What is Accounting?
Accounting is the process of identifying, recording, and reporting financial information relating to a particular entity to interested parties. The main way of communicating this financial information is through financial statements, such as the balance sheet and income statement.
Accounting information is vital for the company’s management and employees – it allows management to track the financial performance of the company and allows employees to evaluate the company’s profitability and long-term survival. Financial information is also of crucial importance to outside parties, such as investors, lenders, and suppliers, who need to know whether to invest in, or extend credit to, the company.
Accounting data is presented in a number of financial statements. For example, the balance sheet provides a snapshot of a company’s financial position at a given point in time, while the income statement measures the company’s financial performance over a given period.
A company’s financial accountants are tasked with producing statutory financial statements. These are the financial statements that are required to be filed under local laws and regulations. For example, in the US, the Securities and Exchange Commission (SEC) sets reporting requirements for listed companies. The rules require companies to file certain financial statements on a quarterly and annual basis to ensure the market obtains meaningful data in a timely manner.
Accountants use best practice standards when drawing up financial reports. Although these standards may vary from one jurisdiction to the next, convergence of standards is gradually taking place worldwide. A company’s accounts must generally be independently verified by the company’s registered auditors. The auditors are not employees of the company. Rather, they are independently appointed professionals who review the company’s financial accounts on a regular basis. Note that the auditors do not make changes to the accounts – they are responsible only for providing an opinion about whether the accounts are accurate and show an unbiased view of the state of the company’s finances.
[Financial Markets 101: Different Types and What Shapes the Market]
An Overview of Financial Statements
A company’s financial statements summarize the measurements of the company’s financial performance and position. The key financial statements of a company are its:
- Balance sheet
- Statement of retained earnings
- Income statement
- Statement of cash flows
Balance Sheet
The balance sheet is a list of a company’s assets and claims against those assets. This means showing all of the assets that the company controls balanced against everything the company owes to its providers of finance in the form of debt and equity.
Statement of Retained Earnings
A statement of retained earnings (or statement of stockholders’ equity) details the change in stockholders’ equity over an accounting period.
Income Statement
The income statement summarizes a company’s income for the year (as earned) and expenditure (as incurred) over the accounting period.
Statement of Cash Flows
The statement of cash flows (or cash flow statement) reports changes in cash and cash equivalents during a time period. Cash flow is vital because a company needs to have enough cash on hand to pay its expenses and purchase assets. While an income statement can tell you whether a company made a profit, a cash flow statement can tell you whether the company actually generated cash.
Key users of financial statements include:
- Management and employees
- Customers
- Suppliers
- Lenders
- Shareholders
- Government agencies
- Analysts
- Competitors
Earnings Management
Earnings management – also known as creative accounting – is the transformation of financial accounting numbers from what they actually are to what the company management preparing a financial report desires, through the use (or avoidance) of existing accounting rules.
Earnings management is generally used to portray a healthier picture of an entity’s financial position and/or performance. Corporate managers who engage in abusive earnings management must often lie to auditors, analysts, investors, and their own colleagues to cover such activities.
The motives behind earnings management are to meet internal or external targets or expectations, or to smooth earnings over time (to boost the company’s share price).
Double-Entry Accounting
Financial statements are prepared according to the double-entry system. This is a system that accountants use to record transactions. In double-entry accounting, every transaction has two entries in a company’s general ledger (the master set of accounts that summarize all of a company’s transactions) – a debit and a credit.
Debits must always equal credits (credits this can be checked using a trial balance of debits and credits).
Accounting Concepts
Accounting has adopted certain concepts to help ensure that financial accounting information is presented accurately and consistently.
These concepts are:
- The consistency concept
- The going concern concept
- Accruals (or Matching) concept
- Prudence (or conservatism) concept
The consistency concept means that accounting methods, once adopted, must be applied consistently going forward. A business should not change its accounting policy unless there are reasonable grounds for doing so. For example, if a company uses accelerated depreciation for its noncurrent assets, it should not change to using straight-line depreciation which would reduce the depreciation charge and increase income unless there is a valid reason for doing so. Any accounting policy change must be thoroughly explained in the notes to the accounts.
The going concern concept states that when a company’s financial statements are being drawn up it is assumed that the company will be able to continue to operate for the foreseeable future. If this is not the case, then the statement must be prepared using the net realizable values of the assets, that is, what the assets would sell for if the business were to be liquidated. The accruals or matching concept requires revenues and costs to be recorded in the accounting period in which they are earned or incurred, rather than when money is received or paid. For example, a sale occurring at the end of Year 1 with payment received early in Year 2 should still be recorded as revenue for Year 1 (not Year 2).
Finally, the prudence or conservatism concept dictates that income and gains should not be anticipated, but rather included in the accounts when realized in cash or other real assets. However, losses and liabilities should be included, at least as an estimate, as soon as they are known when reasonable clarity.
Accounting Standards
Accounting standards are authoritative statements of best accounting practices issued by standard setters so that financial statements are meaningful across a wide range of businesses – without standards, comparative analysis of different companies would be almost impossible.
The two most important bodies charged with setting financial accounting standards are the IASB and FASB.
Conclusion
In conclusion, accounting is the process of identifying, recording, and reporting financial information relating to a particular entity to interested parties. There are several important elements of accounting you should be aware of, including:
- Financial statements
- Earnings management
- Double-entry accounting
- Accounting concepts
- Accounting standards
If you’re interested in learning more about accounting and financial statement analysis, Intuition Know-How offers a comprehensive digital learning course on the topic.
Below is a full list of tutorials from the suite of content:
- Financial Statement Analysis
- Accounting – An Introduction
- Accounting Mechanics – Scenario
- Balance Sheet – An Introduction
- Balance Sheet – Analysis
- Income Statement – An Introduction
- Income Statement – Analysis
- Statement of Cash Flows – An Introduction
- Statement of Cash Flows – Analysis
- Three-Statement Modeling
