accounting

Define Accounting

Accounting is a system of recording information about a business. The information that is collected and recorded is primarily numerical. This information is presented in specific formats to various people to help them make business decisions.

To account for something

To account for something means keeping a record of a specific item or transaction in your business using the accounting system.

What do accountants and bookkeepers do?

An accountant or bookkeeper collects documentation and records this information, categorizes it (i.e., organizes the different bits of information under certain categories), and presents it in specific formats.

• Bookkeepers are usually involved more in data collection and entry.
• Accountants can fulfill this role too, but more often these days are involved in preparing and presenting financial statements and fulfilling an advisory or consulting role.

Financial statements

Accounting information is finally presented in the form of financial statements.

Financial statements are the key reports of a business. Financial statements generally show the financial position of a business, its financial performance, and cash flow management.

Financial statements are generally prepared annually and specifically for external parties. They must be prepared in accordance with generally accepted accounting principles (in the US) or International Financial Reporting Standards (outside the US). 

Financial Accounting versus Management Accounting

Financial accounting is the record-keeping leading to the preparation of annual financial statements.

Management accounting also involves record-keeping and preparing reports, such as financial position and business performance. Still, these reports are intended for internal personnel and cover a shorter period (like a month or quarter). Management accounting often includes budgeting and planning, whereas financial accounting provides historical reports.

The basic accounting equation or formula

Assets = Owner equity + Liabilities

Assets are the possessions of the business. They add value to the business and will bring benefits in some form—for example, furniture, machinery, vehicles, computers, stationery, or cash.

Liabilities are debts. The amount of liabilities represents the value of the business assets owed to others. People outside the business can lay claim to the value of the assets.

Owner's equity, or equity, is the value of the business assets to which the owner can lay a claim. It is the value of the assets that the owner really owns.

What the basic accounting equation means

In a nutshell, the accounting equation above shows us:

• How much of the assets are owed to others (liabilities), and
• How much is owed by the owner (equity)

The Accounting Equation and Financial Position

When compared to one another, the three elements (assets, owner's equity, and liabilities) show the business's financial position.

Look at the examples below.

Which of the following businesses, A or B, would you invest in?

Business A

Assets = Equity + Liabilities

$100,000 = $10,000 + $90,000

Probably not. 90% of the assets of this business will be used to pay debts in the future. The equity, which reflects the business's net worth (the owner's actual worth), is only $10,000. The financial position of this business is thus poor.

Business B

Assets = Equity + Liabilities

$100,000 = - $20,000 + $120,000

In this case, you certainly would be pretty apprehensive about investing. The total debts of the business are greater than the assets it has to pay off these debts. As a result, the owner is making a loss. The owner may have to fork out $20,000 out of their own pockets to pay the liabilities. Where the total debts of the business are greater than its assets, we say that the business is insolvent. This means that it cannot pay all its debts. The financial position of this business is terrible.

Business C

Assets = Equity + Liabilities

$100,000 = $60,000 + $40,000

This business looks a bit healthier. The business can comfortably pay all of its debts. Only 40% of the assets will be used to pay the debts – 60% of the assets are owned by the owner. The net worth of the business is $60,000. The financial position of this business is quite good.

Define Profit

Profit is the positive amount you are left with when your total income exceeds your total expenses.

Profit = Income – Expenses

Define Income

Income is simply the event that results in money flowing into the business. Examples of income:

• Sales
• Services rendered
• Interest received
• Rent received

Each of the above represents an event, like a sale, which results in money flowing into a business.

Financial Statements

There are four basic financial statements.

1. The income statement presents the revenues, expenses, and profit/losses generated during the reporting period. This is usually considered the most important of the financial statements since it presents the operating results of an entity.
2. The balance sheet presents the entity's assets, liabilities, and equity as of the reporting date. Thus, the information shown is as of a specific point in time. The report format is structured so that the total of all assets equals all liabilities and equity (known as the accounting equation). This is typically considered the second most important financial statement since it provides information about the liquidity and capitalization of an organization.
3. Statement of cash flows presents the cash inflows and outflows during the reporting period. This can provide a useful comparison to the income statement, especially when the amount of profit or loss reported does not reflect the cash flows experienced by the business. This statement may be presented when issuing financial statements to outside parties.
4. Statement of retained earnings presents changes in equity during the reporting period. The report format varies but can include the sale or repurchase of shares, dividend payments, and changes caused by reported profits or losses. This is the least used of the financial statements and is commonly included in the audited financial statement package.

List of 10 basic accounting principles

1. The historical cost principle requires companies to record the purchase of goods, services, or capital assets at the price they paid. Assets are then added to the balance sheet at their historical without being adjusted for fluctuations in market value.
2. The revenue recognition principle requires companies to record revenue when it is earned instead of collected. This accrual basis of accounting gives a more accurate picture of financial events during the period.
3. The matching principle states that all expenses must be matched and recorded with their respective revenues in the period they were incurred instead of when they are paid. This principle works with the revenue recognition principle to ensure all income and expenses are recorded on an accrual basis.
4. Full Disclosure principle requires that any knowledge that would materially affect a financial statement user's decision about the company must be disclosed in the footnotes of the financial statements. This prevents companies from hiding material facts about accounting practices or known contingencies in the future.
5. The cost-benefit principle limits the required amount of research and time to record or report financial information if the cost outweighs the benefit. Thus, if recording an immaterial event would cost the company a material amount of money, it would be foregone.
6. Conservatism principle – Accountants should always err on the most conservative side possible. This prevents accountants from overestimating future revenues and underestimating future expenses that could mislead financial statement users.
7. Objectivity principle – Financial statements, accounting records, and financial information should be independent and free from bias. The financial statements are meant to convey the company's financial position and not to persuade end-users to take specific actions.
8. Consistency principle – All accounting principles and assumptions should be applied consistently from one period to the next. This ensures that financial statements are comparable between periods and throughout the company's history.
9. Accrual principle – The accrual principle is the concept that you should record accounting transactions in the period they occur rather than the period in which the related cash flows occur. The accrual principle is a fundamental requirement of all accounting frameworks, such as Generally Accepted Accounting Principles and International Financial Reporting Standards).
10. Economic entity principle – The economic entity principle is an accounting principle that states that a business entity's finances should be kept separate from those of the owner, partners, shareholders, or related businesses.

List of key accounting assumptions

• The monetary unit assumption assumes that all financial transactions are recorded in a stable currency. This is essential for the usefulness of a financial report. Companies that record their financial activities in currencies experiencing hyperinflation will distort the company's accurate financial picture.
• The periodicity assumption states that companies should be able to record their financial activities during a specific period. The standard periods usually include an entire year or quarter year.