Though it dates back to the Mesopotamian era, accounting has always remained a cornerstone in the life of a company. We often hear about it, sometimes wonder what’s its real definition, but why is accounting important?
Well, when you are faced with multiple tax and legal constraints, you can legitimately ask yourself this question.
This is why in this article, we’ll talk about its definition and its role to help you to better understand it and all its contours. Because, at the heart of accounting issues, it is indeed a question of the good management of your company.
What is accounting?
In the most general terms, accounting is the process of regularly measuring, recording, and organizing financial information, which allows you to establish real-time accounts and report on the financial situation of your business.
It aims to identify the ins and outs of your business’s cash flow, such as revenues and expenses, etc. by recording all financial transactions in an accounting book, called a general ledger.
Simply put, it is to observe the amount of money you are making versus the amount you are spending to evaluate your financial position, to see what should or needs to be improved to prevent bankruptcy.
What is the purpose and importance of accounting?
As you have previously read, accounting helps you track your income and expenditure, prove whether it is ok for investors to invest and loans to lend you money.
It confirms the legitimacy of your business and company, to know if the statutory compliance is respected. There are many reasons as to why accountancy is necessary in a company, and these are:
The organization aspect: It helps to stay on top of the amount of money and transactions you have made. While it is easy to get carried away, having a visual or physical representation of your financial situation such as your income statement, which indicates your loss and profits, or a balance sheet, which depicts the financial state at a given period, is really used to keep you and your business’ head above water.
Inspect your business’ performance: If you keep your business’ accounting relevant, it would also help you to compare your previous accounting records with the recent ones. You would be aware of your gross margin, which is the amount of money a company is left with after direct cost, as well as any probable debts to see if any changes should be made and if you are properly managing your company. It holds you accountable to the famous words known as tax, tax return, VAT, etc.
Upholding statutory compliance: With no accounting, there are no financial statements. And, as I have said before, it is evidence that proves if you are following the rules and regulations. Otherwise, this omission can lead to issues like fines, lawsuits, license confiscation, or the thing a business dreads, which is getting audited by the IRS. You want to avoid them at all costs because if payments are not taken into consideration, it engenders seizing of assets or even worse prison time.
It helps with budgeting: Of course, if you spend more than what you have, you can quickly spiral into debts and the company shut down. So, it poses the question of “what do we need to cut back on?”
Implement new strategies: Thanks to the visual accounting numbers, you can clearly analyze your current financial situation and, if you can do better than, well, change strategies. Sometimes, I won’t lie it does not always work out, but that is the point of accounting as it evaluates your revenue and expenses.
Your value or not for investments and loans: Investors or lenders, e.g, banks won’t lend to a company they have not investigated. To do so, they ask to review financial statements from your accounting books and if you are not in possession of them, I must say you will not be profitable for anyone for that matter.
The role of accounting in companies
As we now know, accounting plays a vital role in companies’ business. Without it, your tax return won’t be valid, and this leads to the IRS getting involved.
In practical terms, accounting is concerned with :
- Drawing up the company's accounts, gathering and coordinating all financial data.
- The accountant's role in the company is to enter accounting information and to ensure its reliability and veracity.
- Good bookkeeping should favor a good relationship between financial information and financial transactions, i.e. sales, purchases, investments, etc.
The different types of accounting
Financial accounting may be the common type, but others exist. And here are the 8 that people use.
First, we have:
1. Financial accounting: an accounting system that tracks the records of financial transactions, which generates financial statements.
It usually adheres to the guidelines of the GAAP rules, that is to say, the Generally Accepted Accounting Principles that have been fixed by the FASB, a.k.a. the Financial Standards Board to emphasize the uniformity of the process.
There are two types of financial accounting, that companies use when recording financial transactions, which are cash and accrual accounting that call for the use of double-entry accounting. Large companies use it is to produce and verify financial statements to compare past performance with the current one, over a given time.
2. Management accounting: Whereas financial accounting is for external reporting, management accounting is for internal reporting. It is shared with members in the organization, concerning the decisions to take for the business.
This information could be externally shared, but only when it is to be compared with financial accounting to notify shareholders and creditors of your work performance.
There are 3 types of course, that are known as:
- Strategic management
- Performance management
- Risk management
Any one of them could be used based on the needs of the company at that specific time.
3. Governmental accounting: It is the government known as the Governmental Accounting Standards Board (GASB) that deals with this form of accounting.
They survey resources and public activities, which they separate into different funds to track income, expenses to simplify the evaluation of how a road project’s, for example, is being performed and how the money is being spent. It is to know whether and by how much the funds (the expenses) or resources, are decreasing to see what decisions should be made.
There are 5 types of funds:
- General fund
- Permanent fund
- Capital projects fund
- Special revenue fund
- Debt services fund
And these must be used separately to give a specific and précised report of expenditures.
4. Public accounting: This type of accounting centers around auditing, tax returns and evaluations, and preparations of financial statements. It is public firms that perform the accounting procedures for businesses. It is to guide customers in the right direction and advise them on financial matters, such as accounting software, if necessary.
5. Cost accounting: Its main focus is the cost that the business requires. It takes into account the cost that certain companies incur when buying materials, for example, to accomplish a project. Therefore, to get that statement, one must take into account their fixed cost like rent, admin cost, and their variable cost, like the materials needed for production to know if their company’s business is profitable. And how do you know, you ask? Well, it is basically: Revenue - Expenses = Profit.
If this number is negative, then you most likely acquired a loss and if it is positive then, you have earned a profit and have become profitable.
6. Forensic accounting: In this case, it is used in embezzlement and fraud cases, basically meaning not to fraud, or you will land in a court having to justify your reasons for such an act, especially if a forensic accountant is called to expose your wrongdoings.
It is the investigation of individual and business’ financial activities. It is usually performed by the police department, attorneys, and banks who investigate businesses’ and individuals’ financial transactions to later provide a report of their findings.
7. Tax accounting: This accounting follows the Internal Revenue Code (IRC) to guarantee that companies and individuals are following the tax and rules regulations of that given time. They could either use it to prepare for tax returns or simply tax planning to decrease that lovely tax amount at the end of the year.
8. Auditing: examines a business’ financial record to see whether what has been submitted or calculated by a company is correct. If you fail the audit, then you might risk the chance of paying an additional 20% related penalty or even worse, facing criminal charges. Accounting is very important to determine your gains and expenses.
It is performed independently and in many ways to ensure that businesses are following the rules and regulations. You have the:
- Compliance audit: as its name indicates, it is to see if a company is complying with the rules and regulations.
- Investigative audit: Even there is one or not, its purpose is to detect criminal activity.
- Financial audit: Commonly used, is the analysis of financial statements.
- Tax audit: Performed by the IRS to verify the accuracy of tax returns.
To conclude, we have seen that a company that is managed without accounting can encounter many risks. As a business owner, it is your duty to provide financial statements, and if you don’t, you risk the chance of losing your business because of debt as you didn’t analyze nor budget your revenue and expenses well enough. Stakeholders will not invest in your business or product because you will have nothing to show for your finances and finally, the famous government and IRS will come knocking at your door to shut you down and inflict criminal charges.
So what will you choose? It is up to you. Though, it is kindly recommended to stay on the right side of the law than losing more if you had just recorded the right financial statements and followed the rules. Which side are you on? Profit or loss?