Accounting Terminology and Definitions
Businesses operate with the aim of achieving their objectives, particularly the primary goal of maximizing value for their owners. Accounting serves as the means to measure, interpret, and communicate the outcomes of economic activities, maintaining a systematic and accurate record of business transactions. This information, generated through accounting, proves crucial for decision-making at various organizational levels and is accessed by both internal and external stakeholders.
According to the ICMA, accounting is defined as the process of identifying, classifying, measuring, recording, and communicating transactions and events of an economic entity in monetary terms. There are three main types of accounting, each serving distinct user groups:
A. Financial accounting produces information for external users, including creditors, shareholders, potential investors, and other stakeholders. It adheres to the country-specific Generally Accepted Accounting Principles (e.g., US GAAP) or the International Financial Reporting Standards. Financial accounting and reporting standards may vary across countries, and they undergo periodic changes. Internal managers, owners, shareholders, potential investors, creditors, lenders, banks, suppliers, and other entities such as government agencies and advocacy groups utilize financial reports for decision-making, evaluation, investment decisions, credit rating assessment, lending decisions, and various individual purposes.
B. Managerial (or management) accounting generates information for internal users to facilitate managerial decision-making. Unlike financial accounting, managerial accounting is consistent across countries and has not undergone significant changes over time. The ICMA defines managerial accounting as the process of identifying, measuring, accumulating, analyzing, preparing, interpreting, and communicating financial information for internal decision-makers. This aids in planning, evaluating, controlling entities, and ensuring appropriate resource use and accountability.
C. Tax or statutory accounting and reporting involves the preparation of accounting information for submission to tax authorities, adhering to the applicable tax laws and regulations of local jurisdictions, when applicable. This type of accounting typically goes beyond the requirements of the FMAA.
Forms of Business Organizations
A. Sole Proprietorship: A sole proprietorship is a business where a single individual operates for profit, taking on all losses and retaining all profits.
- For tax and legal purposes, a sole proprietorship is not considered a separate entity from its owner.
- Its duration is limited to the life of the owner.
- It entails unlimited liability, meaning the owner is personally responsible for any business debt exceeding existing assets.
B. Partnership: A partnership is an association between two or more individuals operating a business for profit.
- The duration of a partnership is limited to the lives of its partners.
- Changes in the partnership structure require the formation of a new partnership.
- Partnerships may have unlimited liability, where partners are personally liable for the partnership’s debt beyond its assets, or limited liability, where partners are not personally liable for debts beyond the partnership’s assets.
- Partnerships can take the form of a general partnership, a limited partnership, or a limited liability partnership.
a. General Partnership:
i. For tax and legal purposes, a general partnership is not considered a separate entity from its owners. ii. It is easy to form and may be established without formal intent. iii. All partners are considered general partners. iv. All partners have unlimited liability.
b. Limited Partnership:
i. A limited partnership must be established according to statute (requiring the filing of a Limited Partnership Certificate with relevant authorities). ii. A limited partnership must include at least one general partner and one limited partner. iii. General partners have unlimited liability. iv. Limited partners have limited liability. v. Ownership interest of limited partners is akin to owning a security. vi. Only general partners are authorized to manage the partnership. vii. A limited partner may not have their name included in the partnership’s name.
C. Limited Liability Partnership (LLP):
i. An LLP must fulfill the requisite statutory requirements. ii. Typically limited to certain professional services (legal, audit, etc.). iii. All partners have limited liability to the partnership’s assets. iv. Each partner may personally have unlimited liability for personal malpractice. v. All partners may share in the management.
B. Corporation is a distinct legal entity from its owners and is the predominant business organization for larger companies. It can take the form of a private corporation, where shares are owned privately, or a public corporation, where shares are publicly traded. Public corporations face heightened scrutiny from governmental bodies such as the Securities and Exchange Commission and the Public Company Accounting Oversight Board in the USA. In the USA, a regular corporation is known as a C-Corporation. Key characteristics of public corporations include:
- It is a legal entity separate from its owners.
- Formation and activities are regulated by state or federal legislation.
- Owned by shareholders.
- Shareholders elect the board of directors.
- Management is appointed by the board of directors.
- Has an unlimited life.
- Earnings are subject to double taxation: at the corporate level and personal level.
- Enjoys limited liability.
C. Other Forms of Business Organizations:
- Limited Liability Company (LLC) permits investors limited liability and preferential tax treatment, subject to conditions and restrictions.
- Joint-Venture (JV) is a partnership arrangement between two or more parties for a specified purpose or objective.
- S-Corporation (in the USA) is a corporation not taxed at the corporate level, limited to 75 shareholders, and may issue only one class of stock.
- Professional Corporation is limited to specific licensed professionals.
D. Nonprofit Organizations are entities with objectives focused on public benefit or social causes. They are typically tax-exempt, funded by grants and donations. While they may generate surplus revenues over expenses, profit is not their primary goal. Any surplus is typically reinvested in the organization’s activities.
A. Assets represent probable future economic benefits controlled or obtained by a specific entity due to past transactions or events. This category encompasses cash, accounts receivable, inventory, prepayments, and property, plant, and equipment.
B. Liabilities denote potential future sacrifices of economic benefits arising from an entity’s present obligations to transfer assets or provide services to other entities in the future, resulting from past transactions or events. Examples of liabilities include accounts payable, notes payable, taxes payable, and loans payable.
C. Equity, also known as owner’s equity or owners’ equity, is the residual interest in the assets of an entity after deducting its liabilities. Equity typically comprises amounts invested by owners/shareholders and retained earnings, which is income generated by the business but not distributed to owners.
D. Assets have debit balances, increased with a debit (Dr), and decreased with a credit (Cr). On the other hand, liabilities and owners’ equity have credit balances, increased with a credit (Cr), and decreased with a debit (Dr). The concepts of debits and credits.
