FUNDAMENTALS OF ACCOUNTING

INTRODUCTION
Intended learning outcomes
i. Nature, purpose of accounting
ii. Objectives of accounting
iii. Users of accounting information
iv. Qualitative characteristics of accounting information
v. Accounting principle/Fundamental assumptions
vi. Fundamental accounting equation
vii. Elements of financial statements
 DEFINITION OF ACCOUNTING
 Accounting is the process of;
Collecting-information relating to business events
Recording-classifying data in prescribed manner
Summarizing-to produce statements and reports
Interpreting and communicating- financial
information to permit informed decisions.

 Accounting is the process of collecting, recording,

summarizing, analyzing and reporting the financial
transactions in a manner that adheres to certain accepted
standard formats, helping to evaluate a past performance,
present condition, and future prospects as well.
 NEED FOR ACCOUNTING
 In all activities and organizations (business or non-
business) 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 is often called the language of business.

The basic function of any language is to serve as a
means of communication. Accounting also serves this
function.
 THE NEED FOR ACCOUNTING

 Accounting helps answering questions like;

 Am I making or losing money from my business?

 How much am I worth?

 Should I put more money in my business or sell it and go into

another business?

 How much is owed to me, and how much do I owe?

 How can I change the way I operate to make more profit?

 OBJECTIVES OF ACCOUNTING
 Keeping systematic record.
 To provide information about financial
performance.
 Ascertain the financial position of the business.
 Portray the liquidity position.
 To protect business properties.
 To facilitate rational decision – making.
 To satisfy the requirements of law.
BRANCHES OF ACCOUNTING
FINANCIAL ACCOUNTING
 Financial accounting is primarily concerned with the

preparation of financial statements for the basic purpose of

providing information to various interested groups like
creditors, banks, shareholders, financial institutions,
government, consumers, etc.

 Financial accounting is charged with the primary

responsibility of external reporting. The users of information
generated by financial accounting, like bankers, financial
institutions, regulatory authorities, government, investors, etc.
want the accounting information to be consistent so as to
facilitate comparison.
MANAGEMENT ACCOUNTING
Management accounting is ‘tailor-made’ accounting. It facilitates the management
by providing accounting information in such a way so that it is conducive for
policy making and running the day-to-day operations of the business.

 Its basic purpose is to communicate the facts according to the specific needs of
decision-makers by presenting the information in a systematic and meaningful
manner.

 Management accounting, therefore, specifically helps in planning and control. It

helps in setting standards and in case of variances between planned and actual
performances, it helps in deciding the corrective action.

 An important characteristic of management accounting is that it is forward

looking. Its basic focus is one future activity to be performed and not what has
already happened in the past.
COST ACCOUNTING
 Cost accounting makes elaborate cost records regarding various products, operations and
functions. It is the process of determining and accumulating the cost of a particular product or
activity. Any product, function, job or process for which costs are determined and accumulated,
are called cost centres.

 The basic purpose of cost accounting is to provide a detailed breakup of cost of different
departments, processes, jobs, products, sales territories, etc., so that effective cost control can be
exercised.

 Cost accounting also helps in making revenue decisions such as those related to pricing, product-
mix, profit-volume decisions, expansion of business, replacement decisions, etc.

 The objectives of cost accounting, therefore, can be summarized in the form of three important
statements, viz, to determine costs, to facilitate planning and control of business activities and to
supply information for short- and long-term decision.
USERS OF ACCOUNTING INFORMATION
Owners/shareholders:
The owners provide funds or capital for the organization.

They possess curiosity in knowing whether the business

is being conducted on sound lines or not, and whether the
capital is being employed properly or not.
Management:
The management of the business is greatly interested in
knowing the position of the firm.

Thus, the management is interested in financial accounting

to find whether the business carried on is profitable or not.

The financial accounting is the “eyes and ears of

management and facilitates in drawing future course of
action, further expansion etc.”
Creditors:
Creditors are the persons who supply goods on credit, or
bankers or lenders of money.

It is usual that these groups are interested to know the

financial soundness before granting credit.

The progress and prosperity of the firm, two which credits

are extended, are largely watched by creditors from the
point of view of security and further credit.

Income statement and statement of financial position are

nerve centers to know the soundness of the firm.
Employees:
Payment of bonus depends upon the size of profit earned by
the firm. The more important point is that the workers expect
regular income for the bread.

The demand for wage rise, bonus, better working conditions

etc. depend upon the profitability of the firm and in turn
depends upon financial position. For these reasons, this
group is interested in accounting.
Investors:
The prospective investors, who want to invest their money
in a firm, of course wish to see the progress and prosperity
of the firm, before investing their amount, by going
through the financial statements of the firm.

This is to safeguard the investment. For this, this group is

eager to go through the accounting which enables them to
know the safety of investment.
Government:
Government keeps a close watch on the firms which
yield good amount of profits.

The state and central Governments are interested in the

financial statements to know the earnings for the
purpose of taxation. To compile national accounting is
essential.
Consumers:
These groups are interested in getting the goods at
reduced price.

Therefore, they wish to know the establishment of a

proper accounting control, which in turn will reduce to
cost of production, in turn less price to be paid by the
consumers.
Research Scholars:
Accounting information, being a mirror of the financial
performance of a business organization, is of immense value
to the research scholar who wants to make a study into the
financial operations of a particular firm.

As such study needs detailed accounting information

relating to purchases, sales, expenses, cost of materials used,
current assets, current liabilities, fixed assets, long-term
liabilities and share-holders funds which is available in the
accounting record maintained by the firm.
QUALITIES OF USEFUL FINANCIAL INFORMATION
QUALITATIVE CHARACTERISTICS
FAITHFUL REPRESENTATION
ENHANCING QUALITIES
 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

 Generally accepted accounting principles encompass the conventions, rules and procedures
necessary to define accepted accounting practice at a particular time....... generally accepted
accounting principles include not only broad guidelines of general application, but also detailed
practices and procedures

 The term ‘Concept’ is used to connote the accounting postulates, i.e., necessary assumptions and
ideas which are fundamental to accounting practice. In other words, fundamental accounting
concepts are broad general assumptions which underline the periodic financial statements of
business enterprises.

 The term convention’ is used to signify customs or tradition as a guide to the preparation of
accounting statements.

 Obviously, accounting standards are needed to:

a) provide a basic framework for preparing financial statements to be uniformly followed by all
business enterprises,
b) make the financial statements of one firm comparable with the other firm and the financial
statements of one period with the financial statements of another period of the same firm,
c) make the financial statements credible and reliable, and
THE FOLLOWING ARE THE IMPORTANT ACCOUNTING
CONCEPTS AND CONVENTIONS:

ACCOUNTING CONCEPTS
The more important accounting concepts are briefly described as
follows;

1. Separate Business Entity Concept

The business is a separate and distinct from owners.
• Private expenses-schools fees,
• Business expenses-business rent

All the books of accounts records day to day financial transactions

from the view point of the business rather than from that of the
owner.
2. Money Measurement Concept
 In accounting, only those business transactions are

recorded which can be expressed in terms of money.

 In other words, a fact or transaction or happening which

cannot be expressed in terms of money is not recorded in
the accounting books.
3. Dual Aspect/Double entry Concept
 Financial accounting records all the transactions and events
involving financial element.

 Each of such transactions requires two aspects to be

recorded. The recognition of these two aspects of every
transaction is known as a dual aspect analysis.

 According to this concept every business transactions has

dual effect.
4. Going Concern Concept
 Accounting assumes that the business entity will continue to

operate for a long time in the future unless there is good

evidence to the contrary.

 The enterprise is viewed as a going concern, that is, as

continuing in operations, at least in the foreseeable future.

 In other words, there is neither the intention nor the necessity

to liquidate the particular business venture in the predictable
future.
6. Accounting Period Concept
 This concept requires that the life of the business should be divided into
appropriate segments for studying the financial results shown by the
enterprise after each segment.

 Although the results of operations of a specific enterprise can be known

precisely only after the business has ceased to operate, its assets have been
sold off and liabilities paid off, the knowledge of the results periodically is
also necessary.

 Although a twelve month periods is adopted for external reporting, a

shorter span of interval, say one month or three month is applied for
internal reporting purposes.
7. Historical Cost Concept
 The term ‘assets’ denotes the resources land building, machinery etc. owned

by a business.

 The money values that are assigned to assets are derived from the cost
concept. According to this concept an asset is ordinarily entered on the
accounting records at the price paid to acquire it.

 The cost concept does not mean that all assets remain on the accounting
records at their original cost for all times to come.

 The asset may systematically be reduced in its value by charging depreciation.

 The prime purpose of depreciation is to allocate the cost of an asset over its
useful life and not to adjust its cost.
8. The Matching concept
 This concept is based on the accounting period concept. In reality
we match revenues and expenses during the accounting periods.

 Matching is the entire process of periodic earnings measurement,

often described as a process of matching expenses with revenues.

 In other words, income made by the enterprise during a period

can be measured only when the revenue earned during a period is
compared with the expenditure incurred for earning that revenue.
9. Accrual Concept
 The effect of a transaction and events should be recorded when
they occur but not when the cash is paid/received and should be
recorded in the right period.
10. Realisation Concept
 According to realisation concept revenue is recognised when sale

is made.

 Sale is considered to be made at the point when the property in

goods passes to the buyer and he becomes legally liable to pay.

 This implies that revenue is generally realised when goods are

delivered or services are rendered. The rationale is that delivery
validates a claim against the customer.
 CONCEPT OF CONVENTIONS
1. Convention of Materiality
 Materiality concept states that items of small significance

need not be given strict theoretically correct treatment.

 In fact, there are many events in business which are

insignificant in nature. The cost of recording and showing in
financial statement such events may not be well justified by
the utility derived from that information.
2. Convention of Conservatism
 This concept requires that the accountants must follow the policy of
‘‘playing safe” while recording business transactions and events.

 That is why, the accountant follow the rule anticipate no profit but
provide for all possible losses, while recording the business events.

 This rule means that an accountant should record lowest possible

value for assets and revenues, and the highest possible value for
liabilities and expenses.

 According to this concept, revenues or gains should be recognised

only when they are realised in the form of cash or assets (i.e. debts)
the ultimate cash realisation of which can be assessed with
reasonable certainty.
3. Convention of Consistency
 The convention of consistency requires that once a firm decided on

certain accounting policies and methods and has used these for
some time, it should continue to follow the same methods or
procedures for all subsequent similar events and transactions
unless it has a sound reason to do otherwise.

 In other words, accounting practices should remain unchanged

from one period to another.
 TYPES OF BUSINESS ORGANIZATIONS
 Sole Proprietorship: is a business wholly owned by a single
individual. It is the easiest and the least expensive way to
start a business and is often associated with small
storekeepers, service shops, and professional people such as
doctors lawyers, or accountants.

 One major disadvantage of sole proprietorship is unlimited

liability since the owner and the business are regarded as the
same, from a legal standpoint.
 Partnerships: A partnership is a legal association of two or more
individuals called partners and who are co-owners of a business
for profit.

 Like proprietorships, they are easy to form. This type of business

organization is based upon a written agreement that details the
various interests and right of the partners and it is advisable to get
legal advice and document each person’s rights and
responsibilities.
 Corporations: is the most dominant form of business
organization in our society.

 A Corporation is a legally chartered enterprise with most legal

rights of a person including the right to conduct business, own,
sell and transfer property, make contracts, borrow money, sue
and be sued, and pay taxes.

 Since the Corporation exists as a separate entity apart from an

individual, it is legally responsible for its actions and debts.
 The strength of a Corporation is that its ownership and
management are separate.

 In theory, the owners may get rid of the Managers if they

vote to do so.

 Conversely, because the shares of the company known as

stock can sold to someone else, the Company’s ownership
can change drastically, while the management stays the same.

 The Corporation’s unlimited life span coupled with its ability

to raise money gives it the potential for significant growth.
 Some of the disadvantages of Corporations are that incorporated
businesses suffer from higher taxes than unincorporated
businesses.

 In addition, shareholders must pay income tax on their share of

the Company’s profit that they receive as dividends. This means
that corporate profits are taxed twice.
 BASIS OF ACCOUNTING
 Cash Based Accounting:
Most of us use the cash method to keep track of our personal
financial activities. The cash method recognizes revenue when
payment is received, and recognizes expenses when cash is paid
out.

For example, your personal checkbook record is based on the cash

method. Expenses are recorded when cash is paid out and revenue
is recorded when cash or check deposits are received.
 Accrual Accounting :
The accrual method of accounting requires that revenue be
recognized and assigned to the accounting period in which it is
earned.

Similarly, expenses must be recognized and assigned to the

accounting period in which they are incurred.
 The accrual method relies on the principle of matching revenues
and expenses.

 This principle says that the expenses for a period, which are the
costs of doing business to earn income, should be compared to the
revenues for the period, which are the income earned as the result
of those expenses.

 In other words, the expenses for the period should accurately

match up with the costs of producing revenue for the period.
 ACCOUNTS
An account accumulates detailed information regarding the
increases and decreases in a specific asset, revenues, expenses,
liability, or shareholders’ equity item.

Accounts are maintained in a general/nominal/main ledger.

Accounts keep track of money spent, earned, owned, or owed.

Each account keeps track of a specific topic only.

 ACCOUNT TYPES (ELEMENTS OF FINANCIAL STATEMENTS)

 Revenue:
 It means the amount which, as a result of operations, is
added to the capital.

 It is defined as the inflow of assets which result in an

increase in the owner’s equity.

 It includes all incomes like sales receipts interest,

commission, brokerage etc., However, receipts of capital
nature like additional capital, sale of assets etc., are not a
pant of revenue.
EXPENSE
 The terms ‘expense’ refers to the amount incurred in the process
of earning revenue.

 If the benefit of an expenditure is limited to one year, it is

treated as an expense (also known is as revenue expenditure)
such as payment of salaries and rent.
ASSETS
 An Asset is a property of value owned by a business.

 Physical objects and intangible rights such as money, accounts

receivable, merchandise, machinery, buildings, and inventories
for sale are common examples of business assets as they have
economic value for the owner.

 Accounts receivable is an unwritten promise by a client to pay

later for goods sold or services rendered.
 Assets are generally divided into three main
groups:

 Current assets
 Non-Current assets
 Intangible assets
CURRENT ASSETS
 Refer to cash and other items that can be turned back into cash
within a year are considered a current asset such as;
 Cash – includes funds in checking and savings accounts
 Marketable securities such as stocks, bonds, and similar
investments
 Accounts Receivables, which are amounts due from customers
 Notes Receivables, which are promissory notes by customers to
pay a definite sum plus interest on a certain date at a certain place.
 Inventories such as raw materials or merchandise on hand
 Prepaid expenses – supplies on hand and services paid for but not
yet used (e.g. prepaid insurance)
NON-CURRENT ASSETS
 Refer to tangible assets that are used in the business. Commonly,
fixed assets are long-lived resources that are used in the
production of finished goods such as;
 Buildings.
 Land
 Equipment
 Furniture
 Certain long-lived assets such as machinery, cars, or equipment
slowly wear out or become obsolete.

 The cost of such as assets is systematically spread over its

estimated useful life.

 This process is called depreciation if the asset involved is a

tangible object such as a building or amortization if the asset
involved is an intangible asset such as a patent.

 Of the different kinds of fixed assets, only land does not

depreciate.
INTANGIBLE ASSETS
 Refers to assets that are not physical assets like equipment and
machinery but are valuable because they can be licensed or sold
outright to others, such as;

 Copyrights
 Patents
 Trademarks
 Goodwill

 Goodwill is not entered as an asset unless the business has

been purchased. It is the least tangible of all the assets
because it is the price a purchaser is willing to pay for a
company’s reputation especially in its relations with
customers
LIABILITIES
 A Liability is a legal obligation of a business to pay a debt.

 Debt can be paid with money, goods, or services, but is usually

paid in cash. The most common liabilities are notes payable and
accounts payable.

 Accounts payable is an unwritten promise to pay suppliers or

lenders specified sums of money at a definite future date.
CURRENT LIABILITIES
 Current Liabilities are liabilities that are due within a relatively
short period of time.

 The term Current Liability is used to designate obligations whose

payment is expected to require the use of existing current assets.
Among current liabilities are Accounts Payable, Notes Payable,
and Accrued Expenses.
LONG-TERM LIABILITIES
 Long-Term Liabilities are obligations that will not become due
for a comparatively long period of time.

 The usual rule of thumb is that long-term liabilities are not due
within one year. These include such things as bonds payable,
mortgage note payable, and any other debts that do not have to
be paid within one year.

 You should note that as the long-term obligations come within

the one-year range they become Current Liabilities.
CAPITAL (OWNERS EQUITY)
 Capital, also called net worth, is essentially what is
yours – what would be left over if you paid off
everyone the company owes money to.

 If there are no business liabilities, the Capital, Net

Worth, or Owner Equity is equal to the total amount of
the Assets of the business.
ELEMENTS OF FINANCIAL STATEMENTS
Key elements includes;
 CHART OF ACCOUNTS

A business will create a list of accounts called a chart of accounts where each account is
assigned both a name and a number.

A common practice is to have the accounts arranged in a manner that is compatible with the
order of their use in financial statements.

For instance, Asset accounts may begin with the digit ‘1’, liability accounts with the digit
‘2’, and shareholders’ equity accounts (excluding revenues and expenses) with the digit
‘3’.

Each business will have a unique chart of accounts that corresponds to its specific needs.

 Assume ABC Corp. uses the following numbering system for its accounts:
 100-199 Asset accounts

 200-299 Liability accounts

 300-399 Share capital, retained earnings, and dividend accounts

 400-499 Revenue accounts

 600-699 Expense accounts

 THE ACCOUNTING EQUATION
 Accounting equation, keeps all the business accounts in
balance.
 The basic accounting equation is given by;

Assets = Capital
100,000=100,000
Assets = Liabilities + Capital
120,000 = 20,000 + 100,000
Liabilities = Assets-Capital
20000 = 120,000-100,000
Capital = Assets – Liabilities
100,000 = 120,000-20,000
 THE ACCOUNTING EQUATION
 The Assets of the company consist of the money invested by the
owner, (i.e. Owner’s Equity), and for example a loan taken from
the bank, (i.e. a Liability).

 The company’s liabilities are placed before the owners’ equity

because creditors have first claim on assets.

 If the business were to close down, after the liabilities are paid
off, anything left over (assets) would belong to the owner.
 THE DOUBLE ENTRY SYSTEM
 Every time a transaction takes place whether it is a sale or
a collection – there are two offsetting sides.

 The entry required a two-part “give-and-get” entry for

each transaction. There must be increase/increase or
decrease/decrease or increase and decrease.
 THE DOUBLE ENTRY SYSTEM
 Here is a simple explanation of the double entry system. Say you
took a loan from the bank for 5,000 and we already established
that:

ASSETS = LIABILITIES + OWNER’S EQUITY

 Since the company borrowed money from the bank, the 5,000 is a
liability for the company. In addition, now that the company has
the extra 5,000, this money is an asset for the company.

 If we were to record this information in our accounts, we would

put 5,000 in the “Assets” side and 5,000 in the “Liabilities” side.
 THE CONCEPT OF DEBIT AND CREDIT
 Recording of transactions require a thorough
understanding of the rules of debit and credit relating
to accounts.

 Both debit and credit may represent either increase or

decrease, depending upon the nature of account.

 For convenience ‘Dr’ is used for debit (Left hand side)

and ‘Cr’ is used for credit (Right hand side).
BASIC RULES OF DEBIT AND CREDIT

ALL Increase in
Assets/Expenses Debit and
Decrease Credit
ALL increase in
Liabilities/Revenues Credit
while Decrease Debit

ALL increase in Owner's Equity

Credit while Decrease Debit
RULES OF DEBIT & CREDIT
FINANCIAL REPORTING STATEMENTS
 Net Income Statement (Profit & Loss): used to inform you
about income earned, expenses incurred and total profit or loss
in a particular period.

 Statement of financial position: A statement of financial

position is like a “snapshot” that gives the overall picture of the
financial health of a company at one moment in time. This
report lists the assets, liabilities, and owner’s equity.

 Cash Flow statement: Provides data regarding all cash inflows

a company receives from both its ongoing operations and
external investment sources, as well as all cash outflows that
pay for business activities and investments during a given
period of time.
 NET INCOME STATEMENT ELEMENTS
(PROFIT & LOSS)
 Answers the question
 How much did we earn? Sales Revenue

 Is a period statement
 Like a movie, shows what happened
-
over a period of time. Expenses

 The “Matching Principle”

 Expenses
=
are “matched” to their
associated revenues in the same Income
period.
NET INCOME STATEMENT
STATEMENT OF FINANCIAL POSITION
 The statement of financial position is a Snap shot
showing what the company owns and owes at a
particular point of time.

 How much did we invest.

 How is the investment being financed.

STATEMENT OF FINANCIAL POSITION ELEMENTS

Assets Liabilities
Probable future
economic sacrifice
Probable future as a result of a past
economic benefits transaction or event
controlled by the
company as a result
of a past transaction Owners’ Equity
or event
Paid in capital
Retained earnings
STATEMENT OF FINANCIAL POSITION
END OF LECTURE 1!
 I HOPE YOU
ENJOYED THE BRIEF
INTRODUCTION TO
ACCOUNTING.