What is Accounting?

They say that accounting is a language of business. You can be a professional musician or a computer genius, but it’s not enough to get money. We also need to think about income and expenditures, and of course taxes. Filing a tax return can be rather a hard problem, especially in our country where we can observe instability in accounting laws and governmental orders concerning this field of business. So to get maximum profit, to speak to taxmen one language and not to let them  tease you every person got in touch with any type of business needs to know rules and principles of accounting.

So, what is it, accounting?

Accounting, as it’s said in dictionaries, is keeping financial records, recording income and expenditures, valuing assets and liabilities and so on. Accounting is a service activity. Its function is to provide quantitative information about economic entities. The information is primarily financial in nature and is used in making economic decisions. Accounting records are used in describing the activities and financial status of many different kinds of economic entities including hospitals, schools, cities, governmental agencies and profit-oriented businesses.

how does it work, you wonder? There are a lot of principles being used in the local and international practice, but to start with you should remember the simple rule: you nave to keep records that accurately reflect your financial life. That’s the bottom line, and then you go and get more complex forms of bookkeeping. By the way it seems to be necessary to explain what bookkeeping means. It’s the process of getting financial information, writing down the details of transactions (all economic exchanges of goods, services, money between two or more people). Actually, bookkeeping is only a part of accounting – the record-making part. And accounting itself includes also analytical and interpretation part, it shows the relationship between the financial results and events which have created them.

There are three main steps in making records in bookkeeping:

1) Recording every purchase and sale that a business makes in a journal

2) Entering these temporary records in the ledger (a book of secondary, final entry, containing individual accounts)

3) Transferring all the relevant totals to the profit and loss account.

The main principle of bookkeeping is a double-entry principle. It states that each transaction must be recorded as two separate entries: a value both received and parted with. Payments made or debits are entered on the left-hand (debtor) side of an account, and payments received or credits on the right-hand (creditor) side.

And what seems to be of importance is the way of recording expenses. You should not just take what comes in and what goes out, but it’s better to set up various categories to keep track of the income and expenses and to help with tax return problems.

As I’ve already said, accounting helps to control, evaluate and plan the work of the company. But what concerns accounting, from the different points of view we can speak about different aims and therefore different areas of accounting. For instance, financial accounting prepares financial statements of various kinds, and managerial accounting prepares financial information, such as budget and other financial reports, necessary for the company itself. We can speak about cost accounting , which aim is to work out the unit cost of product, including materials, labour and all other expenses. And we can speak about tax accounting with the process of calculating an individual’s or a company’s liabilities for tax. All these procedures are usually done by the company’s own accountants, but sometimes it should be checked by a second set of accountants. I am talking about auditing as an inspection and evaluation of accounts necessary to be done for some types of business and preferable for others.

But as you know not everyone wants to pay all taxes, so many companies use all available procedures and tricks to disguise the true financial position of a company. Of course it’s illegal, but rather wide-spread, and even has  its name – creative accounting. This funny name causes many misunderstanding as many people think it’s a certain sphere, area of accounting. But it’s the same as window-dressing or Chinese accounting – just illegal tricks.

So one more question can arise -what particular skills are needed for different kinds of accountants. I don’t speak about creative accounting, but about honest  business. It seems to be rather logical to say that all bookkeepers need accuracy and concentration as well as mathematical (or at least arithmetical) abilities. Tax accounting requires knowledge of tax laws and accounting, auditing requires strong analytic and synthetic skills, while   managerial and cost accounting require analytical and mathematical competence.

In accounting it’s always assumed that a business is a “going concern”, I mean it will continue indefinitely into the future. So, the current market value of its fixed assets is irrelevant, as they are not for sale. Consequently, the most common accounting system is historical cost accounting, which records assets at their original purchase price, minus accumulated depreciation charges. But this method understates the value of appreciating assets such as land, but overstates profits as it doesn’t record the replacement cost of plant or stock. So countries with persistently high inflation often prefer to use current cost or replacement cost accounting, which values assets at the price that would have to be paid to replace them today.

To be able to compare the activity of different companies, working in different spheres, to run accounting of the firm, European and American accountants follow GAAP (generally accepted accounting principles). They allow to run the company using unificated methods and rules, which is very useful. And speaking about our country I can say that Russian accountants are also follow these principles or at least part of them.

So according to International Accounting Standards, we can speak about

1) principle of the separate entity or accounting entity concept . An organisation is a separated establishment and it’s property is separated from the property of its’ owners and other firms’ assets.

2) the continuity or going concern concept. We presume that a firm is going to go on its activity

3) the unit-of-measure concept

4) the time-period or accounting period concept

5)  the revenue or realisation principle

We also know matching principle and consistency one, objectivity and conservatism principles, full disclosure and confidentiality ones and many other.

All these principles are of usage to speak one language with for example the American Institute  of Certified Public Accountants or IPS (Internal Revenue Service) – for American accountants or for instance Ministry of taxes or Institute of Professional Accountants of RF.

All information, all work accountants are doing throughout  a year is combined in the annual report, aimed to provide the shareholders with the information on the company performance and to file the tax return. This report consists of verbal and financial parts. At the second one we can observe figures presented by the three financial statements, notes, letters of auditor’s opinion. I’d like to talk in details about these three financial statements. The profit and loss account (income statement), the balance sheet and the source and application of funds statement (the statement of changes in financial position).

The profit and loss account shows the company’s revenue (inflows of assets received in exchange for goods and services  provided to customers as part of the major or central operations of the business) and expenditures (outflows or using up of assets as a result of the major or central operations of a business). Income statement usually gives figures for total sales or turnover (the amount of business done by a company over a year), and costs and overheads  (the various expenses of operating a business that cannot be charged to any one product, process or department). Part of the profit goes to the government in taxation, part is usually distributed to shareholders as a dividend, and part is retained by the company.

The second financial statement is called the balance sheet which shows a company’s financial situation on a particular date, generally the last day of the financial year. It lists the company’s assets, its liabilities, and shareholders’ (stockholders’) funds, which are written in two parts: assets on the left, and liabilities and share capital – on the right. What is important is that both parts should be balanced, I mean equal as they depict the same, but from the different points of view.

So to show it through mathematical equation I should say that Assets=Liabilities+Owners’ Equity(net assets).

Negative items on financial statements such as creditors, taxation and dividends are usually enclosed in brackets.

May be I should explain more accurately some definitions I’m talking about. First of all assets. it’s anything owned by a business (cash investments, buildings, machines, and so on) that can be used to produce goods and pay liabilities. Assets can be tangible and intangible. Intangibles are those assets whose value cannot be quantified or converted into cash without difficulty, such as goodwill, copyright, trademark, data base, know-how. Tangibles include current (inventory, marketable securities, accounts receivable, cash in hand and at bank) and fixed or capital or permanent (freehold property, machinery, office equipment, motor vehicles, etc) assets.

Liabilities are debts to lenders, all money that a company will have to pay to  someone else in the future, including taxes, debts, interests and mortgage payments. They can be current (to be paid out within one year) or long-term, with the term of payment more then one year. Sometimes this payments can be defined as prepayments (money paid in advance before the goods are delivered to the customer), sometimes – as deferred charges (money, whose payment is put off at a later date).

There are two types of liabilities – current and long-term ones. Current liabilities can be paid out within one year. Non-current or long-term liabilities are those, which should be paid within a period of time which, is more than one year.

Shareholders’ equity (net assets) includes share capital (money, received from the issue of shares), share premium (GB) or paid-in surpluses (US) – money, released by selling shares at above their nominal value -, and the company reserves including the year’s retained profits.

Some ratios can be applied to Balance sheet analysis. They are the liquidity ratio, the current ratio, return on capital employed ratio, profit on sales, debtors ratio, creditors ratio, debt/equity ratio.  Return on capital employed and profit on sales show a company’s profitability.

Return on capital employed =net profit/capital employed. (this ratio allows bankers to compare a company’s performance with similar companies in the industry)

Profit on sales = net profit/turnover (it shows the overall profit margins achieved on sales)

Debtors, creditors and debt/equity ratios display a company’s performance.

Debtors ratio =debtors/sales*365 days (it shows the effectiveness of credit control procedures and allows comparison with payment periods to creditors)

Creditors ratio =creditors/purchases *365 days (due to it we can see how much business is financed by trade creditors)

Debt/equity ratio =long-term loans/shareholders funds (it shows the degree to which the company depends on outside finance, e.g. banks, to run its business)

The third financial statement is the source and application of funds statement and it shows the flow of cash in and out of the business between balance sheet dates. Sources of funds include trading profits, depreciation provisions, borrowing, the sale of assets and the issuing of shares. Application of funds includes the purchases of fixed or financial assets, the payments of dividends, the repayment of loans and trading losses, if exist.

So we can speak about several types of assets. Current assets comprise inventories, marketable securities, accounts receivable, cash in hand and in bank. Liquid assets are anything that can quickly be turned into cash. Fixed assets consist of freehold properties, plants and machinery, office equipment, motor vehicles. We can also use words “capital assets”, “permanent assets” for fixed assets.

I’ve told a lot about different principles of accounting and different financial statements. And at the end I’d like to cover the last aspect – aspect of human factor in accounting. We can’t say that accounting is completely objective, because it’s not merely a collection of arithmetical techniques, but a set of complex processes and most accounting reports depend to a greater or lesser extent on people’s opinion. So to be professional it’s not enough just to study all rules and order of filing documents. You should feel the inner principles of all these numbers, understand accurately where our incomes and expenditures can be and try to get the maximum profit (of course without window-dressing)

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