Fundamentals of Accounting

Course I
Accounting and the Business Environment

Planning, recording, analyzing, and interpreting financial information is called

accounting. A planned process for providing financial information that will be useful to
management is called an accounting system. Organized summaries of a business’s
financial activities are called accounting records.
Accounting is the language of business. Many individuals in a business complete
accounting forms and prepare accounting reports. Owners, managers, and accounting
personnel use their knowledge of accounting to understand the information provided in
the accounting reports. Regardless of their responsibilities in an organization, individuals
can perform their jobs better if they know how to read the language of business.
The development of accounting concepts and principles is closely related to the
economic growth, as businesses grew in size, and outsiders increased their demand for
financial information. A business is an organization that sells products or services to
customers. One major goal of a business is to generate a profit, which is the difference
between the sales price of the goods and services sold by the business and the cost of the
resources used to provide these goods or services. The second major goal of a business is
to stay liquid. Being liquid means being able to generate enough cash from selling goods
or services to pay bills on time.

A. Types of Business Organizations

A business organization can be classified by what it provides to its customers.
• Service companies perform services for customers. Some service companies
require lots of expertise (legal, accounting, medical, or banking services), and others help
with personal services (oil changing, painting, cleaning or hair styling).
• Merchandise companies, also known as retail companies, sell products that are
made by another company.

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• Manufacturing companies make their own products that are sold directly to the
final customer or to other companies who distribute the products to customers.

B. Forms of Business Organization

A business organization can also be classified based on how it is organized. There
are three basic forms of organization:
• A proprietorship – has a single owner, called the proprietor, who is often the
manager. It tends to be a small merchandising store or the professional business of a
physician, attorney or accountant. The advantages of a proprietorship include ease of
formation, total control by the owner and profits that are not shared.
From the accounting point of view, each proprietorship is separate from his owner.
The accounting reports of a proprietorship are separate from the owner’s personal
financial records. From a legal perspective, the business is the proprietor. If the
organization stop operating, the owner is personally responsible for all the debts that the
business owed to creditors.
In this course, we begin discussing the accounting process by looking at a
proprietorship.
• A partnership – joins two or more individuals as co-owners. Each owner is a
partner. It is a business such as a retail store or a professional organization of attorneys or
accountants. It is small or medium-sized, but it can have an unlimited number of partners.
Accounting treats the partnership as a separate organization, distinct from the
personal, financial affairs of each partner. But again, from a legal perspective, a
partnership is the partners. If the organization stops operating, the partners are personally
responsible for all debts that the organization owes to creditors.
• A corporation – is owned by stockholders or shareholders. Stockholders
purchase an ownership interest in a corporation by buying shares of its stock.
Corporations can be small, with as few as two stockholders, but usually they are
quite large because they get funds from their owners, as investors or stockholders. A
corporation begins when the state approves its article of incorporation. It is a legal entity
separate from its owners that conducts business in its own name.

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Like a proprietorship or a partnership, the accounting records of a corporation are

separate from the records of its owners. However, unlike the proprietorship and the
partnership, the owners of a corporation do not lose personal assets if the corporation goes
bankrupt and is unable to pay its bills. So, the amount that the stockholders risk when
buying stock is the amount that they paid for it.
This limited liability of stockholders for corporate debts explains why
corporations are so popular.

C. Organization Accountability
Accountability is the responsibility for one’s actions. Organization accountability
is the organization’s fiduciary responsibility to manage its resources carefully.
Many different individuals and groups of people, called stakeholders (this
category includes invertors, creditors, suppliers, employees, customers, government
agencies, and investees), have an interest in organizations, especially in these activities
that most directly affect them. A business’s activities can be grouped into three
categories:
• Financing activities. Organizations and their management attract investors and
creditors who provide cash or other assets to them. In exchange, they use these resources
responsibly to operate the business profitably, and repay amounts owed when due while
maintaining a positive cash balance.
• Investing activities. Organizations and their management obtain items needed to
operate the business. Some of these are physical, long-term assets as building space,
equipment, and furniture. Others include stock in or loans to other companies as a way of
using extra cash profitably. In exchange, organizations and their management pay
suppliers and investees for these items in a timely manner.
• Operating activities. Organizations and their management generate a profit
from the sale of goods and services.
First, they use resources to sell goods and services. In exchange for the used
resources, suppliers and employees are paid on time and management provides a safe a
work environment.

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Next, customers buy goods and services. In exchange, management provides

quality goods and services in a timely manner.
Finally, organizations and their management meet various regulatory obligations
to the National Tax Administration Agency, Ministry of Public Finance and other central
or local government agencies by reporting financial information, paying taxes, and
obeying laws.

D. Financial Accounting and Management Accounting

To satisfy the needs of stakeholders, managers are required to provide information
that communicates the decisions made and the results obtained from those decisions.
Because organizations are accountable to others for actions taken, managers communicate
using accounting as the language of business. From this position, accounting is the
information system that measures business activity, processes results of activities into
reports, and communicates the results to decision makers. Thus, organization
accountability requires two forms of accounting based on who is being communicated
with:
• Financial accounting for external reporting;
• Management accounting for internal planning, control, and decision making.
Financial accounting produces reports called financial statements that show
financial information about a business. These historical, objective reports, based on
applying some certain rules, communicate financial information in monetary terms
(national currency) to its external stakeholders and must follow the current regulations,
known as generally accepted accounting principles (GAAP). GAAP are the rules that
govern financial accounting, and must be followed when preparing financial statements.
Financial statements allow investors and creditors to make investment decision,
based on financial indicators which are contained in them. They allow suppliers and
customers to determine the financial condition of a business. Finally, they are used by the
organizations for reporting to regulatory agencies.
Management accounting provides financial and nonfinancial information inside
the organization. This forward-looking information helps managers plan, control, and
make decisions consistent with the fiduciary role managers have in operating a business.

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Management accounting information must be useful, and the benefits of this information
must be greater than the costs of obtaining it. However, because it is used internally, it
does not need to fallow GAAP.

E. Accounting Concepts and Principles

Financial statements are used to communicate with those outside the business and
must follow GAAP.
GAAP are, as we mentioned before, the established rules, principles, and concepts
created by the accounting profession. Existing and potential investors and creditors can
compare different companies if they have prepared financial statement using these rules.
Accounting principles focus on the users of accounting information. Principles
have developed over a long period of time, and are continuously subject to revision as
information needs change. It is the responsibility of accounting professionals, teachers
and accounting organizations to keep accounting principles up-to-date, relevant and
useful.
The Entity Concept
The most basic concept in accounting is that of the entity. An accounting entity is
an organization or a section of an organization that stands apart as a separate economic
unit. The entity concept specifies that boundaries must be drawn around each entity so as
not to confuse its financial affairs with those of other entities.
The entity concept states that each business entity should conduct its own separate
accounting. Only assets, liabilities, and owner's equity specifically related to a given
business should be reported in the financial statements of that business. It should be
noted, however, that in some circumstances the investors or owners of a business are
legally liable for debts or damages. This liability depends upon the legal form of the
business. In the event an individual owns more than one unrelated business, each business
must also be treated as a separate entity.
The Reliability (Objectivity) Principle
Accounting information is based on the most reliable data available so that
investors and creditors can use this information to make decisions. Reliable data is
verifiable, which means that it may be confirmed by any independent observer. All

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information must be maintained objectively, which means that it is free of bias and
subject to verification. Objectivity is closely tied to reliability. Objective evidence
consists of anything that can be physically verified such as a bill, check, invoice, or bank
statement. In the event something cannot be supported objectively, a number of subjective
methods are used to develop an estimate. The determination of items such as depreciation
expense and allowance for doubtful accounts are based on subjective factors. Still even
subjective factors are influenced by objective evidence such as past experience.
The Cost Principle
The cost principle states that acquired assets and services should be recorded at
their actual cost, also called historical cost. The cost principle also holds that the
accounting records should keep the historical cost of an asset throughout its useful life
because its cost is a reliable measure.
The Going Concern Concept
Another reason for measuring assets at historical cost is the going concern
concept. This concept assumes that the entity will stay in business for the foreseeable
future, long enough to use existing resources for their intended purpose.
The going concern concept is based on the belief that a business will operate
indefinitely. Assets purchased for long-term use should be recorded at historical cost even
if the market value is above or below the original cost. When expenses are prepaid, they
should be listed as assets. Also, creditors who loan money to a business or investors who
provide money or assets in a business do so assuming the business will remain in
operation indefinitely.
In the event a business is near the end of its life, this information should be
disclosed in the financial statements of a company. Accounting procedures should change
to reflect the special needs of a business in liquidation.
Accounting Period
Financial reports should be issued by businesses at least yearly. Most corporations
issue reports quarterly, as well. Timely information provided by financial reports is
essential for investors, creditors, industry analysts, management, and government
agencies. Periodic income is difficult to determine because of the many adjustments that

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are necessary. The accuracy of financial reports depends on subjective factors such as an
estimation of depreciation and inventory costing.
Matching revenues and expenses
For most businesses, recognition of revenue is based on when the revenue has
been realized, that is, when a price has been agreed with the purchaser and the seller has
completed all obligations. Few businesses rely on collection or receipt of payment. For
some businesses, revenue recognition is spread over time as in the installment or time-of-
completion method. All costs directly associated with given revenues must be matched
with those revenues. Some expenses are not associated with specific revenue items but
with a given time period. Expenditures, for instance for plant asset, must be allocated over
their useful life and remain as unexpired cost or assets.
Adequate Disclosure
All relevant and material facts which affect the reliability and comparability of
financial statements must be disclosed. This usually relates to:
1) accounting methods used,
2) changes in accounting estimates,
3) contingent liabilities,
4) performance of business segments, and
5) any significant event subsequent to the end of the financial period.
Consistency Concept
The purpose of the consistency concept is to assure that financial statements can
be easily compared period to period, and therefore to encourage that the same accounting
principles be used from year to year. When changes in accounting methods are necessary,
such changes should be disclosed and the reasoning explained in notes to financial
statements. If businesses were allowed to change accounting principles whenever they
wished, the amount of net income reported could continuously be manipulated. Different
accounting methods may be used for different business segments.
Materiality Concept
The materiality concept proposes paying attention to important events and
ignoring insignificant accounting items. The extra effort required to process insignificant
items is not cost effective. The concept of materiality also suggests that small asset

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purchases or improvements should be initially written off as an expense. Definitive rules

exist on whether an accounting element is significant or insignificant. Therefore decisions
are based on both objective and subjective criteria.

Conservatism
Conservatism proposes that the information in financial statements should not
foster undue optimistic expectations and bends toward being prepared for the worst
situation. When a policy of conservatism is followed, assets and income tend to be
understated. For instance, depreciation expenses are often accelerated causing lower book
values for plant assets.