What is Accounting?
Accounting is the process of recording and summarizing financial information in a useful way.
You may have already noticed the use of some form of accounting in your daily life.
My mom for example is the chief accountant and treasurer of our house. She keeps a simple diary to record major home expenses such as grocery, utilities, fees and so on. It gives her peace of mind knowing where she has spent the monthly income. The diary also serves as a reminder in case she forgets whether she has already paid someone. She keeps all the receipts in a folder. At the start of each month, she prepares a small budget that lists all major payments expected to be made in the following month. Even though my mom doesn't realize, she is basically performing functions of accounting to manage the home finances.
Accounting, what we normally refer to, is a more formal, efficient and effective version of such processes in a business context.
Importance of Accounting
Accounting provides a basis for decisions through the process of recording, summarizing and presenting historical and prospective information.
The recording part of accounting, often known as book-keeping and financial accounting, is obviously crucial to ensure that those running a business have a formal record of business transactions in order for them to know basic information such:
- How much they owe to suppliers, tax authorities, banks, employees and others?
- How much each customer owes the business?
- How much capital is invested by the owners in the business?
- How profitable is the business?
Such information is necessary for a business to fulfill its legal obligations and asserting its own legal rights. Without proper accounting, it would be very difficult for a business to determine for example the exact amount (net of any discounts, VAT, etc.) it needs to pay a certain supplier (who could be one of dozens of suppliers for that business) from whom they may have made several purchases in last month alone. Organizations need to have a reliable way of recording information relating to transactions and that is where accounting is so vital.
Historical accounting information is summarized to produce financial statements. Financial Statements provide an overview of financial activities of a business during a period (e.g. income and expenses) as well as information relating to its financial position on a certain date (e.g. the amount of cash and inventory). Financial Statements help owners in assessing the performance and position of their business can guide their investment decisions (e.g. whether they should invest more in the business, diversify or dispose their investment).
Maintaining accounting records and preparing financial statements is often a legal responsibility for most businesses above a certain size.
Accounting nowadays is no longer concerned only with historical information. Budgeting, appraisal and analysis based on prospective information has become an important aspect of management accounting.
Management accounting is concerned with providing information to managers for decisions, planning and control of business. Examples of such information include:
- Variance Analysis
- Investment Appraisal
- Relevant Cost Analysis
- Limiting Factor Analysis
- Ratio Analysis