As you begin your journey, you’ll learn the basics of accounting. Let’s take an easy look at what accounting is and how it works.
Enjoy learning!
Definition and Purpose of Accounting
Accounting is the “language of business”. This is how most people describe it because it’s essential in every part of the business world. Just like you need to know a language to communicate with others, anyone who wants to make smart decisions in business, like investors, managers, stakeholders, and other decision-makers, needs to understand what accounting is. This means knowing its terms, concepts, and principles, and how it all works, so they can effectively talk business with others.
Accounting is a process that collects, records, and reports information about a company’s financial health. This includes its performance (like profit or loss), its financial position (like assets, liabilities, and owner’s equity), and changes in that position (like cash flows and working capital).
Every organization, whether a business or a non-profit, aims to create value for its owners and other stakeholders. This goal cannot be reached without a way to monitor the organization’s performance. Performance can be measured both financially (like earnings, wealth, etc.) and non-financially (like customer satisfaction, market share, etc.), but accounting focuses on measuring performance in financial terms.
Inputs to an accounting system include business transactions, usually backed by documents like invoices, board resolutions, and management memos. However, some transactions may happen without formal paperwork. Accounting records and processes all transactions that can be measured using well-known methods. The way accounting is done can change depending on whether the reports are for external stakeholders or just for internal use. This will be discussed below.
There are several definitions of accounting provided by different professional accountancy organizations.
The Accounting Standards Council sees accounting as a service that provides numerical information, mainly financial, about businesses. This information is meant to help people make informed economic decisions, such as choosing between different actions.
The AICPA defines accounting as the art of recording, classifying, and summarizing transactions and events in monetary terms that are at least partly financial. It also involves interpreting the results. This classic definition is the most widely used and accepted.
The AAA gives a broad description of accounting. It defines accounting as the process of identifying, measuring, and sharing economic information to allow informed judgments and decisions by users. The business must recognize which activities can be measured, assign them a value, and communicate this information in reports that are easy for users to understand (as cited by Valix and Peralta, 2000).
The main purpose of accounting is to give business owners and managers the financial data they need to make informed decisions. Accounting provides key insights into a company’s financial health, and its value depends on how relevant and timely the information is. Entrepreneurs and managers rely on accounting information to make smart business moves. Should they rent or build a location? Open a new branch now or wait? Hire more staff or downsize? Invest more funds or seek outside financing? Poor decisions can lead to losses or damage to the company’s assets. With less information, the risk of making poor choices increases. Accounting plays a crucial role in business because it delivers the insights needed to reduce the risk of bad decisions.
There are four main functions of accounting: recording, classifying, summarizing, and interpreting.
This involves systematically recording business transactions in the order they occur in the accounting books. This process is commonly known as “bookkeeping.”
After recording, transactions are classified or sorted into groups based on similarities. This organization makes the next step easier to manage.
Here, all recorded transactions for a specific period (e.g., annually) are summarized into an easy-to-read format, known as financial statements or reports, to make the information more useful for readers.
The reports are then analyzed and interpreted by users. These reports combine numbers and explanations, often shown as percentages or ratios. This step is crucial because readers need to understand the relationships between the figures to make informed business decisions.
