Below are some basic accounting principles and their definitions for your reference.
Please know we will always take the time to explain and define the accounting options we propose so that you can comfortably make an informed decision that is best for you. You can ask us anything, anytime.
Lesson 1 - What is Accounting?
Accounting is famously known as the “language of business”. Through the financial statements, the end-product reports in accounting, it delivers information to different users.
Accounting is a means through which information about a business entity is communicated.
Let’s take a moment to illustrate that.
Meet Mr. Strauss
Mr. Strauss started a printing business. He invested $100,000 personal money to start the company’s operations. After a month, he wants to know how much the business made. He also wants to know if the money he invested is still there.
Without a way of recording the activities of the business, we will not be able to answer his questions. Surely we can tell him, “Mr. Strauss, we made a lot this month!”, but we need proof! And he needs the figures!
We can easily answer Mr. Strauss’ questions if we kept track of the company’s transactions. If we used $30,000 of the $100,000 we had at the beginning to buy printers and pay the bills, then we’d have $70,000 cash left. If we collected $50,000 from our customers, then we would have $120,000. Easy, right?
Okay, that’s just a tiny bit of what accounting can do. What if we have thousands of transactions? Also, there’s a lot more to accounting than just recording. How much income did we make? How much do we owe our creditors? Is this a good investment? Ask away. Accounting would confidently say, “I’ll have the reports prepared.” How cool is that?
Technical definitions of accounting have been published by different accounting bodies. The American Institute of Certified Public Accountants (AICPA) defines accounting as:
the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least of financial character, and interpreting the results thereof.
Though I am not a fan of technical definitions, I believe that studying the statement above will give us a better understanding of accounting.
1. Accounting is considered an art
Accounting is considered an art because it requires the use of skills and creative judgment. One has to be trained in this discipline to be able to perform accounting functions well.
Accounting is also considered a science because it is a body of knowledge. However, accounting is not an exact science since the rules and principles are constantly changing (improved).
2. Accounting involves interconnected “phases”
Recording pertains to writing down or keeping records of business transactions.Classifying involves grouping similar items that have been recorded. Once they are classified, information is summarized into reports which we call financial statements.
3. Concerned with transactions and events having financial character
For example, hiring an additional employee is qualitative information with no financial character. Hence, it is not recorded. However, the payment of salaries, acquisition of an office building, sale of goods, etc. are recorded because they involve financial value.
4. Business transactions are expressed in terms of money
They are assigned amounts when processed in an accounting system. Using one of the examples above, it is not enough to record that the company paid salaries for April. It must include monetary figures – say for example, $20,000 salaries expense.
5. Interpreting the results
Interpreting results is part of the phases of accounting. Information is useless if they cannot be interpreted and understood. The amounts, figures, and other data in the financial reports have meanings that are useful to the users.
By studying the definition alone, we learned some important concepts in accounting. It also gave us an idea of what accountants do.
You may not notice but the simple things you do and encounter everyday can actually be related to some level of accounting. You make budgets, count change and check the receipts from the supermarket. You may also have listed things you spent your money with at one point in your life.
We are surrounded by business – from managing our own money to seeing profit statements of big corporations. And where there is business, there sure is accounting.
Lesson 2 - Purpose of Accounting: Its Practical Importance
In this article you will learn the purpose of accounting and the different types of financial information.
We learned that accounting is the language of business; a means of communicating information about an economic entity to different users for decision-making.
An economic entity is a separately identifiable organization which makes use of resources to achieve its goals and objectives.
An economic entity may be a business entity operating primarily to generate profit, or anon-profit entity carrying out charitable and not-for-profit operations.
This means that a “business entity or business organization” refers to the for-profit type of economic entity. Some authors use “business entity” to refer to both for-profit and not-for-profit organizations. Nonetheless, all economic entities – whether business or non-profit – rely on accounting in processing and providing financial information.
The Purpose of Accounting
From the illustration presented, and for a straightforward answer, it is clear that the ultimate purpose of accounting is to provide information to different users. The users utilize the information in making economic decisions.
It can actually be depicted from some definitions made by accounting bodies. According to the American Institute of Certified Public Accountants (AICPA):
Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions, in making reasoned choices among alternative courses of action.
And then, we have another definition – one which has been in use for a long time already – by the American Accounting Association (AAA).
Accounting is the process of identifying, measuring and communicating economic information to permit informed judgment and decision by users of the information.
Both of the above definitions and the very nature of accounting suggest its basic purpose – to provide information needed by users in making economic decisions.
Here’s a list of the different types of information provided by accounting reports. These things will be clearer when you get to the tutorials on Financial Statements. For now, it is sufficient (and good) to know what information we are talking about.
- Results of operations. This pertains to the profit generated by the company for a certain span of time (for a year, for a quarter, for a month, etc.). This is measured by deducting all expenses from all income. The resulting amount is called net income.
- Financial position. How much resources does the entity currently have? How much does the entity owe third parties? How much is left for the owners after we pay all obligations using our resources? The first question refers to the entity’s total assets; the second to liabilities, and the third to capital.
- Solvency and liquidity. Solvency refers to the entity’s ability to pay obligations when they become due. Liquidity pertains to its ability to meet short-term obligations.
- Cash flows. The financial statements also show the inflows and outflows of cash in the different activities of the business (operating, investing, and financing activities).
- Other information. The financial statements provide qualitative, quantitative, andfinancial information. One of the characteristics of the financial statements isrelevance. Any information that could affect the decisions of users should be included in the financial reports.
Lesson 3 - Users of Financial Statements
We have been talking about accounting and its purpose of providing information to users for decision-making. But, who exactly are these “users of financial statements”?
Also, what information do they need and what decisions do they make?
The following are the different users of accounting information and their specific information needs.
1. Owners and investors
Stockholders of corporations need financial information to help them make decisions on what to do with their investments (shares of stock), i.e. hold, sell, or buy more.
Prospective investors need information to assess the company’s potential for success and profitability. In the same way, small business owners need financial information to determine if the business is profitable and whether to continue, improve or drop it.
In small businesses, management may include the owners. In huge organizations, however, management is usually made up of hired professionals who are entrusted with the responsibility of operating the business or a part of the business. They act as agents of the owners.
The managers, whether owners or hired, regularly face economic decisions – How much supplies will we purchase? Do we have enough cash? How much did we make last year? Did we meet our targets? All those, and many other questions and business decisions, require analysis of accounting information.
Lenders of funds such as banks and other financial institutions are interested in the company’s ability to pay liabilities upon maturity (solvency).
4. Trade creditors or suppliers
Like lenders, trade creditors or suppliers are interested in the company’s ability to pay obligations when they become due. They are nonetheless especially interested in the company’s liquidity – its ability to pay short-term obligations.
Governing bodies of the state, especially the tax authorities, are interested in an entity’s financial information for taxation and regulatory purposes. Taxes are computed based on the results of operations and other tax bases. In general, the state would like to know how much the taxpayer makes to determine the tax due thereon.
Employees are interested in the company’s profitability and stability. They are after the ability of the company to pay salaries and provide employee benefits. They may also be interested in its financial position and performance to assess company expansion possibilities and career development opportunities.
When there is a long-term involvement or contract between the company and its customers, the customers become interested in the company’s ability to continue its existence and maintain stability of operations. This need is also heightened in cases where the customers depend upon the entity.
For example, a distributor (reseller), the customer in this case, is dependent upon the manufacturing company from which it purchases the items it resells.
8. General Public
Anyone outside the company such as researchers, students, analysts and others are interested in the financial statements of a company for some valid reason.
Internal and External Users
The users may be classified into internal and external users.
Internal users refer to managers who use accounting information in making decisions related to the company’s operations.
External users, on the other hand, are not involved in the operations of the company but hold some financial interest. The external users may be classified further into users with direct financial interest – owners, investors, creditors; and users with indirect financial interest – government, employees, customers and the others.
I’ll leave you a question to help you better appreciate the purpose of and need for accounting.
Assume we are looking into two companies – Company A and Company B. Suppose you have $50,000 and are planning to invest your money and receive annual returns from share in profits. In which company would you invest – Company A or B? Can’t pick just yet, right? Then you get the point.