Accounting Explained for Dummies

What is accounting?

Essentially, accounting is the process of recording and reporting financial transactions and financial information about a business.

Accounting is essential for almost any business, enabling management to make meaningful business decisions.

The accounting process is executed by following an accounting cycle which is a holistic process comprising eight steps, starting with ‘identifying transactions’ and ending with ‘closing the books’ for the specific accounting period.[1]

Types of accounting

Basically, accounting encompasses two main types, namely financial accounting, and management accounting.

However, accounting covers more than the two basic types of accounting. The term also includes more specialised types of accounting, such as:

• Cost accounting.
• Tax accounting.
• Forensic accounting.
• Auditing (external and internal).

Financial accounting

Financial accounting refers to the process of record-keeping of the financial transactions of a business in order to create interim and annual financial statements, such as the balance sheet, income statement, and cash flow statement.

This type of accounting is focused on the past performance of a business, meaning the financial data is historical. By means of the financial statements, external stakeholders such as shareholders and lenders are provided with financial data that reflects the performance of a business over a certain period of time.

In accounting, the recording of financial transactions is based on the double-entry system, requiring that every transaction must be recorded in a minimum of two accounts. One account is debited with a certain amount and the second account is credited with the same amount.

Double-entry accounting is also referred to as balancing the books because all the accounting entries are balanced against each other, keeping the accounting equation (assets = liabilities + owner’s equity) always in balance.

Not for nothing is the financial statement, which reflects the accounting equation of a company, called the balance sheet.

Example of a double-entry:

Let us say company ABC sells goods of R10 000 to a customer. The company’s account for revenue/sales is credited with R10 000 and its cash account is debited with R10 000. (To increase an income account, a credit, is required. To increase an asset, a debit is required.)

Typically, basic accounting functions can be performed by a bookkeeper, while advanced accounting is carried out by qualified accountants. South African accountants can obtain qualifications such as:

• CA(SA) – Chartered Accountant of South Africa.
• CIMA – Chartered Institute of Management Accountants.
• ACCA – Association of Chartered Certified Accountants.
• CIA – Certified Internal Auditor.

Financial statements have to be prepared according to generally accepted accounting principles (GAAP). Regardless the type of company, the purpose of GAAP is to ensure that the financial situation of a company is communicated in an understandable manner, consistently applying the following ten general GAAP principles:

1. Principle of sincerity: Accountants are obliged to maintain standards of honesty and accuracy, depicting an impartial and accurate picture of a company’s financial situation.
2. Principle of regularity: Accountants are required to follow GAAP guidelines and regulations at all times.
3. Principle of consistency: Accountants have to apply the same standards in their financial reporting in order to ensure consistency and financial comparability between reporting periods. Changes in standards have to be fully disclosed and explained in the footnotes to the financial statements.
4. Principle of non-compensation: Accurate reports, comprising positive and negative financial information, should be reported without the expectation of extra compensation for publishing accurate reports.
5. Principle of permanent methods: Accounting procedures and techniques used in financial reporting should be consistent, enabling comparisons of a company’s financial facts and figures.
6. Principle of prudence: Financial data have to be based on facts that are not tarnished by speculation.
7. Principle of periodicity: Transactions should be recorded and reported in their relevant accounting periods, such as monthly, quarterly, and annually.
8. Principle of continuity: Valuations of assets should be based on the assumption that the particular business will continue to operate in the future.
9. Principle of materiality: Financial reports provided by accountants must fully disclose all the accounting information and financial data pertaining to a company’s operations.
10. Principle of good faith: All parties involved in the recording of financial transactions and in the reporting of financial information, are required to act honestly and in good faith in all circumstances.

Regarding companies registered in South Africa, the Companies Act (Act 71 of 2008), hereafter referred to as the Act, states in section 28, among other regulations, the following about a company’s accounting records:

• ‘A company must keep accurate and complete accounting records in one of the official languages’[2] of the country.
• Accounting records must be kept in the prescribed manner and form.
• ‘A company’s accounting records must be kept at, or be accessible from, the registered office of the company.’

Methods of financial accounting

Financial accounting comprises two methods: cash and accrual.

Cash method

The cash method uses double-entry accounting to record financial transactions and is a simpler method than the accrual method.

Basically, when a company receives money, income (revenue) is recorded. When money is spent by a company, the expenses are recorded.

Only small businesses use the cash accounting method.

Accrual method 

In accrual accounting, double-entry accounting is also used to record financial transactions. However, revenue is recorded when it is earned (i.e., the company has a right to the income), not when the money is actually received.

Put differently, the accrual accounting method recognises economic transactions regardless of when the cash transactions take place.

For example, a company can invoice a customer for goods or services, even if the client has not yet paid for the goods or services, the income is still recorded in the accounting system.

By following the matching principle, expenses are recognised and recorded in the same period as revenue.

An expense incurred, that is yet to be paid, will be recognised in the accounting records on the same day the expense arises.

Typically, a company obtaining goods or services via credit is required to report the liability no later than the date the goods or services were received.

Accrual accounting is considered the standard financial accounting method for most companies. Public companies are required to use the accrual method.

Management accounting

The purpose of management accounting, also referred to as managerial accounting, is to provide data about the operations of a company to the various managers and directors.

In management accounting, accountants generate reports on a weekly, monthly, or quarterly basis, enabling managers and management teams to make informed decisions about a company’s operations and financial position.

Managerial accounting includes other aspects of accounting such as budgeting, planning, and various financial tools like analysis and ratios.

Typically, three types of management accounting are used by companies:

• Performance
• Strategic
• Risk

Depending on the circumstances, the three types may be used simultaneously, or management may decide to use only one or two of the methods.

Cost accounting

Cost accounting is considered a type of management accounting, allowing management to make decisions about the cost of products.

It is a type of accounting for the recording and analysing of manufacturing or production costs.

Cost accounting is concerned about both fixed costs, such as rent and insurance, and variable costs like labour, materials, electricity, and maintenance, intending to determine break-even points for particular manufactured goods or products.

Typically, a standard cost accounting system will assign a profitable cost per manufactured item. Put differently, information provided by cost accounting is used by a company’s management to determine at what price the company should sell its products or services.

Usually, cost accounting is applied in manufacturing companies, though it can also be used by service businesses and mega farmers producing items such as vegetables.

Contrary to financial accounting, cost accounting is focusing on future financial aspects, rather than reporting about past performances.

Tax accounting

In South Africa, businesses (including companies), trusts, and individuals are subjected to taxes in terms of the Income Tax Act (Act 58 of 1962). Tax regulations and rates are updated from time to time.

In tax accounting, accountants are responsible to ensure that companies adhere to the various tax laws, regulations, and tax rates.

In addition, tax accounting, among other things, implies that:

• taxes are accurately calculated,
• tax returns are promptly provided to the tax authorities, and
• the tax liability of a company is limited as much as lawfully permitted.

Forensic accounting

Forensic accounting is a specialised type of accounting, combining financial accounting, auditing, and investigative procedures.

Forensic accounting is frequently applied in theft, fraud, and in cases of misappropriation of funds. Forensic accountants are in high demand among attorneys, commissions investigating fraud, police departments, and attorneys.

Forensic accountants are required to reconstruct financial data when the accounting records are incomplete or dubious, decoding fraudulent data or changing a cash-based accounting system into an accrual accounting system.

Forensic accounting is usually performed on a project or contract basis.

Auditing

All qualified financial auditors are accountants. However, not all accountants are financial auditors. There are two types of auditing: external and internal.

External auditing

In South Africa, to eventually become a Registered Auditor, a person is required to successfully complete the following process:

• Earn an undergraduate degree from an academic institution accredited by the South African Institute of Chartered Accountants (SAICA).
• Complete either an honours degree or a postgraduate diploma, referred to as a Certificate in the theory of accounting (CTA). Both postgraduate qualifications have to be accredited by SAICA.
• Complete an internship at a SAICA accredited training office. Duration of internship can vary from 3 to 5 years.
• Write and pass the following two exams of the Independent Regulatory Board for Auditors (IRBA): The Initial Test of Competency (ITC) and the Assessment of Professional Competence (APC). The APC exam can only be written once a candidate has passed the ITC exam.
• A person will be eligible to register as a Chartered Accountant (SA), commonly referred to as ‘a CA’, once he or she has passed the APC exam and successfully completed the required internship.
• Once qualified as a CA, a person will be required to complete an ‘additional internship’, called the Audit Development Programme. During the 18 months of this internship, a candidate will have to prepare a portfolio of evidence, indicating that the necessary competencies have been achieved in order to convince IRBA that the candidate is eligible to be registered as a Registered Auditor.

Concerning South African companies operating under the Companies Act of 2008, section 30 of the Act regulates that the financial statements of public companies and companies owned by the government be audited. Other types of companies, including private companies, are exempt from audits except under certain circumstances and in terms of certain regulations.

In addition, section 90 of the Act states that a public company or state-owned company must appoint an auditor upon its incorporation and each year at its annual general meeting (AGM).

There are different types of audits that can be performed by auditors. For example:

• Financial audit: The most common and frequent kind of audit, designed to provide an independent analysis of the accuracy of a company’s financial statements and to ensure that GAAP standards have been applied.
• Investigative audit: This is done when fraud is suspected or when a company’s financial statements are suspected of misrepresentation. For example, when PwC was appointed to do a re-audit of Steinhoff’s 2017 financial year’s financial statements.
• Compliance audit: A type of audit executed to determine whether a company follows specific internal or regulatory standards.
• Tax audit: Typically, a type of audit done by a tax authority’s auditors to obtain additional information regarding tax claims or tax queries.

Internal auditing

The Institute of Internal Auditors South Africa (IIA SA) is part of the Institute of Internal Auditors (Inc.), an international network that represents the interests of Internal Auditors worldwide.

The IIA SA defines internal auditing as ‘an independent, objective assurance and consulting activity designed to add value and improve an organisation’s operations. It helps an organisation accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.’

Internal audits enable the management of a company to correct flaws in the accounting process prior to external audits.

In South Africa, to obtain the Certified Internal Auditor (CIA®) designation to become an Internal Audit Professional, a person must meet all the eligibility requirements set by IIA SA.[3]

[1] See the article, ‘The Accounting Cycle – Explained for Dummies’, for more information about the accounting cycle.)

[2] Accentuations in citations are also from the article writer.

[3] For more information about the eligibility requirements, refer to the website of the Institute of Internal Auditors South Africa – iiasa.org.za