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Accounting Daily

Introduction to Accounting

Accounting is more than recording transactions. It creates useful financial information so owners, managers and other stakeholders can understand a business and make informed decisions. This guide introduces the ideas tested in the Chapter 1 quiz.

1. Types of businesses

A trading business earns revenue by selling goods. It therefore normally holds goods for resale as inventory. A service business earns revenue by providing services rather than selling trading goods.

Example: A supermarket is a trading business because it buys goods for resale. A tuition centre is a service business because customers pay for teaching services.

Common mistake: A service business can still own equipment and other assets. Owning equipment does not make it a trading business.

2. Forms of business ownership

Sole proprietorship

A sole proprietorship has one owner. The owner contributes capital, controls the business and is personally responsible for its debts and losses.

Limited liability partnership (LLP)

An LLP has two or more partners who contribute capital and share control. Partners generally have limited liability for normal business debts, subject to circumstances such as fraud.

Private limited company

A private limited company can raise finance through sources such as bank borrowing or issuing new shares. Shareholders benefit from limited liability, and the company can continue independently of changes in its owners.

Think about the trade-offs: ownership choices affect control, liability, continuity, transfer of ownership and access to capital.

3. Stakeholders and information needs

Stakeholders use business information for different decisions. Internal stakeholders include owners, managers and employees. External stakeholders include investors, lenders, suppliers, customers, government and competitors.

  • Owners and managers assess performance and make business decisions.
  • Employees may consider stability and whether to remain with the business.
  • Lenders and suppliers assess creditworthiness and the ability to repay amounts owed.
  • Investors assess performance when deciding whether to hold, sell or acquire investments.
  • Customers may care whether a supplier is likely to continue operating.
  • Government uses information for matters such as regulation and taxation.
  • Competitors may compare performance when developing their own strategies.

Useful decisions can require both accounting information, such as profit and liabilities, and non-accounting information, such as economic outlook or market trends.

4. The role of accounting

Bookkeeping focuses on recording transactions. Accounting is broader: it includes recording, summarising, analysing, interpreting and reporting financial information.

Accounting also supports stewardship: managing business resources on behalf of owners. The information produced helps stakeholders make informed decisions about those resources.

Professional ethics

Integrity requires honesty and strong moral principles. Objectivity requires professional judgement that is not distorted by bias, personal interests or inappropriate influence from others.

Example: An accountant who refuses pressure to alter a report is protecting objectivity. An accountant who reports information honestly even when the result is unfavourable demonstrates integrity.

5. Accounting theories

Accounting entity

The business is treated separately from its owner. Personal transactions are not business expenses; withdrawals of business resources for personal use are treated separately, such as drawings.

Accounting period

Financial information is prepared for fixed periods so performance can be analysed and compared over time.

Going concern

Accounting normally assumes that the business will continue operating into future periods.

Monetary

Items must be capable of measurement in money terms to be recorded in the accounts. Valuable qualities such as customer loyalty may therefore not appear as recorded amounts when no reliable monetary value can be assigned.

Historical cost

Transactions are initially recorded using their cost at the date of the transaction rather than simply replacing that amount with a later market value.

Accrual basis

Income and expenses are recognised in the period in which they are earned or incurred, rather than merely when cash is received or paid.

Revenue recognition

Revenue is recognised when the relevant goods are delivered or services are provided, rather than simply when cash arrives.

Matching

Expenses incurred to generate income are recognised in the same accounting period as the related income.

Objectivity

Accounting records should be supported by reliable, verifiable evidence such as invoices and other source documents.

Prudence

Accounting should avoid overstating assets and profits and should appropriately recognise losses and liabilities. A common application is valuing inventory at the lower of cost and net realisable value.

Consistency

Using the same accounting methods from period to period improves meaningful comparison of financial information.

Materiality

An item is material when it could affect users' decisions. Immaterial items may be treated more simply; for example, a very low-value stationery item may be expensed rather than recorded as a non-current asset.