What Is the Practice of Accounting?
Every business engages in the practice of accounting. Without it, there’d be no way of knowing the financial health of the organization. Moreover, if it’s a publicly traded company or a private firm with investors, accounting is a staple part of operations that can determine everything from the company’s value to how much it’s taxed.
Accounting is an extremely complex and nuanced discipline. Professionals study for years to become certified public accountants (CPAs) and even longer to specialize in different areas of accounting. Moreover, companies may employ entire teams of accountants to keep the business’s ledger up to date and accurate. It’s a practice that’s top-of-mind for every business, every day.
To say that accounting is the single most important aspect of business operations isn’t an understatement. It’s second only to sales, which generates the transactions the business accounts for.
What Is the Function of Accounting?
As its core, the function of accounting is to record business transactions in a ledger. This represents the inflows and outflows of money, representing total cash flow. Accountants then summarize, analyze and report these transactions in a way that paints a picture of the financial health of the business. The goal of any business is to have more money coming in than going out and to understand why.
The larger and more complex the business becomes, the more involved the process becomes. This can include generating a wide range of financial statements and reports for everyone from the chief financial officer (CFO) to regulatory bureaus, such as the Internal Revenue Service (IRS) or the Securities and Exchange Commission (SEC). The purpose of these reports varies as well. CFOs may use them to make recommendations about the trajectory of the business, while the IRS compares them against taxation models.
The practice of accounting has wide ramifications for anyone engaged with the business. As such, it’s governed by very strict rules and standards. Companies need to follow these standards closely or risk fines – or even prosecution if there’s intentional accounting mismanagement (see: Enron).
Understanding Generally Accepted Accounting Principles (GAAP)
To ensure accounting is a uniform practice across every company, businesses must follow Generally Accepted Accounting Principles (GAAP). GAAP provides a standard for what, how and when to report financial data and makes it easy for anyone with knowledge of these standards to evaluate and understand a company’s financial reporting. The Financial Accounting Standards Board (FASB) established GAAP and maintains and updates these standards annually. Every CPA accredited through FASB practices GAAP.
Types of Accounting
Because accounting has such a wide bearing on so many different facets of company operation, there are different modes of accounting to satisfy the needs of various parties. Each type of accounting uses the same data from company transactions yet delivers insights through different modes of reporting.
- Financial accounting. This generates statements for the purposes of general financial reporting. It involves reports like the profit and loss (P/L) statement, cash flow statement and the balance sheet.
- Managerial accounting. This caters to management. It often combines with budgets and forecasts to show the company’s performance. And it also provides context for decision making about how to govern the organization efficiently.
- Cost accounting. This uses financial data to help decision-makers better understand the implications of costing. For example, it can help determine the price of goods and the cost of materials.
Each mode of accounting relies on the same data – or subset of the same data – to identify opportunities for making the business more profitable and efficient.
Accounts Payable vs. Accounts Receivable
Accounting as a practice breaks down into two sides: accounts payable vs. accounts receivable. Or, in simpler terms: current liabilities vs. current assets. These two sides of the balance sheet paint a picture of the financial health of a business at any given time.
- Accounts payable is money owed to suppliers and vendors for goods and services.
- Accounts receivable are funds owed to the business by customers for goods or services.
Accounting records these transactions to represent the company’s current financial state. If accounts payable exceed accounts receivable, it means the company is in debt. If the opposite is true, the company is profitable. And the larger the company, the more complex this expression of transactions becomes.
Cash vs. Accrual
There are two basis options for looking at business financial accounting: cash and accrual. The difference rests in when financial transactions appear on the company’s ledger. There’s often a gap of time between transactions and when funds actually become available, which is where cash and accrual differ.
- Cash basis recognizes a transaction only when funds exchange hands.
- Accrual basis recognizes transactions at the point of origination.
Cash and accrual are best illustrated in an example. Say ABC Company sells $1,000 worth of widgets to a customer on NET 15 terms. On a cash basis, the company would account for the transaction when the customer pays in 15 days. On an accrual basis, the company would account for the transaction as soon as the widgets leave inventory.
Cash vs. accrual has a significant impact on the company’s financial health at any given time. Accrual basis is widely considered the standard in professional accounting since it best represents cash flow in real time. Cash basis is often used to gain a snapshot of the company’s health over a specific time period, such as a quarter or the trailing year.
The Importance of Accounting for Investors
The intricacies of accounting are too broad and complex to explain in-depth here. Nonetheless, it’s vital for every investor to get a basic handle on the practice. And this understanding can help you build wealth in your life. Therefore, sign up for the Liberty Through Wealth e-letter below for more financial insights and analysis.
The ability to read a balance sheet or evaluate a company’s financial statements positions investors to better understand the financial health and well-being of a company. Moreover, the accounting of a business is a window into its operations. Investors who can see through that window clearly will make smarter decisions about the companies they choose to take a stake in.