Definition
Accounting is the process of recording and summarizing financial information in a useful way.
Explanation
Even if you’re new to accounting, you may have noticed some use of accounting in your daily life.
My mom for example is the chief accountant of our family. At the start of each month, she prepares a budget that lists all expected payments and income for the month. She then records all payments and receipts in her personal diary such as groceries, utilities, taxes and so on. Tracking home expenses against the monthly budget helps her avoid overspending and also gives her peace of mind knowing where the money was spent in case she forgets. She keeps all the invoices and bank statements in a shoe box. Once every year my Mom files her taxes and this is where all her hard work in maintaining the financial record pays off as she has all the required information on her finger tips (and a shoe box). Even though my mom doesn’t know, she is performing basic functions of an accountant to manage the home finances.
Accounting is just a more formal and efficient version of such processes in the context of a business. Businesses use accounting to keep their financial information organized which helps them in making sense of their financial data and also keeps them compliant of financial regulations.
Explanation
Accounting consists of 2 parts:
1. Book-keeping
2. Analysis
Book-keeping, which is also known as financial accounting, is the process of recording and summarizing financial information. Book-keeping involves the recording of transactions (e.g. sales, purchases, and expenses) which are then summarized and presented in the form of financial statements which show the overall health of the business.
Book-keeping helps to organize the financial data which facilitates the effective management of the business by providing key information such as:
- 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?
Bookkeeping is the backbone of an accounting system and forms the basis of analysis in management accounting.
Management accounting, also known as managerial accounting, provides information to management for analysis, decision making, planning and control of the business. For example, information relating to investment decisions, budgeting and performance measurement.
Importance of Accounting
Record
Organizations need to have a reliable and systematic way of recording financial information. Accounting is necessary to ensure that those running the business have a reliable record of financial transactions.
Legal
Accounting helps organizations to determine their financial rights and obligations. Without proper accounting, it would be very difficult for a business to calculate, for example, the exact amount a supplier needs to be paid taking into account cost of purchase, discounts, sales tax, withholding tax, duties, refunds, etc.. Accounting is therefore necessary for a business to fulfill its legal obligations and asserting its own legal rights.
Maintaining accounting records and preparing financial statements is also often a legal responsibility for businesses above a certain size.
Performance
Accounting information is summarized to produce financial statements. Financial Statements provide an overview of the financial activities of a business during a period (e.g. cash flow, income and expenses during the year) as well as information about its financial position on a specific date (e.g. amount of cash and inventory at the end of the year).
Financial Statements help owners in assessing the performance and position of their business which can guide their investment decisions (e.g. whether they should invest more in the business, diversify or dispose their investment).
Planning and Control
Accounting helps organizations to plan their finances by developing budgets and forecasts. Variance analysis provides a mechanism for the monitoring of expenses incurred by organizations by comparison with the budgeted expenditure. This process helps organizations in planning their finances ahead and controlling any deviations from the budget.
Decisions
Accounting provides a basis for managerial decisions. Examples of such decisions include:
- Investment Appraisal
- Make or Buy decisions
- Pricing Decisions
- Limiting factors analysis
Summary
Accounting is a reliable process for recording, organizing and analyzing financial information which helps in the effective management of the business.
