Basic Accounting Concepts 1 – Define Accounting

by Peter Baskerville

Plain English accounting targeting the basic accounting concepts that define accounting
Accounting is an ancient art indeed, with archaeological evidence identifying an accounting system being widely used in the Near East from about 8,000 BC to 3,000 BC. [1] In the 21st century, our accountants are proud to declare their accounting system as the “language of business”. Now that may well be the case, but the rest of us don’t quite understand why that language has to be so foreign and at times, so mysterious. This series looks to demystify the accounting definition and the basic accounting concepts to allow the users of accounting information, like entrepreneurs, to extract the maximum value from its outputs and processes.

Accounting for Entrepreneurs

This training session is targeted at non-accountants who have no intention of ever becoming an accountant. Whilst specifically developed for intending and practicing entrepreneurs, other non-financial managers and investors may also find the training session beneficial.

This training session assumes that you know nothing about accounting but that you realise to be effective in your role, you need to understand the accounting definition, what accounting does and where it fits into your world. So, this session seeks to deliver the accounting definition training from the users point of view.
                                                                                                              

Key Words – Accounting Definitions

accounting, bookkeeping, accountant, financial accounting, management accounting, financial statements, entrepreneurs, financial information, accounting function, basic accounting concepts, different branches of accounting, define accounting, accounting concepts, accounting definitions.
                                                             

Learning Outcomes

At the completion of this training session, you will be able to:

  1. Define the role, function and purpose of accounting.
  2. Explain the key benefits of the accounting function for the entrepreneur
  3. Explain the difference between a bookkeeper and an accountant.
  4. Describe the differences between the two main branches of accounting

                                                                                                        

Introduction – Define Accounting

Whilst many things in life change, it appears that some elements of accounting don’t. Take for instance the 500 year old concept of ‘double entry bookkeeping’ that was first published and practiced in 1494 by a Venetian monk, Luca Pacioli. We still use his system today, in fact accounting as an organized method for record-keeping has been around for almost as long as the industries of trade and business. Many of the principles established hundreds of years ago are still used as the basis for all our accounting functions today. A comprehensive knol on The History of Accounting Part I is provided by Christine Errico and talks about this very issue.

This session is a foundation stone on which all future Basic Accounting Concepts will be built (see Basic Accounting Concepts 2 – Debits and Credits). It is essential then, that you fully understand this session that covers the nature, purpose and rationale of accounting. Now, entrepreneurs are by nature exceptional readers of market changes and emerging opportunities but if they can also add a workable understanding of accounting to their skill set they can become exceptional exploiters of those opportunities as well. Unfortunately, ‘hard-nosed’ business acumen is not always an entrepreneur’s natural skill but they can enhanced this acumen significantly with a full understanding of accounting concepts and its processes.

This training session is divided into four (4) parts. Each part provides the ideas, knowledge and skills necessary to answer the focus question posed at the beginning. External links to definitions are provided where appropriate. Each part is wrapped up by a summary. You are encouraged to participate in the training by completing the activities set at the conclusion of each part. A questionnaire has been prepared at the conclusion of this session with answers provided at the end of this page. This will help you gauge your degree of learning achieved in this training session. Additional resources and a glossary are provided to add a greater depth to your learning experience.
                                                          

What you will need

  • It is advisable to open a blank page of your word processor and save it as “Basic Accounting Concepts” or you could just use a pen and note paper or write the activity outcomes into a designated exercise book.
  • It is also advisable to have a 2nd web browser or tab open so that you can complete the research activities without exiting this training session.

                                                                                                 

Session – Accounting Definition

PART 1 – What is accounting?

 It depends. It depends on who you are asking. For the accountant, it is one area of business activity that they use to derive an income. A more professional way of putting that could be, that accounting is an occupation that is engaged in the service of providing reliable and relevant financial information that can be used by others to make informed decisions.
One ‘official’ definition of accounting is provided by The American Accounting Association which defines accounting as follows: “the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information.”
For the rest of us, the definition and purpose of accounting could be any one or a combination of the following:
  1. Professors of Accounting may call it “The language of business.”
  2. Economists may define it as the practical application of economic theory in that it measures income and values assets.
  3. Corporate managers may define it as a set of timely gauges that helps them actually manage the organisation
  4. Labor unions may see it as a monitor of an organisations activities and performance, particularly in relation to the benefits secured by employees Vs owners.
  5. A Board of Directors or a Chief Executive Officer (CEO) may see accounting as a data process and reporting system that provide the information needed for sound financial or economic decision making for their organisation.
  6. Banks and other providers of loan funds may see it as a process of providing reports showing the financial position of an organisation in relation to the assets owned, amounts owed to others and monies invested as well as the profitability of the organisation’s operations in relation to repaying the loan with interest.
  7. Governments may see it as a way of making organisations accountable to the general community by way of taxation contributions and transparency in the outcomes from their decision making.
  8. Potential investors may see it as a method of evaluating an organisation’s effectiveness in relation to industry benchmarks and the investor’s required returns.
  9. Investors in some failed enterprises may sadly call it a method of fooling some of the people, some of the time with what has been dubbed Creative Accounting’.

One final point to make here, is that accounting is not an end in itself. It is not art to be hung in a museum as a ‘beautiful set of numbers’. Accounting is a means to an end i.e. it provides the most relevant and reliable information possible to allow for the real work to be done – the making of the best possible decisions.

Summary – Define Accounting
We can see from these definitions that accounting can be divided into two main elements:
  • an information process that identifies, classifies and summarises the financial events that take place within an organisation and
  • a reporting system that communicates relevant financial information to interested persons which allows them to assess performance, make decisions and/or control the economic resources in the organisation.
Activity 1
  • Research the internet to find the website of an “accounting association” based in your country.
  • Search the site to find their definition of accounting and write it down.
  • Use underlying or coloring to identify the two main parts identified in the summary definition above.

PART 2 – How does the accounting function benefit the entrepreneur?

Success in any business needs a potent combination of both innovative problem solving (value creation) and business acumen (value maintenance and control). Accounting won’t help much with the former but it is the central pillar on which business acumen is built. Entrepreneurs by nature rely heavily on their innovative insights but the successful ones also know how and when to apply business acumen in their decisions via the reality checks and the more objective results provided by the accounting function.

Listed below are a few ways in which the accounting function impacts on and/or benefits the entrepreneur:
  1. The most obvious one is the help in preparing our financial records for tax assessment purposes. This is usually annually for income tax but laws in some countries require more frequent reporting due to value added taxes and employee withheld taxes. Depending on your business structure and industry, you may also be required to provide your financial information to government agencies or even some trade associations under membership rules.
  2. Another common use of the accounting function for entrepreneurs is in the preparation of financial forecasts. This may be in the preparation of a business plan/proposal or when applying to a funder for a loan or selling a share of the business to an investor/partner. You must still tell the written and oral story of the business but by providing your assumptions to an accountant, they can translate that story into a language that is understood by all in common. Hence, accounting has come to be known as the “language of business”
  3. It helps you calculate the break even for your planned venture. This is a critical number for an entrepreneur to both know and be able to reasonably defend to any interested stakeholder.
  4. The accounting function helps keep you ‘in the game’. Entrepreneurs by nature live in the future because that’s where they believe their reward will materialize, trouble is, the vast majority of people want to be paid in the present. The accounting function with its cash flow modelling and profit reporting can assist the entrepreneur in ensuring that they actually make it to their future reward.
  5. It’s a reality check. Entrepreneurs know that things change. They know that the real opportunity that emerges if often times not the primary one that they set out to exploit. The accounting function helps you to quickly pick the emerging winners and identify the losers. Sure, entrepreneurs are very persistent people in any race but the smart ones know when to ‘stop flogging a dead horse’ and climb aboard a winner when the objective assessment shows that it is required.
  6. Once a new venture is trading, the accounting function can help monitor important key indicators like gross profit margin which is the difference between your selling price and cost of producing/buying the product. Your accountant can set you up with many other key indicators which will become the instrument panel by which you guide and direct your enterprise.
Summary – Accounting benefit for entrepreneur
  • We have seen that accounting is an important function that helps entrepreneurs in both establishing and managing their enterprises. It helps with tax assessment, preparing financial forecasts, calculating your breakeven, it keeps you in the game, it’s a reality check and can be used to create an instrument panel to efficiently manage your new enterprise all the way to success.
Activity 2
  • Research the internet to find the website of an accountant in your area.
  • Search their site to find the list of services they provide.
  • Identify three that match the six outlined above and/or identify one service from their site that is not mentioned above.

PART 3 – What is the difference between a bookkeeper and an accountant?

We hear the two terms of bookkeeper and accountant used so often and interchangeably when dealing with the finances aspects of a business. The reality is that they are two quite distinct roles requiring two quite distinct skill sets.

As mentioned in the summary of PART 1, the broad concept of accounting consists of two main elements.
  1. the information process that identifies, classifies and summarises the financial events that take place within an organisation and
  2. the reporting system that communicates relevant financial information to interested persons which allows them to assess performance, make decisions and/or control the economic resources in the organisation.

Now, as a rule, bookkeepers only do the first element whilst accountants, who could do both, generally stick with the second. This is because accountants are uniquely specialised professionals (read expensive) whose time would be poorly invested in tasks that a computer + accounting software + a competent clerk could easily perform.

Bookkeeping is generally considered the tedious, clerical and exacting role in the accounting function which is why it has been largely taken over by computer processors with their inbuilt software systems. Bookkeeping is all about the routine and systematic recording of the organisation’s financial transactions, both incoming and outgoing, on a day-to-day basis. The bookkeeper function today is performed primarily by skilled clerical personnel who may or may not have had any formal accounting training because the role calls for a more follow-the-instructions approach than a creative one. Bookkeeping in large part is a task oriented function i.e it records transactions
Bookkeepers need to classify transactions into the correct compartment as previously determined by the accountant and business owner. They must also have the basic knowledge of the ‘double entry system’ used in accounting to ensure that financial transactions are recorded correctly. A final check in the process for this is called a ‘trial balance’ which makes sure that the accounting system has been correctly followed. At this point the bookkeeper usually hands the details over to the accountant who performs the second element of the accounting function – reporting.
With a small amount of training on one of the computerized accounting program on offer today, there is no reason why an entrepreneur would not be able to be his/her own bookkeeper. This could help initially with costs (accountants don’t come cheap) but more importantly because it keeps the entrepreneur abreast of the up-to-the-minute changes and development that are happening within their venture.
Accountants on the other hand deal with the big picture or the overall structure and design of both capturing the financial information and the appropriate reporting. Accounting is more results oriented i.e. involved more with the interpretation and use of accounting information than with its actual preparation.
Accountants work with entrepreneurs initially to categorise all typical transaction types into groups that they both believe will ultimately lead to meaningful reports for the entrepreneur whilst also complying with government regulations. As mentioned earlier, the bookkeeper is responsible for the accounting process up to the trial balance stage. Now, whilst a correct ‘trial balance’ means that the double entry accounting system has been correctly applied, it does not mean that the transactions have been placed in their correct classification. The accountant will conduct a scan of the entries, usually by viewing the detailed general ledger, to ensure that there are no irregularities. Having checked that all is in order, the accountant then prepares the financial statements.
First priority is usually given to the government and statutory requirements involving the preparation of the Profit & Loss Statement and the Balance Sheet, although depreciation schedules and some end-of-period adjustments, called ‘accruals’, will first need to be completed. They then work to prepare reports and give advice that assists the entrepreneur in the development of their enterprise. These could be evaluating the efficiency of their operations, resolving complex financial reporting issues, cash flow and profit forecasting, auditing to check the accuracy of the information, tax planning and lawful tax minimisation and redesigning the entrepreneur’s accounting systems to ensure maximum efficiency.
Now unless you are prepared to invest up to 6 years study to become a qualified accountant, the accounting function will be beyond us. So, this is a key appointment in the founding team for an entrepreneur and the best accountants add far more value than they charge. This article on choosing an accountant may help you find the right one.
Summary – Accountant Vs Bookkeeper
  • The bookkeeper function generally performs the first element of the accounting process being the identification, classifying and recording of the financial transactions for an organisation. It is a daily task orientated role that generally ends at the point of the ‘trial balance’.
  • The accountant function on the other hand is results oriented, in that it is more focused on the interpretation of the financial information which results in reports to governments and government agencies as well as to the organisation’s management.
  • The two roles are vital parts of a whole and whilst they can be combined into one role they are generally separated due to cost efficiencies and lack of specialised technical skills.
Activity 3
      • Read the two descriptions of the bookkeeper and the accountant detailed above.
      • Draw a matrix of 6 rows and 2 columns like the one shown.
      • Complete the matrix by comparing 5 aspects on which the bookkeeper and the accountant differ in their roles.

 Bookkeeper

 Accountant

 1.  1.
 2.  2.
 3.  3.
 4.  4.
 5.  5.

PART 4 – What are the different branches of accounting?

Every organisation has a wide range of stakeholders who are interested in the performance or activities of that organisation. Stakeholders are simply any person(s) that are directly or indirectly affected by the activities of the organisation.

For example, business managers need accounting information to assist them in making sound decisions. Investors watch the profits in the hope of ‘dividends’. Creditors and lenders are watchful of the organisation’s ability to meet its financial obligations. Governmental agencies need information to ensure the correct tax was collected and to regulate business activities. Brokers and business analysts use financial information to form an opinion on investment recommendations. Employees chose successful companies that enhance their career prospects, and they often have bonuses or share options that are tied to enterprise performance. This a but a small sample of people that are interested in the financial information of an organisation.
Now for reporting purposes, accountants group these stakeholders into 2 main user group:
  1. External users who are outside the organisation like Governmental agencies, Lenders, Investors (Owners), Creditors, Suppliers, Customers, Trade associations and society at large.
  2. Internal users who are inside the organisation like a Board of directors, Chief executive officer (CEO), entrepreneurs, Chief financial officer (CFO) , Vice presidents, employees and Line managers like Business unit managers, Plant & Store managers.

Accounting information and financial reports designed for external users is called Financial Accounting whereas Managerial Accounting provides accounting information to internal users that is most useful in the management of a company. Now whilst the reporting styles in each branch are vastly different, the underlying objective is the same – to satisfy the information needs of the user.

Financial Accounting
Financial accounting is focused on producing a limited set of specific prescribed financial statements in accordance with generally accepted accounting principles. The central outputs from financial accounting are audited financial statements such as the balance sheet and income statement that provides a scorecard by which a company’s overall past performance can be judged by outsiders.
This branch of accounting targets those external stakeholders that have an interest in the reporting enterprise, but that are not involved in the day-to-day operations. The reports produced by this branch are used for so many different purposes that it is often called “general-purpose accounting”. In addition to the financial statements, external stakeholders also have access to financial reporting via press releases that are sent directly to investors and creditors or via the open communications of the internet.
The emphasis in financial accounting is on summaries of financial consequences of past activities and decisions. So, only summarized data is prepared, that covers the entire organization. The data prepared must be objective, precise and be verifiable, usually by an outside ‘auditor’. This style of reporting must follow the generally accepted accounting principles that are set by peak accounting bodies in conjunction with government agencies. The numbers used in financial accounting are historical in nature.
Now whilst appearing set in stone, financial statements are actually based on estimates, judgments, and assumptions. This is why financial statements usually include ‘notes to the accounts’ which are the explanations from management that help explain and interpret the numerical information. A more specialised area of financial accounting is Tax Accounting.
Entrepreneurs rely heavily on the specialist knowledge and skill of the accountant to perform this function but entrepreneurs should still play a part in the process. Ideally they would scan the detailed general ledger looking for anomalies, they would make sure their stocktake was carried out and calculated according to their accountants instructions, they would scan the financial reports looking for any numbers that ‘didn’t seem right’. These should be discussed with the accountant before the reports are sent because whilst accountants know all about accounting they know a lot less about your business than you do.
Management Accounting
Managerial accounting deals with information that is not made public and is used for internal decision making only. These reports are far more detailed than financial accounting and can cover performances and activities by departments, products, customers, and employees. It is an accounting system that helps management achieve the goals and objectives of the organisation with an emphasis on the measurement, analysis, communication and the control of financial and non-financial information.
This branch of accounting is primarily interested in assisting the organisation’s department heads, division managers, and supervisors make better decisions about the day-to-day operations of the business and in particular, those relating to the planning and control decisions
.
The essential data is conveyed in a wide variety of reports and is specifically targeted at those who direct and control the organisation. These reports help to promote more efficient and effective plan making, resources organizing, personnel directing, motivating and performance evaluation, and operations control.
Unlike financial accounting, there are no external rules governing management accounting. The emphasis in this branch is on making decisions that affect the future with results being compared to budgets, activity-based costing, financial planning or to industry benchmarks. These reports are delivered frequently and in a timely way according to the requirements of management. Most reports are analytical in nature with a heavy emphasis on variances in the key indicators that monitor the financial performance of the business unit. A more specialised area of management accounting is Cost Accounting.
For the entrepreneur, the no.#1 most critical management accounting report is the 13 week moving cashflow forecast. Get your accountant to set this up for you using a spreadsheet program like Microsoft Excel. You should learn to update it weekly and so manage the life blood of your business  – your cash. You should also identify the key performance indicators for your business and have these monitored closely at appropriate intervals. (i.e. Sales – daily, Expenses – monthly, Average unit sale & average customer sale – weekly)
Summary – different branches of accounting
  • There are many stakeholders who are interested in the financial performance of an organisation. Each of these would prefer a customised report detailing only their area of concern. Since this is not feasible, accountants have created two branches of financial information reporting:
    • financial accounting which prepares highly regulated reports for external stakeholders who are not engaged in the day to day operations of the organisation.
    • management accounting which provides customised, appropriate and timely financial information to those internal managers entrusted with the day to day operations of the organisation.
  • Both branches still uphold the underlying accounting objective – to satisfy the information needs of the user.
Activity 4
  • Read the two descriptions of financial accounting and management accounting detailed above.
  • Draw a matrix of 6 rows and 2 columns like the one shown.
  • Complete the matrix by comparing 5 aspects on which financial accounting and management accounting differ in their approaches.

Management Accounting

 Financial Accounting

 1.  1.
 2.  2.
 3.  3.
 4.  4.
 5.  5.
                                                                                                                      

Additional Resources – Accounting Definition

1 – For an overview of financial accounting and some basic accounting concepts see: The quick MBA accounting

2 – For an introduction to accounting and the accounting process see:
3 – For another series of lectures on the topic ‘Introduction to Accounting” see:
4 – For a glossary of accounting terms see:
5 – For another accounting start point see:
                                                                                                   

Questionnaire – Accounting Definition 

On a separate piece of paper or on a blank word processing document, write down your answers to the following questions. Comparing these answers with those provided at the end of this page will help you establish the extent to which the learning has taken place on this session topic.
___________________________________________
Q1 – A key purpose of accounting is to promote informed judgements and decisions by users of the financial information
  • True
  • False
__________________________________________
Q2 – If you could simplify accounting for an organisation into three steps it would be (1) Identify the financial events (2) Classify and record the financial events and (3) …………….. on the financial events of the organisation?
 _________________________________________
Q3 – Which one of the following is NOT a benefit for the entrepreneur from the accounting process?

(A) It’s a reality check

(B) It helps calculate the tax assessment
(C) It only has to report the good results
(D) It helps monitor key indicators
_________________________________________
Q4 – All bookkeepers can also perform the functions of an accountant.
  • True
  • False
_________________________________________
Q5 – Bookkeepers are usually engaged in the accounting process up to the …………..
_________________________________________

Q6 – Which one of the following is NOT a function usually performed by the accountant?

(A) cash flow and profit forecasting
(B) recording the day to day financial transactions
(C) resolving complex financial reporting issues
(D) tax planning
________________________________________
Q7 – There are two main branches of accounting. One is management accounting the other is ………………….. accounting.
________________________________________
Q8 – In reporting, Management accounting must comply with generally accepted accounting principles.
  • True
  • False
________________________________________

Q9 – Which one of the following is NOT a characteristic of management accounting?

(A) no external governing rules
(B) emphasis on decisions that affect the future
(C) results are compared to budgets
(D) only a limited set of prescribed reports compiled
_________________________________________
Q10 – Which one of the following is NOT a characteristic of financial accounting?
(A) Reported frequently and as required
(B) the data is objective and usually verified
(C) the numbers are historic in nature
(D) presents summarized data only covering the entire organisation
                                                                                            

Conclusion – Accounting Definition

The key learnings from this training session were:

  1. that accounting can be divided into two elements regarding financial events within an organisation i.e. recording and reporting.
  2. that there are many benefits for the entrepreneur from the accounting function both in the establishment and the operation of their venture.
  3. that bookkeepers generally control the accounting process up to the trial balance before accountants take over to prepare the financial statements and the management reports.
  4. that there are two main branches of accounting (a) Financial accounting that prepares prescribed reports for external stakeholders and (b) Management accounting that prepares customized reports for those engaged directly in the management of the organisation (internal).
Now, if you were able to complete all set activities and achieved 100% correct answers on the questionnaire, then congratulations your learning is complete and you are now ready to progress to the next topic. If you answered a question incorrectly then review the session part identified in the table below. Also, if you had difficulties completing any of the activities, then it is recommended that you link to the Additional Resources, as these may help you to complete them. If you have further questions you could post a question to the website Ask the Accountant.
The key learning from this session concerning the accounting definition, the role of bookkeeping Vs accountant and the different branches of financial and management accounting will provide the underpinning knowledge for the next learning level, which deals with the accounting equation.
                                                                     

Answers to Questionnaire

 Question #

 Correct Answer

 This topic was covered in PART

 Q1  True  PART 1

 Q2  Report or Summarize

 PART 1

 Q3  (C) it only has to report the good results

 PART 2

 Q4  False  PART 2
 Q5  Trial Balance

 PART 3

 Q6  (B) recording the day to day financial transactions  PART 3
 Q7  Financial  PART 3
 Q8  False  PART 4

 Q9  (D) only a limited set of prescribed reports compiled  PART 4
 Q10  (A) Reported frequently and as required  PART 4

 About the Author

Peter Baskerville is a lecturer, educational resource developer and entrepreneur.

He has authored courses in post graduate education in entrepreneurship for the Queensland Education Department TAFE and developed teaching resources for IBSA the Commonwealth Government’s vocational skill authority. He has lectured at Southbank Institute of Technology, private RTO’s and been a guest lecturer with indigenous organisations as well as mentoring Brisbane City Council multi-cultural scholarship winners. He hold interests in businesses operating in the hospitality and educational resource development sectors.


Basic Accounting Concepts
                                                                        

Reference & Image Source

#1 – Image source by zolierdos Uploaded 28 Dec 08 – http://www.flickr.com/photos/zoliblog/2964370804/ Attribution-Share Alike 2.0 Generic
#2 – Image source by Matt McGee
Uploaded 28 Dec 08 – Attribution-No Derivative Works 2.0 Generic http://www.flickr.com/photos/pleeker/2687435704/
#3 – Image source by karl5
http://www.flickr.com/photos/cwkarl/ Attribution-No Derivative Works 2.0 Generic – Uploaded 28 Dec 08
#4 – Image Source by Philip http://www.flickr.com/photos/phillip/345829246/ Attribution-No Derivative Works 2.0 Generic Uploaded 28 Dec 08
[1] Denise Schmandt-Besserat’s book Before Writing (1992, vols I and II) (small clay counters)

Author: Peter Baskerville
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3 Responses to Basic Accounting Concepts 1 – Define Accounting

  1. APAU says:

    PERFECT ONE THANK YOU

  2. Pingback: Basic Accounting Concepts | General Finance

  3. rohith says:

    Thanks very much sir.

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