introduction to accounting
It is not easy to provide a concise definition of accounting since the word has a broad application within businesses and applications.
The American Accounting Association define accounting as follows:
"the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information!.
This definition is a good place to start. Let's look at the key words in the above definition:
- It suggests that accounting is about providing information to others. Accounting information is economic information - it relates to the financial or economic activities of the business or organisation.
- Accounting information needs to be identified and measured. This is done by way of a "set of accounts", based on a system of accounting known as double-entry bookkeeping. The accounting system identifies and records "accounting transactions".
- The "measurement" of accounting information is not a straight-forward process. it involves making judgements about the value of assets owned by a business or liabilities owed by a business. it is also about accurately measuring how much profit or loss has been made by a business in a particular period. As we will see, the measurement of accounting information often requires subjective judgement to come to a conclusion
- The definition identifies the need for accounting information to be communicated. The way in which this communication is achieved may vary. There are several forms of accounting communication (e.g. annual report and accounts, management accounting reports) each of which serve a slightly different purpose. The communication need is about understanding who needs the accounting information, and what they need to know!
Accounting information is communicated using "financial statements"
What is the purpose of financial statements?
There are two main purposes of financial statements:
(1) To report on the financial position of an entity (e.g. a business, an organisation);
(2) To show how the entity has performed (financially) over a particularly period of time (an "accounting period").
The most common measurement of "performance" is profit.
It is important to understand that financial statements can be historical or relate to the future.
Accounting is about ACCOUNTABILTY
Most organisations are externally accountable in some way for their actions and activities. They will produce reports on their activities that will reflect their objectives and the people to whom they are accountable.
The table below provides examples of different types of organisations and how accountability is linked to their differing organisational objectives:
Accountable to (examples)
Private or public company
- Making of profit- Creation of wealth
- Shareholders- Other stakeholders (e.g. employees, customers, suppliers)
- Achievement of charitable aims- Maximise spending on activities
- Charity commissioners- Donors
- Provision of local services- Optimal allocation of spending budget
- Local electorate- Government departments
Public services (e.g. transport, health) (e.g. Natinoal Healthe Servise, Prision Servise)
- Provision of public service (often required by law)- High quality and reliability of services
- Government ministers- Consumers
- Regulation or instigation of some public action- Coordination of public sector investments
- Government ministers- Consumers
All of the above organisations have a significant roles to play in society and have multiple stakeholders to whom they are accountable.
All require systems of financial management to enable them to produce accounting information.
How accounting information helps businesses be accountable
As we have said in our introductory definition, accounting is essentially an "information process" that serves several purposes:
- Providing a record of assets owned, amounts owed to others and monies invested;
- Providing reports showing the financial position of an organisation and the profitability of its operations
- Helps management actually manage the organisation
- Provides a way of measuring an organisation's effectiveness (and that of its separate parts and management)
- Helps stakeholders monitor an organisations activities and performance
- Enables potential investors or funders to evaluate an organisation and make decisions
There are many potential users of accounting Information, including shareholders, lenders, customers, suppliers, government departments (e.g. Inland Revenue), employees and their organisations, and society at large. Anyone with an interest in the performance and activities of an organisation is traditionally called a stakeholder.
For a business or organisation to communicate its results and position to stakeholders, it needs a language that is understood by all in common. Hence, accounting has come to be known as the "language of business"
There are two broad types of accounting information:
(1) Financial Accounts: geared toward external users of accounting information (2) Management Accounts: aimed more at internal users of accounting information
Although there is a difference in the type of information presented in financial and management accounts, the underlying objective is the same - to satisfy the information needs of the user. These needs can be described in terms of the following overall information objectives:
Collection in money terms of information relating to transactions that have resulted from business operations
Recording and Classifying
Recording and classifying data into a permanent and logical form. This is usually referred to as "Book-keeping"
Summarising data to produce statements and reports that will be useful to the various users of accounting information - both external and internal
Interpreting and Communicating
Interpreting and communicating the performance of the business to the management and its owners
Forecasting and Planning
Forecasting and planning for future operation of the business by providing management with evaluations of the viability of proposed operations. The key forecasting and planning tool is the "Budget"
The process by which accounting information is collected, reported, interpreted and actioned is called "Financial Management". Taking a commercial business as the most common organisational structure, the key objectives of financial management would be to:
(1) Create wealth for the business(2) Generate cash, and(3) Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources invested
In preparing accounting information, care should be taken to ensure that the information presents an accurate and true view of the business performance and position. To impose some order on what is a subjective task, accounting has adopted certain conventions and concepts which should be applied in preparing accounts.
For financial accounts, the regulation or control of what kind of information is prepared and presented goes much further. UK and international companies are required to comply with a wide range of Accounting Standards which define the way in which business transactions are disclosed and reported. These are applied by businesses through their Accounting Policies.
The main financial accounting statements
The purpose of financial accounting statements is mainly to show the financial position of a business at a particular point in time and to show how that business has performed over a specific period.
The three main financial accounting statements that help achieve this aim are:
(1) The profit and loss account for the reporting period
(2) A balance sheet for the business at the end of the reporting period
(3) A cash flow statement for the reporting period
A balance sheet shows at a particular point in time what resources are owned by a business ("assets") and what it owes to other parties ("liabilities"). It also shows how much has been invested in the business and what the sources of that investment finance were.
It is often helpful to think of a balance sheet as a "snap-shot" of the business - a picture of the financial position of the business at a specific point. Whilst this is a useful picture to have, every time an accounting transaction takes place, the "snap-shot" picture will have changed.
By contrast, the profit and loss account provides a perspective on a longer time-period. If the balance sheet is a "digital snap-shot" of the business, then think of the profit and loss account as the "DVD" of the business' activities. The story of what financial transactions took place in a particular period - and (most importantly) what the overall result of those transactions was.
Not surprisingly, the profit and loss account measures "profit".
What is profit?
Profit is the amount by which sales revenue (also known as "turnover" or "income") exceeds "expenses" (or "costs") for the period being measured.