The Nitty-Gritty of Accounting

By: Sam Kern

Accounting is as ancient as man's attempts to transact with fellow human beings. With the predominance of money measurement in economically useful activities, accounting became the most vital tool. At the center of all accounting principles is the urge to ensure accuracy and consistency. This takes the form of double entry system of accounting. The 15th century Italian mathematician, Frater Luca Pacioli, first extolled about the features of the system.

Double entry method offers a convenient and accurate format for recording transactions. Put simply, all transactions have two aspects. Therefore, omissions or numerical errors would automatically stand out. Thus, it acts as a self-correcting mechanism.

The basic aspects of accounting relate to correct classification of transactions. There are four major accounting heads: assets, liabilities, revenues and expenses. At any given point of time, the firm's assets should equal its liabilities. This is the accounting equation. If they do not match, there is an apparent error in the accounting process.

The enterprise's assets represent the productive resources used by it. Plant and Machinery, building, stock of raw materials and stores, debtors or accounts receivables, cash and bank balances are some of the assets. Liabilities are the sources that finance the assets. Owner's capital, long-term loans, short-term bills, sundry creditors and other financing are the liabilities.

When revenues exceed expenses, the firm makes a profit and in the reverse it is a loss. Ultimately, profit or loss reflects in the financial position or the values of assets and liabilities on the given date. An increase in assets or decrease in liabilities means profit and decrease in assets or increase in liabilities mean loss.

Profit is the driver in any business enterprise and no wonder entrepreneurs seek to maximize it. More critical than profit is the measure of profitability because the latter reveals the firm's efficiency in utilization of financial resources. Return on Investment is the most common profitability ratio. The claim over profits of a business depends on the organizational type. In ownership or partnership firms, the owner or partners have total claim over the profit. In joint stock companies, the stockholders are entitled only to the dividend as declared by the board of directors.

The work of an accountant is crucial as he reports the performance of the enterprise to the management and the owners. Based on the figures supplied by him, important decisions like capacity expansion, make or buy, retaining or hiving off unprofitable lines of business and employee incentive computation are taken.