ROLE OF ACCOUNTING

The difference between book-keeping and accounting

Bookkeeping is a process of detailed recording of all the financial transactions of a business.
Accounting uses the bookkeeping records to prepare financial statements at regular intervals.
The purpose of accounting is to measure the profit or loss and value of a business.
An income statement (trading, profit and loss account) is drawn up periodically (often at yearly
intervals), to check whether the business is making a profit or a loss.

The owner of the business also needs to know the financial position at regular intervals so a
statement of financial position is prepared. This shows what the business owns, its assets; and
what the business owes, its liabilities.
The term financial statements (final accounts) is often used as a collective name for an income
statement and a statement of financial position.
The accounting year of a business is the 12-month period covered by an income statement.
Different businesses will have different accounting years. Some may produce an income statement
at the end of every calendar year covering the period 1 January to 31 December.

Accurate financial summaries and statements will help the owners of a business to make
decisions about its future.
Many different people and organisations connected with the business will also want information
about its profitability.

Entrepreneurs who invest their time and money in starting and running businesses do so
to make a profit. They will clearly want to know whether their aim is being met and by how
much.
Suppliers who provide goods to the business on credit will want to know that it is capable
of earning enough money to pay them on time and will continue to be successful so that it
can make repeat purchases from them.
A bank will want to know how much profit or loss a business is making before it decides
whether or not to lend it money and on what terms.

Employees of a business will be dependent on its continued success for their jobs and the
payment of their wages and salaries.
The tax authorities of the government will want to check whether a business and its
owners are paying the right amount of tax on their earnings or profits.

Using information and communication technology (ICT)

ICT can be a fast, easy and accurate way to record transactions and prepare accounts.
ICT refers to computer equipment, specialised computer programs or software used to perform
different tasks, and the electronic methods of communication with customers and suppliers linked
to the Internet.
Businesses can use ICT to carry out a wide range of book-keeping and accounting tasks. The use of
ICT in a business for book-keeping and accounting offers a
number of advantages:

Improved accuracy
Increased speed of processing information
The ability to process high volumes of information
The ability to check errors and perform reconciliations
Flexible reporting
Ease and capacity of information storage
Improved security

Despite the clear advantages of using ICT in business for book-keeping and accounting, all
organizations still need to be aware of its possible downsides.
These are:

Computer equipment and specialised software can be costly to buy and install.
Users may input data and program computers incorrectly.
People need to be trained to use computers and to understand book-keeping and accounting

The Double Entry system of book-keeping

The accounting equation

A business needs money to invest in productive assets.
To start up and run a business an entrepreneur will need money to obtain machinery, equipment,
vehicles or simply to hold as cash to buy goods and to pay expenses. These are the productive
resources or assets entrepreneurs will put to work in their businesses to make and sell goods or
services to customers to earn income.
All businesses will need a combination of different assets:

Non-current assets remain productive for several years and can be used over and over again
in day-to-day operations to the benefit of the business. They include the business premises,
machinery, equipment, furniture and vehicles.

Current assets are used up quite quickly in business. They include inventories of goods for
resale to customers and cash either held on the business premises or in the business bank
account. Inventories of goods will be sold off for cash and cash itself will be used to invest in
other assets or to pay for running expenses.

The total assets of a business will therefore include the cash, inventories, premises, machinery,
vehicles, equipment and any other resources it owns that will enable it to earn an income.
To obtain assets entrepreneurs will have to use their own money or borrow money from other
people and organisations, or use some combination of their own and borrowed funds:

Owners capital or equity is the money invested in business assets by the business owners
from their own funds.

Liabilities are financial obligations to repay money owed to other people and organisations.
These include non-current liabilities, such as bank loans, which are amounts repayable in
more than one year, and current liabilities which will require repayment quickly, often within
a few months in the accounting year, for example bank overdrafts and debts to suppliers for
goods purchased from them on credit.

The accounting equation is the most important relationship in accounting.

The total money invested in the total assets of a business will always be equal to the amount of
capital owed by the business to its owners and the total of its liabilities to other people and
organisations. That is:

Owners capital + Total liabilities = Total assets

This is a very simple but critically important relationship in business accounting. It tells us that the
resources supplied by the business owners or from other sources will always be exactly equal to the
resources of the business.
The relationship is called the accounting equation and it is usually shortened and rewritten as
follows:

Assets = Capital + Liabilities

Or, by simply rearranging the accounting equation:

Capital = Assets Liabilities

The e accounting equation will always hold however much the business changes or grows over
time. That is, the total assets of a business will always be equal to the sum of its owners capital
and total liabilities. This is the basis of all accounting.
The financial position of a business will change with each new transaction but the two sides of the
accounting equation will always remain in balance.

Transaction 1: the introduction of capital

Transaction 2: the creation of a non-current liability (a bank loan)

Transaction 3: cash payment to acquire a non-current asset (equipment)

Transaction 4: creation of a non-current liability to acquire a noncurrent asset

(van)

Transaction 5: the purchase of a current asset (inventory) on credit

Transaction 6: the sale of a current asset (inventory) for immediate payment

Transaction 7: the sale of a current asset (inventory) on credit terms and the
creation of another current asset (a trade receivable)

Transaction 8: a reduction in a liability

Transaction 9: the collection of a trade receivable

Every business transaction has two effects and will keep the two sides of the accounting equation
in balance.
1. Assets are listed in a statement of financial position in their order of permanence
This means assets are listed according to how long they last and remain in use in the business.
So, the premises of the business will always be listed first followed by other non-current assets
such as machinery, equipment and vehicles.
Current assets are used up quite quickly. They are listed after non-current assets and in the
following order: inventory, trade receivables and then cash in bank.
2. Each transaction has two effects
In some cases a transaction swapped one asset for another, with one increasing and the other
decreasing by the same amount. For example if childrens clothes were sold for cash, inventory
is reduced but cash increased.
3. Regardless of the transaction, the total assets of the business always remain equal
to the sum of its total liabilities and owners capital
This means the two sides of the accounting equation always remained in balance:
Assets = Capital + Liabilities

Double-entry book-keeping
Book-keeping involves the recording of business transactions in journals and accounts.
Records will be completed from a number of source documents issued or received by the business
when transactions take place. For example, a business will issue a sales invoice to a customer when
it sells goods on credit and a sales receipt when a payment for goods is received. Similarly, a
business will receive a purchase invoice from a supplier when it buys goods on credit and will
receive a receipt when it has settled its debt or purchased goods for cash.
Invoices, receipts, cheques and other documents provide the details and evidence necessary for a
business to make book-keeping entries in its books of prime entry. These are the books in which
transactions are first recorded in the date order they occurred.
A business will usually keep separate books for different types of transaction and usually write them
up at the end of each day of trading. The books are:

a purchases journal to record purchases on credit of goods intended for resale to customers
a purchases returns journal to record any goods subsequently returned to their suppliers
a sales journal to record goods sold to customers on credit terms
a sales returns journal to record any goods subsequently returned by customers
a cash book to record all cash and bank account payments and receipts
a general journal to record transactions that are not entered into any of the other books of
prime entry, for example, the purchase and sale of noncurrent assets on credit.

Ledgers
A business will usually open and maintain a separate account in its ledger for each type of asset it
owns, each expense it incurs, each liability and source of income, as well as for each of one its
suppliers of goods on credit and for each of its credit customers.
The process of writing up the books in business

Ledger accounts can be personal, real or nominal.

Personal accounts are accounts for credit transactions with named suppliers and customers:
Trade payables are accounts with named suppliers who have supplied goods on credit terms.
Trade receivables are accounts for named customers to whom the business has sold goods.
Balances on personal accounts at the end of an accounting year will therefore represent the assets and liabilities
of the business and will also be reported in its statement of financial position.
Real accounts are used to record transactions involving capital, assets and liabilities.
accounts for non-current assets including the premises, machinery, vehicles and equipment owned by the
business;

 cash and bank accounts in the cash book to record all cash transactions;
other payables for items of value or amounts owed by the business to all other organisations or individuals.
other receivables for items of value or amounts owed to the business by all other organisations and
individuals
Nominal accounts are used to record expenses including wages, electricity and rent, and incomes received from
different sources including total sales revenue, interest on business savings and sales commission.
Nominal accounts are opened at the start of an accounting year and then closed at the year end. The balance
accumulated on each account for income earned or expense incurred is then transferred to the income statement
to calculate profit or loss for that year.