The Purpose of Accounting (Copy)

1. The Fundamentals of Accounting

1.1 The Purpose of Accounting

Book-keeping vs Accounting

• Book-keeping:
  • Book-keeping is the process of recording financial transactions in the books of accounts.
  • It involves maintaining systematic records of:
    • Sales and purchases
    • Receipts and payments
    • Income and expenses
    • Assets and liabilities
  • It is a sub-part of accounting and does not involve analysis or interpretation.
  • Performed regularly by bookkeepers, often using source documents like receipts and invoices.
  • Objective: Ensure accurate and complete records.

  Example:

  • Recording the sale of goods worth $500 to a customer in the sales journal.
  • Entering a bank deposit into the cash book.
• Accounting:
  • Accounting is a broader process that includes book-keeping plus:
    • Classification of transactions
    • Summarising the data
    • Analysis and interpretation
    • Reporting financial performance and position
  • Produces useful information in the form of financial statements (e.g. income statement, balance sheet).
  • Used by management, investors, tax authorities, and other stakeholders for decision-making.
  • Objective: Provide meaningful financial information for stakeholders.

  Example:

  • Preparing an income statement to determine if the business made a profit or a loss.
  • Using balance sheet data to evaluate liquidity and solvency.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Accounting Full Scale Course

Purposes of Measuring Business Profit and Loss

• To Determine Business Performance:
  • Knowing if the business is profitable or making a loss helps assess its success.
  • This is primarily done using the Income Statement (Trading and Profit & Loss Account).
• To Make Comparisons:
  • Compare current year’s profit/loss with previous years.
  • Compare with competitors or industry benchmarks.
• To Calculate Tax Liabilities:
  • Profits form the basis of income tax or corporate tax calculations.
• To Evaluate Return on Investment (ROI):
  • Investors use profit figures to assess if they are getting adequate returns.
• To Support Loan Applications:
  • Banks and lenders assess profitability to judge whether a business is creditworthy.
• To Decide on Dividends:
  • Owners/shareholders decide how much profit to retain or distribute.
• To Control Costs and Expenses:
  • Analysing profit and loss helps identify unnecessary expenditures and areas for cost-cutting.
• To Plan for Growth:
  • Accurate profit data helps in strategic planning, reinvestment, and business expansion.

Example:

• A business made a net profit of $20,000. The owner may use this to:
  • Pay $10,000 as dividends
  • Retain $10,000 for reinvestment

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Accounting Full Scale Course

Role of Accounting in Monitoring Progress

• Provides Financial Reports:
  • Income Statement, Balance Sheet, and Cash Flow Statements track progress over time.
  • Enables tracking monthly, quarterly, or yearly performance.
• Supports Budgeting:
  • Historical accounting data helps in setting budgets and future financial goals.
• Tracks Cash Flow:
  • Helps identify if business is managing cash well (inflows vs outflows).
  • Liquidity management becomes easier.
• Monitors Asset Growth or Reduction:
  • Tracks changes in inventory, debtors, equipment, and capital.
• Helps Detect Errors and Fraud:
  • Regular and accurate accounting helps spot discrepancies, missing funds, or unauthorised transactions.
• Assists with Tax Compliance:
  • Accurate records ensure the business stays compliant with government tax laws and filing deadlines.

Example:

• If monthly profit is dropping, business can investigate:
  • Increase in expenses
  • Drop in sales
  • Inventory shrinkage
  • Staff inefficiency

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Accounting Full Scale Course

Role of Accounting in Decision-Making

• Helps with Strategic Decisions:
  • Example: Should the business expand to a new market?
• Assists in Pricing Decisions:
  • Knowing costs allows for setting a price that ensures profit.
• Aids Investment Decisions:
  • Business can decide which asset or project to invest in based on expected returns.
• Enables Cost Control:
  • Identifying high-expense areas and finding cheaper alternatives.
• Supports Hiring and Operational Choices:
  • Can the business afford new staff?
  • Is there a need for new machinery?
• Improves Supplier and Customer Decisions:
  • Which suppliers offer better credit terms?
  • Which customers are profitable or risky (based on debtor days)?

Example:

• Business sees high sales but low profit — may decide to:
  • Reduce operating costs
  • Increase selling price
  • Replace high-cost suppliers

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Accounting Full Scale Course

Summary Table: Book-Keeping vs Accounting

Uses of Accounting Information by Stakeholders

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Accounting Full Scale Course

Application Example

Scenario:
A small bakery is considering opening a second branch.

Use of Accounting Information:

• Review income statements to check if profits are sufficient.
• Analyse cash flow to see if there is spare cash.
• Compare fixed and variable costs to predict expenses for the new branch.
• Forecast expected revenue from sales based on past trends.

Decision Outcome:

• If profit and cash flows are strong, they can go ahead.
• If margins are tight, delay expansion or look for cheaper locations.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Accounting Full Scale Course