Accounting is the systematic recording of the financial transactions of a business. The recording process includes setting up a system of record keeping, tracking transactions within that system, and aggregating the resulting information into a set of financial reports.
Accounting tells you whether or not you’re making a profit, what your cash flow is, what the current value of your company’s assets and liabilities is, and which parts of your business are actually making money.
So, in brief, Accounting is the art in which financial transactions are:
Documented: Required vouchers & supports are received and placed in appropriate places. For example, a purchase voucher is stored in the purchase register. Documentation increases accountability and also allows us to rectify errors in future, if any.
Recorded: All business transactions of a financial character are recorded in the accounting software and other relevant books. The recording process is different in both manual and computerized accounting system. In computerized accounting system, recording is done by creating vouchers in accounting software. Other relevant books are created by software itself. In the case of manual accounting, financial transactions are recorded in different books and records like Journal Book, Sales Book, Purchase Book, Ledger, Stock Book, etc.
Analyzed: Financial statements are prepared using the aforementioned records and prepared financial statements are analyzed to find out the performance as well as position of the business and are communicated to intended users. Decision making in any business is influenced by reports generated through an accounting system.
The accounting cycle is a process designed to make financial accounting of business activities easier for business owners. There are mainly five types of accounting cycle which are describe below:
1. Financial Transactions:
Every business gets involved in number of financial transactions like sales, purchase, payment, receipt etc. A financial transaction can be defined as a business event that has a monetary impact on an entity’s financial statements, and is recorded as an entry in its accounting records.
1.1 Financial vs Non Financial Transactions
Here are some examples from which we will be clear about what is financial transactions and what is not.
Opening a bank account is not a financial transaction, but if we deposit cash in that account then it is a financial transaction as it changes the value of assets (cash and bank).
If we appoint a new employee in our company, appointing new employee is not a financial transaction, but if we pay salary to that employee then it is a financial transaction as it changes the value of asset (cash/bank) and liability (salary payable).
If we change our company’s ATM Pin it is not a financial transaction, but if we withdraw cash from the ATM then it is a financial transaction as it changes the value of assets (cash and bank).
1.2 Types of Financial Transactions
There are mainly six types of financial transactions that occur in a business. The six types of financial transactions are described below:
- Fixed Assets Purchase
Documentation refers to set a record that a business keeps to provide evidence or information for every financial transaction. For example, a purchase voucher is stored in the purchase register. Documentation provides evidence that:
- Recorded transaction has occurred.
- Recorded transaction is accurate.
- Occurred transaction is authorized.
A journal is a detailed record of all the transactions done by a business. When a transaction is recorded in a company’s journal, it’s usually recorded using a double-entry method. The rule of passing a journal entry is that the entry must have at least two accounts, with one debit and another credit amount. The debit amounts will always equal the credit amounts.
A ledger is a book or collections of accounts in which account transactions are recorded. Ledgers are used by accountants to prepare balance sheets, track income and expenditures. Each account has an opening or carry-forward balance, and would record each transaction as either a debit or credit in separate columns, and the ending or closing balance. Accounting software like tally, busy etc. prepares accounting ledger automatically once the financial transaction is recorded in it.
5. Trial Balance:
Trial Balance is a statement summarizing the closing balance of all the ledger accounts, prepared with the view to verify the arithmetical accuracy of ledger posting. In Trial balance, all the ledger balances are posted either on the debit side or credit side of the statement. The total of debit balance in trial balance should match with a total of credit balance, only then it is said to be arithmetically accurate. Trial balance is a primary source for preparing various financial statements such as Profit & Loss account, Balance sheet etc. Accounting software like tally, busy etc. prepares trial balance automatically once the financial transaction is recorded in it.
Reports are compilations of financial information that are derived from the accounting records of a business. These statements include the following reports:
Profit & Loss Statement: Profit & Loss statement states the sales earned during a period less expenses, to arrive at profit or loss. This is the most commonly used accounting report which is used to judge the performance of a business.
Balance Sheet: Balance Sheet shows the ending asset, liability, and equity balances as of the balance sheet date. It is used to judge the financial position of the business as of certain date.
Statement of Cash Flow: Cash flow shows the sources and uses of cash related to operations, financing, and investments. This is the most accurate source of information regarding the cash-generating ability of an entity.
Major Areas Covered by Accounting:
Accounting covers the following major areas:
Business Performance: Accounting covers the preparation of the income statement & cash flow over a period of time which shows the real performance of the business.
Legal Compliance: Accounting covers compliance with legal frameworks like payment of taxes, VAT & TDS Returns, advance payment, etc.
Budget & Projection: Budgeting functions like financial projections, costing budget and operational plan, etc. are prepared using accounting functions.
Prevent Fraud & Manipulation: Regular monitoring of accounts like cash books and fixed asset registers help to prevent fraudulent activities like cash embezzlement, misappropriation of assets, etc.
Assist Auditors: The auditor’s main objective is to examine the financial statements and their preparation lies under the function of accounting. So, accounting makes auditing possible.
Needs of Accounting:
Accounting is necessary for different parties related to business like:
Management: The management has to make operational and financing decisions about the business. To make those decisions management needs to understand the profitability, liquidity, and cash flows of the business which is only possible with the help of accounting.
Employees: An employee with good knowledge of accounting will have more involvement in the business. Additionally, employees can determine the ability of the firm to pay salaries and bonuses as well as career growth in the longer term.
Shareholders: Shareholders want to understand the performance of their investment. They want to know the ability of the firm to survive, prosper and pay dividends. They can get that information through the financial statements. Preparation of those financial statements comes under accounting.
Creditors: Creditors want to determine the ability of the business to pay its due at an appropriate time using accounting reports.
Regulators and Government: Government wants to determine whether the business paid the appropriate amount of taxes. A profit and loss account is used to determine the tax amount which is a major accounting report.
Bank and Financial Institutions: Banks and financial institutions need accounting to estimate the ability of the business to pay back all the loans and related interest charges.