Accounting Principles
Balance sheet vs Income Statement
Basic Accounting Concepts
Ethics
What is Accounting?
Accounting Basics
Overview
Welcome to Mdumiseni’s video course in the basics of accounting. This course introduces the viewer to the most important principles in accounting. While this course is complicated and requires some understanding of mathematical principles, it is an introductory level course in that no prior background or experience in accounting is required.
Best of luck and we welcome your feedback.
Introduction to Accounting
Welcome to Mdumiseni’s video course in the basics of accounting. This course introduces the viewer to the most important principles in accounting. While this course is complicated and requires some understanding of mathematical principles, it is an introductory level course in that no prior background or experience in accounting is required.
Section one is the introduction
Section two of this course starts with explanations of the basic Accounting concepts.
Section three explains the Accounting cycle.
Section four explains the basic Accounting documents: the balance sheet, and the income statement.
Section five explains the Accounting principles. We will look at the overview of the Accounting policy and the definition and explanation of GAAP principles.
In our last section, we will look at ethics. The focus will be on the Code of Ethics and the basic principles of ethics.
At the end of this course, you will know about the basics of Accounting concepts, the Accounting cycle, the Accounting documents and their importance, the Accounting principles and their policy as well ethics.
Best of luck and we welcome your feedback.
Table of Content
| Description | Section |
| Introduction to Accounting | Section 1 |
| Basic Accounting Concepts | Section 2 |
| Accounting Cycle | Section 3 |
| Accounting Documents | Section 4 |
| Accounting Principles | Section 5 |
| Ethics | Section 6 |
Basic Accounting Concepts
Accrued expenses/ expenses payable | Expenses that are still owing at the end of the financial year. |
| Accrued income/income receivable | Income that is still owing to the business at the end of the financial year. |
| Asset | Item of value owned by a person or business which enables a profit to be made. |
| Bad debts Creditors People/suppliers the business owes money to. | Debts written off as the debtors are unlikely to settle their accounts. |
| Cost of sales | Cost of sales is the cost price of all goods that have been sold. |
| Debtors | People who owe the business money for goods bought on credit. |
| Depreciation | The amount by which fixed assets reduce in value over time due to use. |
| Income received in advance/deferred income | Income that has already been received by a business but which is for the next financial year. |
Accounting Cycle
What Is the Accounting Cycle?
The accounting cycle is a collective process of identifying, analyzing, and recording the accounting events of a company. It is a standard 8-step process that begins when a transaction occurs and ends with its inclusion in the financial statements.
The key steps in the eight-step accounting cycle include recording journal entries, posting to the general ledger, calculating trial balances, making adjusting entries, and creating financial statements.
How the Accounting Cycle Works
The accounting cycle is a methodical set of rules to ensure the accuracy and conformity of financial statements. Computerized accounting systems and the uniform process of the accounting cycle have helped to reduce mathematical errors. Today, most software fully automates the accounting cycle, which results in less human effort and errors associated with manual processing.
Steps of the Accounting Cycle
There are eight steps to the accounting cycle.
- Identify Transactions:
An organization begins its accounting cycle with the identification of those transactions that comprise a bookkeeping event. This could be a sale, refund, payment to a vendor, and so on.
- Record Transactions in a Journal:
Recording of transactions using journal entries. The entries are based on the receipt of an invoice, recognition of a sale, or completion of other economic events.
- Posting:
Once a transaction is recorded as a journal entry, it should post to an account in the general ledger. The general ledger provides a breakdown of all accounting activities by account.
- Unadjusted Trial Balance:
After the company posts journal entries to individual general ledger accounts, an unadjusted trial balance is prepared. The trial balance ensures that total debits equal the total credits in the financial records.
- Worksheet:
Analyzing a worksheet and identifying adjusting entries make up the fifth step in the cycle. A worksheet is created and used to ensure that debits and credits are equal. If there are discrepancies then adjustments will need to be made.
- Adjusting Journal Entries:
At the end of the period, adjusting entries are made. These are the result of corrections made on the worksheet and the results from the passage of time. For example, an adjusting entry may accrue interest revenue that has been earned based on the passage of time.
- Financial Statements:
Upon the posting of adjusting entries, a company prepares an adjusted trial balance followed by the actual formalized financial statements.
- Closing the Books:
An entity finalizes temporary accounts, revenues, and expenses, at the end of the period using closing entries. These closing entries include transferring net income into retained earnings. Finally, a company prepares the post-closing trial balance to ensure debits and credits match and the cycle can begin anew.
Timing of the Accounting Cycle
The accounting cycle is started and completed within an accounting period, the time in which financial statements are prepared. Accounting periods vary and depend on different factors; however, the most common type of accounting period is the annual period. During the accounting cycle, many transactions occur and are recorded.
At the end of the year, financial statements are generally prepared, which are often required by regulation. Public entities are required to submit financial statements by certain dates. Therefore, their accounting cycle revolves around reporting requirement dates.
The Accounting Cycle Vs. Budget Cycle
The accounting cycle is different than the budget cycle. The accounting cycle focuses on historical events and ensures incurred financial transactions are reported correctly. Alternatively, the budget cycle relates to future operating performance and planning for future transactions. The accounting cycle assists in producing information for external users, while the budget cycle is mainly used for internal management purposes.
In our next section, we will begin discussing the Accounting documents.
Accounting Documents
The Balance Sheet
To examine the financial status of a company at a fixed point in time, accountants prepare a statement of financial position, which is more commonly called a “balance sheet.” The balance sheet consists of three major components: assets, liabilities, and owner’s equity. In a corporation, owner’s equity is called shareholder equity, since it is the shareholders who own the business.
Assets are what a business owns and include cash, inventory, plant and equipment, and intellectual property, such as copyrights, trademarks, and patents. Assets also include monies owed to a business, which are called receivables.
For example, a business may have accounts that record credit it has extended to its customers. Another type of asset is the expected benefit from an already incurred expense. The expense is referred to as “prepaid,” such as the subscription fee for Industry Today that Mdumiseni Corporation paid in our earlier example. Assets are listed on a balance sheet in order of their liquidity, with the most liquid of assets, cash, appearing first.
A second component of the balance sheet is liabilities, which are what the business owes. These accounts include monies owed by the business that represent future obligations, called “payables,” such as payments owed to a business’s suppliers. Payables also include loans, which may be notes payable or mortgages. Liabilities also include deferred income, which is monies the business has received for a good or service that the business has not yet provided. When a business incurs an expense for which there is no present legal obligation, it records it as an “accrued liability.”
For example, a balance sheet that is compiled in the middle of a two-week payroll period would reflect an accrued liability of half of the pending payroll amount. The balance sheet reflects the liability, but the company has not yet disbursed the funds.
If assets represent what a business owns and liabilities represent what a business owes, then what has left over the difference between the two amounts- is called “owner’s equity,” which is, by one measure, the worth of the business. We can represent the relationship among the three components in a mathematical equation, which is called the “fundamental accounting equation.” It may be expressed as: Assets equals liabilities plus owner’s equity. Note that if a company’s liabilities exceed its assets, the company is insolvent. Another way of stating the fundamental accounting equation would be that liabilities equals assets minus owners’ equity, or owners’ equity equals assets minus liabilities.
For example, assume Mdumiseni Corporation has R10 million in assets and R7 million in liabilities. Mdumiseni Corporation would therefore be worth the difference between the assets and liabilities, that is, R3 million.
Structurally, the assets are listed on the left of a balance sheet while the liabilities are listed on the right side. Also, assets that are expected to be converted into cash or consumed within one year are called “current assets” and are listed first in order of liquidity. Assets not expected to be converted into cash or consumed within one year are called “long-term assets” and are listed after the current assets. It is the same with liabilities. Liabilities that are expected to be paid within one year are short-term liabilities and are listed first and long-term liabilities, which are those liabilities where payment is not expected to occur within one year, follow.
The Income Statement
While the balance sheet shows the financial health of a company at a given time, the statement of results of operations, commonly called the “income statement,” shows the income or loss of a company over a year. The income statement shows revenues and gains, along with expenses and losses. Revenues are the monies earned by a company for the sales of its goods and services, along with miscellaneous earnings which would include interest and dividends. Capital gains are those amounts that the company realizes, not as a result of its ordinary course of business, but, rather, from the sale of its assets, marketable securities, and other transactions, collectively referred to as other comprehensive income. Since assets are recorded at historical cost, the gain is the sale price less the amount originally paid for the asset.
For example, Mdumiseni Corporation purchases a plant for R1 000 000 in Mpumalanga, but three years later Mdumiseni determines it would be better to conduct its manufacturing operations in KwaZulu Natal. It sells its Mpumalanga plant for R1 300 000, thus realizing a gain of R300 000 on the sale.
The income statement also lists expenses and losses. Expenses are costs incurred in running the business and generating income. They include the cost of goods the company has sold, salaries and wages, rent, interest, and income taxes. Since some assets may lose value over time, a company will need to periodically deduct the lost value. This is called “depreciating” an asset, and it is accomplished by recording the reduction in value as a depreciation expense.
For example, Mdumiseni Corporation’s plant in Mpumalanga loses value through normal wear and tear. Mdumiseni, therefore, deducts R50 000 annually as a depreciation expense to reflect the loss in value of its Mpumalanga plant. For accounting purposes, the R1 000 000 plant will be worth R950 000 at the end of its first year, R900 000 at the end of its second year, and so on.
Note that, while the building itself can be depreciated, the land itself cannot, as land does not necessarily lose its value as it ages. The amounts that can be depreciated for tax purposes are set forth in tax regulations.
In addition to expenses, the income statement will show losses, which are costs that are not incurred in the ordinary course of business. Losses may include litigation, natural disasters or changes in employee pension fund liabilities.
The income statement typically lists revenues and gains first, followed by expenses and losses. Revenues and gains minus expenses and losses equals “net income,” which is how much the business earned in the time reflected by the income statement. Some companies use this “single step” approach, while others use a “multiple step” approach in the calculation of income or loss.
In the multiple step approach, “gross profit” is sales minus cost of goods sold. Subsequently, subtracting operating expenses from the company’s gross profit will give the company’s “operating margin” or “net operating margin.” Other amounts added or subtracted produce a final “net income” or “net loss” figure. This number, when used in calculations involving the number of outstanding shares held by shareholders, can provide an earnings per share amount, which is an important metric for investors and creditors.
One important relationship between the balance sheet and the income statement is that the increase in net income on the income statement equals the increase in owners’ equity on the balance sheet. For observers to evaluate the financial health of a business, financial statements will typically include income statements for three successive reporting periods.
In our next section, we will begin discussing the Accounting principles.
Accounting Principles
Accounting policy
In our everyday life, we often come across circumstances that are repetitive in nature (always the same) but may in each instance have different results if we were to act differently. If we do not have guidelines to indicate how we should act, our actions may be inconsistent.
If we have guidelines as to how we should act in certain circumstances, we are determining a policy that will result in consistent actions.
The same applies to accounting. We often find repetitive transactions and consistency require that a business should determine an accounting policy according to which they can manage such transactions. Thus, accounting policy is a set of decisions about the way in which a business will manage the same types of transactions in order to achieve consistent results.
1.1 Publicising the accounting policy
As the accounting policy represents a business’s decisions on factors that could be managed in different ways, it is necessary that the business publicizes the accounting policy it will use in its Financial Statements. A business should, for example, indicate how the depreciation of Vehicles and Equipment will be calculated.
1.2 Generally accepted accounting practice (GAAP)
If each person were to develop his or her own language or grammar rules, it would cause communication chaos. For this reason, we have generally applicable grammar rules.
Accounting, as a special system of communication, has exactly the same problem. If each business were to present Financial Statements according to its own theory and principles, chaos would erupt in the economic and business world.
For this reason, a basis has been developed for measuring and presenting the results of financial events (transactions).
This basis is a general framework and includes accounting concepts, principles, methods, and actions known as Generally Accepted Accounting Practice (GAAP).
From now on we are going to use the abbreviation GAAP.
In RSA the Accounting Standards Board plays an important role in the development of
GAAP by setting certain accounting standards. By setting these standards for certain events (e.g. presenting tax in the Financial Statements), the objective is to limit the variety of available accounting practices without striving towards strict uniformity or a set of rigid rules. The objective of accounting standards is to promote the general application of certain issues in Financial Statements and to eliminate unacceptable alternatives.
After being approved by the Accounting Standards Board the standards are published in a series of publications, called accounting standards. After 1994 we became part of the International Financial Reporting Standards (IFRS). A business will use the IFRS to prepare its Financial Statements. It is important to note that GAAP/Accounting.
Standards change constantly in order to keep up with changes in the business world. These statements are issued by the South African Institute of Chartered Accountants (SAICA). SAICA is a professional body that is responsible for training and developing the accounting profession.
The following factors affect the way in which the Financial Statements are presented.
You must ensure that you understand these concepts clearly as they will assist you when you have to draw up the Financial Statements of a sole trader.
GAAP Principles
2.1 Historical cost
The concept of historical cost means that assets purchased by a business must be recorded in the books at cost price (purchased price).
Example:
If we bought Land and buildings three years ago at a total cost of R500 000 and entered it into the books at that price and the asset is re-valued today at R650 000, the amount that will be entered in the Financial Statements will still be R500 000 (the price that we originally bought it for).
2.2 Prudence
This is also known as the principle of conservatism. When the accountant is uncertain about the value of an element or event (assets/liabilities/income/expenses), the prudence principle must be applied. This means that the accountant who prepares the
Financial Statements should be conservative in their approach to these uncertainties. The value that has the least influence on the equity of the business must be used.
Example:
If a debtor is in financial difficulty, the accountant may write his account off even though the business will continue to do everything possible to receive the money the debtor owes them.
2.3 Materiality
The materiality principle demands that all-important (large) transactions and events should be indicated separately in the Financial Statements, as these may influence decision-making. Unimportant amounts need not be indicated separately but should be added to other amounts of similar nature or functions.
Here is also another part that is important. The accountant will be conscious of whether an adjustment entry will be important (material) to the financial results of a business.
An adjusting entry might be omitted if the amount is regarded as insignificant.
Example:
All interest expense items should be shown separately in the Financial Statements as this will be important (material) to a decision on how to raise additional funds.
2.4 Business entity rule
The objective of accounting is to present information about the financial situation of a specific business or individual. Such a business or individual is known as an entity. The concept entity refers to a unit that exists independently and can be clearly defined.
The financial affairs of the business must be kept separately from the financial affairs of the owners. The business must have a separate bank account and in the Financial Statements of the business, no transactions of the personal affairs of the owner will be shown.
Example:
If the owner inherited R500 000 from his/her grandfather, the money will be deposited in the owner’s personal bank account and not in the business’s bank account.
2.5 Going concern
The concept of going-concern means that an entity (business) will continue to exist for a certain period and that the Financial Statements of a business are prepared as though the business will continue to exist for some time.
Example:
Stock, fixed deposit, and land and buildings are not valued on the basis of the amount that would be received for them if they were sold immediately.
2.6 Matching
All transactions or events that take place during a certain financial period must be recorded in the books during that financial period – irrespectively of when the cash is received or paid. Income and expenses incurred in order to receive such income, need to be brought into account during the same period. This implies that expenses incurred in order to create income must be ‘matched’ to that income during the present financial period.
Example:
If a building is a rent from somebody and we only paid R55 000 (R5 000 per month) for 11 months, the R5 000 will be matched with the R55 000 because it is part of this financial year. The amount recorded in the Financial Statements will be R60 000.
In our next section, we will begin discussing ethics.
Ethics
Code of Ethics
- A Code of ethics is a statement of norms and beliefs of the business, describing acceptable behavior in the workplace.
- It makes it possible for every person involved in the business to know and understand what is considered right and wrong in specific situations.
- Most codes will value honesty, integrity, and diversity.
Basic principles of ethics
2.1 Ethical conduct
- The word ethics is defined as a set of moral principles of a profession according to which a person should behave.
- Both employees and employers have a responsibility towards themselves, fellow colleagues, clients, and the profession to act morally and ethically.
- In any profession, a set of rules should be laid down so that everyone knows what is acceptable.
- This ethical code of conduct should be drawn up in such a way that subordinates don’t feel that rules are applicable only to them.
- Both employees and employers should be involved in setting up a code of conduct for a business.
2.2 Leadership
- Leadership is a position or state of being in control of a group of people or an organization.
- A leader has to take control and people have to follow.
- Good leadership is visible when the followers obey the leader because they respect what the leader says and does.
2.3 Discipline
- Employees must work and behave in a controlled way and this involves obeying specific rules.
- The Code of ethics describes acceptable behavior in the workplace and consequences for incorrect behavior.
- Employees who do not follow the Code of ethics will be disciplined.
2.4 Transparency
- Transparency means that behavior must be such that it is clear that you have nothing to hide.
2.5 Accountability
- Being accountable means taking responsibility for what you say and do, and being able to justify your actions.
2.6 Fairness
- Fairness is the quality of being reasonable and just. It means that you judge a situation objectively and without bias or any preconceived ideas. Customers or clients must feel that they are treated fairly.
2.7 Sustainability
- All businesses need to act in a way that shows respect towards the environment and the use of resources. Sustainability makes a difference in the long term. Businesses should not waste resources or damage the environment.
2.8 Responsible management
Responsible management takes into account three important things, often called the 3Ps:
- People: A responsible manager considers all the stakeholders of the business – employees, suppliers, and customers – and deals with them in an ethical way.
- Planet: A responsible manager takes the environment into account and does everything possible to ensure that the environment is looked after and not destroyed.
- Profit: A responsible manager ensures that the business makes the maximum profit, but only by using ethical practices.
2.9 Integrity
Integrity can be defined as honesty, efficiency, sincerity, honesty towards oneself, the upholding of values and norms. Success in a business can only be achieved when employees and clients respect the integrity of the business and the integrity of the business is reflected in the management and leaders. Why is integrity important for managers?
- It builds confidence – when people know that managers don’t use their position to enrich themselves through the business, confidence, loyalty, and support will grow.
- This influences others – the managers conduct influences amongst others the employees and employers. His/her character determines the character of the business.
- It creates high standards – the manager’s integrity will set a positive example for employees. Remember, people do what people see.
2.10 Confidentiality
Most information in a business should be kept confidential. It is important that employees should not leak information that is intended only for the business to people outside the business. For example, the manager has to make decisions about a large contract that the business might obtain. If this information is disclosed to people outside the business, a rival business might use the information to obtain the contract.
Employees who are disloyal towards the business will share confidential information with people who should not have access to it.
2.11 Objectivity
Objectivity is described as the ability to act in an unbiased way. This means that you should not be influenced by personal feelings and preferences.
An objective person makes decisions based on true facts and not based on his/her personal feelings. An objective person will be fair and unbiased in carrying out his/her duties and will not be influenced by others.
2.12 Professional ability and proper care
When offering professional services, one offers one’s knowledge, skills, experience, care, and diligence. Professional people should not render services for which they are not qualified unless they can obtain advice and assistance. Professional people should maintain a high standard of professional knowledge and skills so that a client and employer have the advantage or qualified professional services in line with the most recent practical, legal and technical developments.
2.13 Professional conduct
This concerns the conduct in the workplace of all the people connected to an enterprise.
At all times a person should conduct himself in such a way that his/her behavior doesn’t have a negative influence on the enterprise. An employee must be polite and show consideration towards all parties with whom he/she has a contact in the enterprise.
2.14 Technical standards
Each employee should have all the relevant technical and professional skills that his/her position requires. All tasks assigned to employees by their employer should be carried out with integrity. These should also conform to all the technical and professional standards that are laid down by the enterprise, the authorities concerned and applicable legislation.