What is Accounting & Importance of Accounting
What is accounting?
Accounting can define as information science that is used to collect and organize financial data for organizations and individuals. It is the processing, and communication of financial and non-financial information about the performance of an entity.
Accounting is an information science because it is concerned with analyzing, collecting, and organizing information.
Importance of Accounting
Accounting plays an important role in any business operations as it helps track income and expenditures, ensure statutory compliance, and provide investors, management, and government with quantitative financial information that can be used in making business decisions.
Accounting is also important as it helps the owners, managers, investors and other stakeholders in the business evaluate the financial performance of the business
Accounting helps us organize and represent financial information, and it helps corporations and individuals understand their finances and make decisions about the future.
Accounting helps in making use of the past in order to take action in the present and change the future.
Types of Accounting Areas
Here is where it all starts the collection of information. Modern society, as we know it, simply cannot function without bookkeeping. Bookkeeping is fundamental for corporations, banks, investment funds and even individuals.
Bookkeeping is a fundamental activity as it ensures that financial information has been gathered systematically.
Recording every single transaction that takes place within the firm is paramount at any level of complexity.
It is a proper bookkeeping that ensures that all necessary information has been recorded and is ready to use. Bookkeeping is the cornerstone around which all accounting is constructed.
Financial accounting focuses on the three main statements: income statement, balance sheet, and cash flow.
It is prepared for its ownership, lenders, financial analysts, and other external stakeholders.
It is highly regulated, given that the information is prepared for third-party users and should read it without having inside information.
According to a specific set of rules, the fact that the information is prepared renders it comparable with the one prepared by other companies, which in turn facilitates investors and lenders.
Financial statements are prepared according to a uniform set of rules called accounting principles.
Financial Reports & Why it is important
These reports’ main aim is to allow externals like banks and investors to get an idea of your business. How many sales you had? Was the company profitable? How was it financed? etc.
The set of financial reports that accompany prepares for people that are outside the organization. Such reports enable outsiders to gain an understanding of the company’s business.
About how many sales the company made this year, how many sales the company had last year, and they also show how profitable the company’s business was and what kind of costs incurred.
In addition to that, financial accounting reports show what a company owns and what it owes. They show how much cash was available in the company’s bank accounts at the time of preparation of the report.
We can conclude that financial accounting allows people who are outside an organization to make a reasonable judgment about its business.
Helps a company get a bank loan. A bank would be willing to lend money, knowing how you are going to repay the loan. Without financial reporting, most businesses would have been denied the capital they need as we know it.
Helps investors make the decision. An investor would be willing to put up their money, knowing about its business’s financials.
It enables them to communicate their financial performance to those who are interested.
Helps in monitoring business performance. They analyze the company’s financial statements and all of the necessary details to understand the company’s business.
3 Main Financial Accounting Statements
Financial accounting revolves around three main statements. The income statement, also known as profit and loss, or simply P and L, the balance sheet and the cash flow statement.
Each one serves a different purpose and contains important information about how a business is running.
The income statements
Answers the question., how did the company perform throughout the period under consideration? Did it produce a profit or a loss?
Typically, an income statement is prepared for one year, but sometimes larger companies are presented quarterly.
The P& L statement helps us understand whether the operations of the firm created economic value. It also enables us to find important trends, such as revenue growth and gross profit incidents on revenues.
The Balance Sheet
The balance sheet answers the questions; What does a company owes and own on a specific date, and what is its financial position?
It shows the assets that the business controls, the liabilities that it owes, and the amount of equity that belongs to equity holders. It is called a balance sheet because total assets must equal liabilities plus shareholders’ equity.
It is important to remember that assets stand on the balance sheet’s left side, while liabilities and shareholder’s equity are on the right side.
Statement of Cash Flows
The statement of cash flows answers the question; How much cash did the company make during the period under consideration? Where did it come from?
Given that income and cash generation are two different things, we need a statement that shows us the cash movements, providing an idea of the liquidity generated by the firm’s operations.
You will find these statements in every company’s annual report for Anyone who wants to get an idea about a given business should start here.
Main Income Statement Items
We have to start with revenue, also known as net sales. This item represents an inflow of economic resources, and usually, the main type of revenue is the day to day sales, customers buying goods that the firm sells.
There can be other sources of revenue, as well. Companies can and do make money outside their core operations.
For example, they can earn money by renting some of their real estates or selling goods that they do not typically sell.
The account that unites these sources of additional revenue is called other revenue.
This is the top line of the income statement. This is how the firm makes money.
The sum of net sales and other revenue equals total revenue.
Example of Revenue Generation
Think of a dairy company that produces milk and cheese and then sells it to chains of supermarkets. When the company sells milk and cheese daily, it registers sales right. Its clients, the supermarket chains, have to pay for the goods that they have received.
This is the firm’s core business, and the number of sales that the firm makes will be registered as net sales.
Simultaneously, the company also rents out a real estate property that it owns and receives rental income for it. It will be registered as other revenue because it is not part of the firm’s core business.
Such distinction is necessary because it allows us to separate sales coming from core business activities from income. That is a result of non-core activities.
As we said before, the sum of net sales and other revenue equals total revenue below total revenue will be listed.
The firm’s expenses outflows of the economic resource are in order to fuel its sales and produce the goods that it delivers to clients the firm needs to sustain certain costs.
The most common types of expenses are the cost of goods sold, selling, general and administrative costs, depreciation and amortization, and interest expenses.
The cost of goods sold our expenses that are necessary to produce the goods that the firm sells.
Our dairy company needs to buy raw milk from the local producer’s transport process and then package it before selling it to the large supermarket chains.
It sustains additional costs in order to produce cheese from the milk.
All of the expenses that are directly attributable to the production of goods that are later sold are registered as the cost of goods sold.
The difference between total revenues and cost of goods sold is called gross profit.
This is the profit a company makes after deducting the costs associated with making and selling its products.
Selling, general, and administrative expenses are a large category of costs. The dairy company classifies here it’s expenses for advertising and promotions, salaries of its management and personnel that is not directly involved with the production, accounting office and auxiliary personnel rent for its offices, and utility bills such as electricity, phone, and water bills.
Depreciation and amortization are two accounts that reflect the using up of tangible and intangible assets.
Depreciation refers to assets of a physical nature, while amortization is the term that is used for intangible assets, goodwill licenses, copyrights, etcetera.
Every year, the plants that the dairy company owns become one year older, and therefore, their value is reduced. In order to account for such a reduction, the company registers a depreciation expense.
Interest expenses are the costs that accompany bears for receiving financing.
Typically, firms received bank loans and pay interest expenses for the amounts they owe. From our example, the dairy company had to ask for a bank loan when it acquired a new milk processing system.
The bank agreed to lend the necessary funds at an interest rate of 6% Every year. The firm has to pay an interest expense on the amount that it’s still owed.
Such interest expense is registered in the company’s income statement.
Finally, there are taxes. There are two things that no person can avoid, and one of them is paying taxes.
Every firm pays corporate taxes that are proportional to the amount of pretax profit that is generated. The rules, according to which the firm generates the amount of pretax income is measured may vary depending on the country where the company operates.
Once all expenses are considered, we arrive at the bottom line, which is called net income.
Net income is the excess of revenues over expenses, the profitability of a venture after accounting for all costs.
A Balance Sheet is a statement that shows what the company owns and owes. Every balance sheet has two sides on one side of the company’s assets.
What the company owns and on the other side are the company’s liabilities and equity What the company owes. It is important to remember that assets stand on the left, and liabilities and equity are on the right side.
Cash: The cash account is one of the most important drivers for a business. It shows how much of the firm’s assets are cash or can easily be converted into cash.
It gives us an idea of the liquidity of the company. We know very well that a business cannot function properly if sufficient cash is not available for its day to day operations.
Accounts receivable, also known as trade receivables: When customers buy affirms products, they have to pay for them. Until they do, the firm will register this amount in accounts receivable, which indicates the money owed by customers.
The firm registers that it has earned a payment from these customers but has not yet received the payment.
Inventory: Inventory is the account that shows the value of raw materials goods, in the process (Work in Progress), and finished goods that are ready to be sold to customers.
Finished goods are products that can be immediately shipped to customers while raw materials and work in progress goods require additional processing.
Property, plant, and equipment: Are a group of assets that are vital to business operations.
Imagine a production company it certainly needs plants and equipment in order to transform raw materials into finished products.
Usually, this is a hefty investment that cannot be easily liquidated. The value of property, plant, and equipment is reduced each year. Should we say, depreciated in order to account for the fact that the asset will be obsolete after it’s useful economic life ends?
These are some of the main types of assets that we will see in financial statements.
Accounts payable: Accounts payable are certainly one of the most important items on the liability side. When a company buys raw materials for its production process, it registers the amount in accounts payable until the actual payment has been made.
The firm owes its supplier a given amount of money because it received the goods.
Financial liabilities: Financial liabilities are a significant item for a lot of businesses out there. A financial liability appears on the balance sheet of a company when it receives external financing, which is usually a bank loan.
The firm uses the funds in order to finance its operations and commits to repaying its lender in the future.
On the same side of liabilities stand the ownership claims, such as paid-in capital. This is the firm’s capital that it technically owes to its owners.
This capital would not be repaid to the shareholders, but the company will try to pay them a decent number of dividends.
A balance sheet shows what a company owns and owes at a specific point in time. On the left side are the company’s assets; the things that it owns, and on the right side are the company’s liabilities and equity, showing how the company was financed. This is what the balance sheet portrays.
The reason it is called the balance sheet is that assets must equal liabilities and equity. The two sides have to be equal, or else a mistake has been made.
This principle is known as the accounting equation and is one of the core principles around which accounting has been built.
Assets are equal to liabilities and equity.
(Assets = Liabilities + Equity)
The accounting equation must be satisfied for every business you will ever see. It balances for the Gelatos shop on the next corner as well as for Walmart and Chevron.
It is available only for insiders and not defined by accounting principles and is, in most cases, more detailed than financial accounting.
It contains strategic information that shouldn’t be seen by the firm’s competitors. Managerial accounting looks into topics like pricing, competition, marginality, budgeting, and so on.
The company does not want to reveal this information to outsiders because, well, otherwise, outsiders will prepare a counter plan and gain strategic advantage.
Of course, managerial and financial accounting are often interrelated, and it is a frequent practice to reconcile managerial and financial accounting figures.
The fourth type of accounting that we need to mention is tax accounting. This is the accounting that will determine the amount of taxes that a company has to pay.
Tax accounting is a very technical field that varies for every single legislation in the world.