Definition of accounting
Accounting is the process of recording, summarizing, analyzing, and interpreting financial transactions and information of a business entity. It involves the measurement, processing, and communication of financial and non-financial data to stakeholders, such as investors, creditors, and management, to assist in decision-making and financial reporting. Accounting principles and standards are followed to ensure accuracy, transparency, and integrity in recording and reporting financial information.
Importance of accounting in business
Accounting plays a crucial role in business for several reasons:
- Financial monitoring and control: It provides a systematic way to monitor and control a business’s financial transactions. It enables recording and tracking of all financial activities, including income, expenses, assets, liabilities, and equity. This information is essential for understanding the financial health of the business and making informed decisions.
- Decision-making: Accurate and up-to-date information helps business owners, managers, and investors make better decisions. It provides insights into the profitability and performance of different products, services, or business units, enabling informed choices in terms of pricing, cost control, investments, and strategic planning.
- Financial reporting and compliance: Accounting is crucial for the preparation and presentation of accurate and reliable financial statements. These statements, including the balance sheet, income statement, and cash flow statement, provide an overview of the financial position and performance of the business. They also comply with standards and regulations, ensuring transparency and accountability to stakeholders, such as investors, lenders, and tax authorities.
- Tax planning and compliance: Accounting facilitates proper tax planning and compliance. By accurately recording and reporting financial transactions, businesses can calculate and pay taxes correctly, minimizing the risk of penalties or legal issues. It also helps identify eligible deductions and credits, optimizing the tax burden and maximizing after-tax profitability.
- Risk management: Accounting contributes to risk management by providing data and analysis necessary for identifying and mitigating financial risks. By tracking and measuring financial performance, businesses can identify areas of concern, such as excessive debt, declining revenue, or ineffective cost control, and take necessary actions to address them before they escalate into significant problems.
- Investor and stakeholder confidence: Accurate and transparent practices help build investor and stakeholder confidence in a business. Financial statements, audited by an independent third party, provide credibility and reliability, increasing the trust of investors and lenders. This confidence translates into increased access to capital and opportunities for growth.
In summary, accounting is critically important in business as it enables financial monitoring and control, supports decision-making, ensures compliance with regulations, optimizes tax planning, manages risks, and enhances investor confidence. It provides the information and tools necessary for businesses to thrive and succeed in a competitive environment.
Key Principles of Accounting
- Accrual principle: This principle states that financial transactions and events should be recorded in the records when they occur, regardless of when the cash is received or paid. It ensures that income and expenses are recognized in the appropriate period, matching revenues with expenses.
- Entity principle: According to this principle, a business should be treated as a separate entity from its owners or other businesses. This means that the financial transactions of the business must be recorded separately from personal transactions of owners or employees.
- Going concern principle: This principle assumes that a business will continue to operate indefinitely, unless there is significant evidence to the contrary. It allows businesses to prepare financial statements on the basis that they will continue to operate and generate profit in the future.
- Historical cost principle: This principle states that assets should be recorded in the records at their original cost, regardless of their current market value. It provides a reliable basis for recording and reporting assets, as it avoids subjective estimates of value.
- Matching principle: The matching principle requires that expenses should be recorded in the same period as the revenues they help to generate. It ensures that expenses are properly matched with the revenues they generate, resulting in accurate financial statements.
- Materiality principle: This principle states that significant information should be disclosed in financial statements, while immaterial information can be omitted. Materiality is determined by the impact of information on users’ decisions, and this principle allows for the omission of insignificant details that would not affect users’ understanding of the financial statements.
- Objectivity principle: The objectivity principle states that financial information should be based on factual evidence, rather than personal opinion or bias. This ensures that financial statements are reliable, objective, and free from bias.
- Revenue recognition principle: According to this principle, revenue should be recognized when it is earned and realizable, regardless of when payment is received. It ensures that revenue is recognized in the appropriate period when the goods or services are provided, and not necessarily when cash is received.
Types of Accounting
1. Financial Accounting
Aims at finding out profit or losses of a financial year as well as the assets and liabilities position, by recording various transactions in a systematic manner.
2. Cost Accounting
Helps the business to ascertain the cost of production/services offered by the organization and also provides valuable information for taking various decisions and also for cost control and cost reduction.
2. Management Accounting
helps the management to conduct the business in a more efficient manner. The scope of management accounting is broader than that of cost accounting. In other words, it can be said that the management accounting can be considered as an extension of cost accounting. It utilises the principles and practices of financial accounting and cost accounting in addition to other modern management techniques for efficient operation of a company. The main thrust in management accounting is towards determining policy and formulating plans to achieve desired objectives of management. Management Accounting makes corporate planning and strategies effective
1.1 Financial Accounting
Financial Accounting aims at finding the results of a financial year in terms of profits or losses and assets and liabilities. In order to do this, it is essential to record various transactions in a systematic manner. Financial accounting is defined as Art and science of classifying, analysing and recording business transactions in a systematic manner in order to prepare a summary at the end of the year to find out the result of concerned financial year. The above definition is explanatory, however, for understanding clearly, the following terms are explained:
Business transactions: A transaction means an activity; a business transaction means any activity which creates some kind of legal relationship. For example, purchase and sale of goods, appointing an employee and paying his salary, payment of various expenses, purchase of assets etc.
Classification of transactions: Before recording any transaction, it is essential that it is to be classified. A transaction can be classified as cash transaction and credit transaction. Similarly transactions of receiving income and payment of expenditure can be segregated. Even in case of expenditure, transactions involving revenue expenditure and capital expenditure can be segregated.
Recording of transactions: The essence of financial accounting is recording of transaction. In accounting language, recording of the transaction is known as entry. There are well defined rules for recording various transactions in books of accounts. As per the rules of financial accounting, each and every transaction is recorded at two places and hence it is called double entry system.
Summary of transactions: After recording all transactions, it is essential to prepare a summary of them so as to draw meaningful conclusions. The summary will help in finding out the Profit/Loss of a particular year and also ascertaining Assets and Liabilities on a particular date. In fact, the very purpose of financial accounting is to know the results of a particular year. From this angle, the process of preparing the summary is extremely important.
2.1 Cost Accounting
It is a type of accounting process that aims to capture a company’s cost of production by assessing the input costs of each step of production as well as fixed costs such as depreciation of capital equipment. Cost accounting will first measure and record these costs individually, then compare input results to output or actual results to aid company management in measuring financial performance.
Cost accounting is often used within a company to aid in decision-making, financial accounting is what the outside investor community typically sees. Financial accounting is a different representation of costs and financial performance that includes a company’s assets and liabilities. Cost Accounting can be more beneficial as a tool for management in budgeting and in setting up cost control programs, which can improve net margins for the company in the future.
3.1 Management Accounting
Management accounting is the application of professional knowledge and skill in the preparation and presentation of information in such a way as to assist management in the formulation of policies and in planning and controlling the operations of the organisation.
The main purpose of management accounting is to provide information to the management team at all levels within the organisation for the following purposes:
(a) Formulating the policies strategic planning
(b) Planning the activities of the organisation corporate planning
(c) Controlling the activities of the organisation
(d) Decision-making long-term and tactical
(e) Performance appraisal at strategic and operational level
A management accounting/cost statement provides information to allow managers to plan, control and organise the activities of the business.
The purpose of a costing/management accounting information system is:
- To provide information about product costing to be used in financial statements.
- To provide information for planning, controlling and organising.
Types of Financial Statements
There are four main types of financial statements:
- Income Statement: Also known as the profit and loss statement, the income statement shows a company’s revenues, expenses, and net income or loss over a specific period of time. It provides information about a company’s profitability and is useful for assessing its financial performance.
- Balance Sheet: The balance sheet provides a snapshot of a company’s financial position at a specific point in time. It lists a company’s assets, liabilities, and shareholders’ equity. The balance sheet helps to determine a company’s liquidity, solvency, and overall financial health.
- Cash Flow Statement: The cash flow statement tracks the inflows and outflows of cash within a company during a specific period. It shows how cash is generated and used by a business and provides insights into its operating, investing, and financing activities. The cash flow statement helps in evaluating a company’s ability to generate cash and its liquidity.
- Statement of Shareholders’ Equity: Also known as the statement of changes in equity, this financial statement details the changes in a company’s equity over a specific period. It shows the beginning balance of shareholders’ equity, any contributions, distributions, net income or loss, and other significant transactions that affect equity. The statement of shareholders’ equity helps in understanding the ownership structure and changes in a company’s equity position.