GMAT / GRE Tutorial Series: Accounting

Accounting Concepts, Principles, and Basic Terms

Introduction to accounting

From a general standpoint, accounting and accounts do seem like a tough subject that involves a lot of numbers and calculations that are difficult to decipher.

Accounting is ideally a business language used by accountants and auditors.

The American Accounting Association defines accounting as:

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

The American Institute of Certified Public Accountants defines accounting as:

“The art of recording, classifying, summarizing in a significant manner and in terms of money, transactions, and events which are, in part at least of financial character, and interpreting the results thereof.”

Accounting not only documents financial transactions and indicates the financial position of a business enterprise; it also analyses and reviews the information in documents called “financial statements.”

It is crucial to record every financial transaction of a business organization for the sake of its creditors and investors. Accounting is based on a regulated system that follows standardized principles and systematic procedures.

Accounting is done by well-qualified professionals who obtain their degrees after years of practice and study.

While small business firms may hire an accountant or a bookkeeper to record monetary transactions, a large corporation usually has an accounts department that provides information to:

• Managers who direct the company.
• Investors wanting to know the health of the company.
• Analysts and stock traders dealing with the company’s stock.
• The government decides the tax to be collected from the company.

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Accounting Principles

While personal systems of accounting may have worked a long time ago when most companies were owned by sole proprietors or partners, in this era of joint-stock companies, it is necessary to have a uniform and standardized system of accounting in place for the purpose of understanding the performance and value of companies.

Therefore, accounting principles built on fundamental concepts, conventions and traditions have been developed by accounting authorities and regulators and these standards are practiced all over the world. These principles that stand as a guide for the accounting of financial transactions and preparing financial statements are known as the “Generally Accepted Accounting Principles,” or GAAP.

The application of the principles ensures that financial statements are both informative and reliable, common practices and conventions are followed and the common rules and procedures are complied with. This observance of accounting principles has helped in creating a universally accepted grammar and vocabulary for recording financial statements.

Just as there may be variations in the usage of the same language among people living in different countries, the application of accounting rules and procedures may have minor differences depending on the accountant.

For instance, two accountants may select two different but equally correct approaches for documenting a particular transaction based on their own professional judgment and knowledge.

Accounting principles are approved provided they are (1) reliable (2) can be understood by those with a basic knowledge of finance (3) objective (4) feasible (they can be applied without incurring high costs) and (5) applicable in practical situations.

Accounting principles contain both accounting concepts and accounting conventions. Here is a brief explanation of these two.

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Accounting Concepts

1. Business entity concept: A business and its owner should be considered separately when taking into account their financial transactions.
2. Money measurement concept: A business transaction should be recorded only if it is expressed in terms of money. Other types of transactions may be recorded separately.
3. Dual aspect concept: For every credit, a corresponding debit takes place. A transaction is recorded only by taking this dual aspect into consideration.
4.  Going concern concept: In accounting, it is assumed that a business will continue for a fairly long time and carry out its commissions and obligations. Accordingly, the business will not be forced to stop functioning and liquidate its assets at “fire-sale” prices.
5. Cost concept: The fixed assets of a company are recorded at its original cost in the initial year of accounting. Subsequently, the depreciated values of these assets are recorded. This concept applies only to fixed assets and does not take into account the rise or fall in its market price.
6. Accounting year concept: Indicates a period of time chosen by each business to complete a cycle of the accounting process. It can be monthly, quarterly, or annually—as per a fiscal or a calendar year.
7. Matching concept: As per this principle, every revenue entry in a given period must have an equivalent expense entry. This is followed to ensure the profit or loss calculations are recorded accurately.
8. Realization concept: Based on this concept, revenue is recognized only when it is earned. Until the goods or services have been delivered to the buyer, an advance or fee paid is not considered a profit.

Accounting Conventions

Accounting follows five important conventions:

conservatism; consistency; full disclosure; and materiality.

Conservatism is the convention by which, the lower-value transaction is recorded in case two values are available. As per this convention, profit should never be overestimated, and losses should be anticipated or provided for.

Consistency specifies that the same accounting principles be used for every accounting cycle, so that the same standards are followed to calculate profit and loss.

Materiality means that all financial information considered to be material to the company has to be recorded. Accountants should record important data and leave out irrelevant information.

Full disclosure requires the reporting of all information, both favorable and harmful to a business organization, and which are of material concern to creditors and debtors. 

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Basic Accounting Terms

Here is a quick review of a few important accounting terms.

Accounting equation: This equation is the foundation for the double-entry system is written as follows:

Assets = Liabilities + Stakeholders’ equity

This indicates that all the assets owned by a company have been financed in the form of loans from creditors and equity from investors. An asset can be in the form of inventory, account receivables, cash, supplies, land, etc., that a company holds.

Accounting methods: Companies can select from two methods—cash accounting or accrual accounting. In cash basis accounting, usually preferred by small businesses, all revenues and expenditures are recorded when the payment is received or sent. In accrual basis accounting, income is recorded on the statement when it is earned and expenses are recorded when incurred.

Account receivable: The sum of money due to a firm by its customers after goods or services have been delivered and/or used.

Account payable: The amount of money owed by a firm to its suppliers/creditors, etc.; in return for goods and/or services they have delivered.

Accrual accounting: See “accounting methods.”

Assets (fixed and current): Current assets are assets that will be used within one year or the current operating cycle.

inventory, accounts receivable and cash are examples of current assets (see above).

Fixed assets (or non-current) may provide long term benefits to a company—for example, land and machinery.

Balance sheet: A financial report that indicates the company’s assets and liabilities and owner’s equity at a given period of time.

Capital: It is a financial asset and it can include funds in the form of deposits, machinery, goods, etc. to support a business. The working capital of a business is the difference between current assets and current liabilities.

Cash accounting: See “accounting methods.”

Cash flow statement: It is a financial statement of a business that indicates the balance between the amount of cash earned and the cash expenditure incurred.

Credit and debit: A credit is an accounting entry that either decreases an asset/expense account or increases a liability/equity account. This entry is made on the right side of an accounting entry.

A debit on the other hand, is an accounting entry that either decreases a liability/equity account or increases an asset/expense account. This entry is made on the left side.

Double-entry bookkeeping: According to the concept of double-entry bookkeeping, each transaction always affects two accounts, involving a credit in one account and a debit in another.

For example, a retailer that collects Rs. 20,000 in cash from a customer makes this entry in the revenue credit side and also in the cash debit side. In case the customer has been offered the service on credit, this entry is made in “account receivable” (Also see “single-entry bookkeeping,” below.)

Financial statement: A financial statement is a document that indicates the financial transactions of a business or a person. There are three most vital financial statements for businesses. These are the balance sheets, cash flow statements, and profit and loss statements (all three listed here alphabetically).

General ledger: A complete record of financial transactions spread over the entire lifecycle of a company.

Journal entry: An entry in the journal that records financial transactions as per chronological order.

Profit and loss statement (income statement): A financial statement that summarizes a company’s performance by analyzing revenues, costs, and expenses during a particular time.

Single-entry bookkeeping: This accounting principle is mainly used by small-time dealers and vendors. The incomes and expenses are recorded using both daily and monthly summaries of cash receipts and disbursements. (Also see “double-entry bookkeeping,” above.)

Types of accounting: Financial accounting features information about a company’s performance to investors and credits. Management accounting provides financial data to managers for the purpose of business development and growth.

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