MBA (Weekend) Program; 23rd Batch
MKT-503; Principles of Accounting
Principles of Accounting: Lecture 1
Definition and Terms of Accounting
• Definition: Accounting is often called the "language of business." It's a systematic
process of identifying, recording, measuring, classifying, verifying, summarizing,
interpreting, and communicating1 financial information.
o Example: Think about a small coffee shop. Accounting helps the owner track
how much money comes in from selling coffee (revenue), how much is spent
on beans and milk (expenses), and ultimately, whether the shop is making a
profit.
• Key Terms:
o Transaction: Any business event that has a monetary impact on the financial
statements of an organization.
▪ Example: Selling a cup of coffee, paying rent for the shop, buying a new
coffee machine.
o Assets: Resources owned by a business that have future economic value.
▪ Example: Cash, a delivery van, equipment like an espresso machine,
money owed by customers (accounts receivable).
o Liabilities: Obligations or debts of a business owed to outsiders (creditors).
▪ Example: Loans from a bank, money owed to suppliers (accounts
payable), salaries owed to employees.
o Equity (or Owner's Equity/Stockholders' Equity): The owners' claim on the
assets of the business. It's the residual interest in the assets after deducting
liabilities.
▪ Example: If a business has assets of $10,000 and liabilities of $6,000,
the equity is $4,000.
o Revenue (or Income): The inflow of assets (or reduction of liabilities) from
delivering or producing goods, rendering services, or other activities that
constitute the entity's ongoing major or central operations.
▪ Example: Money earned from selling coffee and pastries.
o Expenses: The cost of assets consumed, or services used in the process of
generating revenue.
▪ Example: Cost of coffee beans, employee salaries, rent, electricity
bills.
o Profit (or Net Income): The excess of revenues over expenses during an
accounting period. If expenses exceed revenues, it's a Net Loss.
▪ Example: If the coffee shop earned $5,000 in revenue and had $3,000
in expenses, the profit is $2,000.
The Accounting Process
The accounting process (also known as the accounting cycle) is a series of steps followed to
record and report financial information. The basic steps are:
1. Identifying Transactions: Recognizing recordable business events.
o Example: A customer pays for a book.
2. Recording Transactions: Documenting transactions in chronological order, usually
in a journal. This is often called bookkeeping.
o Example: Recording the date, accounts affected (e.g., Cash and Sales
Revenue), and amounts for the book sale.
3. Posting: Transferring journal entries to the appropriate accounts in the ledger. A
ledger is a collection of all accounts for a business.
o Example: The cash received from the book sale is added to the 'Cash' account
in the ledger, and the revenue from the sale is added to the 'Sales Revenue'
account.
4. Trial Balance: Preparing a list of all accounts and their balances at a specific point in
time to check if total debits equal total credits. (We'll cover debits and credits in detail
later!)
o Example: Listing all assets, liability, equity, revenue, and expense account
balances to ensure the accounting equation (Assets = Liabilities + Equity)
remains balanced.
5. Adjusting Entries: Making entries at the end of an accounting period to record
revenues and expenses that haven't been recorded yet but belong to the period.
o Example: Recording the depreciation expense for equipment used during the
period.
6. Adjusted Trial Balance: Preparing a new trial balance after adjusting entries.
7. Preparing Financial Statements: Creating reports like the Income Statement,
Balance Sheet, and Cash Flow Statement.
o Example: Using the adjusted trial balance figures to create a report showing
the company's profit for the period (Income Statement).
8. Closing Entries: Transferring temporary account balances (revenues, expenses,
dividends) to permanent equity accounts at the end of the period.
o Example: Resetting the Sales Revenue and Rent Expense accounts to zero for
the next accounting period.
9. Post-Closing Trial Balance: A final trial balance prepared after closing entries to
ensure only permanent accounts have balances.
Accounting Information
• Definition: Accounting Information is the financial data about a business that has
been recorded, classified, summarized, and communicated. It helps stakeholders
make informed decisions.
• Characteristics of Useful Accounting Information:
o Relevance: It can make a difference in a decision.
o Faithful Representation (Reliability): It accurately reflects the economic
events it represents; it is complete, neutral, and free from error.
o Comparability: Users can identify similarities and differences between
different companies or over different periods for the same company.
o Verifiability: Different knowledgeable and independent observers could
reach a consensus that a particular depiction is a faithful representation.
o Timeliness: It is available to decision-makers before it loses its capacity to
influence decisions.
o Understandability: It is classified, characterized, and presented clearly and
concisely.
o Example: An investor looking to buy shares in a company would want timely
and reliable information about its profitability (Income Statement) and
financial position (Balance Sheet) to make an informed investment decision.
Users and Uses of Accounting Information
There are two main categories of users of accounting information:
1. Internal Users: Individuals inside the organization who plan, organize, and run the
business.
o Examples:
▪ Management: To make decisions about planning (e.g., setting
budgets), controlling (e.g., comparing actual results to budgets), and
evaluating performance (e.g., assessing profitability of a product line).
▪ Employees: To assess the company's profitability and stability, which
can affect their job security and compensation.
▪ Owners (in closely held businesses): To determine the success and
future prospects of their investment.
o Uses: Developing strategic plans, setting goals, evaluating employee
performance, determining price points for products.
2. External Users: Individuals and organizations outside the company who want
financial information about the company.
o Examples:
▪ Investors (Current and Potential): To decide whether to buy, hold, or
sell shares of a company. They are interested in the company's earning
potential and financial health.
▪ Creditors (e.g., Banks, Suppliers): To assess the company's ability to
repay its debts.
▪ Government and Regulatory Agencies (e.g., Tax Authorities): To
ensure compliance with tax laws and other regulations.
▪ Customers: To assess the stability and long-term viability of a
business, especially if they rely on it for products or services.
▪ Public: To understand a company's impact on the economy,
environment, and society.
o Uses: Making investment decisions, extending credit, assessing tax liabilities,
ensuring regulatory compliance.
Accounting Systems
• Definition: An Accounting System is the set of methods, procedures, and controls
that an organization uses to collect, record, process, and report financial data. It can
be manual or computerized.
o Manual System: Transactions are recorded by hand in journals and ledgers.
Suitable for very small businesses with few transactions.
▪ Example: A freelance writer might use a simple spreadsheet or a
physical ledger book.
o Computerized System: Uses accounting software to process transactions.
More efficient, accurate, and can handle large volumes of data.
▪ Example: Small businesses might use software like QuickBooks or
Xero, while larger corporations use sophisticated Enterprise Resource
Planning (ERP) systems like SAP or Oracle.
Financial Accounting Information
• Definition: Financial Accounting is the branch of accounting focused on preparing
financial reports for external users like investors, creditors, and regulatory agencies.
It follows a standardized set of rules and principles known as Generally Accepted
Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).4
• The primary output of financial accounting are the financial statements. The main
financial statements are:
1. Income Statement (or Profit and Loss Statement): Reports a company's
financial performance (revenues, expenses, and profit/loss) over a specific
period.
▪ Example: "For the Year Ended December 31, 2024, Company X had
Revenues of $500,000, Expenses of $350,000, resulting in Net Income
of $150,000."
2. Balance Sheet (or Statement of Financial Position): Presents a snapshot of
a company's assets, liabilities, and equity at a specific point in time. It shows
what a company owns and owes.
▪ Example: "As of December 31, 2024, Company Y had Assets of
$1,000,000, Liabilities of $400,000, and Equity of $600,000." (Note:
Assets = Liabilities + Equity)
3. Statement of Cash Flows: Shows the movement of cash both into and out of
a company during a specific period. It categorizes cash flows into operating,
investing, and financing activities.5
▪ Example: It would show how much cash was generated from selling
products, how much was spent on new equipment, and how much was
borrowed from a bank.
4. Statement of Changes in Equity (or Statement of Retained Earnings):
Details the changes in a company's equity accounts over a specific period.
Basic Functions of an Accounting System
Regardless of whether it's manual or computerized, an effective accounting system
performs several basic functions:
1. Input: Capturing economic data from source documents (e.g., sales invoices,
purchase orders, checks).
o Example: A sales invoice showing the details of a sale to a customer.
2. Processing: Transforming the raw data into useful information. This involves:
o Journalizing: Recording transactions.
o Posting: Transferring to ledger accounts.
o Summarizing: Aggregating data (e.g., preparing a trial balance).
o Example: Recording all sales invoices for the month and then totaling them to
get the total sales revenue.
3. Output: Communicating the processed information to users, primarily through
financial statements and other reports.
o Example: Generating an Income Statement at the end of the month.
4. Storage: Keeping a historical record of financial data. This is crucial for audits, tax
purposes, and future reference.
o Example: Storing past years' financial statements and supporting documents
electronically or in physical files.
5. Control: Implementing procedures to ensure the accuracy and integrity of financial
data and to safeguard assets.
o Example: Requiring two signatures on checks over a certain amount, or
restricting access to accounting software.
Designing and Installing an Accounting System
Developing or choosing an accounting system involves several considerations:
1. Analyze Needs: Understand the specific information needs of the business and its
users. Consider the size and complexity of the business, the volume of transactions,
and regulatory requirements.
o Example: A multinational corporation will have vastly different needs than a
local bakery.
2. Design the System:
o Determine the chart of accounts (a list of all accounts used by the business).
o Establish procedures for collecting, processing, and reporting data.
o Select appropriate technology (software, hardware).
o Example: Deciding which specific expense accounts are needed (e.g., 'Rent
Expense', 'Utilities Expense', 'Office Supplies Expense').
3. Implementation and Installation:
o Set up the software and hardware.
o Transfer data from any old system.
o Train employees on how to use the new system.
o Test the system thoroughly.
o Example: Training sales staff on how to enter sales transactions into a new
point-of-sale system that integrates with the accounting software.
4. Monitoring and Review: Continuously monitor the system's effectiveness and make
adjustments as needed. Ensure it remains relevant as the business evolves.
o Example: Regularly reviewing internal controls to prevent fraud or errors.
External Financial Reporting
• Definition: External Financial Reporting is the process of communicating financial
information to parties outside the organization. This is primarily done through the
financial statements we discussed earlier (Income Statement, Balance Sheet, Cash
Flow Statement, Statement of Changes in Equity).
• Key Objectives:
o Provide information useful for making investment and credit decisions.
o Provide information useful in assessing future cash flows.
o Provide information about an enterprise's resources (assets), claims to those
resources (liabilities and equity), and the changes in them.
• Regulatory Framework: External financial reporting is governed by accounting
standards (like GAAP in the U.S. or IFRS internationally) to ensure consistency,
comparability, and reliability. Publicly traded companies are usually required by law
to file their financial statements with regulatory bodies (e.g., the Securities and
Exchange Commission - SEC in the U.S.).
o Example: Apple Inc. publicly releases its quarterly and annual financial
statements, prepared according to GAAP, which are then analyzed by
investors and financial analysts worldwide.
