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Accounting - 7707

The Fundamentals of Accounting

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The Fundamentals of Accounting

What is Accounting?

Accounting is the art of Classifying, Recording (also known as bookkeeping), Summarizing, Interpreting, and Communicating business transactions.

So, how do you define a transaction? 

Transaction refers to day to day activities of a business that involves monetary values.

What is a business?

Business is an entity that transforms resources into business objectives.

Entity: 

Trading
Service                 
Farming
Mining
Fishing
Manufacturing, etc.

Business Objectives: 

profit-making
Servicing
Survival
Growth
Competition
Monopoly 

What is the Difference between Accounting and Book-keeping?

Detailed recording of all the financial transactions is known as book-keeping and this comes beneath the umbrella term accounting. Accounting uses these books kept records to prepare financial statements at regular intervals.

CLASSIFYING OF ACCOUNTING TRANSACTIONS:

In accounting all transactions are classified into five categories:

1. Assets: resources of all business
2. Liabilities: obligations of all business
3. Capital: investment of the owner
4. Expenses: day to day running cost of the business
5. Revenues: earnings of trade

Assets: 

They are all the stock of resources used by a business whether owned or owed. Assets have two types: Non-current assets and Current assets.

Non-Current Assets:

Non-current assets are those which are utilized in business even after an accounting period has ended. They are also referred to as fixed assets. Examples include machinery, building, motor vehicles, furniture, and so on.

Current Assets:

Current assets are those assets that are utilized in business for less than an accounting period, they change their form continuously and hence are not fixed in nature. Examples include inventory (stock), receivables, prepayments, cash in the bank, cash in hand. 

Accounting period: is usually one year long but in the case of new business it is permissible to have an accounting period of eighteen months refers to the time frame after which the business has to report its performance. 

Inventory: is also called stock of goods, these are the things bought by the business or made by the business with an intention of resale yet unsold.

Receivables: are all those people who owe us money, trade receivables are all those people to whom the business has sold goods on credit.

Prepayments: are expenses paid in advance before availing of the service.

Liabilities:

These are the obligations or owing of the business which the business has to repay for smooth prevailing of its processes. They are the outstanding amounts due on the business and they have two different types: current liabilities and non-current liabilities.

Current Liabilities:

These are those obligations that need to be repaid in an accounting period. Examples include payables, accruals, bank overdrafts. 

Payables: are all those people to whom the business owes money, trade payables are all those people from whom the business has got goods on credit. 

Accruals: are the outstanding amounts for which the business has already utilized
o the services, these are the expenses incurred but yet not paid.

Bank overdraft: is the facility provided by the bank to its loyal customers, which they can withdraw more amount of money from the bank, interest on overdraft is charged on daily basis and thus it is the most expensive source of finance.

Non-Current Liabilities:

No current liabilities are those liabilities that need to be repaid after an accounting period usually after a long period they are subject to a fixed rate of interest which is changed on an annual basis. Examples include bank loans and debentures.

Debentures are the IOU (I owe you) certificates issued by the financial institutions on a long term basis. These debentures are to be repaid on maturity and are usually secured against the mortgage. A mortgage is collateral and acts as a security that the person who is taking the loan must keep an asset of equivalent or more amount than the loan so that in case of non-payment, this amount of loan could be recovered by selling the asset. 

Capital:

They are the resources owned by the business and hence is an investment of the owner. 

Assets are the resources owned and owed, liabilities are the resources owed and capital is the resources owned. This brings the accounting equation into existence: 

 Assets= capital + liabilities


If two of the components and their values are given we can find out the third one. Mathematically, both sides of the equation will be equal. This means that assets will always comprise of all the capital and liabilities.


Example #1:

January 2007:  Hiba set up a venture and named it ‘The Cookie Shop’. She opened a business bank account for it and deposited $30,000 which would be considered as an investment.


Solution:

AssetsCapabilitiesLiabilities
Bank $30,000$30,000Nil

Expenses:

They are the day to day running cost of the business without which it is practically impossible to run the business. These are the costs of running a business smoothly. Examples include rent, utility bills, wages, and salaries. Depreciation and so on. Depreciation is the loss in the value of non-current assets. 


Revenues:

They are the earnings or income of a business. It must also be understood that revenues and profits are not the same. Profits are achieved when expenses are deducted from the revenues.


Profits = revenues - expenses


If a company earns $20,000 and has expenses of $10,000, then its profit would be the difference between the revenue and the expense i.e. $10,000. 


RECORDING OF TRANSACTION:

Once the transactions are classified we need to record the transaction in an appropriate ledger. Ledgers are also known as T accounts because they are in the shape of the T.T account will always have a title and the left side is known as a debit while the right side is named as credit, but transactions will be recorded differently depending on the accounting head. In accounting when the transactions are recorded in the ledger, we have to follow the double-entry system according to which every debits followed by an equal amount of credit. In easier words, debit is something that comes into the business while credit is when something goes out of the business. In reality, each accounting head (assets, liabilities, expenses, revenues, capital) has a separate rule of debit and credit which has to be followed when recording transactions.  This recording of transactions is known as BOOKKEEPING.


Title of Account

Debit

Credit

Asset

 Debit

If an asset is deposited it is debited.

Credit

If an asset is withdrawn it is credited.

Expenses

Debit

If expense rises it is debited.

Credit

If expense reduces it is credited.

Revenue

Debit

If revenue decreases it is debited.

Credit

If revenue increases it is credited.

Liabilities

Debit

If liabilities decrease, it is debited.

Credit

If liabilities increase it is credited.

Capital

Debit

If capital decreases it is debited.

Credit

If capital increases it is credited.


SUMMARISING THE TRANSACTION:

Once the transactions are recorded in the ledger, we summarize the transactions by making the four: trial balance, income statement, statement of financial position, cash flow statement. 

Trial balance: it is a list of balances drawn out from the ledgers to ensure whether ledgers are prepared correctly or not. Any errors in the ledgers will be found with the help of a trial balance.

The income statement is prepared to identify whether the business is making profits or bearing losses, this would help them decide if the business is bearing losses to bring it back up by using some tactics or strategies. If it's making a profit then it would be easier to expand as they would be receiving returns on their investment.

Statement of financial position is prepared to identify the balances of the assets, capital, and liabilities, making it easier to have a check on regular intervals but this also helps monitor the progress of the business.

The cash flow statement is prepared to identify the cash positions of the business as to how much cash came into the business and how much went out of the business. It helps in determining the liquidity position of the business.


INTERPRETING OR ANALYSING THE TRANSACTION: 

Once the transaction is summarized we get to and should analyze the results whether the financial performance and reputation of the business have enhanced, fallen, or has continued to be the same. If the performance has upgraded what caused the progress if the statements have fallen, the owners need to figure out the issue and if it has persisted, they need to figure out ways for enhancing their statements and business. And then the analysis is started to comparing the current statements and business performance with its past years' performance, companies' current year performance with its expected performance, and its current year performance with its competitors' current year performance. Progress of the business is monitored through these financial statements and decision making regarding the business is easier with all the figures and ratios in front of them and can base their development of the business.


COMMUNICATING THE TRANSACTIONS:

Once the business performance is analyzed we need to communicate the findings to all the relevant stakeholders. Stakeholders are all those people who are directly or indirectly associated with the business such as owners, investors, stakeholders, customers, suppliers, government, authorities, and banks, and so on.

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