What It Is

Accounting is the process of systematically recording, measuring, and communicating information about financial transactions.

How It Works

At the heart of accounting is the double-entry bookkeeping method. This involves making at least two recording entries for every transaction: a debit in one account and a credit in another account. The method helps prevent errors because the sum of the debits should equal the sum of the credits. The three major financial statements produced by accounting are the income statement, the balance sheet, and the cash flow statement.

Accounting can be done on a cash basis (cash accounting) or on an accrual basis (accrual accounting). Cash accounting records cash inflows and outflows in the period in which they occur. Accrual accounting records income and expenses in the period to which they are attributable rather than when cash payments come and go. For example, a check written in April for March's utilities would appear as a March expense under the accrual method and as an April expense under the cash method.

There are two general kinds of accounting. Financial accounting is the recording and communication of economic information in accordance with Generally Accepted Accounting Principles (GAAP) and is primarily for external users. Managerial accounting is the recording and communication of economic information that may or may not be in accordance with GAAP and is for internal users. Other accounting specialty areas exist, such as tax accounting, oil and gas accounting, or forensic accounting.

There are two kinds of users of accounting information: internal users and external users. Internal users are usually company managers who use accounting information to decide how to plan and control operations on a daily and long-term basis. External users are existing or potential investors, creditors, analysts, financial advisers, regulatory authorities, unions, and the general public. They use accounting information to make a myriad of decisions about whether to buy, hold, sell, lend, continue a relationship, or make an agreement.

The Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), the IRS, and other regulatory bodies set accounting standards and requirements for accounting frequency and presentation.

Why It Matters

Accounting is tremendously important because it is the language of business, and it is at the root of making informed business decisions. Without accounting, managers would not know which products were successful, which business decisions were the right ones, and whether the company was earning money. It would not know how much to pay in taxes, whether to lease or buy an asset, or whether to merge with another company. In short, accounting doesn't just count the beans, it measures a company's success at meeting its goals and it helps investors understand how efficiently their economic resources are being used. This is why companies must be proficient in accounting in order to make good decisions.

Accounting can be controversial, in that accounting rules and methods are sometimes subject to interpretation or can appear to distort a company's true performance. This is another important reason that effective leaders and managers must thoroughly understand the accounting impact of their decisions.

Source: Investing Answers