NATURE OF ACCOUNTING

Most of the world’s work is done through organizations i.e. groups of people who
work together to accomplish one or more objectives. In doing this work, an
organization uses resources e.g. labour, materials, various services, building and
equipment. These resources need to be financed or paid for. To work effectively,
the people on an organization need information about the amounts of these
resources, the means of financing them and the results achieved through using
them. Parties outside the organization need similar information to make
judgments about the organization.

Accounting is a system that provides such information. This accounting is the

process of identifying, measuring and communicating economic information to
permit informed judgments and decisions by users of the information.

Accounting is a systematic and comprehensive recording of financial

transactions pertaining to a business.

It is the art of recording, summarizing and classifying in significant manner and

in terms of money, transactions and events, which are in part of list of a financial
character and interpretation of results thereof.

The objectives of accounting

Accounting has many objectives including letting people and organizations

know;

- If they are making a profit or a loss

- What their business is worthy
- What a transaction was worth to them
- How much cash they have
- How wealthy they are
- How much they are owed
- How much they owe to someone else etc. However, the primary objective
of accounting is to provide information for decision making.
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Functions of accounting

The main functions of accounting are the following:-

i) Ascertainment of profit and loss

The main purpose of any business is to make a profit. For this purpose,
accurate and complete recording of all business transactions is
essential because this information will be helpful to determine whether
there was profit or loss in any trading period. No business can survive
in the long period without making reasonable profits.

ii) To facilitate credit transactions

Most of the business transactions are made on credit basis. If goods
are purchased from a suppliers on credit basis, then this supplier is
known as the creditor and if the goods are sold to a customer on credit
basis, then this customer is known as the debtor.
Accounting records facilitate such credit transactions because these
records will determine the amounts due to creditors and debtors.

iii) Assessment of tax.

Taxes are imposed by the government in all countries.
Accounting records must be maintained properly, otherwise a business
enterprise may be required to pay high tax to the government.

iv) Evaluation of assets and liabilities

Every business enterprise has some assets and liabilities. Assets are
the possessions of the business and liabilities are the amounts which
are due to other persons.
A statement of assets and liabilities can be prepared on any particular
date which is known as balance sheet. Thus, the balance sheet shows
the value of the assets and liabilities of any given business.
v) A tool for control
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 A proper and accurate accounting system controls the unnecessary
expenses and misappropriation of funds of an organization.

vi) Acts as a basis for further or future planning.

Accounting records provides sufficient data relating to sales, profit, etc
for making decision about the future programs

Users of accounting information

Possible users of accounting information include;
i) Managers
These are the day to day decision makers. They need to know how well
things are progressing financially and about financial status of the
business.

ii) Owners (s) of the business

They want to able to see whether or not the business is profitable and
the same time, to know the financial resources of the business.

iii) A prospective buyer.

When the owner wants to sell a business, the buyer will want to know
whether the business is making a profit or not before deciding to buy
it.

iv) The bank

If the owner wants to borrow money from the financial institutions for
users in the business, then the bank will need such information before
deciding to give out money.

v) Tax inspectors
The information is needed for the purpose of tax calculations.
vi) A prospective partner.
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 If the owner wants to share ownership with someone else, then the
partner to be would want see such information in order to making
proper decisions.

vii) Investors
They want to know whether or not to invest their money in the
business.

The accounting equation

By adding up what the accounting records say belongs to a business
and deducting what they say the business owes, you can identify7 what
a business is worth according to those records. The whole of financial
accounting is based on this very simple idea. It is known as the
accounting equation.
It can explained by saying that if a business is to be set up and start
trading, it will need resources.
Let us assume first that it is the owner of the business who has
supplied all of the resources.
This can be shown as;
Resources supplied by the owner = Resources in the business
The amount of resources supplied by the owner is called capital. The
actual resources that are then in the business are called assets.

This means that when the owner has supplied all of the resources, the
accounting equation can be shown as
Capital = Assets
Usually, however people other than the owner have supplied some of
the assets. These are called liabilities, the name given to the amounts
owing to these people of these assets.
The accounting equation has now changed to
Capital = Assets – Liabilities
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 i.e. Assets = Capital + Liabilities

The total of both sides will always equal each other. i.e.the capital will
always equal to the assets of the business minus the liabilities.
Assets consists of property of all kinds, such as buildings, machinery,
stocks of goods and motor vehicle. Other assets include debts owned
by customers and the amount of money in the organization’s bank
account.

Liabilities in clued amounts owed by the business for goods and

services supplied to the business and for expenses incurred by the
business that have not yet been paid for they also include the funds
borrowed by the business.

Capital is often called the owner’s equality or net worth. It comprises

the funds invested in the business by the owner plus any profits
retained for use in the business less any share of profits paid out of the
business to the owner.

Accounting Concepts

Accounting principles are built on a foundation of a few basic concepts. These

concepts are so basic that most accountants do not consciously think of them,
they are regarded as self – evident.

In order to understand accounting, one must understand the following concepts;

1) The Money measurement concept

In financial accounting, are and is made only of information that can be

expressed in monetary terms.

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The advantage of such a record is that money provides a common
denominator by means of which heterogeneous facts about an entity can be
expressed as numbers that can be added and subtracted.

Although it may be a fact that a business owns £30,000 of cash, £6000 of

raw materials, six trucks, 50,000 square feet building space, and so on.

These cannot be added together to produce a meaningful total of what the

business owns.

Expressing these in monetary terms, £30,000 of cash, £6000 of raw materials

£150,000 of trucks and £4000,000 of buildings, makes such an addition
possible. Thus despite the old cliché about not adding apples and oranges, it
is easy to add them if both the apples and the oranges are expressed in terms
of their respective monetary values.

Despite its advantage, the money measurement concept imposes a severe

limitation on the scope of accounting report.

Accounting does report the state of the president’s health, that the sales
manager is not on speaking terms with the production manager that a strike
is beginning or that a competitor has placed a better product on the market.

Accounting therefore does not give a complete account of the happenings in

an organization or a full picture of its condition.

It follows, then that the reader of accounting report should not expect to find
therein all of the facts or perhaps even the most important ones about an
organization.

Money is expressed in terms of its values at the time an event is recorded in

the accounts.

Subsequent changes in the purchasing power of money do not affect this

amount thus a machine purchased in 2006 for £200,000 and land purchased
20 years earlier for£200,000 are each listed in 2006 accounting records at
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£200,000, although the purchasing power of the dollar in 2006 was much
less than it was 20 years earlier.

Accountants know fully well that the purchasing power of the money changes.
They do not however attempt to reflect such changes in the accounts.

2) The entity concept

Accounts are kept for entities as distinguished from the persons who are
associated with these entities. An entity is any organization or activity for
which accounting reports are prepared. Examples of entities include
business companies, governments, churches, universities and non-
business organizations.

In recording events in accounting, the important question is how do these

events affect the entity. How they affect the persons who own, operate or
otherwise are associated with the entity is irrelevant.

For example, suppose that the owner of a clothing store removes £100
from the store’s cash register for his or her personal use. The real effect of
this event on the owner as a person may be negligible, although the cash
has been taken out of the business’s pocket and put into the owner’s
pocket either pocket the cash belongs to the owner. Nevertheless, because
of the entity concept, the accounting records show that the business has
less than it had previously.

It is sometimes difficult to define with precision the entity for which a set
of accounts is kept. Consider the case of a married couple who owns and
operates an unincorporated retail store and those of its owners. A creditor
of the store can sue and if successful, collect from the owner’s personal
resources of the business.
In accounting by contrast, a set of accounts is kept for the store as a
separate business entity and the events reflected in these accounts must
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 be those of the store. The non business events that affect the couple must
not be included in these accounts.

In accounting, the business owns the resources of the store, even though
the resources are legally owned by the couple and debts owned by the
business are kept separate from personal debts owed by the couple. The
expenses of operating the store are kept separate from the couple’s
personal expenses for food, clothing, housing and the like.

3) The going concern concept

Unless there is a good evidence to the contrary, accounting assumes that
an entity is a going concern, i.e. it will continue to operate for an
indefinitely long period in the future.

The significance of this assumption can be indicated by contrasting it with

a possible alternative namely, that the entity is about to be liquidated.
Under the latter assumption, accounting would attempt to measure at all
times that the entity’s resources are currently worth to potential buyers.
Under the going concern concept, by contrast, there is no need to
constantly measure an entity’s worthless to potential buyers and it is not
done.

Instead, it is assumed that the resources currently available to the entity

will be used in its future operations.

4) The cost concept

It states that an asset is ordinary entered initially in the accounting
records at the price paid to acquire it i.e. at its cost.

5) The dual-aspect concept

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 The economic resources of an entity are called assets. The claims of
various parties against these assets are called equities.

There are two types of equities;

a) Liabilities which are the claims of creditors (that is, everyone other than
the owners of the business) and
b) Owners’ equity, which is the claims of the owners of the business.

Since all the assets of a business are claimed by someone (either by its
owners or by creditors) and since the total of these claims cannot exceed
the amount of assets to be claimed it follows that;
Assets = Equities
This is the fundamental accounting equation expressed in its general form.
All accounting procedures are derived from this equation.
To reflect the two types of equities, the expanded version of the equation
is;
Assets = Liabilities + Owners’ equity.

6) The accounting period concept

Accounting measures activities for a specified interval of time called
accounting period. The accounting period universally accepted is one year
although some businesses may do it quarterly or half yearly or monthly.

7) The conservatism concept

Managers are human beings. Like most humans, they would like to give a
favourable report on how well the entity for which they are responsible has
performed. Yet as the financial accounting standards board says, prudent
reporting based on a healthy skepticism builds confidence in the results
that in the long run, best serves all of the divergent interest of (financial
statement users).

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 This long standing philosophy of prudent reporting leads to the
conservatism concept.

The concept is articulated as a preference for understatement rather than

overstatement of net income and net assets. When dealing with
measurement of uncertainties thus, if two estimates of some future
amount are about equally likely, there is a preference for using the smaller
number when measuring assets or revenues and the larger for liabilities
or expenses.

8) The matching concept

The sale of merchandise has two aspects;
i) Revenue aspect reflecting an increase in retained earnings equal to
the amount of revenue realized.
ii) An expense aspect, reflecting the decrease the decrease in retained
earnings because the merchandise (an asset) has left the business.

In order to measure correctly this sale’s net effect on earnings in a period,

both of these aspects must be recognized in the same accounting period.
This leads to the matching concept; when a given event effects both
revenues and expenses, the effect on each should be recognized in the
same accounting period.

9) The consistency concept

The concept states that once an entity has decided on one accounting
method, it should use the same method for all subsequent events of the
same character unless it has a sound reason to change the method(s).

If an entity frequently changed the manner of handling a given class of

events in accounting records, for example frequently changing between the
straight line method and an accelerated method for depreciating its

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 building, comparison of its financial statements for one period with those
of another period would be difficult.

10) The materiality concept

In law there is a doctrine called de minimis nin curat lex, which means
that the court will not consider trivial matters. Similarly, the accountant
does not attempt to record events so insignificant that the work of
recording them is not justified by the usefulness of the results.
Unfortunately, there is no agreement on the exact line separating material
from immaterial events. The decision depends on judgment and common
sense of the parties involved.

Rule of double entry system.

1. An increase of asset is debited and a decrease of asset is credited
2. An increase of capital is credited and a decrease of capital is debited
3. An increase of liabilities is credited and a decrease is debited.

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