Introduction to Accounting
Accounting is an information management process that systematically accumulates, records and reports information about an organization’s financial performance (i.e. profit or loss), its financial position (i.e. assets, liabilities and shareholder’s equity) and changes in financial position (i.e. cash flows and working capital).
Every organization, whether business or not-for-profit, aims to create maximum value addition for its owners and other stakeholders. This goal cannot be achieved without a mechanism to monitor the performance of the organization. Performance measurement may be carried out along both financial (i.e. earnings, wealth etc.) and non-financial (e.g. customer satisfaction, market share etc.) dimensions and accounting is concerned with performance measurement in financial terms.
Inputs to an accounting system include business transactions which are usually supported by source documents, such as invoices, board resolutions, management memos, etc. but transactions may also take place without formal documentation. Accounting records and processes all quantifiable transactions using well established procedures and techniques. The methods of accounting are affected by whether the reports to be produced will be presented to wider stakeholders rather than just for internal use. This is discussed below.
Based on its purpose and potential users, accounting practice and profession is often classified as:
- Financial Accounting: is concerned with the preparation of financial reports (i.e. income statement, balance sheet etc.) which are presented to the owners and other stakeholders. The aim is to monitor the performance of management and the board of directors and the organization in general. Financial accounting follows rules and principles of accounting which are usually in the form of a set of standards, most popular being International Financial Reporting Standards (IFRS) and each country’s own Generally Accepted Accounting Principles (GAAP).
- Management Accounting: is concerned with producing reports to support management in decision making and performance monitoring of business segments, production facilities etc. Since management accounting serves internal users, it is not usually subject to reporting regulations.
Users of the Financial Statements
The most basic objective of financial accounting is preparation of general-purpose financial statements, which are financial statements meant for use by stakeholders external to the entity, who do not have any other means of getting such information, i.e. people other than the management. These stakeholders include:
- Investors and financial analysts: Investors need the information to estimate the intrinsic value of the entity and to decide whether to buy, hold or sell the entity's shares. Equity research analysts use financial statements to conduct their research on earnings expectations and price targets.
- Employee groups: Employees and their representative groups are interested in information about the solvency and profitability of their employers to decide about their careers, assess their bargaining power and set a target wage for themselves.
- Lenders: Lenders are interested in information that enables them to determine whether their loans and the interest earned on them will be paid when due.
- Suppliers and other trade creditors: Suppliers and other creditors are interested in information that enables them to determine whether amounts owing to them will be paid when due and whether the demand from the company is going to increase, decrease or stay constant.
- Customers: Customers want to know whether their supplier is going to continue as an entity, especially when they have a long-term involvement with that supplier. For example, Apple is interested in long-term viability of Intel because Apple uses Intel processors in its computers and if Intel ceases operations at once, Apple will suffer difficulties in meeting its own demand and will lose revenue.
- Governments and their agencies: Governments and their agencies are interested in financial accounting information for a range of purposes. For example, the tax collecting authorities, such as IRS in USA, are interested in calculating taxable income of the tax-paying entities and finding their tax payable. Antitrust authorities, such as Federal Trade Commission, are interested in finding out whether an entity is engaged in monopolization. The governments themselves are interested in efficient allocation of resources and they need financial accounting information of different sectors and industries to decide on federal and state budget allocation, etc. The bureaus of statistics are interested in calculating national income, employment and other measures.
- Public: The public is interested in an entity's contribution towards the communities in which it operates, its corporate social responsibility updates, its environmental track record, etc.