Definition of Accounting

Accounting is defined as ‘the art of recording, classifying and summarizing in a

significant manner and in terms of money, transactions and events which are of
financial character and interpreting the result thereof” – American Institute of
Certified Public Accountants (AICPA).

Accounting is an Art:
An art is that part of knowledge, which helps us in attaining our aim or object. It
shows the way which we may reach our objective in the best possible manner. In
this context, our objective is to ascertain the financial position at given point of
time. This is possible by way of recording (Journal), classifying (grouping the
similar nature of in one head is known as Ledger), summarizing the business
transactions (trial balance). Hence the accounting is an art.

Recording, Classifying and summarizing:

Recording business transactions is the first step in accounting mechanics. The
transactions that are systematically recorded in accounting records are called
subsidiary books and journal.
 Definition of Accounting

Classification is the process of grouping of transactions or entries or entries of one nature

which known as Ledger. The recorded data from the journal has been transferred to
ledger. For example sales of any nature i.e. cash or credit sale is written in the sale
accounts. Recording and classifying data into a logical form is referred to as “Book
Keeping”
Summarizing is the art of preparing a consolidated statement at the given point of time.

In a significant manner:
Recording, classifying and summarizing the business transactions have some common
method. If each company has following different methods to prepare these statements, it
would be very difficult to understand by the users. For this purpose, the business
community formulated some common principles, standards and systems.

Records transactions in term of money:

Recording business transaction in terms of money is the common measure of recording
and helps in better understanding of the business transactions. For example, you may
purchase one table. If you are going to enter in a book, purchase of furniture without
mentioning the worth of the furniture is meaningless.
 Definition of Accounting

Deals with transactions and events shows financial character:

All business transactions can not be measured in terms quantity i.e. value of
transactions. Only those transactions and events which are of financial
character (able to measure) will be recorded in terms money. If a transaction
has no financial character then it will not be measured in terms of money and
will not be recorded.

Interpretations :
Accounting is not only recording, classifying and summarizing the
transactions and events of financial character, but also interpreting the
information based on requirement. For instance, Accountant may concern
about the performance of collection activities, cost how and where we can
minimise the cost to improve profitability; he can find out a device for better
material management and so on.
 Accounting as an information system

Accounting is an information system which provides the useful information for making
business decisions. Accounting provides “information that is useful in making business
and economic decisions for making reasoned choices among alternative uses of scarce
resources in the conduct of business & economic activities”.
(Stamford, Connecticut: Financial Accounting Standards Board, 1978)
 Accounting vs. Bookkeeping

The accounting process includes the bookkeeping function. Bookkeeping usually

involves only the recording of economic events. It is therefore just one part of the
accounting process.
In total, accounting involves the entire process of identifying, recording, and
communicating economic events.

Who Uses Accounting Data

There are two broad groups of users of financial information: internal users and external
users.

INTERNAL USERS
Internal users of accounting information are managers who plan, organize, and run the
business. These include marketing managers, production supervisors, finance directors,
and company officers.
In running a business, internal users must answer many important questions, as shown in
following Illustration:
 Who Uses Accounting Data

To answer these and other questions, internal users need detailed information on a
timely basis.
Managerial accounting provides internal reports to help users make decisions
about their companies.
Examples are financial comparisons of operating alternatives, projections of
income from new sales campaigns, and forecasts of cash needs for the next year.

EXTERNAL USERS
External users are individuals and organizations outside a company who want
financial information about the company. The two most common types of external
users are investors and creditors.
Investors (owners) use accounting information to decide whether to buy, hold, or
sell ownership shares of a company.
Creditors (such as suppliers and bankers) use accounting information to evaluate
the risks of granting credit or lending money.
Illustration 1-3 shows some questions that investors and creditors may ask.
 Who Uses Accounting Data

Financial accounting answers these questions. It provides economic and

financial information for investors, creditors, and other external users. The
information needs of external users vary considerably.
Taxing authorities, such as the Internal Revenue Service, want to know
whether the company complies with tax laws.
Regulatory agencies, such as the Securities and Exchange Commission
or the Federal Trade Commission, want to know whether the company is
operating within prescribed rules.
Customers are interested in whether a company like Telsa will
continue to honor product warranties and support its product lines.
Labor unions such as the Major League Baseball Players Association
want to know whether the owners have the ability to pay increased wages
and benefits.
Generally Accepted Accounting Principles

Assumptions
Assumptions provide a foundation for the accounting process. Two main assumptions are
the monetary unit assumption and the economic entity assumption.

MONETARY UNIT ASSUMPTION

The monetary unit assumption requires that companies include in the accounting records
only transaction data that can be expressed in money terms. This assumption enables
accounting to quantify (measure) economic events.
For example, the health of a company’s owner, the quality of service, and the morale of
employees are not included. The reason: Companies cannot quantify this information in
money terms.
ECONOMIC ENTITY ASSUMPTION
An economic entity can be any organization or unit in society. It may be a company (such
as Crocs, Inc.), a governmental unit (the state of Ohio), a municipality (Seattle), a school
district (St. Louis District 48), or a church (Southern Baptist).
The economic entity assumption requires that the activities of the entity be kept
separate and distinct from the activities of its owner and all other economic entities.
 The Basic Accounting Equation

The two basic elements of a business are what it owns and what it owes.
Assets are the resources a business owns.
For example, Google has total assets of approximately $93.8 billion.
Liabilities and owner’s equity are the rights or claims against these
resources. Thus, Google has $93.8 billion of claims against its $93.8 billion
of assets.
Claims of those to whom the company owes money (creditors) are called
liabilities.
Claims of owners are called owner’s equity.
Google has liabilities of $22.1 billion and owners’ equity of $71.7 billion.
We can express the relationship of assets, liabilities, and owner’s equity as
an equation.
This relationship is the basic accounting equation. Assets must equal the
sum of liabilities and owner’s equity.
 The Basic Accounting Equation
Assets
Assets are resources a business owns. The business uses its assets in carrying out such
activities as production and sales. The common characteristic possessed by all assets is the
capacity to provide future services or benefits.
For example, consider Campus Pizza, a local restaurant. It owns a delivery truck that
provides economic benefits from delivering pizzas. Other assets of Campus Pizza are tables,
chairs, jukebox, cash register, oven, tableware, and, of course, cash.
Liabilities
Liabilities are claims against assets—that is, existing debts and obligations. Businesses
of all sizes usually borrow money and purchase merchandise on credit.
These economic activities result in payables of various sorts:
• Campus Pizza, for instance, purchases cheese, sausage, flour, and beverages on credit
from suppliers. These obligations are called accounts payable.
• Campus Pizza also has a note payable to First National Bank for the money borrowed to
purchase the delivery truck.
• Campus Pizza may also have salaries and wages payable to employees and sales and real
estate taxes payable to the local government.
All of these persons or entities to whom Campus Pizza owes money are its Creditors.
 The Basic Accounting Equation
Owner’s Equity
The ownership claim on total assets is owner’s equity.
It is equal to total assets minus total liabilities. Here is why: The assets of a business are
claimed by either creditors or owners. To find out what belongs to owners, we subtract the
creditors’ claims (the liabilities) from assets. The remainder is the owner’s claim on the
assets—the owner’s equity.
Since the claims of creditors must be paid before ownership claims, owner’s equity is
often referred to as residual equity.
INCREASES IN OWNER’S EQUITY
In a proprietorship, owner’s investments and revenues increase owner’s equity.
INVESTMENTS BY OWNER
Investments by owner are the assets the owner puts into the business. These investments
increase owner’s equity. They are recorded in a category called owner’s capital.
REVENUES
Revenues are the gross increase in owner’s equity resulting from business activities entered
into for the purpose of earning income. Generally, revenues result from selling merchandise,
performing services, renting property, and lending money. Common sources of revenue are
sales, fees, services, commissions, interest, dividends, royalties, and rent. Revenues usually
result in an increase in an asset.
 The Basic Accounting Equation
DECREASES IN OWNER’S EQUITY
In a proprietorship, owner’s drawings and expenses decrease owner’s equity.
DRAWINGS
An owner may withdraw cash or other assets for personal use. We use a separate
classification called drawings to determine the total withdrawals for each accounting period.
Drawings decrease owner’s equity. They are recorded in a category called owner’s drawings.
EXPENSES
Expenses are the cost of assets consumed or services used in the process of earning revenue.
They are decreases in owner’s equity that result from operating the business.
For example, Campus Pizza recognizes the following expenses: cost of ingredients (meat,
flour, cheese, tomato paste, mushrooms, etc.); cost of beverages; salaries and wages expense;
utilities expense (electric, gas, and water expense); delivery expense (gasoline, repairs,
licenses, etc.); supplies expense (napkins, detergents, aprons, etc.); rent expense; interest
expense; and property tax expense.

In summary, owner’s equity is increased by an owner’s investments and by revenues

from business operations. Owner’s equity is decreased by an owner’s withdrawals of
assets and by expenses.
 Transaction Analysis
TRANSACTION (1). INVESTMENT BY OWNER
Ray Neal starts a smartphone app development company which he names Softbyte. On
September 1, 2017, he invests $15,000 cash in the business. This transaction results in an
equal increase in assets and owner’s equity.
 Transaction Analysis
TRANSACTION (2). PURCHASE OF EQUIPMENT FOR CASH
Softbyte purchases computer equipment for $7,000 cash. This transaction results
in an equal increase and decrease in total assets, though the composition of assets
changes.
 Transaction Analysis
TRANSACTION (3). PURCHASE OF SUPPLIES ON CREDIT
Softbyte purchases for $1,600 from Mobile Solutions headsets and other
computer accessories expected to last several months. Mobile Solutions agrees to
allow Softbyte to pay this bill in October.
 Transaction Analysis
TRANSACTION (4). SERVICES PERFORMED FOR CASH
Softbyte receives $1,200 cash from customers for app development services it
has performed.
 Transaction Analysis
TRANSACTION (5). PURCHASE OF ADVERTISING ON CREDIT
Softbyte receives a bill for $250 from the Daily News for advertising on its online
website but postpones payment until a later date. This transaction results in an
increase in liabilities and a decrease in owner’s equity.
 Transaction Analysis
TRANSACTION (6). SERVICES PERFORMED FOR CASH AND CREDIT
Softbyte performs $3,500 of app development services for customers. The
company receives cash of $1,500 from customers, and it bills the balance of $2,000
on account.
 Transaction Analysis
TRANSACTION (7). PAYMENT OF EXPENSES
Softbyte pays the following expenses in cash for September: office rent $600,
salaries and wages of employees $900, and utilities $200. These payments result in
an equal decrease in assets and owner’s equity.
 Transaction Analysis
TRANSACTION (8). PAYMENT OF ACCOUNTS PAYABLE
Softbyte pays its $250 Daily News bill in cash. The company previously [in
Transaction (5)] recorded the bill as an increase in Accounts Payable and a
decrease in owner’s equity
 Transaction Analysis
TRANSACTION (9). RECEIPT OF CASH ON ACCOUNT
Softbyte receives $600 in cash from customers who had been billed for services
[in Transaction (6)]. Transaction (9) does not change total assets, but it changes the
composition of those assets.
 Transaction Analysis
TRANSACTION (10). WITHDRAWAL OF CASH BY OWNER
Ray Neal withdraws $1,300 in cash from the business for his personal use. This
transaction results in an equal decrease in assets and owner’s equity.
Transaction Analysis
 Financial Statements
Companies prepare four financial statements from the
summarized accounting data:
1. An income statement presents the revenues and expenses
and resulting net income or net loss for a specific period of
time.
2. An owner’s equity statement summarizes the changes in
owner’s equity for a specific period of time.
3. A balance sheet reports the assets, liabilities, and owner’s
equity at a specific date.
4. A statement of cash flows summarizes information about
the cash inflows (receipts) and outflows (payments) for a
specific period of time.