Accounting Essentials: Concepts, Terms and Meaning

ACCOUNTING

ESSENTIALS

(Concepts, Terms and Meaning)

Godwin O. Akasie

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©2010 Godwin Akasie. All rights reserved.

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First published by AuthorHouse 10/19/2010

ISBN: 978-1-4520-4305-0 (sc)

ISBN: 978-1-4918-8718-9 (ebook)

Contents

A

B

C

D

E

F

G

H

I

J

L

M

N

O

P

Q

R

S

T

U

V

W

Y

Z

APPENDIX

Publisher’s Notes

Accounting, as a subject of study, is an engaging course, all pervading and directly or indirectly impacts on virtually all we do, both in business and our private lives. It is a living subject as it continues to grow, develop and expand in scope and depth with the evolution of businesses and societies.

Several terms are used to define, describe and convey the meanings of what the Accountant proposes to portray in the financial presentations. While some terms readily lend themselves to easy interpretation, appreciation and usage, some are much more difficult to understand by the casual reader and even by the student of accountancy in his or her early stages of apprenticeship.

This compendium contains a compilation ofsome selected accounting related concepts, terms and topics (picked at no particular order), together with their meaning as intended by the Accountant. It also includes some Economics and Finance terms. They were put together in this format in an attempt to assist the reader’s comprehension of the accounting terminologies as commonly used by the practitioners.

The work is not intended to be a stand alone exposition and exhaustive, but as an adjunct of the main texts on the various topics covered. As a reference book, it is proposed to provide a handy companionship to the student of accountancy, finance, economics and anyone who wishes to learn and appreciate the contents of published financial statements and the invaluable presentations of the Accountants.

Access to the Accounting Standards and the Guidelines as listed toward the last pages of the book could provide a useful tool in the hands of a strong admirer as well as the practitioner of the subject of accountancy.

We welcome comments and suggestions on how to improve the content quality of this collection.

Godwin O. Akasie

Acknowledgements:

-   Bibliography and Major Sources-

ACCA Financial Reporting Study Text: FTC Foulks Lynch, A Kaplan Professional Company, Berkshire, 2005

Cost Accounting (A Managerial Emphasis): Charles T. Horngren, Prentice/Hall International Inc., London, Fourth Edition, 1977.

Financial Accounting Manual, 1 and 2,A. R.Jennings, D.P Publications, Winchester, Hants. SO22 5HY, 1982

Financial Reporting Standards (FRSs) (various) issued by the International Accounting Standard Board (IASB)

Institute of Chartered Accountants of Nigeria-Accounting Standards and Guidelines

Lecture Notes-unpublished works: P.N Uchendu and others, 1979-1983

Partnership Act, 1890

The ICSA Study Text in Financial Accounting: John Richard Edwards, ISCA Publishing Ltd, London, 2002-2003

Brief Historical Development of Accounting

The historical development of accounting can be treated under the following headings:

-   Early financial Accounting;

-   Venture Accounting;

-   Luca Paccioli;

-   Subsequent Writers; and

-   The Joint Companies.

Early Financial Accounting

4500.jpg    The beginning of accounting—With the recognition of personal property came the recording of personal wealth and transactions to account for such property. The first accounting records predate the invention of money by several thousands of years. However, it seems that financial accounting records became popular in classical Greece and Rome in 600 BC or thereabout.

4502.jpg    The Charge and Discharge System-The early accounts were kept on the basis ofcharge and discharge. The person entrusted with money or property, accounted periodically to his master. He set out in detail two lists of items in money, weight, or measure whose totals are always equal. The charge was made up of balance due to the master at the beginning of the period, plus money or goods received during the period. The discharge consisted of the amounts disbursed or goods sold or consumed during the period, plus the money or goods due to the accountant’s master at the end of the period. This method was used as internal control to save the property of the master from waste and misappropriation.

4505.jpg    The Double Entry System-This tradition developed gradually over a long period of some eight centuries. Synonymous with the modern bookkeeping, the system was based on two principles, namely: (i) that in any business, the assets are equal to the claims put against them; and (ii) that every transaction is dual in nature.

Double entry was first used in connection with the commercial revival accompanying the Italian Renaissance. Few pages in the account books ofFlorentine Banking and Money Lending Partnership of 1211 A.D, which is the earliest accounting record of that time, show the recognition of the dual nature of transactions. However, the system was that of the oldest diary or paragraph accounting in which each transaction was described in a separate paragraph without attempt at classification or formal arrangement. Nonetheless, the commercial stewards of Genoa in 1340 A.D kept records which are probably the earliest indication of the use of double entry. In the records, the two aspects of each transaction were completely separated, with each aspect classified into accounts which are remarkably similar in nature to those in use today.

Venture Accounting-The early Italian accounts did not cover any specific period of time. A set of books was kept for each venture undertaken by a merchant and accounts would only be prepared when the venture was finally wound up. In venture accounts, the cost of buying the goods would be debited to the venture account to which all sales proceeds would be credited. When all the stocks had been sold or when it was felt that no more sales would be made, the excess of income over expenditure was transferred to a profit and loss account. A loss would occur if too little stock had been sold. The expenses of the venture such as wages were also transferred to the profit and loss account so as to get the net profit of the undertaking.

Luca Paccioli (Fra Luca Bartolomeo de Paccioli, 1445-1517)-Luca Pacioli is regarded as the Father of Accounting. Born in 1445, he was a Franciscan monk and a mathematician. In 1494 A.D, he wrote a book called, Somma de Arithmetica, Geometria Proportioni et Proportionalita (translated as everything about arithhmetic, geometry and proportion). A section of the book was devoted to bookkeeping under the title, De Computis et Scripturis (translated as of reckoning and writing) where he described the commercial practice in Venice at that time. The reason for including a bookkeeping section in a mathematical treatise, according to Paccioli, was stated in the preface of the book, to wit: In order that the subject of the Most Gracious Duke ofUrbino may have complete instructions on the conduct of business, I have determined to go outside the scope of this work and add this most necessary treatise".

Paccioli was living in Urbino when he completed his book. His treatise was a standard text of bookkeeping for two centuries with the main books of accounts described. These were: (i) The Memoria (Memorandum or waste book); and (ii) The Ledger (the proper book of accounts). The symbols for plus and minus, which became standard notation in Italian Renaissance, were introduced for the first time in any published works by Paccioli. In 1504 A.D. the book was translated into English, French, German, and Dutch so that it exercised a considerable influence throughout Europe in the development of accounting thought. Anybody could by following Paccioli’s clear, comprehensive instructions set up his own bookkeeping system.

Subsequent Writers-Following Paccioli’s writing, subsequent writers on the subject of accounting, presented with such a clear basic text, tended to concentrate on the methodology of the system rather than its suitability to give them the sort of accounting information they needed. In 1530 A.D., Simon Stevens of Bruges developed the idea ofBalance Sheet. Other early writers in the subject of accounting include, among others, the English writers-John Gough (who published his work in 1543) and John Mellis (in 1588).

The Joint Stock Companies-

4507.jpg    Separation of ownership from management-The Venetian businesses had been conducted as a sub-section of short-term enterprises and many businessmen would literally own their accountants. Even in the middle ages, the accountant would in many cases be a member of the household. But by the 19th century, the ownership and management of businesses had been completely separated. This is because enterprises like the construction of railways and canals were too expensive to be undertaken by an individual or a group of bankers. These massive projects were financed by Joint Stock Companies whose shareholders had little control over the management of their funds.

4509.jpg    Requirement of Periodic Financial Statements-Unlike the old ventures, the cycle of operations of the joint stock companies was continuous and it was obvious that periodic financial statements had to be produced if shareholders were to be given any indication of the security of their investments. In 1844 A.D., the first Act regulating the Joint Stock Companies stipulated that a true and fair view of company’s activities should be given to the shareholders annually in the company’s balance sheet. Besides, the Act stated that the books should be open for inspection at annual general meetings.

Despite the fact that the form to be taken by the accounts was clearly laid down in the Act, it was still possible for unscrupulous managers to exploit the situation, thereby reducing the amount of payout to shareholders by way of dividends. This was made possible, inter alia, by continuously revaluing the assets upwards, and making progressively larger provisions for depreciation. However, the 1888 A.D. Companies Act reduced the opportunity for management to mislead the shareholders by making it mandatory for auditors, with sound financial training, to examine the company’s books and accounts impartially on behalf of the shareholders. Though this provision was soon to be withdrawn and could not become binding on all the limited liability companies until 1908, it was, however, the first legal recognition of the status of a qualified accountant.

Since then, accounts and accounting process have grown in depth and diversity to what they are in the modern world.

A

ABC method—In stock management and accounting, ABC method is the method that classifies items in terms of importance. Here, more emphasis is placed on higher money (Naira) value items (As) than on lower money (Naira) value items (Bs), while the least important items (Cs) receive the least time and attention. Stock is evaluated frequently when using the ABC method. The procedure for ABC analysis is as follows: (a) Separate finished goods into types (sets of different models, sizes, and so on); separate raw materials into types.

(b)   Calculate the annual money (Naira) usage for each type of stock (by multiplying the unit cost by the expected future annual usage).

(c)   Rank each stock type from highest to lowest, based on annual Naira usage. (d) Classify the inventory as A-the top (say 25%); B-the next (35%); and C-the last (40%) of Naira usage, respectively. (e)Tag the stock with its appropriate ABC classification and record those classifications in the item stock master records.

Abnormal Returns-This is the difference between the actual return and that which is normally expected from the transaction (project).

Abnormal Spoilage-In costing accounting, this represents the spoilage that is recognized as a loss when discovered. Normal spoilage is inherent in the manufacturing process and is unavoidable in the short run. Abnormal spoilage is spoilage beyond the normal spoilage rate. It is controllable because it is a result of inefficiency. It is not a part of cost of good produced, but rather it is a loss for the period. Costs are assigned to the spoiled units and then credited to work-in-progress stock and thereafter debited to the Profit and Loss Account for the period.

Above the Line-This term is used to mean an item that is included in the total which has been calculated. While Below the Line refers to items that are beneath the line at which the total is made up. Below the line items are outside the total that has been calculated.

Absorption Costing-Is the method of costing in which the costs of manufacturing-the variable and fixed-are treated as product costs, while the non-manufacturing costs-administrative and selling expenses-are classified as period costs. Under absorption costing, the unit cost of production includes an absorbed amount calculated from the overheads by means of overhead absorption rates, i.e. fixed plus variable costs. The fixed production costs are absorbed into the units produced and charged in the period of sale.

Absorption and Direct /Variable Costing Compared

Absorption Variance-Is the difference between the budgeted cost (using the absorption costing method) of manufactured products and the actual cost of the manufactured products.

Accelerated Depreciation-Is that method of depreciation which takes into consideration high amounts of depreciation in the earlier years and lower amounts in the later years of a fixed asset’s economic life.

Acceptable Valuation Methods for Stock-These are FIFO (First-in-first-out), Unit Cost, Average Cost, and in certain cases, Standard Cost and Adjusted Selling Price. (LIFO, Replacement Cost and Base Cost methods are not acceptable under SSAP 9).

Account-This term is used to refer to a section of the General Ledger, i.e. a ledger record; it is a summarised form of all transactions that have taken place with the particular entity or value specified (e.g. Tunde’s Account, Plant & Equipment Account, Rent Account, Electricity Account, Salaries and Wages Account etc).

Accounts-This is used to refer to the financial records of the transactions of a business entity.

Accounts Classification-Basically, there are two classes of accounts namely: Personal Accounts, and Impersonal Accounts.

Accountant-An Accountant is a person who performs accounting services; he/she maintains the business records of an entity-a person or an organisation. Accountants prepare financial statements and tax returns, audit financial records, and develop financial plans. They work in private accounting (e.g., for a company), public accounting (e.g., for a professional firm), not-for-profit accounting (e.g., for a governmental agency and charities and clubs). Accountants often specialise in a particular area such as taxes, cost accounting, auditing, and management advisory services. A book keeper is normally distinguished from an accountant as one who employs lesser professional skills. The bookkeeping function is primarily one of recording transactions in the journal and posting to the ledger.

Accounting-This term may refer to (a) a subject of study, an all-embracing term covering many areas of disciplines including auditing, taxation, financial statement analysis, and (b) The term also refers to the process of recording, measuring, interpreting, and communicating financial information about the reporting entity to the users (internal and external) such as the Shareholders, Managers, Government, Creditors and potential Investors. The accountant prepares financial statements to reflect the entity’s financial condition and operating performance. Also, the accounting practitioner renders personal accounting services to clients such as preparing personal financial statements and tax planning. Accounting-related functions include financial accounting, cost and management accounting, not-for-profit accounting, and financial planning.

Accounting Classification-A usual classification of the subject of Accounting is into what is called Financial Accounting, and Cost and Management Accounting. When this classification is used, financial accounting is considered as being restricted to the provision of accounting information for external user groups (external reporting), while Cost and Management accounting, on the other hand, are used to describe the provision of information for management (internal reporting). However, this definition of financial accounting is too narrow. Financial accounting therefore is more generally defined as "consisting of statements prepared to summarise the overall financial progress and position of an entity, whether prepared for managers, owners, creditors or any other interested party. It reports to interested parties the results of the decisions taken by management. Cost Accounting is the establishment of budgets, standard costs and actual costs of operations, processes, activities or products, and the analysis of variances, profitability or social use of funds. Management Accounting is the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of information used by management to plan, evaluate, and control the activities of a business entity. It is concerned with day-to-day planning, control, and decision making.

Accounting Bases-These are the methods developed for expressing or applying fundamental accounting concepts to the financial transactions and items of a business entity. By their nature, the accounting bases are more diverse and numerous than the fundamental concepts, since they evolve in response to the variety and complexity of types of business and business transactions, and for this reason they may justifiably exist more than one recognised accounting basis for dealing with particular items, e.g. Stock valuation, provision for depreciation, accounting for leases and hire purchase contracts. All these have different bases of accounting for them. As an example, for depreciation, the straight-line method or the Reducing Balance method could be used.

Accounting Policies-Are the specific accounting bases, principles, conventions, rules and practices judged by the business entity to be most appropriate to their circumstances and adopted by them for the purpose of preparing their financial statements i.e. for reflecting transactions and other activities in the financial statements. Policies must be consistent with accounting standards and provisions of the Companies Act with the aim of giving a true and fair view and must be assessed against the objectives of relevance, reliability, comparability and understandability. The two most important concepts that affect the selection of accounting policies are the going concern and accrual concepts. Business entities are required to prepare financial statements on the basis of going concern and accrual concepts, except for cash flow information and/or if the entity is in the process of liquidation.

Accounting Principles-These are the rules and guidelines of accounting. They determine such matters as the measurement of assets, the timing of revenue recognition, and the accrual of expenses. The ground rules for financial reporting are referred to as generally accepted accounting practice (GAAP).

The UK Companies Act recognises the four fundamental accounting concepts of going concern, accruals, prudence and consistency as Accounting Principles. The other principle is the requirement of a business entity in deciding the aggregate value of any item to be included in the financial statement, to separately determine the value of the individual asset or liability under consideration. For instance, when stock is valued at the lower of cost and net realisable value, the amount must first be calculated for the separate types of stock and then added together. The sixth principle as recognised by the Companies Act is the principle of Substance over form which requires a business entity, in deciding how values are reflected in the financial statements, to have regard to the economic substance (rather than only the legal form) of the transaction or arrangement under consideration.

Other principles or conventions include:

(a)   Entity   or Accounting Unit Convention-For accounting purposes, the business is a different entity, separate from the proprietors or owners with different accounts kept for its transactions.

(b)   Accounting   Period Convention-For accounting purposes, the lifespan of the business entity is arbitrarily divided into fixed periods of time referred to as the accounting period, normally one year in interval, at the end of which financial statements are prepared to reflect the transactions that occurred.

(c)   Materiality   Convention-In accounting, financial statements are to consider the relative importance (materiality) of each item as an individual or collectively as a group in the overall context of the financial statements. As an example, an expense of=N=20,000 could be material to an entity making a profit of=N=60,000.00 per annum but it is not material to an entity which makes an annual profit of =N=100,000,000.00.

(d)   Objectivity   Convention-This requires business entities to reflect in the financial statements, as objectively as possible, transactions as historical events. This is the main objective of historical cost accounting, although some aspects of historical cost accounting deviate from this principle, e.g. provision for depreciation which is based on the estimated useful economic life of the asset and its scrap value.

(e)   Stable   Standard of Measurement-This principle requires business entities to express all transactions in terms of a common unit of measurement namely the monetary unit (e.g. Nigeria Naira) from one accounting period to another. The financial statements prepared on historical cost basis assume that the monetary unit will remain stable. But in period of inflation, the purchasing power of the monetary unit may differ, thus affecting negatively the meaningful comparison of results obtained through historical cost accounting.

(f)   Substance   over form convention-Requires that the economic substance of a transaction be considered in reflecting it in the financial statements rather than simply based on the legal form. For instance, assets acquired on hire purchase terms or under finance leases, are recorded in the user’s financial statements despite the fact that they are not owned by the user.

Accounting Concepts-These are the broad basic assumptions that underlie the periodic financial statements of a business entity. They are practical rules rather than theoretical rules and are capable of variation and evolution as accounting thought and practice develops. The Four Fundamental Accounting Concepts-which underlie the financial statements of business entity, are: Going Concern, Accrual, Consistency, and Prudence.

Accounting Convention-Is the method or procedure employed generally by accounting practitioners. Accounting convention is based on custom and is subject to change as new developments arise. The accountant, in performing the reporting function, should follow existing accounting conventions that apply to the given situation.

Accrual Concept-At times, this is also referred to as the Matching Concept-and relates to the matching or comparing of costs with the associated revenues during a reporting period. It requires revenues to be matched with related expenses when measuring profits, revenues and expenses to be included in the Profit and Loss Account as they are earned or realised and incurred rather than when they are received and paid. Normally, revenue is recognised when realised. Revenue realisation is taken to mean the date of disposal or sale rather than the day of actual receipt of related cash. Thus, it becomes imperative to compare the revenue reported in the period with the cost or expenses incurred in earning the revenue in order to show how effectively and efficiently the resources of the entity have been used during the period. An entity is required to prepare its financial statements, other than cash flow information, on the accrual basis of accounting.

Accounting Cost-Is the monetary value of an economic resource used up in the production of goods or delivering of services.

Accounting Entity Assumption-This is an assumption that considers the company as a legal entity separate from its owners.

Accounting Entity-Is a business or any other economic unit (including its subdivisions) that is being separately accounted for. A system of accounts is kept for the entity. An accounting entity is isolated so that recording and reporting for it are possible. Examples of accounting entities are companies, partnerships, clubs, trusts, and charities. A distinction is made between an accounting entity and a legal entity. For example, a sole proprietor’s accounting entity might be the business whereas the legal entity would include his personal assets. Also, in the corporate environment, affiliated or associated companies can be differently organised for legal and accounting purposes.

Accounting Equation—This forms the basis ofall accounting. It shows the balance sheet as: Assets = liability + equity. It can also be expressed as: Assets-Liabilities = owner’s equity. Other expressions are:

4511.jpg    Assets-Liabilities = Ownership interest

4513.jpg    Assets-liabilities = Contributions from owners + Gains—Losses—Distributions to owners.

4515.jpg    Assets = Capital employed = Liabilities

4517.jpg    Assets = Capital + Total Liabilities

4519.jpg    Working capital = Current Assets—Current Liabilities

Accounting period-This refers to any period for which a company prepares its accounts and it is usually 12 months. The first accounting period does not start until a company starts to trade, or when its profits first become liable to corporation tax. The end of accounting period is earliest of: 12 months after the start of period, end of company’s period of accounts, and date the company ceases to trade. And corporation tax is based on profits made during an accounting period.

Accounting Profit or Loss—This is the difference between the total incomes and the total explicit costs. It is the profit or loss for the accounting period under review using certain types of income and expenditure items that are allowed.

Accounting Ratio-This is usually the result of comparing two or more sets of accounting data. In most cases, this is done by dividing one of the items on the financial statement by another. Ratios help with the interpretation of financial statements by focusing on specific relationships.

Accounting Software—These are programs used to maintain books of account on the computers. The software can be used to record transactions, maintain account balances, and prepare financial statements and reports. Many different accounting software packages exist, and the right package must be selected given the client’s circumstances and needs. An accounting software package typically contains numerous integrated modules (for example, spreadsheet and word processing abilities). Some modules are used to account for the general ledger, accounts receivable, accounts payable, payroll, stock, and fixed assets.

Accounting System-This represents the methods, procedures, and standards followed in accumulating, classifying, recording, and reporting business activities and transactions. The accounting system includes the formal records and original source data. Regulatory requirements may exist on how a particular accounting system is to be maintained such as in the financial institutions-insurance and banking.

Accounts Payable-Are the amounts owed by a business entity to another. It is a summary from the purchases ledger. It is a record of debts to be paid: a record that shows how much a company owes suppliers for the purchase of goods or services received on credit. Normally, it is a credit balance in the books-shown as a Credit Entry in the Trial Balance and a current liability in the Balance Sheet.

Accounts Receivable-This is the record of money owed: a record that shows how much is owed to a company by customers who have purchased goods or services on credit. Normally, this is a Debit Balance in the books-shown as a Debit Entry in the Trial Balance, and a Current Asset in the Balance Sheet.

Accrual—Is the recognition of expenses when incurred or revenue when earned regardless of when the actual cash is paid or received.

Accrued Expenses—Are expenses incurred during an accounting period for which payment is not made at the end of that accounting period. They are reflected as current liabilities in the Balance Sheet.

Accrued Income-This refers to income earned during an accounting period but not received (in cash) by the end of that period. They are shown as current assets in the Balance Sheet.

Accumulated Depreciation Account-This is an account in the General Ledger which records the cumulative amount of depreciation that has been charged against that asset. When the value in this account is equal to the purchase price of