The fundamentals of accounting
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1.1 The purpose of accounting 1.2 The accounting equation Accounting is the process of recording business transactions, producing financial statements relating to business activities and analysing the financial performance of a business. The starting place for accounting is the recording of business transactions in financial terms. Book-keeping involves record-keeping for the transactions taking place within a business. In this chapter, you will be introduced to the concepts of accounting and book-keeping. You will also be introduced to the terminology used to record certain types of transactions.
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Chapter 1 . Unit 1
The purpose of accounting Learning objectives By the end of this unit, you should be able to: • understand and explain the difference between book-keeping and accounting • state the purposes of measuring business profit and loss • explain the role of accounting in providing information for monitoring progress and decision-making.
Starting point Answer these questions in pairs. 1
Why do we need to record business transactions?
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What skills do you think an accountant needs?
Exploring Discuss these questions in pairs. 1
How do you think business performance can be judged?
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What do you think are the main goals of a business?
Developing The differences between book-keeping and accounting Book-keeping and accounting relate to the financial records of a business. They are not the same as each other but are closely connected.
Book-keeping Book-keeping involves keeping records of all the financial transactions of a business. This involves recording details of each financial transaction, the amounts of money involved and when each transaction took place. Financial transactions occur frequently. In a small business, there may be a small number of transactions each day. In a large business, the number of transactions taking place may be enormous.
Key term Book-keeping: The process of recording the financial transactions of a business.
Recording these transactions requires care and attention to detail. Transactions should be recorded soon after they occur
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1.1 and accurately. Inaccurate records result in a risk of incorrect decision-making which can have serious consequences. For example, if expenses are not recorded then a manager may buy more materials than can be afforded out of the business bank account. Book-keeping involves recording transactions in the ‘books’ of the business. These books are divided up by type of transaction. Transactions are recorded in two separate places: • All similar transactions are recorded in specific books according to the type of transaction. These are known as books of prime entry (explored in Unit 2.3). • Transactions are also recorded in the ledger accounts of the business. The ledgers (explored in Unit 2.1) contain the accounts of the business.
Accounting Book-keeping involves the recording of financial transactions within a business. The activity of accounting includes bookkeeping but also involves other activities. Accountants use the financial records produced by those completing book-keeping. The records are used to construct the financial statements of the business. These statements tell users of accounting data important information about the state of the business. Two important financial statements are: 1
The income statement, which shows the profit earned or loss made by the business
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The statement of financial position, which shows business resources and how those resources are financed.
Key terms Accounting: The process of recording financial transactions, producing financial statements and analysing financial performance of a business. Financial statements: Statements produced for an accounting period summarising business performance. They include an income statement and a statement of financial position
Another function of accounting is to analyse the financial performance of the business. This involves using financial data from the financial statements to assess how well the business is performing.
The purpose of measuring business profit and loss Business objectives are the aims and goals of a business. Most businesses have profit-related objectives. Profit maximisation is a common business objective. This is where the business aims to make as high a level of profit as is possible. Other business objectives include:
Key term Profit maximisation: Aiming to earn as high a level of profit as is possible.
• Growth – measured by sales value or by sales volume (the quantities of goods sold) • Market share (how much of the market the businesses’ sales account for)
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• Survival • Break-even (often a financial objective of not-for-profit organisations, such as charities) • Social objectives • Environmental objectives. Business objectives can change over time for the same business. For example, a business experiencing difficult economic conditions may aim for survival rather than profit maximisation. 1
Explain how and why the objectives of businesses may change over time.
Profit is measured as the difference between the income earned and the expenses paid by a business for an accounting period. If income is greater than expenses, a profit is made. However, if expenses are greater than income, the business makes a loss for that period. Profit is not the same thing as money. For example, a business can spend money buying items to be sold for profit. This means money is leaving the business but the money received from the sale of the items may not happen until a much later time period after profit has already been recorded. Key knowledge
Key terms Profit: Total income less total expenses for a period of time. Accounting period: The time period for which financial statements are prepared. Income statement: A financial statement showing a business’s income and expenses for an accounting period and the resulting profit or loss.
Income greater than expenses → Profit Expenses greater than income → Loss An accounting period is the period used to calculate the profit or loss made by the business. For most businesses, the accounting period is one year. The accounting year may not start on 1 January. Many businesses have accounting periods starting on 1 April. Some businesses start their accounting periods at other times. All accounting periods are likely to start at the beginning of a month. Key knowledge Profit is stated in the income statement of a business. The income statement is a financial statement produced for an accounting period showing the total income earned and the total expenses paid by the business. The income statement will show the profit or loss made by the business for that period. 2
Why do many businesses have 1 April as the start of the annual accounting period?
It is important to measure how much profit is made in order to make decisions about how it can be used: • Business owners may take money out of the business for their personal use. It is important that they do not take out so much that it affects the running of the business.
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1.1 • Profit can be reinvested within the business to enable the business to expand. • Profit can be used to pay any debts the business has. As well as decisions about spending, there are other reasons why knowing how much profit has been made is important for a business: • Paying tax – Many businesses pay tax as a percentage of their profit so calculating how much profit has been made is necessary in order to calculate the amount of tax to be paid. • Obtaining credit – Lenders will often only lend a business money if they have proof that the business is likely to survive and be able to repay the money lent. Profit is a good indicator of the long-term success of a business. • Keeping shareholders happy – Limited companies are businesses owned by shareholders. Limited companies regularly give profits to shareholders as dividend payments and making these payments is very important in keeping shareholders happy and attracting new shareholders if necessary. • Attracting investors – Companies may need to attract new investors and profit is a sign of a good investment. • Encouraging entrepreneurship – Profit provides a motive for people to take calculated risks in running a business, such as the decision to expand or to launch new products.
The role of accounting in providing information for monitoring progress and decision-making Accounting involves producing the financial statements of the business. These provide useful information about the business.
Monitoring progress Financial statements are analysed to monitor the progress of the business. Which areas of the financial statement are monitored will depend partly on who is looking at the information contained on the statements. Financial statements are explored in Chapters 5 and 6. • Business owners are interested in the profit earned as it is the main objective of most businesses. They will look at the size of the profit compared with previous years’ profits and the profits earned by similar businesses. • The size of the debts of the business will be monitored closely. If debts rise, there is a risk that the business will not be able to meet the repayments or that the interest on the debts may rise to a level similar to or even greater than the profits earned by the business.
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• Suppliers want to be sure that they will receive payment before allowing a business to buy goods on credit. The financial statements provide information on the stability of a business. 3
Why would a bank be interested in the progress of a business?
Decision-making The information contained within the financial statements can help in business decision-making: • Knowing the size of the profit allows the owners to decide whether they can afford to buy more assets. • Knowing the cash balance of the business allows decisions to be made on whether to arrange another source of finance. • Knowing the sales revenue allows decisions to be made about expansion of operations and recruitment of staff. Management accounting is another aspect of accounting. It involves the use of financial and accounting data by managers to make decisions. Managers compare the actual performance of the business, for example in terms of sales revenue or profits earned, with budgeted levels of performance. They also plan by setting targets for future performance.
Key term Management accounting: Using financial information to make business decisions concerning costs, revenues and output.
Applying Discuss these questions in pairs. 1
Explain why the workers in a business would be interested in the profits earned by the business
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Explain why rising profits may not be seen as satisfactory progress by business owners.
Knowledge check 1
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Which of the following is not a likely business objective? A Profit maximisation
C
B
D Income statement
Growth
Survival
A business sells 1100 units at $8 each. Total expenses are $5400. Calculate the profit for this period. A $8800
C
B
D $14 200
$5400
$3400
Which of the following is not a reason for buying shares in a limited company? A To receive dividends
C
B
D To obtain credit
To profit from rising share prices
To control the business
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1.1 4
State three reasons why it is important to measure profit (or loss) for an accounting period.
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Explain the difference between book-keeping and accounting.
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Explain how accounting can provide information for A monitoring progress
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making decisions.
Check your progress Read the unit objectives below and reflect on your progress in each.
I struggle with this and need more practice.
• Understand and explain the difference between book-keeping and accounting
I can do this reasonably well.
• State the purposes of measuring business profit and loss
I can do this with confidence.
• Explain the role of accounting in providing information for monitoring progress and decision-making.
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