Chapter 1: Accounting and Business Environment

Introduction

According to real business environment, all students of administrative sciences need to know accounting. Because, you have to read financial statements and understand the meaning of accounting numbers in order to know your business and make effective and efficient decisions. Accounting is a complex and sophisticated task. It is critical to success and gaining competitive advantage for any type of organizations.

Individual decision makings also need accounting. Accounting is one of the most important aspects of being financially literate which refers the knowledge, skills, and confidence to make responsible financial decisions. Therefore, without knowing the meanings of accounting numbers, you cannot define yourself as financially literate.

Accounting Information: Basic Activities and Information Users

In a general sense, Accounting is an information system which provides financial information about the entity for decision makers. This system includes three kinds of basic activities which are identifying, recording and communicating of the financial transactions of an entity.

Basic Activities in Accounting Process

The first step of the accounting process consists of identifying the financial transactions related with the organization. Once the financial transactions are realized and identified in Turkish Liras or in another currency, these events are recorded to provide the history of financial activities of the organization. Recording is a systematic way of keeping chronological diary of events measured in monetary unit. At the last step, company communicates the summarized information obtained from the records to decision makers (information users) by using standardized reports which are called financial statements.

Information Users

The accountant must be clear for whom the information is being prepared and for what purpose the information will be used. There are likely to be various information users such as owners, managers, creditors, suppliers etc. You should understand the needs of users because information users focus on different financial information according to their relevant decisionmaking issues. Two main groups of information users are internal users and external users. The primary external users are investors and creditors, because they have a direct financial interest in a business.

Financial accounting provides financial information to meet the information needs of external information users. Managerial accounting provides financial information to meet the information needs of managers.

Ethical Behavior, Measurement Principles and Basic Assumptions

Since the financial information plays a critical role in decision making, the financial information must be sufficient, useful, and understandable. Like other professions accounting also has a theory consisting of principles, assumptions and standards. Therefore, accountants follow certain rules, principles, assumptions, and standards in financial accounting process. Beside the specific rules, the quality of financial information primarily depends on ethical behavior of individuals.

Ethics are the humanly devised rules, procedures, and norms to judge one’s action as right or wrong, honest or dishonest, and fair or not fair.

The rightness of an action generally depends on the skills and knowledge of the accountant. In other words, the possibility of making a mistake, for instance in classifying or measurement of financial transactions, will be low if the accountant of a company has sufficient skills and knowledge.

Honesty refers to a facet of moral character.

Standardization

Accounting standards are a set of principles companies follow when they prepare and publish their financial statements, providing a standardized way of describing the company’s financial performance.

• Many countries except United States have adopted the International Financial Reporting Standards (IFRS) issued by International Accounting Standards Board (IASB).
• The Financial Accounting Standards Board (FASB) is the primary accounting standardsetting body in the United States and issues Financial Accounting Standards that are called Generally Accepted Accounting Principles (GAAP) which is a common set of standards used by accountants in United States.

Measurement Principles

Measurement refers to the valuation of assets and liabilities in accounting process. Standards generally use one of two main principles in measurement: Historical cost principle or fair value principle. The historical cost principle states that assets are recorded at their cost. The fair value principle states that assets and liabilities are reported at their fair value.

The relevance of fair value and necessity of faithful representation are the main factors used in determining which measurement principle to apply. Relevance refers the impact capacity of financial information generated by an accounting system on the decisions of information users. Therefore, relevance also contains materiality concept which is the universally accepted accounting principle that all material matters are to be disclosed. Faithful representation means the factuality of financial statements.

Effective financial reporting aims to provide faithful representation, and so the level of the relevance of accounting information affects the factuality of financial statements.

Basic Assumptions

Assumptions provide the main conceptual frame of accounting information system. In general, as a basic step, we have to be aware of some basic assumptions to understand the nature of accounting activities. The main assumptions are the monetary unit assumption, the economic entity assumption, and the going concern assumption.

• The monetary unit assumption requires that financial transactions can only be recorded if the transaction data can be expressed in money terms.
• The economic entity assumption requires that the financial transactions of the entity should be recorded separately from the economic activities of its owner and all other economic entities.
• The going concern assumption assumes that the business entity will remain in operation forever. Under the going-concern concept, unless there is evidence to the contrary, accountants assume that the business will remain in operation long enough to use existing assets for their intended purpose

Basic Accounting Equation and Elements of Financial Statements

The basic accounting equation provides the underlying framework for recording and summarizing the financial transactions of a business entity. It shows the relationship among assets, liabilities, and owner’s equity. Assets are on the left side of the equality while liabilities and owner’s equity are on the right side of the equality. But the left side of the equality will alvays be equal to the right side of the equality.

There are three elements which reflect the financial situation of an organization: Assets, liabilities, and owner’s equity.

• Assets are economic resources that are expected to benefit the business in the future.
• Liabilities are debts that are owed to creditors. Liabilities are claims of creditors against to assets of the company.
• Owner’s equity is the owner’s claims to the assets of the business

There are four main factors which increase or decrease the level of owner’s equity: Contributions by owner(s), distributions to owner(s), revenues and expenses.

• Contributions by owner are the assets put in the business by the owner.
• Distributions to owner are withdrawals of cash or other assets by the owner for personal use.
• Revenues are the gross increase in owner’s equity resulting from business activities entered into for the purpose of earning income.
• Expenses are the cost of assets consumed or services rendered in the process of earning revenue.

The net effect of revenues and expenses on owner’s equity occurs by calculating the net income or loss. Net income results when revenues exceed expenses and loss results when expenses exceed revenues. In this sense, net income increases owner’s equity while loss decreases owner’s equity. Therefore, net income or loss is the financial result of the performance of a business in a given period.

Effects of Financial Transactions on the Accounting Equation

A financial transaction is any event that affects the financial position of the business and can be measured with faithful representation. Transactions may be identified as either external or internal transactions.

• External transactions are realized between the company and a third party (an outside enterprise). Sale of goods to customers is an example of external transaction.
• Internal transactions refer financial transactions which occur entirely within one company. The use or consume of raw materials for the production is an example of internal transaction.

Accountants must analyze each economic event before recording whether it suits the monetary unit assumption and affects the items of accounting equation. This process is called as identification of transaction.

Dual effect means that at least two items must be affected by a transaction and accounting equation has to remain in balance after making the changes in accounting equation.

Financial Statements

Financial statements are the business documents that are used to communicate financial information needed in decision making process.

Comparability is extremely important for information users because it makes them enable to compare company’s performance over different accounting periods or with other companies. Therefore, accounting produces financial statements to inform information users in standardized way. There are four main financial statements prepared by using summarized accounting data: Income statement, owner’s equity statement, balance sheet and statement of cash flows.

• Income statement reports the revenues and expenses and resulting net income or loss of a company for a specific period of time.
• Owner’s equity statement details the changes in owner’s equity over an accounting period.
• Balance sheet reports the assets, liabilities, and owner’s equity of the business at a specific date.
• Statement of cash flows summarizes information concerning the cash inflows (receipts) and outflows (payments) for a specific period of time.

Accountants should follow an order to prepare the four financial statements. Because they need to calculate net income or loss to prepare owner’s equity statement, need to calculate closing balance of owner’s equity to prepare balance sheet and need the balance amount of cash item reported in balance sheet to check the accuracy of the closing balance of statement of cash flows.