What is accounting?
Accounting is the art of recording, classifying, summarizing, and reporting business
transactions to all decision makers in the form of financial statements.
It also defined as the system of collecting, storing and processing financial
and accounting data that are used by decision makers.
The main purpose of accounting is to provide decision makers with information
useful in taking economic decisions.
Users of accounting information
Financial accounting information is designed to serve internal and external users to
assist investors and creditors in deciding where to place their scarce investment. In
addition, it assists Company’s managers and employees to run and control daily
business operation.
Internal Users External Users
Owners Financial Analysts
Managers External Auditors
Creditors Banks
Suppliers Stock Exchange Market
Employees Lawyers
Customers Tax Authority
The Accounting cycle:
The accounting cycle is the formal process by which companies produce their financial
statements and update their financial records for a specific period of time. It also defined
as the sequence of procedures used to keep track of what has happened in the business
and to report the financial effect of those things. The financial reports will only make
sense if the accounts have been analyzed correctly and the accounting equation remains
balanced. This is the fundamental building block of accounting.
1. The Accounting Equation
The accounting recording system is based on the fact that all economic resources
acquired by an entity must be funded from somewhere. Usually, the owner is the one
who is responsible for that in the first instance. Later, other people such as creditors or
banks may put up money to provide further resources for the company. The relationship
between resources and the funds provided to acquire these resources is expressed in
accounting like this:
ASSETS = LIABILITIES + OWNER’S EQUITY
This equation must remain in balance and for that reason our modern accounting system
is called a dual-entry system. This means that every transaction that is recorded in
accounting records must have at least two entries; if it has one entry only, the equation
would necessarily be unbalanced.
The equation’s three parts are explained as follows:
1. Assets: what the business has or owns (equipment, supplies, cash, accounts
receivables)
2. Liabilities: what the business owes to outsiders (bank loan, accounts payables)
3. Owner’s Equity: what the owner owns (investment and business profit)
From the equation, we can see that what the business owns (assets) are equal to what it
owes to creditors (liabilities) and owners (equity).
Classification of assets:
Current assets
Current assets are cash and other types of assets that are reasonably
expected to be converted into cash, sold, or used up during the normal
operating year.
Examples of current assets:
Cash, Bank, Goods, Accounts Receivable, Prepaid expenses, Inventory
and Marketable securities
Fixed assets
Fixed assets are assets that are used in the normal operations of the entity
to produce and sell goods or perform services for customers. Fixed assets
are expected to serve for a number of years and not subject to re-sell.
Examples of fixed assets:
Land, cars, buildings, equipment, and furniture
Intangible assets
Intangible assets are assets that have no physical substance, but they are
expected to provide benefits to the entity for several years.
Examples of intangible assets:
Patents, trademarks, copyrights, goodwill, franchise fees, and trade name.
Classification of Liabilities:
Short-term liabilities:
Obligations of the entity that are reasonably expected to be paid or settled
within a year or the normal operating cycle.
Examples of short-term liabilities:
Short-term notes payable, accounts payable, salaries and wages payable
and other types of accrued liabilities for services received but not yet paid
for.
Long-term Liabilities:
Obligations that are not require payment within the entire year or the
normal operating cycle.
Examples of long-term liabilities:
Loan, bonds, and any other obligation that mature in a period more than
one year beyond the balance sheet date is reported as long-term.
Classification of Owner’s Equity
– It represents the resources invested in the business by the owner.
– It is increased by the owners’ investments or profits from the business and
decreased by owners’ withdrawals or losses from business.
Owner's equity is equal to total assets minus total liabilities.
Components of Owner’s Equity:
OE = Capital + Revenues - Expenses - Withdrawals
Capital: Represents the owner’s investments in the company.
Revenues: Cash in-flows resulting from the sale of goods or the rendering of services.
Expenses: Cash out-flows resulting from the sale or the delivery of goods or the
rendering of services.
Withdrawals: Represents money withdrawn by the owner for his personal expenses.
Net Income: The result of subtracting expenses from revenues.
After illustrating the components of owner’s equity, one can infer that the Accounting
Equation has a second form which is:
Assets = Liabilities + (Capital + Revenues – Expenses – Withdrawals)
