Accounting forms the backbone of modern finance. Accounting helps show how cash flows through a business and how it is being utilized to create value in the organization. It provides complete transparency into the functioning of operational and financial aspects of a business and helps comply with regulatory and legal requirements as well.
Accounting is a critical part of finance. Here’s a look into what the financial term is and what its scope is.
What is accounting?
Every business deals with financial transactions. Recording these financial transactions is accounting. The process primarily includes three activities – summarizing the transactions, analyzing the transactions, and finally, reporting the business transactions. The reports are usually made for government regulators and tax authorities. However, a lot of reporting is also done for the purpose of giving a company’s oversight or management a thorough account of the incomes and expenditure of the organization.
This involves preparing financial statements of the organization. These financial statements showcase the flow of cash within the company and also give a summary of its financial position at the end of specific periods and day-to-day operations.
How does accounting work?
Accounting is a vital part of every business. Companies either have a department in-house or outsource the function to an external party. In-house, this is usually the care of a single accountant or a bookkeeper if the organization is small. In larger entities, there usually are entire teams of people to take care of the function.
The majority of reports by the accounting department relate to managerial and cost. These are regularly in use by the management of the company to take important business decisions.
Accountants usually have many years of study and a degree before they get an appointment in the department. This is mainly due to the fact that accounting and preparing financial statements, especially of large organizations, involves going through thousands of financial transactions and consolidating them into reports showing cash flows, business operations, and the financial position of the company for specific periods.
Basic accounting activities are by bookkeepers. However, for advanced functions, only those with the respective qualifications are in employment.
Requirements
In most countries outside the US, the International Accounting Standards Board has regulations and standards to follow while preparing financial statements. These are collectively popular as International Financial Reporting Standards (IFRS).
In the US, accountants use the generally accepted principles (GAAP) for preparing financial statements. These principles are standards to ensure consistency of practices across industries in the country that result in comparable financial statements.
The different types
There are three main types of functions:
- Financial accounting: Financial accounting is the process of creating annual and interim financial statements. These are usually consolidation into the cash flow statement, the income statement, and the balance sheet for every accounting period. Almost every company will have at least one annual report made for various purposes including accountability and reporting, for legal requirements, or for issuing external audit reports to lenders.
- Cost accounting: Cost accounting factors in all the costs and expenses involved in manufacturing a product. It helps businesses make critical decisions regarding costing. This information is then used by various people in the management, floor managers, and top leadership to identify what their selling price should be based on the total costs involved.
- Managerial accounting: Managerial accounting uses financial information from business operations and summarizes it in a different way when compared to financial accounting in order to enable better managerial decision making. It usually involves every bit of data and information that can help a company’s management make better decisions.
Accounting explained with an example
Under the GAAP, accounting takes place using the double-entry method. Under this method, two entries in two separate places in the books of accounts occur to balance the financial statements later.
For example, accounts receivables got on record as a debit in the balance sheet. At the same time, the income statement sees credit with sales revenue. When the payment is received from the client, the accounts receivables are credited and the cash is debited. This is the double-entry method. This makes sure that both sides of the books of accounts are in balance. If the financial statements do not balance each other, it means there is some error.
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Why it is very important for investors
An investor needs to look at the financial health and business operations of a company before deciding whether to invest in it or not. This is where the financial statements play a very important role. They help give complete transparency into the cash flowing through the business and how its financial health stands based on its assets and liabilities. Without accounting, investors will not be able to make informed decisions. It also helps comply with legal and regulatory requirements. Simply put, modern finance cannot function efficiently without accounting.
