Accounting Concept

 

FINANCIAL AND ACCOUNTING SYSTEMS

This chapter provides an overview of the concept of Financial and Accounting Systems, Integrated and Nonintegrated Systems and further acquaint the students about Regulatory and Compliance requirements with Financial and Accounting systems.

 

From a business perspective, a Process is a coordinated and standardized flow of activities performed by people or machines, which can traverse functional or departmental boundaries to achieve a business objective and creates value for internal or external customers.

 

In accounting language, a Voucher is a documentary evidence of a transaction. There may be different documentary evidences for different types of transactions.

 

Voucher Types
1	Contra	Accounting	For recording of four types of transactions as under. • Cash deposit in bank. • Cash withdrawal from bank. • Cash transfer from one location to another. • Fund transfer from our one bank account to our own another bank account.
2	Payment	Accounting	For recording of all types of payments. Whenever the money is going out of business by any mode  (cash/bank).
3	Receipt	Accounting	For recording of all types of receipts. Whenever money is being received into business from outside by any mode (cash/bank).
4	Journal	Accounting	For recording of all non-cash/bank transactions. E.g. Depreciation, Provision, Write-off, Write-back, discount given/received, Purchase/Sale of fixed assets on credit, etc.
5	Sales	Accounting	For recording all types of trading sales by any mode (cash/bank/credit).
6	Purchase	Accounting	For recording all types of trading purchase by any mode (cash/bank/credit).
7	Credit Note	Accounting	For making changes/corrections in already recorded sales/purchase transactions.
8	Debit Note	Accounting	For making changes/corrections in already recorded sales/purchase transactions.
9	Purchase Order	Inventory	For recording of a purchase order raised on a vendor.
10	Sales Order	Inventory	For recording of a sales order received from a customer.
11	Stock Journal	Inventory	For recording of physical movement of stock from one location to another.
12	Physical Stock	Inventory	For making corrections in stock after physical counting.
13	Delivery Note	Inventory	For recording of physical delivery of goods sold to a customer.
14	Receipt Note	Inventory	For recording of physical receipt of goods purchased from a vendor.
15	Memorandum	Accounting	For recording of transaction which will be in the system but will not affect the trial balance.
16	Attendance	Payroll	For recording of attendance of employees.
17	Payroll	Payroll	For salary calculations.

Business : A business is defined as an organization or enterprising entity engaged in commercial, industrial, or professional activities. The term "business" also refers to the organized efforts and activities of individuals to produce and sell goods and services for profit.

 

Types of Business :

There are three major types of businesses:

1. Service Business

A service type of business provides intangible products (products with no physical form). Service type firms offer professional skills, expertise, advice, and other similar products.

Examples of service businesses are: salons, repair shops, schools, banks, accounting firms, and law firms.

 

2. Merchandising Business

This type of business buys products at wholesale price and sells the same at retail price. They are known as "buy and sell" businesses. They make profit by selling the products at prices higher than their purchase costs.

A merchandising business sells a product without changing its form. Examples are: grocery stores, convenience stores, distributors, and other resellers.

 

3. Manufacturing Business

Unlike a merchandising business, a manufacturing business buys products with the intention of using them as materials in making a new product. Thus, there is a transformation of the products purchased.

A manufacturing business combines raw materials, labor, and overhead costs in its production process. The manufactured goods will then be sold to customers.

 

Hybrid Business

Hybrid businesses are companies that may be classified in more than one type of business. A restaurant, for example, combines ingredients in making a fine meal (manufacturing), sells a cold bottle of wine (merchandising), and fills customer orders (service).

 

 

 

 

 

Forms of Business Organization

These are the basic forms of business ownership:

 

1. Sole Proprietorship

A sole proprietorship is a business owned by only one person. It is easy to set-up and is the least costly among all forms of ownership. The owner faces unlimited liability; meaning, the creditors of the business may go after the personal assets of the owner if the business cannot pay them.

The sole proprietorship form is usually adopted by small business entities.

 

2. Partnership

A partnership is a business owned by two or more persons who contribute resources into the entity. The partners divide the profits of the business among themselves.

In general partnerships, all partners have unlimited liability. In limited partnerships, creditors cannot go after the personal assets of the limited partners.

 

3. Corporation

A corporation is a business organization that has a separate legal personality from its owners. Ownership in a stock corporation is represented by shares of stock.

The owners (stockholders) enjoy limited liability but have limited involvement in the company's operations. The board of directors, an elected group from the stockholders, controls the activities of the corporation.

In addition to those basic forms of business ownership, these are some other types of organizations that are common today:

 

Limited Liability Partnership (LLP)

Having characteristics of both a corporation and a partnership. An LLP is not incorporated; hence, it is not considered a corporation. But, the owners enjoy limited liability like in a corporation.

 

Cooperative

A cooperative is a business organization owned by a group of individuals and is operated for their mutual benefit. The persons making up the group are called members. Cooperatives may be incorporated or unincorporated.

 

Some examples of cooperatives are: water and electricity (utility) cooperatives, cooperative banking, credit unions, and housing cooperatives.

Non Profit Organisation

A type of business that uses its profits for charitable purposes. Tax-exempt, but must follow special rules.

 

 

Different Types of Accounting Systems :

1. Single Entry System : where a small business records every transaction as a line item in a ledger.

2. Double Entry System : The double-entry system of accounting or bookkeeping means that for every business transaction, amounts must be recorded in a minimum of two accounts. The double-entry system also requires that for all transactions, the amounts entered as debits must be equal to the amounts entered as credits. Double entry also means that the accounting equation (assets = liabilities + owner's equity) will always be in balance.

3. Cash System of Book-Keeping :

4. Indian System of Book-keeping :

 

Types of Accounting Methods

CASH ACCOUNTING METHOD

Cash accounting records income and expenses as they are received and paid (when the money trades hands).

 

ACCRUAL ACCOUNTING METHOD

Accrual accounting records the amounts when a transaction (a bill going out or an invoice coming in) occurs, not when the cash is actually exchanged. It is believed that this method of accounting gives a more accurate picture of a company’s finances.

 

 

 

 

 

 

 

Accounting Terms

Balance Sheet Terms

1. Accounts Payable (AP)

Accounts Payable include all of the expenses that a business has incurred but has not yet paid. This account is recorded as a liability on the Balance Sheet as it is a debt owed by the company.

 

2. Accounts Receivable (AR)

Accounts Receivable include all of the revenue (sales) that a company has provided but has not yet collected payment on. This account is on the Balance Sheet, recorded as an asset that will likely convert to cash in the short-term.

 

3. Accrued Expense

An expense that been incurred but hasn’t been paid is described by the term Accrued Expense.

 

4. Asset (A)

Anything the company owns that has monetary value. These are listed in order of liquidity, from cash (the most liquid) to land (least liquid).

 

5. Balance Sheet (BS)

A financial statement that reports on all of a company’s assets, liabilities, and equity. As suggested by its name, a balance sheet abides by the equation <Assets = Liabilities + Equity>.

 

6. Book Value (BV)

As an asset is depreciated, it loses value. The Book Value shows the original value of an Asset, less any accumulated Depreciation.

 

7. Equity (E)

Equity denotes the value left over after liabilities have been removed. Recall the equation Assets = Liabilities + Equity. If you take your Assets and subtract your Liabilities, you are left with Equity, which is the portion of the company that is owned by the investors and owners.

 

8. Inventory

Inventory is the term used to classify the assets that a company has purchased to sell to its customers that remain unsold. As these items are sold to customers, the inventory account will lower.

 

9. Liability (L)

All debts that a company has yet to pay are referred to as Liabilities. Common liabilities include Accounts Payable, Payroll, and Loans.

 

Income Statement Terms

10. Cost of Goods Sold (COGS)

Cost of Goods Sold are the expenses that directly relate to the creation of a product or service. Not included in this category are those costs that are needed to run the business. An example of COGS would be the cost of Materials, or the Direct Labor to provide a service.

 

11. Depreciation (Dep)

Depreciation is the term that accounts for the loss of value in an asset over time. Generally, an asset has to have substantial value in order to warrant depreciating it. Common assets to be depreciated are automobiles and equipment. Depreciation appears on the Income Statement as an expense and is often categorized as a “Non-Cash Expense” since it doesn’t have a direct impact on a company’s cash position.

 

12. Expense (Cost)

An Expense is any cost incurred by the business.

 

13. Gross Margin (GM)

Gross Margin is a percentage calculated by taking Gross Profit and dividing by Revenue for the same period. It represents the profitability of a company after deducting the Cost of Goods Sold.

 

 

 

 

14. Gross Profit (GP)

Gross Profit indicates the profitability of a company in dollars, without taking overhead expenses into account. It is calculated by subtracting the Cost of Goods Sold from Revenue for the same period.

 

15. Income Statement (Profit and Loss) (IS or P&L)

The Income Statement (often referred to as a Profit and Loss, or P&L) is the financial statement that shows the revenues, expenses, and profits over a given time period. Revenue earned is shown at the top of the report and various costs (expenses) are subtracted from it until all costs are accounted for; the result being Net Income.

 

16. Net Income (NI)

Net Income is the dollar amount that is earned in profits. It is calculated by taking Revenue and subtracting all of the Expenses in a given period, including COGS, Overhead, Depreciation, and Taxes.

 

17. Net Margin

Net Margin is the percent amount that illustrates the profit of a company in relation to its Revenue. It is calculated by taking Net Income and dividing it by Revenue for a given period.

 

18. Revenue (Sales) (Rev)

Revenue is any money earned by the business.

 

General Terms

 

19. Accounting Period

An Accounting Period is designated in all Financial Statements (Income Statement, Balance Sheet, and Statement of Cash Flows). The period communicates the span of time that is reported in the statements.

 

20. Allocation

The term Allocation describes the procedure of assigning funds to various accounts or periods. For example, a cost can be Allocated over multiple months (like in the case of insurance) or Allocated over multiple departments (as is often done with administrative costs for companies with multiple divisions).

 

21. Business (or Legal) Entity

This is the legal structure, or type, of a business. Common company formations include Sole Proprietor, Partnership, Corporation, Limited Liability Partnership (LLP), Co-operative, Non Profit Organization. Each entity has a unique set of requirements, laws, and tax implications.

 

22. Cash Flow (CF)

Cash Flow is the term that describes the inflow and outflow of cash in a business. The Net Cash Flow for a period of time is found by taking the Beginning Cash Balance and subtracting the Ending Cash Balance. A positive number indicates that more cash flowed into the business than out, where a negative number indicates the opposite.

 

23. Certified Public Accountant (CPA)

CPA is a professional designation that an accountant can earn by passing the CPA exam and fulfilling the requirements for both education and work experience, which vary by state.

 

24. Credit

A credit is an increase in a liability or equity account, or a decrease in an asset or expense account.

 

25. Debit

A debit is an increase in an asset or expense account, or a decrease in a liability or equity account.

 

26. Diversification

Diversification is a method of reducing risk. The goal is to allocate capital across a multitude of assets so that the performance of any one asset doesn’t dictate the performance of the total.

 

 

27. Enrolled Agent (EA)

An Enrolled Agent is a professional accounting designation assigned to professionals who have successfully passed tests showcasing expertise in business and personal taxes. Enrolled Agents are generally sought out to complete business tax filings to ensure compliance with the IRS.

 

28. Fixed Cost (FC)

A Fixed Cost is one that does not change with the volume of sales. For example, rent and salaries won’t change if a company sells more. The opposite of a Fixed Cost is a Variable Cost.

 

29. General Ledger (GL)

A General Ledger is the complete record of a company’s financial transactions. The GL is used in order to prepare all of the Financial Statements.

 

30. Generally Accepted Accounting Principles (GAAP)

These are the rules that all accountants abide by when performing the act of accounting. These general rules were established so that it is easier to compare ‘apples to apples’ when looking at a business’s financial reports.

 

31. Interest

Interest is the amount paid on a loan or line of credit that exceeds the repayment of the principal balance.

 

32. Journal Entry (JE)

Journal Entries are how updates and changes are made to a company’s books. Every Journal Entry must consist of a unique identifier (to record the entry), a date, a debit/credit, an amount, and an account code (that determines which account is altered).

 

33. Liquidity

A term referencing how quickly something can be converted into cash. For example, stocks are more liquid than a house since you can sell stocks (turning it into cash) more quickly than real estate.

 

34. Material

Material is the term that refers whether information influences decisions. For example, if a company has revenue in the millions of dollars, an amount of $0.50 is hardly material. GAAP requires that all Material considerations must be disclosed.

 

35. On Credit/On Account

A purchase that happens On Credit or On Account is a purchase that will be paid at a future time, but the buyer gets to enjoy the benefit of that purchase immediately.

 

36. Overhead

Overhead are those Expenses that relate to running the business. They do not include Expenses that make the product or deliver the service. For example, Overhead often includes Rent, and Executive Salaries.

 

37. Payroll

Payroll is the account that shows payments to employee salaries, wages, bonuses, and deductions. Often this will appear on the Balance Sheet as a Liability that the company owes if there is accrued vacation pay or any unpaid wages.

 

38. Present Value (PV)

Present Value is a term that refers to the value of an Asset today, as opposed to a different point in time. It is based on the theory that cash today is more valuable than cash tomorrow, due to the concept of inflation.

 

39. Receipts

A Receipt is a document that proves payment was made. A business produces receipts when it provides its product or service and it receives receipts when it pays for goods and services from other businesses. Received Receipts should be saved and catalogued so that a company can prove that its incurred expenses are accurate.

 

 

40. Return on Investment (ROI)

Originally, this term referred to the profit that a company was making (Return), divided by the Investment required. Today, the term is used more loosely to include returns on various projects and objectives.

 

41. Trial Balance (TB)

Trial Balance is a listing of all accounts in the General Ledger with their balance amount (either debit or credit). The total debits must equal the total credits, hence the balance.

 

42. Variable Cost (VC)

These are costs that change with the volume of sales and are the opposite of Fixed Costs. Variable costs increase with more sales because they are an expense that is incurred in order to deliver the sale. For example, if a company produces a product and sells more of that product, they will require more raw materials in order to meet the increase in demand.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Types of accounts

A Real Account is a general ledger account relating to Assets and Liabilities other than people accounts. These are accounts that don't close at year-end and are carried forward. An example of a Real Account is a Bank Account.

 

A Personal account is a General ledger account connected to all persons like individuals, firms and associations. An example of a Personal Account is a Creditor Account, Capital Account, Drawings Account.

 

A Nominal account is a General ledger account pertaining to all income, expenses, losses and gains. An example of a Nominal Account is an Interest Account.

 

Golden rules of accounting

Rules for Debit Credit

In Accounts, there are only 2 things

1. Profit and Loss – Containing Expenses and Income

2. Balance Sheet – Containing Liabilities and Assets

 

Rules for Accounting

All Expenses – Debit

All Incomes – Credit

All Liabilities – Credit if Increase (Debit if Decrease)

All Assets – Debit if Increase (Credit if Decrease)

Steps Involved in Accounting Process

 

 

 

 

 

 

 

 

 

Comparison of Accounting in Textbooks and Accounting in Practical Life

Accounting in Textbooks	Accounting in Practical Life
We do accounting manually by pen and notebook (Manual Accounting)	We do accounting on computers in some software like Tally, Busy, Marg (Computerized Accounting)
Steps We first 1. Pass Entries 2. Make Ledgers 3. Make Trial Balance 4. Make Profit and Loss 5. Make Balance Sheet	Steps We Only 1. Make Ledgers Name 2. Pass Entries Automatically Ledgers, Trial Balance and Balance Sheet updated
We study accounts and tax separately   Journal Entries of sale, purchase, expense, income do not have taxes like GST, TDS (Both Separate Subjects)	We do accounting for different bills having taxes like GST, TDS etc.
There are more chances of error	There are fewer chances of errors; however accounting entries should be correct.