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In all activities whether business activities or non - business activities and all organizations whether business organization like a manufacturing entity or trading entity or non - business organizations like school , colleges, hospitals, libraries, clubs , temples, political parties which require money and other economic resources , accounting is required to account for these resources. In other words, wherever money is involved accounting is required to account for it. Accounting os often called the language of business. The function of any language is to serve as a means of communication.
What is Accounting ?
Accounting is the process of recording, classifying, summarizing, analyzing and interpreting the financial transactions and communicating the results thereof to the persons interested in such information. Accounting is a service activity. Its purpose is to offer quantitative information, mainly financial in nature, about economic bodies that is intended to be useful in making economic decisions, in making reasoned choices among another courses of action. Accounting is an information science used to collect, classify, and manipulate financial data for organizations and individuals.
American Institute of Certified Public Accountant (AICPA) defines accounting as ; Accounting is the art of identifying, recording, classifying and summarizing, in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results thereof. Definition of accounting is usually accepted by accounting professionals and organization around the world.
Warren Reeve Fess thought accounting is an information system that provides reports to stakeholders about the economic activities and conditions of a business.
Accounting may be best defined as identification, measurement and communication of financial information about economic entities to interested persons. This is another meaning said by Donald Kieso, Jerry Weygandt, Terry Warfield in the intermediate accounting tenth edition.
Without accounting, there is no easier and concise way to understand the transactions, financial results of operation and condition of an individual, business or organization. Accounting makes it easier for interested party to understand the business process just by looking at the accounting reports.
Accounting are based on principles and assumptions. Below are the basics :
This statement said that personal and private transactions of the owner are kept separate within the business. This assumption enables the accountant to distinguish between the transactions of the business and those of the owners. For example, if the owner brings in cash or any other asset, it will result in increase in assets of the business and capital of the firm. This capital represents firm's liability to the owner. The expenses of the owner paid by the firm assets are recorded as withdrawals from the business. This means the profit and loss account will show the revenues and expenses related to the business entity only.
This states that only transactions which can be expressed in money term are included in the recordings. The different items, expressed in varied basis of measurement, like area, volume, numbers, cannot be added together because of heterogeneity of scales of measurement. It is clear that the money measurement assumptions makes the accounting records clear, simple, comparable and understandable.
This assumption permits the accountant to divide the lifespan of the business enterprise into different time periods known as accounting period (quarterly, half-yearly, annually) for the purpose of preparing financial statements. Hence, financial statements are prepared for an accounting period and results thereof are reported on periodic basis.
This assumption assumed that a business should operate in a continual basis for a foreseeable future. That is a company cannot open only for a certain period of time. Since, this assumption believes in continuity of the business over unspecified period, it is also known as continuity assumption.
This refers to double entry book keeping. This system record transactions two times , every debit entry has a credit entry. When an investment is made by the owner in the business, it results in increase in an asset and increase in owner's equity. Thus, this transaction is recorded considering these two aspects, i.e. asset and owner's equity.
This principle is concerned with the revenue being recognized in Income Statement. Revenues are the amount a business earns by selling its products or providing services to the customers. In some cases, revenue may be realized at the time of receiving cash and not at the time of providing services. For example, a lawyer may charge the fee from his client and treat it as revenue earned for the current period, whereas legal services may be provided in future.
Historical cost principle requires that all transactions should be recorded at their acquisition cost. Asset is recorded in the accounting records at cost proce on the date it is purchased. If nothing is paid to acquire an asset, nothing will be recorded as an asset. The advantage of using historical cost for recording the transactions is that it is objective, verifiable and reliable. Thus, it instructs reliability to the financial statements.
This shows that it is important to match related cost and expenses to revenue for a reporting period. The Matching Principle by relating expenses to the associated revenues helps in measuring income (profit) for the given period. It is of great significance since the performance of an entity is usually measured in terms of income earned by the entity. We do not recognize the expense when cash is paid or when a product is produced. It is recognized when the service or the product actually contributes to the revenue.
This principle is about the financial statements of an organization must disclose all the relevant and reliable information. Disclosure should be full, fair and adequate so that users can make correct assessment about financial performance and position. Changes which are made in the account must be disclosed.
This concept implies that accounting data should be definite, verifiable and free from personal bias. Each recordings should have an suitable evidence to support it. In accounting the transactions are recorded on the basis of source documents.
Purpose of Accounting
Essential Characteristics of Accounting
It's an information system which means it involves a process or procedure.
It has an economic value which means it is stated in terms of money or currency.
It communicates financial information of a business to stakeholders or interested parties.
The purpose of accounting is to collect and report on financial information about the performance, financial position, and cash flows of a business. This information is then used to reach decisions about how to manage the business, or invest in it, or lend money to it .This information is stored in accounting records with accounting transactions, which are recorded either through such regular business transactions as customer invoicing or supplier invoices, or through more specialized transactions, known as journal entries.
Once this financial information has been stored in the accounting records, it is usually assembled into financial statements, which include the following documents:
Statement of cash flows
Statement of retained earnings
Financial statements are assembled under certain sets of rules, known as accounting frameworks, of which the best known are Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).Accountant may create additional reports for special purposes, such as determining the profit on sale of a product, or the revenues generated from a particular sales region.
Accounting is involved within organizations as a means of determining financial stability. Accountants are responsible for determining an organization's overall wealth, profitability, and liquidity. Without accounting, organizations would have no basis or foundation upon which daily and long-term decisions could be made. The budgets for marketing activities, profit reinvestment, research and development, and company growth all branch from the work of accountants. Accounting is one of the oldest and most respected professions in the world, and accountants can be found in every industry from entertainment to medicine.
Branches of Accounting
Auditing - a service concentrated by CPA's in public practice who examine records and statements and express an opinion regarding their fairness.
Cost Accounting - underlines the determination and the control costs particularly the costs of manufacturing. The purpose of this branch is to ascertain the cost, to control the cost and to communicate information for decision making.
Management Accounting - concerned with the application of appropriate techniques and concepts. It is designed to help all levels of management in planning and controlling the activities of business enterprise and in decision making. The purpose of this branch of accounting is to supply any all information that management may need in taking decision and to evaluate the impacts of its decisions and actions.
Financial Accounting - The main purpose of financial accounting is to prepare financial reports that provide information about a firm's performance to external parties such as investors, creditors, and tax authorities.
Tax Accounting - includes the preparation of tax returns.
Budgetary - represent the plan of action financial operation for a period of time.
Users of Accounting
There are 2 types of users of accounting, which is Internal and External. Users of accounting normally look forward in business's accounting in order to know more about the business. Each user have different point of view for accounting records. For example Bank may need to know about the liquidity position of the business so as to approve a loan for a business. Employees may need to know the stability and profitability of the company so as to assess the ability to pay remuneration, retirement benefits and employment opportunities.
Objective of Accounting :
A. To maintain record of the business
B. To calculate profit or loss
C. To know financial position
D. To provide financial information to various users
However accounting has its benefits and limitations. Below are the brief description :
They reduce or eliminate confusing variations in the methods used to prepare accounts.
They provide a focal point for debate and discussions about accounting practice.
They 7 companies to disclose the accounting policies used in the preparation of accounts.
They are a less inflexible alternative to enforcing conformity by means of legislation.
They have obliged companies to disclose more accounting information than they would otherwise have done if standards did not exist.
The development of IFRS involves a full consultative process in which user groups are directly involved. (IFRS refer to International Financial Reporting Standards)
A set of rules which give backing to one method of preparing accounts might be inappropriate in some circumstances.
Standards may be subject to lobbying or government pressure.
Earlier standards were not based on a concrete framework of accounting but the IASB is committed to rectifying this. (IASB refer to International Accounting Standards Board)
There may be a trend towards rigidity, and away from flexibility in applying the rules. Some commentators feel that professional judgment should be used on technical matters.
Functions of Accounting;
1.Identifying is the start process of doing accounting. Example the sale or return of a product, the purchases made by the business or other financial activities are being identify by the management on the other hand not all transactions are recorded in the Journal Entry. For example Drawing that is what the owner have withdrew from the business, it can be Cash or Goods.
2. Measuring is the task of determining transactions or events in common measuring units. For example converting the currency of the business, changing the currency of the sales made by the business from Dollar to Euro or Pound Sterling.
3. Recording is the transaction listed in the appropriate journal, maintaining the journal's correct order of transactions. The journal is also known as the '' Book of original entry '' and is the first place of a transaction is listed. Example record the Sales and purchases of a business.
4. Classifying is the transactions which are posted to the account that is impacts. For example Sales for the year will enter in the Sales account. These accounts are part of the General Ledger, where you can find a summary of all the business's accounts. An example for this is that differentiating accounts where there must be no merging of other accounts.
5. Summarizing is done at the end of the accounting period which maybe a month , quarter or a year it differs from business's practices. For example in the trial balance it consists of all income and expenditure. That is Debit the expenditure and Credit the income, if the trial balance does not balance it results in an error.
6. Analysis is the process of looking and adjusting errors which are found in the Trial Balance. Adjustments are also made to account for the depreciation of assets and to adjust for one time payment that should be allocated on a monthly basis to more accurately match monthly expenses with monthly Revenues. After you make and record adjustments, you take another trial balance to be sure the accounts are in balance. And for example check the strength and weakness of the business liquidity and check the account accordingly.
7. Interpreting is the procedure of explaining obtained figures of an organization .For example the profit of the business is decreasing, thus accountant have to explain why is it reducing or what will happen in the future.
8. Communication that is financial statement are prepared and published. It consist of Trading ,Profit/loss and a Balance sheet. These accounts are used by tax authority , government, customers, employees and the public.
Q.2 Distinguish between Financial Accounting and Managerial Accounting
Accounting is a vital part of any individual, business or organization's economic foundation. It plays a major role in defining financial condition and performance, in terms of operation, profitability and sustainability. Accounting is essential for a business as it will determine whether it will make a success or loss. To be not simple Michael Russell defines accounting as the recording of financial or money transactions. Not all transactions need to be recorded. Mostly, only business transactions are recorded, personal transactions are rarely recorded by individuals.
Purpose of Accounting
The purpose of accounting is to provide the information that is needed for sound economic decision making. The main purpose of financial accounting is to prepare financial reports that provide information about a firm's performance to external parties such as investors, creditors, and tax authorities. Managerial accounting contrasts with financial accounting in that managerial accounting is for internal decision making and does not have to follow any rules issued by standard-setting bodies.
Many small businesses utilize an accounting system that recognizes revenue and expenses on a cash basis, meaning that neither revenue nor expenses are accepted until the cash associated with them actually is received. Most larger businesses, however, use the accrual method.
Under the accrual method, revenues and expenses are recorded according to when they are earned and incurred, not necessarily when the cash is received or paid. For example, under the accrual method revenue is recognized when customers are invoiced, regardless of when payment is received. Similarly, an expense is recognized when the bill is received, not when payment is made.
Financial accounting is one of the areas of accounting which is primarily concerned on the recording, summarizing and communicating business transactions to external and internal stakeholders in the form of financial statements. These financial statements are intended to be used to form sound judgment regarding the financial condition and performance of a business, and other relevant decision making.
Financial accounting is the process of identifying, measuring, recording, classifying, summarizing, analyzing, interpreting and communicating financial transactions. It ascertain financial performance and financial position of a business. In financial accounting there is no forecast on this side, it allows only actual transactions. Financial statements will consist of Income Statement, which shows the profit or loss over a period of time, and a Balance Sheet, which is a summary of the Assets, Liabilities and Equity of the business at a specific date.
Purpose of doing Financial Statements
The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions (IASB Framework).
Financial statement is to enable a business to establish the result of its operations over a period of time and to determine its worth at a specific date.
Financial Statements provide useful information to a wide range of users. A manager are required to manage the affairs of the company by evaluating its financial performance and position and taking important business decisions. To assess the risk and return of their investment in the company and take investment decision based on their analysis, this are done by Shareholders.
The notes to the financial statement gives an in depth understanding of the financial performance of the company.
Financial accounting relies on the following underlying concepts: Assumptions: Separate entity assumption, going-concern assumption, stable monetary unit assumption, fixed time period assumption. Principles: Historical cost principle, matching principle, revenue recognition principle, full disclosure principle. Modifying conventions: Materiality, cost-benefit, conservatism convention, industry practices convention.
Advantages of Financial Accounting
Financial account enables managers to know the financial state of the business.
They are useful to government for tax purposes.
It helps managers to know the liquidity state of the business.
useful to creditors and other financial institutions such as banks for collateral security.
It enables managers to know the profit or loss incurred by the organization within a specified period.
They help during planning process and when making financial decisions.
Provides information during budgeting
Disadvantages of Fincancial Accounting
No detail information about cost: Financial Accounting provides information as a whole in terms of income, expenses, assets and liabilities. It does not provide detail of cost involved by departments, processes, products, services or other unit of activity within the organization.
No cost control method: It does not have proper mechanism to control expenditure on various elements of cost, material and labour. As a result, misappropriation, wastage and losses of materials are left unchecked. Proper utilization of labour becomes impossible and suitability of different labour incentive plans goes without evaluation.
No information on efficiency: It does not have a system to judge the» efficiency in the use of material, labour and overhead costs of the organization in comparison to the standard fixed for their use.
No classification of expenses: It does not classify expenses as direct and indirect or fixed and variable. Besides, these are also not allocated to different stages of production or departments or processes to show the controllable and uncontrollable items on overhead cost.
Management accounting combines accounting, finance and management with the leading edge techniques needed to drive successful businesses. The key difference between managerial and financial accounting is that managerial accounting information is aimed at helping managers within the organization make decisions. In contrast, financial accounting is aimed at providing information to parties outside the organization.
Managerial accounting information include:
Information on the costs of an organization's products and services.
For Example, managers can use product costs to guide the setting of selling prices. In addition, these product costs are used for inventory valuation and income determination.
Budget. A budget is a quantitative expression of a plan.
Performance reports: These reports often consist of comparisons of budgets with actual results. The deviations of actual results from budget are called variances.
Other information which assist managers in their planning and control activities.
Examples are information on revenues of an organization's products and services, sales back logs, unit quantities and demands on capacity resources.
Cost accounting is the third major sphere of accounting it is the process of determining the cost of a specific output or activity. Although it is sometimes confused with the managerial accounting function, cost accounting information is used by decision makers both inside and outside an organization. Cost and managerial accounting differ in that the latter goes beyond the role of cost accounting by combining multiple management disciplines with financial information to facilitate internal decision making. Thus, cost accounting may be seen as a necessary component of managerial accounting, but its focus is much narrower.
Since it is focused on making future decisions with the help of past financial data, it is forward looking and therefore progressive in nature.
It is meant for internal users like top management and therefore it is not necessary that it is made by following strict guidelines which is the case with financial accounting.
It is flexible in nature and therefore it can be prepared anytime and they are not required to be made yearly they can be made monthly or on weekly basis.
It takes all the data and then present it in such a way that a proper analysis about the feasibility and profitability of any business decision can be made.
It is dependent on cost accounting and financial accounts and therefore the accuracy of it is also dependent on how accurate that data is, hence it is one of the limitations as far as its usability is concerned.
It is affected by the bias of top management and therefore it is likely that they may tweak it in such a way so as to benefit themselves rather than shareholders.
Since it does not follow accounting principles, it cannot be compared with other company's and hence proper evaluation about the management may not be possible on the basis of management accountancy.
Differences of Financial and Managerial Accounting
Financial accounts are supposed to be in accordance with a specific format by IAS so that financial accounts of different organizations can be easily compared. Management accounting does not have any specific format. Financial accounting helps in making investment decision, in credit rating. On the other hand Management accounting helps management to record, plan and control activities to aid decision-making process. Financial accounting can be used by internal and external member of an organization for example creditors, shareholders and Bank. But a management accounting system produces information that is used within an organization, by managers and employees.
Financial accounting focuses on history that is with past and actual data whereas Management accounting focuses more about the future.
The financial accounting, the origin of preservation of knowledge gives emphasis on recording keeping on a whole firm basis for the purpose of decisions by all the users of accounting information, both external and internal. While Management accounting uses cost data for provision of information for strategic management decisions. It is mainly concerned with the provision of help to the managers to asses them in the process of decision making and design business strategies.
Although there is a difference in the type of information presented in financial and management accounts, the underlying objective is the same to satisfy the information needs by the user.