Introduction to Accounting

Accounting is the process of identifying, measuring, recording and communicating the financial information of a business to its users. In one sentence: accounting is the language of business — it tells the owner and others how much the business earned, spent, owns and owes.

It helps to separate three terms students often confuse:

• Book-keeping — only the recording part: writing transactions in the books day to day. It is routine and clerical.
• Accounting — a wider process that summarises, analyses and interprets what book-keeping has recorded, and reports it.
• Accountancy — the whole body of knowledge (the rules, principles and practice) that governs accounting.

So the order is: Accountancy → Accounting → Book-keeping, from the widest to the narrowest.

The American Institute of Certified Public Accountants (AICPA) defined accounting as "the art of recording, classifying and summarising in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof."

The objectives of accounting are to: (i) keep a systematic record of transactions; (ii) ascertain the profit or loss of the business; (iii) ascertain the financial position (assets and liabilities) through the balance sheet; (iv) provide information to users for decisions; and (v) help in compliance with legal requirements such as tax.

The main functions follow from the definition — recording, classifying, summarising, dealing only with what can be measured in money, and analysing & interpreting the results so that decisions can be made.

Accounting is useful only because people use the information it produces. These users fall into two groups.

Because different users need different information, accounting has grown into specialised branches:

• Financial accounting — records transactions and prepares the profit & loss account and balance sheet for outside users. (This is the focus of Class 11.)
• Cost accounting — ascertains the cost of products and services and helps control costs.
• Management accounting — presents accounting information to management for planning, decision-making and control.

The two main qualities that make accounting information useful for all these users are reliability (free from error and bias, verifiable) and relevance (it must help the decision at hand). Information should also be understandable and comparable across years and firms.

Like any tool, accounting has clear advantages but also real limitations — a good student must know both.

Advantages: it replaces memory with a permanent record; it helps ascertain profit and financial position; it provides evidence in legal matters; it helps in comparing performance over years; it assists in valuing the business when sold; and it helps in assessing tax and raising loans.

Limitations:

• It records only what can be measured in money, so it ignores valuable things like the skill of staff or customer goodwill that cannot be priced.
• It is affected by the personal judgement of the accountant (e.g. choice of depreciation method), so figures are estimates, not exact truths.
• It may ignore the effect of changing price levels (assets are shown at historical cost, not current value).
• It can be window-dressed — manipulated to look better than reality.

Finally, every accountancy student must master the basic terms — the vocabulary used throughout the course:

Knowing these terms precisely is the foundation for everything that follows — the accounting equation, journal, ledger and final accounts all use them.