This article deals with basic accounting principles that most business people and managers need to be familiar with.
What is accounting?
Accounting is the main way information about economic activities is communicated. Accountants analyze, classify, record, summarize and interpret economic transactions. This information is then provided to decision makers in the form of financial statements. The primary emphasis is on providing clear information to others, so that they can make informed decisions for the organization.
Accounting is also important for the day-to-day operation of businesses. It helps companies pay their bills and taxes, keep track inventory, and reduce theft and fraud.
Accounting to Help Decision-Making and to Measure Performance
Organizations have financial goals. Accountants use available data to measure the results of the activities of an organization. The results are then reported to help decision makers measure financial success. Accounting information is helpful to those responsible for making decisions about the activities of an organization. Business owners, managers, investors as well as politicians are all examples of this type of decision maker.
Accounting helps decision makers in various ways including:
- Evaluating organizational performance
- Showing where and when money has been spent
- Showing what is owed
- Predicting future effects of today’s decisions
- Comparing one possible course of action to another
- Finding current problems, inefficiencies and opportunities
Financial and Managerial Accounting
Accounting can be subdivided into two fields –financial and managerial. “Financial accounting” serves decision makers outside the organization such as government agencies, shareholders and banks. “Managerial accounting” serves internal decision makers such as managers and owners. The financial statements we discuss on this website are common to all areas of accounting.
Generally Accepted Accounting Principles
Accountants are required to adhere to a set of guidelines and detailed practices in accounting. These are known as the Generally Accepted Accounting Principles or GAAP (pronounced “gap”). It allows for a relatively standardized way of reporting financial information. This is helpful because if different accountants were to use different measures and rules, decision makers would find it more difficult to compare and interpret accounting information. Different countries have their own versions of GAAP, but they usually have a lot in common.
With respect to corporations, financial statements that are prepared for external stakeholders, such as governments and shareholders, are required to conform to GAAP. Accounting information intended for internal use only, doesn’t have to adhere to GAAP.
Financial Statements
As mentioned, financial statements prepared by accountants are used to help decision makers make informed decisions. The main financial statements used by decision makers are the balance sheet, income statement and cash flow statement.
- The balance sheet shows the financial status of a business at a particular point in time. How much cash the company has on hand, how much it owes, and the value of its inventory are all examples of what you’d find on a balance sheet. The balance sheet is sometimes called the statement of financial position.
- The income statement is a measure of the performance of a business over a period of time. The income statement is also called the profit and loss statement or simply the “P & L statement”.
- The cash flow statement (or statement of cash flow) reports the cash payments and cash receipts of a business over a period of time. As the name implies, the focus is on cash.
Details about these statements can be found in other articles:
Balance sheet: Measuring Financial Position
Income statement: Measuring Performance
Cash flow statement: Measuring Cash Flow
Accrual vs Cash Accounting
Accounting is generally done on either an accrual basis or on a cash basis. Accounting on an accrual basis means recognizing the impact of transactions on financial statements in the period of time when expenses and revenues occur, not necessarily when cash exchanges hands. Accounting on a cash basis means the impact of transactions on the financial statements are recognized when cash is received or disbursed.
An example should help clarify. Suppose you sell a product to a customer and agree to let the customer pay in 60 days. With accrual accounting, you record the sale as revenue as soon as the customer has bought the product, even though it has not been paid for yet. In cash accounting, your financial statements would not be affected until you received payment.
The same principle applies if you bought office equipment for your business and the vendor offered you 60 day terms. With accrual accounting, the expense would be recorded on your financial statements immediately. With cash accounting, the transaction would only be recorded in your financial statements when you paid for the equipment.
The accrual basis generally the recommended way of accounting but very small businesses often use the cash basis because it can be simpler and easier to manage.
For years accountants have debated the merits of accrual versus cash accounting. There seems to be a general consensus that while cash is important, focusing on it creates a narrow and incomplete picture. Accrual basis accounting is a better measure for relating company efforts to its accomplishments. It produces a more complete picture of the company’s value-producing efforts.
The Accounting Time Period
In order to gauge an organization’s performance, owners and managers want periodic reports that can be used to measure progress. A company’s fiscal year is a year established for accounting purposes. Companies measure and report income for each fiscal year. Many companies choose January 1st as the start, and December 31st as the end of their fiscal year. While any start date can be chosen, January 1st is popular simply because it corresponds to the calendar year.
Interim reports are sometimes provided at various times thought the fiscal year (quarterly, monthly etc.).