Accounting: An Introduction (Chapter 1)-The World of Accounting

Think tank
All professions arose from a need for certain services. In the book you will
meet Wayde from Wayde Sports Suppliers. Wayde has his own business but
he does not know if he is making a profit. Actually, he has no idea what is
going on in his business financially. Wayde requires the services of an accountant as he has
not had accounting at school and wonders how it originated.

1.1 Accounting in society

Human knowledge may be classified into three broad disciplines - biological sciences (for
example, biology and physiology), physical sciences (for example, physics and chemistry)
and social sciences (for example, psychology and economics). Accounting forms part of the
economic sciences and is thus a discipline of the social sciences.
There are various definitions of accounting, but in our view the following description
embraces the essence of it: The practice of and knowledge of systematically identifying,
measuring, recording and reporting of quantitative information, which is primarily financial
in nature, concerning economic activities of entities.
It is important that the information provided by the accounting process is relevant, reliable,
comparable and understandable for users worldwide. Therefore, there are certain
guidelines with which one must comply. These guidelines are the set of assumptions,
concepts, principles, methods and procedures, policy factors and standards jointly known
as Generally Accepted Accounting Practice (GAAP) that were developed internationally by
the accounting profession. Most of these standards are currently reflected in the
International Financial Reporting Standard (IFRS). The treatment of accounting in this
textbook is based on GAAP with reference to IFRS made throughout the book.

1.2 Historical background of the development of accounting

1.2.1 Origin
In order to understand accounting in its true perspective, and to appreciate the role it
plays in society, it is necessary to study its historical development. History does not only
provide for what exists today, it also gives clues as to what developments are expected in
the future.
Modern accounting, in the form of the double-entry system, has its origins in Italy towards
the end of the 13th century.
In accordance with the double-entry system, the financial position of an entity is indicated in
terms of the equation: Assets=Equity (Interest of owners) + Liabilities (Interests of
outsiders).
The chain of circumstances that created the right climate for the development of a system
that today, after seven centuries, is still the basis of modern accounting, commenced earlier
than the 13th century.
1.2.2 Earlier developments

1.2.2.1 The Roman Empire

The world of accounting 3
Around 100 BC the Roman Empire stretched from Spain in the west to the Caspian Sea and
the Persian Gulfin the east, and from Britain in the north to Egypt in the south. The various
areas were linked to Rome by some 80 000 km of roads that were originally built for
military purposes but which soon supported the extensive trade between Rome and its
provinces.
The nature and extent of the commercial and related business activities in the Roman
Empire created a need for a reasonably refined bookkeeping system. The head of every
Roman household kept a set of bookkeeping records. The most important of these was
originally a simple record of cash receipts and cash payments.
Later on, debt transactions were also recorded in such a way that amounts owed by
debtors and amounts owed to creditors could be determined independently. Although the
records were not kept in accordance with the double-entry system, the debt transactions
were, even in those days, recorded in practically the same way as they would be centuries
later when they were recorded within the framework of a double-entry system.
Where large investments were made, it was the practice of the Romans to appoint in-
vestment managers who were required to keep special investment registers. This was a
situation in which a responsible person was accountable to a principal with regard to the
management of the principal's investments. This undoubtedly created a need for a record-
keeping system, and for reporting on assets that earned revenue and consequently
influenced the equity of the owner of the assets.

1.2.2.2 The Renaissance

The Italian city-states, which had been involved in trade with the East since the Roman era,
provided the transport and other service facilities to serve the growing trade between East
and West. These cities consequently developed into powerful centres of commerce and by
the 13th century were on the crest of a wave of prosperity. Commerce and the related
economic activities that are necessary to support large-scale trading activities, such as
manufacturing, banking and transportation, were the most important activities of the
inhabitants of the Italian states. As opposed to the feudal system era, in which capital lay
unproductively in castles and luxury status symbols, capital was productively applied in
these Italian cities to stimulate commerce. Fortunes were made and reinvested. The
economic boom also led to a social revolution. The entire population participated in the
development and the medieval feudal system was replaced by a monetary economy based
on private ownership of property.
Business methods in these flourishing centres of commerce were revolutionarily different
from those under the feudal system. In the first place, the volume of trading activity
increased. The traditional one-man business was replaced by family partnerships and
other types of organisations. By approximately 1200 AD, the so-called capitalist system of
commerce had begun to replace the medieval monetary system in Italy and wealthy
entrepreneurs were providing materials, tools and operating capital for individual
tradesmen who manufactured goods under the control and for the account of the
entrepreneur.
Credit transactions began to play an ever more important role and by the 13th century
the Italian bankers were the most prestigious in Europe.
Early in the 13th century Arabic numbers and computing methods were introduced to Italy.
In Italy, therefore, circumstances, and the time were ripe for the further development of a
bookkeeping system whereby entrepreneurs could keep pace with the financial results of
their activities and financial relationships with outsiders, and exercise control over their
assets and the handling of their interests. The need arose for a system suitable for the
recording of large volumes of business transactions, and that could process the recorded
data in such a way that, firstly, all the detailed day-ta-day financial information necessary
for the management of a business entity was readily available and, secondly, an overall
picture of the entity's financial position and results could be obtained. This gave birth to the
double-entry system.
The oldest double-entry records that have been traced are those of the Massari of Genoa,
dating from 1340. The system was already established in 1340, and indications are that it
was in use in Genoa from 1327 onwards. The oldest extant double-entry records from
Venice date back to 1406 . The firm, Francesco del Bene, wool processors of Florence, had
already developed a double-entry cost-accounting system for manufacturing activities by
1318.
Up to approximately 1500 the double-entry system was mainly used exclusively in Italy;
thereafter it spread throughout Europe.

1.2,2.3 Luca Pacioli

Benedetto Cotrugli was probably the first writer on accounting. He completed a work on
the commercial function in 1458 and in one chapter presented a brief discussion of
bookkeeping. However, the work was published only some time later. The first published
work was the full description of the double-entry system by Luca Pacioli in his Summa de
arithmetica geometria proportioni et proportionalitate that was published in Venice in
1494. His Summa, which was a mathematical work, contained a section on the Venetian
method of double-entry bookkeeping. Pacioli was an eminent sage and in the course of his
career he served as professor of mathematics at various universities in Italian cities. From
1514 onwards he was professor at the Sapienza in Rome.
In the rest of Europe the first works on double-entry bookkeeping appeared towards the
middle of the 16th century: in Antwerp in 1543, in London in 1547 and in Germany in
1549.
The early literature mainly described the technique of bookkeeping - of how trans-
actions could be recorded in accordance with the double-entry system. The development
of the theory of accounting, the why as opposed to the how, began only in the 19th century.

1.2,2,4 Double-entry bookkeeping after Pacioli

The development of bookkeeping may be divided into three eras:
D The period more than 100 years between 1450 and 1560 when business practices were
more sophisticated than the textbooks and during which authors tried to promote
bookkeeping mechanics as developed by merchants;
1. The period from 1560 to approximately 1800 when major improvements were made to
the bookkeeping model and theoretical research on bookkeeping began, especially with
the emergence of financial statements and the acknowledgement of the entity as being
separate and distinct from its owners;
2. The period after 1850 when manufacturing operations, income tax implementations and
the emerging profession acted as major stimulants.
1.2.3 Later developments

1.2.3.1 The influence of technological development

From the middle of the 18th century a series of technological developments and inventions,
inter alia, that of the steam engine by Watt, ushered in the Industrial Revolution in
England, Europe and the United States of America. These inventions and developments led
to mass production techniques and the erection of factories that replaced the home
industries. Entities became capital intensive and the cost of buildings and equipment, which
had formerly not been an important factor, made up an ever-greater proportion of total
production costs. Far larger volumes of raw materials were handled in order to gain the
benefits of mass production, which meant that rawer materials and finished products were
kept in stock Credit transactions in various forms grew in extent and transport, insurance
and financing services increased in significance. These phenomena led to the development
of cost accounting.
This development process is still in progress. Apart from the usefulness of extracting
information regarding the cost of an entity for the purposes of price and profit
determination, management also needs this information for the purposes of planning and
control.
Management accounting thus developed out of cost accounting.
Technological developments regarding transport and specifically the Internet in the
20th century led to globalisation. With world markets becoming more accessible, companies
were conducting business beyond their countries' borders. There was a growing need
to establish a set of international accounting guidelines and in 2001 the International
Accounting Standards Foundation was formed that today is responsible for the publication
of the IFRS statements.

1.2.3.2 The influence of the development of forms of entities

The development of different forms of entities from sole proprietors, through partnerships
to companies had a great influence on the development of accounting.
1. The sole proprietor
• The records of the ancient Greek or Roman one-man business, squire, church and
state revealed the first traces of accounting responsibility. Here, the accent fell in the
first place on responsibility and the prevention of theft and fraud - so-called stewardship
accounting. Because of the nature of the development of the economy during
the time of the Roman Empire, there was no call for or necessity of calculating a
"profit"; no distinction was made between capital and revenue, and the double-entry
system was unknown.
• The entity concept (the entity as an entity distinct from the owner) had its origin in
the way in which, for example, the Roman slave, charged with the bookkeeping of the
estate, had to render account to his master.
2. The short-term partnership
• During the Renaissance, the partnership in temporary form made its appearance, which
necessitated the determination and division of profits. The short-term partnership usually
consisted of two partners: a senior partner who provided the funds and exercised control,
and a second partner who undertook the journeys and traded the goods.
The profit was calculated after each "entity" or journey, and the senior partner usually
received three-quarters, and the travelling partner one-quarter, of the profits.
3. The long-term partnership
• During the 13th century the primarily short-term partnership of the 12th century
developed into a more permanent partnership, particularly in the overland trade be-
tween Italy and Champagne (France). The immediate consequence was that the entity
concept, equity in the form of capital and retained earnings, and an accurate
division of profits came strongly to the fore. New fields of investment and the expansion of
the size of entities necessitated careful bookkeeping. During the 14th century
one of the larger Italian entities had already created reserves to make provision for
eventualities and adjustments.
• The greatest achievement of the Italian traders, in terms of accounting, was the blending
between the years 1200 and 1400, of the heterogeneous elements in accounting
into an integrated classification (or accounting) system based on the principle of a
double entry for each transaction.
4. Companies
• Early in the 17th century, entrepreneurs had already begun to take an interest in
entities that would require more capital than a single individual or even a partner-
ship could provide. Hence, companies with limited liability were born. These are
organisations that possess a legal personality in their own right, entirely distinct from
the individuals involved in them. The capital of companies with limited liability is
provided by a large number of shareholders who, in proportion to the capital each
has contributed, share in the declared profits of the companies. This notwithstanding, they
are not co-owners of the company's assets, nor are they co-liable for the
commitments of the company; the company is the exclusive owner of its assets and it
alone is liable for its debts.
• This form of entity created particular problems with regard to the protection of the
shareholders who were not involved in the management of the companies.
• The legal prescriptions that were wanting in respect of large, unregistered "share
partnerships", and the possibility of fraud and deceit of shareholders, gave rise to the
first general company legislation in the United Kingdom in 1844.
• The legislation made provision, inter alia, for the keeping of proper books of account
in the form of a cash book, journal and ledger, based on double entry, the drawing up
of statements of financial position, the matching of expenditure with revenue, and
the appointment and duties of auditors. It further prohibited the payment of dividends
other than out of profits earned.
• In 1900, company law in the United Kingdom also made compulsory the annual
auditing of all registered companies, and in 1908 the publication of a statement of
financial position by public companies was made mandatory.
• In the United States of America (USA) a law permitting the formation of companies
was promulgated in New York in 1811. The first modern company law in the USA
was, however, passed in Connecticut in 1837.
Although the development of the forms of entities contributed to the greater structuring of
accounting systems, this development originally resulted from an emphasis on the
determination and division of profits, and on the determination of the owner's equity in an
entity.
However, the requirement of adequate disclosure of information on a company's business
affairs to shareholders of necessity flowed increasingly from the company movement
Requirements that must be met by the financial reports of companies are today generally
The world of accounting 7 prescribed by legislation, in the case of South Africa by the
Companies Act 71 of 2008 together with the Regulations of 2011.

1.2.3.3 The influence of the professional movement

One of the most important stages in the development of accounting was undoubtedly the
emergence and development of the two professions of accountancy and auditing.
Accounting grew rapidly into a specialised discipline, and people began to qualify
themselves in order to enter the field in a professional capacity. The earliest reference to
professional accountants is as old as the literature on the double-entry system.
The formation of professional societies began towards the middle of the 19th century .
The year 1853 saw the establishment of the Society of Accountants in Edinburgh and of an
Institute of Accountants and Actuaries in Glasgow, and during the next two decades a
number of similar societies were formed in England. In 1880, various professional
accountants' societies in Great Britain were amalgamated into the Institute of Chartered
Accountants in England and Wales that developed into one of the most influential
professional accountants' societies.
In the USA, the first society of accountants was founded in New York in 1897 . The Institute
of Certified Public Accountants in the USA is one of the largest and most influential
professional societies today.
An important phase in the development of various professional societies was the decision to
make recommendations on accounting practice to members. In 1935, the American
Accounting Association decided to formulate basic principles applicable to financial
statements. In 1939, the American Institute of Certified Public Accountants initiated the
publication of bulletins on topical accounting subjects, and in 1942 the Institute of
Chartered Accountants in England and Wales commenced publication of a series of
recommendations.
Today, the issuing of recommendations on accounting practice is one of the most important
functions of professional societies of accountants and auditors throughout the
world.
The first organised society of accountants in South Africa came into being in 1894 with
the formation of the Institute of Accountants and Auditors in the then Zuid-Afrikaansche
Republiek. Today the profession in South Africa is organised into various national accounting
institutes and societies, the most prominent being The South African Institute of Chartered
Accountants (SAICA) formed in 1980, and the South African Institute of Professional
Accountants (SAIPA) (formerly known as CFA and CPA) .
In 1951, the Public Accountants' and Auditors' Act, which controls the practising section
of the accountancy profession in South Africa, was promulgated. This legislation created
the Public Accountants' and Auditors' Board, whose functions for the most part embrace
the registration of accountants and auditors permitted to practice in public, discipline in
the profession, and the training of accountants. In 2006, the Independent Regulatory Board
of Auditors was established for the new auditing profession. Other professional bodies in
the accounting field in South Africa include the ICFP (Institute of Commercial Fraud
Practitioners), CIMA (Chartered Institute of Management Accountants), ACCA (Association
of Chartered Certified Accountants) and the AA T (Association of Accounting Technicians).

1.2.3.4 The development of accounting in modern Africa

The 90's have been a significant time for the development of accounting in Africa. Since
the year 1991 there has been remarkable economic and political developments in Africa.
Different economic regions and alliances developed, such as the Southern African
development Community (SADC), Common Market for Eastern and Southern Africa,
(COMESA), Indian Ocean Commission, (lOC) etc., to compete in the global trade. The Africa
Growth and Opportunity Act 2000 was a turning point in the economy of the African
countries. Stemming from this, more textiles products could be exported to the American
market The number of foreign customers and suppliers started increasing, even into other
products. This necessitated that countries in the region review their accounting practices
in order to keep up with the global developments in the accounting profession. The
adoption of International Accounting Standards (lAS) became paramount during this time.
In the early 2000's, African countries including South Africa started adopting IAS for
financial reporting purposes. These standards were later developed into International
Financial Reporting Standards (lFRS), which are broadly used nowadays. South Africa has
become one of the leaders in financial reporting and governance and has won many
awards in this regard.

1.3 The aim of accounting

The aim of financial reporting, and also accounting, is to provide financial information
concerning the economic activities of an entity to the present and future investors (owners),
financiers, creditors and other interested parties, to enable them to make informed
decisions.
Financial information is information expressed in monetary terms. This information includes
information on the financial position (assets, liabilities, etc.) of an entity at a particular
time, the results (revenue and expenses) of an entity's activities for a particular period and
the flow of cash.
Economic activities include all activities that use resources to create value.
An entity is any economic unit whose financial results are determined separately from
those of other units. All economic activities in society are undertaken by either a person or
group of persons or by an organisation of one kind or another. In accounting terms, such a
person, group of persons or organisation, whose financial results can be determined
individually, is known as an entity.
In the private sector there are essentially four types of business organisations with prof-
it motives that may be considered as being individual entities:
1. sole proprietors;
2. partnerships;
3. close corporations;
4. companies.
Furthermore, we find a wide variety of organisations in the private sector with various
objectives, not necessarily that of pursuing a profit motive that may be considered to be
individual entities:
1. charitable organisations;
2. churches;
3. educational institutions;
4. clubs;
5.associations;
6. trusts.
In the public sector the state as a whole and individual government establishments, such as
provinces, state departments, local governments, boards and commissions, may be
considered to be accounting entities.
The stakeholders requiring financial information about an entity include those persons
or institutions who own the entity, or manage and operate the entity, and all other persons
and institutions external to the entity who have a financial interest of one form or another
in the entity.
Financial information generated by the accounting process is used primarily for decisions
aimed at planning in advance or at exercising control. For planning decisions, financial
information is used to determine future actions to be taken, often based on what has
happened in the past The accounting process provides historical information - it records
what has happened in the past and reports on this . In many cases, decision-makers require
this information in order to forecast future financial results.
Planning decisions may be very simple, for example, decisions regarding the performing
of routine activities; on the other hand, they may be very complex, for instance regarding
the financial strategy and planning of an entity for the ensuing financial year.
Control decisions require using financial information to evaluate the results of financial
activities. In its simplest form, a control decision might be that the decision-maker is
satisfied with results and that no further action is required. When the decision-maker is
not satisfied with the results, the situation would require additional action that often
results in additional corrective steps being taken. The most important control function of
financial information is the provision of accountability for stewardship. Financial account-
ability is the responsibility of a person to whom another person has entrusted funds, to
give account to the provider of the funds regarding the use thereof.

1.4 Financial results

In accounting, the financial results of an entity's economic activities are primarily measured
in terms of the financial position at a particular time and in terms of the financial
performance for a particular period.
The financial position reflects the accumulated net worth (or wealth) of an entity at a
specific time in terms of its assets held and, against that, the interests of the various parties
that funded the assets, namely, owners and debt suppliers. The financial position is
reflected in a financial report, known as a statement of financial position. The statement of
financial position presents a static view of the financial position at a specific time. It may be
compared to a photograph that depicts a scene only at the time the photograph was taken .
The statement of financial position on 31 December 2018 of a small entity, Jacob Small
Repairs, is shown in Example 1.1. The first section of the statement of financial position
indicates the assets in which the funds of the entity have been invested, while the second
section indicates the amount and the sources of the funds made available to the entity.
The statement of financial position in Example 1.1 shows that Jacob Small Repairs held
assets in the amount of R1470 000 on 31 December 2018. The statement of financial
position also shows the amounts of the various types of assets as separate items.
The statement of financial position also indicates the sources of the funds used to ac-
quire the assets. Jacob Small personally contributed R840 000 towards the assets while the
creditors contributed R630 000.
Accounting distinguishes between two types of sources of funds, namely equity funds,
contributed by the owners of the entity and liabilities, being the funds provided by creditors
as illustrated in Example 1.1.
Equity funds represent the interests of the owners in the assets of the entity. Liabilities
are the amounts owed to creditors from whom the entity has borrowed funds. Liabilities
reflect the claims of the creditors against the assets of the entity. The statement of financial
position reflects the three elements of financial position: assets, liabilities and equity, as
illustrated in Example 1.1. Each element is divided into items indicating different types of
assets, liabilities and equity.
The objective of any business entity is to earn a profit The financial performance reflects
the profit made or the loss incurred by the entity over a specific period. Financial
performance is reported in a statement of profit or loss and other comprehensive income.
The statement of profit or loss and other comprehensive income reports the two elements
of financial performance, income that was earned and expenses that were incurred, to
determine the resultant profit or loss during the specific period. The statement of profit or
loss and other comprehensive income shows the amounts of the various types of income
and expenses as separate items. The statement of profit or loss and other comprehensive
income may be compared to a movie that reflects the history of what happened during that
period. The statement of profit or loss and other comprehensive income of Jacob Small
Repairs is illustrated in Example 1.1.
The financial position is always determined at the end of the same period for which the
financial performance is determined. A statement of financial position therefore reports
the financial position at the end of the period over which the statement of profit or loss and
other comprehensive income reports profit or loss. Profit is added to equity and loss is
deducted from equity.
The statement of financial position and the statement of profit or loss and other
comprehensive income, together with a variety of additional information, as will be shown
later, form a set of financial statements.

1.5 The domains of accounting

Accounting may be divided in accordance with the nature of the information that it provides
into:
1.financial accounting; and
2.management accounting.
Financial accounting caters primarily for the external users of financial information. External
users are persons and institutions who exist outside the entity and are not directly
involved in the management and operations of the entity, such as owners who are not
involved in the management and operations of the entity, creditors, clients, employees as
well as numerous other institutions who have no direct financial interest in the entity but
for various other reasons take an interest in the financial information of the entity. This
group includes government institutions, the community within which the entity functions,
interest groups or even the public at large.
Financial accounting primarily produces the formal financial statements - the statement
of financial position, the statement of profit or loss and other comprehensive income and
the statement of cash flows (which is addressed later) - that contain financial information
regarding the entity as a whole.
Management accounting caters primarily for the internal users of financial information
of the entity. These users are primarily the internal management and operational personnel
of the entity, all requiring a wide variety of financial information in order to manage
the entity on a day-to-day basis. Management accounting produces reports regarding
specific aspects of the entity's business in accordance with the needs of the various internal
users.
Other courses closely related to the field of accounting are auditing, taxation, financial
management, strategy, risk management and governance.

1.6 Why study accounting?

Knowledge of accounting is used at two levels in practice:

1. by the users of financial information; and
2. by the preparers of financial information.
It is not necessary for all users of financial information to be trained accountants although
anyone who has to make decisions regarding financial affairs based on information derived
from the accounting process should have at least a basic understanding of accounting. This
would ensure that the decision-maker would have a proper understanding of the
information in financial statements and reports when making rational decisions. Moreover,
knowledge of accounting will enable any individual to manage his or her personal financial
affairs more effectively. The more complex the information on which the decision is to be
based, the greater the knowledge of accounting the decision-maker will need to have. For
example, determining the income tax implications of complex transactions or designing a
complex financial plan will require more than just a synoptic understanding of accounting.
The accountant who accepts responsibility for the design of accounting systems, the pro-
cessing of financial information in the accounting process and the preparation and
interpretation of financial reports, requires a profound knowledge of the theory and
practice of the subject.
A wide variety of career opportunities exist for those with training in accountancy. The
accounting profession enjoys a great deal of prestige in society and provides a great deal of
job satisfaction and security. The accountant, in the performance of his normal
responsibilities, acquires a thorough insight into all the aspects of an entity's activities. An
accounting qualification and more specifically a professional qualification, is thus an
excellent entry opportunity into the business world.

Revision exercises

Exercise 1,1
(1) Who can be regarded as the developer of the current double-entry system?
(a) Pacioli
(b) Cotrugli
(c) The Institute of Chartered Accountants in England and Wales
(d) None of the above

(2) Identify the financial statement that reports on financial performance.

(a) Statement of financial position
(b) Statement of profit or loss and other comprehensive income
(c) Statement of cash flows
(d) None of the above

(3) Which one of the following is not a domain of accounting?

(a) Financial accounting
(b) Management accounting
(c) Auditing
(d) None of the above

Solutions
(1) a. Pacioli
(2) b. Statement of profit or loss and other comprehensive income
(3) c. Auditing

Exercise 1.2
(1) Which country's bankers were recognised as the most prominent bankers in the 13th
century?
(2) What are the guidelines for the measurement and disclosure of transactions that were
developed to ensure uniformity of standards for the accounting profession, known as?
(3) What is the aim of accounting?

Solutions
(1) Italy
(2) Generally Accepted Accounting Practice
(3) The aim of financial reporting, and also accounting, is to provide financial information
concerning the economic activities of an entity to present and future investors (owners),
financiers, creditors and other interested parties, to enable them to make informed
decisions.

Exercise 1.3
(1) What is meant by an entity's "financial position"?
(2) What is lFRS?