from the business for personal use by the
owners.

Any type of drawings reduces the capital or owner’s equity of a business, so it is important to keep track of
these drawings and manage them within your accounts. However, drawings are not considered a business
expense.

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Accounting Equation
Assets = Liabilities + Owners Equity … (1)

Owners’ Equity = Assets- Liabilities … (2)

The above relationship is known as the ‘Accounting Equation’. The term ‘Owners Equity’ denotes the
resources supplied by the owners of the entity while the term ‘liabilities’ denotes the claim of outside
parties such as creditors, debenture-holders, bank against the assets of the business. Assets are the
resources owned by a business. The total of assets will be equal to total of liabilities plus owners capital
because all assets of the business are claimed by either owners or outsiders.
Illustration
Mr. X is the owner and operator of Dream a. Owner’s equity, as of December 31,
motivational consulting business. At the end 2009.
of its accounting period, December 31, 2009, b. Owner’s equity, as of December 31,
Dream has assets of $800,000 and liabilities 2010, assuming that assets increased by
of $350,000. Using the accounting equation, $130,000 and liabilities decreased by
determine the following amounts: $25,000 during 2010.
Solution
a. Assets =Liabilities + Owner’s Equity

$800,000 = $350,000 + Owner’s Equity

Owner’s Equity = $450,000

b. First, determine the change in Owner’s Equity during 2010 as follows:

Assets = Liabilities + Owner’s Equity

$130,000 = $25,000 + Owner’s Equity
Owner’s Equity = $155,000

Next, add the change in Owner’s Equity on December 31, 2009 to arrive at Owner’s Equity
on December 31, 2010, as shown below.

Owner’s Equity on December 31, 2010 --- > $605,000 = $450,000 + $155,000

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RECORDING OF TRANSACTIONS- VOUCHER SYSTEM,

ACCOUNTING PROCESS, JOURNAL
A business enterprise generally prepares the following two basic financial statements:
 Profit and Loss Account to ascertain the profit earned or loss incurred during an accounting period.
This account sometimes called statement of financial performance.
 Balance Sheet to ascertain the financial position of the business as on a particular (specific) date.
Generally, a business enterprise has numerous transactions every day during an accounting period. Unless
the transactions are recorded and analyzed, it is not possible to determine the impact of each transaction in
the above two basic statements. Traditionally, accounting is a method of collecting, recording, classifying,
summarizing, presenting and interpreting financial data aspect of an economic activity. The series of business
transactions occurring during the accounting period and its recording is referred to an accounting
process/mechanism. An accounting process is a complete sequence of accounting procedures which are
repeated in the same order during each accounting period.
Therefore, accounting process involves the following steps or stages:
1. Identification of transaction
In accounting, only business transactions are recorded. A transaction is an event which can be expressed in
terms of money and which brings change in the financial position of a business enterprise. An event is an
incident or a happening which may or may not being any change in the financial position of a business
enterprise. Therefore, all transactions are events but all events are not transactions. A transaction is a
complete action, to an expected or possible future action.
In every transaction, there is movement of value from one source to another. For example, when goods are
purchased for cash, there is a movement of goods from the seller to the buyer and a movement of cash from
buyer to the seller. Transactions may be external (between a business entity and a second party, e.g., goods
sold on credit to ABC Company or internal (do not involve second party, e.g., depreciation charged on the
machinery).
Illustration: State with reasons whether the following events are transactions or not to Mr. Soresa,
Proprietor.
(i) Mr. Soresa started business with capital (brought in cash) Birr. 40,000.
(ii) Paid salaries to staff Birr. 5,000.
(iii) Purchased machinery for Birr. 20,000 in cash.

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(iv) Placed an order for goods for Birr. 5,000.

(v) Opened a Bank account by depositing Birr. 4,000.
(vi) Received pass book from bank.
(vii) Appointed Sara as Manager on a salary of Birr. 4,000 per month.
(viii) Received interest from bank Birr. 500.
(ix) Received a price list from ABC Co.
Solution: Here, each event is to be considered from the view point of Mr. Soresa’s business. Those events
which will change the financial position of the business of Mr. Soresa, should be regarded as transaction.
(i) It is a transaction, because it changes the financial position of Mr. Soresa’s business. Cash will increase
by Birr. 40,000 and Capital will increase by Birr. 40,000.
(ii) It is a transaction, because it changes the financial position
of Mr. Soresa’s business. Cash will decrease by Birr. 5,000 and Salaries (expenses) will increase by Birr.
5,000
(iii) It is a transaction, because it changes the financial position of Mr. Soresa’s business. Machinery comes
in and cash goes out.
(iv) It is not a transaction, because it does not change the financial position of the business.
(v) It is a transaction, because it changes the financial position of the business. Bank balance will increase
by Birr. 4,000 and cash will decrease by Birr. 4,000..
(vi) It is also not a transaction, because it does not change the financial position of Mr. Soresa.
(vii) It is also not a transaction, because it does not change the financial position of Mr. Soresa.
(viii) It is a transaction, because it changes the financial position of Mr. Soresa’s business. Bank interest will
increase by Birr. 500 and cash will increase by the same amount.
(ix) It is not a transaction, because it does not change the financial position of the business of Mr. Soresa.
2. Recording the transaction
Journal is the first book of original entry in which all transactions are recorded event wise and date-wise and
presents a historical record of all monetary transactions. It may further be divided into sub-journals as well
which are also known subsidiary books.

3. Classifying
Accounting is the art of classifying business transactions. Classification means statement setting out for a
period where all the similar transactions relating to a person, a thing, expense, or any other subject are
grouped together under appropriate heads of accounts.
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4. Summarizing
Summarizing is the art of making the activities of the business enterprise as classified in the ledger for the
use of management or other user groups i.e. Sundry debtors, Sundry creditors etc. Summarization helps in
the preparation of Profit and Loss Account and Balance sheet for a particular fiscal year.
5. Analysis and Interpretation
The financial information or data as recorded in the books of a account must further be analyzed and
interpreted so to draw useful conclusions. Thus, analysis of accounting information will help the management
to assess in the performance of business operation and forming future plans also.
6. Presentation or reporting of financial information
The end users of accounting statements must be benefited from analysis and interpretation of data as some
of them are the ‘stock holders’ and other one the ‘stake holders’. Comparison of past and present statement
and reports, use of ratio and trend analysis are the different tools of analysis and interpretation. From the
above discussion one can conclude that accounting is a art which starts and includes steps right from
recording of business transactions of monetary character to the communicating or reporting the results thereof
to the various interested parties.

VOUCHER
Each transaction is recorded in books of accounts providing all the required information of the transaction.
Since each transaction has an effect on the financial position of the business, there should be a documentary
evidence to establish the monetary accounts at which transactions are recorded and also the transactions are
properly authorized. The common documents that are generally used are as under:
(i) Payment voucher;
(ii) Receipt voucher; and
(iii) Transfer voucher.
(i) A Payment voucher usually on a printed standard form is a record of payment. When payment is made
for an expense, generally a bill is prepared to record full particulars of the claim by the person or organization
receiving payment. From the bill, the accounting department prepares a voucher for each payment to be
made, no matter whether the amount that is paid for the goods purchased, or to pay employee’s salaries, or
to pay for services or to pay for any other asset acquisition.
(ii) A Receipt voucher is a document which is issued against cash receipts. It may also be a printed standard
form. This document shows that a certain sum of money was received from a person or organization and

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also, contains information of the purpose for which the money is received. It is signed by a responsible
employee, authorized by the management to receive the money.
(iii) A Transfer voucher is used to record the residuary transactions. An internal transaction or a transaction
not involving any cash payment or cash receipt is recorded in the transfer voucher. Examples are: Goods
purchased on credit; depreciation of assets, outstanding expenses, accrues income, etc.

Accounting Cycle Steps

1. Transactions are analyzed and recorded in the journal.
2. Transactions are posted to the ledger
3. An unadjusted trial balance is prepared.
4. Adjustment data are assembled and analyzed and Adjusting entries are journalized and posted to the
ledger
5. An adjusted trial balance is prepared
6. Financial statements are prepared
7. Closing entries are journalized and posted to ledger
8. A post-closing trial balance is prepared
9. Reversing entry is prepared

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The Rules of Debit & Credit & Double Entry Accounting System

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Solution

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LEDGER POSTING AND TRIAL BALANCE STRUCTURE

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A specimen of Ledger is given below:

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Objective of Preparing Trial Balance

1. Checking of the arithmetical accuracy of the accounting entries
2. Basis for financial statements
3. Summarized ledger

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Assignment#1

1. Define accounting. What purpose is served by accounting?

2. Discuss the role and activities of an accountant.
3. What are the various interested parties which use accounting? Information? How is such information used?
4. Explain the different types of accounting.
5. Differentiate Financial Accounting and Management Accounting in detail.

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