Key Takeaways
- Accounting is the systematic process of recording, summarizing and communicating financial information about a business that is useful for decision-making.
- Accounting plays an important role in business in providing the necessary information so that various stakeholders could make intelligent decisions involving the business.
- People use accounting in their day-to-day activities that involve their personal finances.
What is Accounting?
Starting a business is probably one of the most fulfilling decisions for many entrepreneurs and business owners. If you’re a business owner, the thought of transforming your idea into a real product and sharing it to the world is enough reason for you to work beyond the typical 40-hour work week.
However, one thing that many business owners would agree is that they don’t have the eagerness required to handle the financial details of their business. This is the reason why business owners hire accountants to do the number crunching and analysis for them.
Accounting, oftentimes considered the “Language of Business”, is the only means through which we can understand financial information about a business. Financial reports, which are the products of the accounting process, are used by business owners, creditors, investors, and other stakeholders to make decisions involving the business.
Accounting can provide answers to a lot of questions that are related to the financials of a business. Some of these questions that are usually asked by stakeholders are as follows:
- How much is the owner/s’ net worth in the company?
- How much assets does the business has? How much of them are owed to creditors?
- How well did the business performed during the previous financial year?
- Does the business have sufficient assets to cover its short-term liabilities?
- How much taxes does the business owe to the government?
- Of the total expenses, how much are spent for wages and salaries?
- Are there account customers defaulting on their payments?
- Can a business secure a loan for its expansion?
Accountants have the proper knowledge and training to collect relevant financial data and organize them into information that are contained in the financial reports. They can analyze these reports and provide different stakeholders with the necessary financial information that the latter need.
Definition of accounting
Accounting is the systematic process of recording, summarizing and communicating financial information about a business that is useful for decision-making by stakeholders.
In addition to this definition of accounting, there are also three other definitions that were set out by several authoritative bodies in different points of time within the last 85 years. Let’s go through each one below.
1941 AICPA definition
The first definition below was formulated in 1941 by the Committee on Terminology of the American Institute of Certified Public Accountants (AICPA) on its “Accounting Terminology Bulletin No. 1: Review and Resume”.
Accounting is 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 a financial character, and interpreting the results thereof.
This 1941 AICPA definition shows that the role of accounting was to report on the stewardship function of the management of a business. It defined accounting in terms of what it did, i.e. to record, classify and summarize the transactions of an entity and interpret the results. Most of the academic community of the 1941 era accepted this transaction-based view of accounting.
1966 AAA definition
The second definition below was from the American Accounting Association (AAA), on its “A Statement of Basic Accounting Theory (1966)”.
Accounting is the process of identifying, measuring and communicating economic information to permit informed judgment and decisions by users of the information.
In the 1966 AAA definition above, accounting was defined as a three-phase process that identifies, measures and communicates economic information that permits informed judgment and decisions by users. It also claimed that there is no implication that accounting information is necessarily based only on transaction data.
1970 AICPA definition
The third definition below was from the Accounting Principles Board (APB) of the AICPA, on its “Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises Statement No. 4 (1970)”. The APB was replaced by the Financial Accounting Standards Board (FASB) in 1973.
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.
The 1970 AICPA definition above superseded the old 1941 definition. It defined accounting in terms of what accounting ought to do, i.e. provide information useful in making economic decisions.
Why are there several definitions of accounting?
The changing and sometimes competing viewpoint of the role of accounting led to the adoption of different definitions of accounting as we have outlined above. This was discussed in the Origins of the Accounting Revolution, a 1994 working paper written by Carl W. Brewer, Ph.D., CPA, who was then the assistant professor of accounting in Sam Houston State University.
The 1941 definition perceives accounting as being focused on the financial history of the firm while the 1966 and 1970 definitions perceive accounting as providing information that is useful for decision making. The viewpoint of accounting seems to shift from being focused on management stewardship and transaction-based to being focused on providing information that is useful in making economic decisions.
Breaking down the definitions
The above technical definitions could be confusing you right now. However, let’s try to break them down below into items that are more understandable and meaningful:
- Identifying – the first step in the accounting process is to identify and recognize information that relate to business activities and transactions that are financial in nature.
- Measuring – after identifying the business transactions, a monetary amount is assigned to make them measurable.
- Recording – the business transactions are recorded in the accounting journal in a chronological sequence and in accordance to accounting standards.
- Classifying – the recorded transactions are classified and grouped into similar transaction classes in the accounting ledger.
- Summarizing – after posting the transactions to the ledger, they are summarized into general-purpose financial statements that include the statement of financial position, income statement, and statement of cash flows. Other financial and management reports are also prepared using the information in the ledger.
- Communicating and interpreting – the financial reports are communicated to various stakeholders. The information in these reports are then analyzed and interpreted to assist stakeholders in making economic decisions.
Importance of Accounting
Now that we learned that accounting is a system that provides financial information for decision-making, let’s try to identify the important roles of accounting to a business and an individual.
Importance of accounting to a business
When you try to look at a company’s financial statements, you’ll most likely see a lot of mind-numbing numbers. However, looking at a different perspective, you’ll realize that these financial reports actually provide an entire picture about what a business does and how it is performing at a specified period of time.
Since accounting information provided in the financial reports are used by various stakeholders within and outside the business organization in making intelligent decisions, it’s very important and critical that these information are accurate and reflect the true condition and performance of the business. These reports should be prepared in accordance with existing accounting standards and regulatory policies.
The role of accounting extends beyond just bookkeeping and financial reporting. It also encompasses tax planning, budgeting, financial statement analysis, cost management, fraud prevention and detection, and auditing.
A budget report is important to managers when comparing the actual results of a business with the established budget. It helps identify any inefficient use of resources during a certain period.
Another role of accounting which is fraud prevention and detection can save a business a fortune that could have been lost from employee thefts and embezzlement. There are a lot of real world cases where businesses closed down their operations due to employee and management fraud.
In today’s globally competitive economic environment, the financial information provided by accounting is more important than ever. Behind these information are facts and numbers that reflect the true financial position and performance of a business. Accurate information will help management in making decisions that could lead to business growth and stability over a long period of time.
Any misleading financial information can also negatively affect the decisions of various stakeholders and even impact the lives of ordinary people. Just like in a war where information is vital to the success of the parties involved, accounting information is also very critical in the survival of the business.
Importance of accounting to an individual
While accounting is generally used in the context of business, it actually affects our day-to-day lives as individuals. You’ll probably use accounting whenever you earn, save and spend money.
Here are some examples of scenarios where you could apply accounting in your personal life.
- When you’re a student and you receive an allowance from your parents, you are likely to account and keep track of your expenses to ensure that you still have enough money to last until you receive your next allowance.
- When you’re applying for any kind of loan such as student loan, personal loan, or mortgage, accounting is also involved in the computation of your monthly principal and interest payments.
- When you’re an employee, the computation of your salary and employment taxes involves accounting.
- When you’re a freelancer or you provide consultation services for a fee, then you’ll need to account and keep track of your revenue, expenses and income taxes.
- When you have to create a family budget and keep track of your household expenses.
- When you decide to invest your savings for your retirement or to grow your wealth, you need to weigh different investment options and choose the one that could give the optimal return for your money. Accounting could help you analyze the fundamentals of your prospective investments.
- When you have to save for a down payment on your first home, buy your dream car, fund your child’s education, or save for that beachside vacation you’ve always wanted, accounting will help you determine the amount you need to save.
From the first time that you received your first allowance from your parents, accounting has always become a part of your life. Anything that involves your personal finances also involves accounting. What’s important is to have a plan, create a budget, and keep track of all your income and expenses. Doing this will surely remove a lot of headaches that usually come with finances, and could create room for more opportunities in life.
Review Questions
- How would you define accounting based on your understanding of this subject?
- Why is accounting considered as the “Language of Business”?
- Why are there three different definitions of accounting from AICPA and AAA?
- How important is accounting to a business?
- How important is accounting in a person’s life?
