What is Accounting and Why is it Important?

Every small business needs to maintain accurate and up-to-date accounting records. Tracking your financial transactions allows you to monitor your company’s performance, keep tabs on your cash flows, and comply with the rules made by regulators and the IRS. 

Sole proprietors often double up as accountants. But as a business grows larger, it could use accounting software to help it carry out this activity. Many small firms hire part-time or full-time accountants to help with their accounting, while bigger companies typically employ a Certified Public Accountant (CPA).

In this post, we’ll discuss the purpose of accounting, the principles that govern accounting activities, and finally, the three different types of accounting.

What is accounting?

The primary objective of accounting is to record every financial transaction that a company enters into and summarize it in a manner that helps business owners and managers run the company efficiently and profitably.

Here’s a quick summary of the reasons that every business needs to keep accounting records:

It creates a permanent record of every financial transaction that a company enters into. 

Apart from the fact that good record-keeping is an essential business requirement, there’s a legal necessity as well.

According to IRS regulations, you need to maintain financial records and documents for a minimum of three years. In specific circumstances, this period is even longer. For example, if you have claimed a loss for a bad debt, you are required to keep records for seven years.

Accounting helps business owners keep a watch on their company’s financial performance and provides them with the data they need to make informed decisions. 

Every company prepares five different basic financial statements. These are:

• The Income Statement
• The Balance Sheet
• The Statement of Shareholder Equity
• The Statement of Cash Flow
• The Notes to Financial Statements

Each of these financial statements is prepared using data sourced from the company’s accounting records. 

Accurate and timely accounting records help in preparing tax returns. Every business is required to file its taxes. And if you do not report income that you should report, you may have to pay a penalty. There is also a penalty for not filing your return by the due date. So, if your company doesn’t keep timely and error-free financial records, you could find yourself in a position where you have to pay the IRS a penalty.

There’s another reason for the importance of accounting in connection with your tax filing. If your records are detailed and well-maintained, you’ll be in a position to claim the tax deductions you’re entitled to. This will reduce your taxable income and boost cash flows.

Accounting principles

Companies need to follow a specific set of rules for creating their accounting records. This is necessary to ensure that the financial statements prepared based on these records disclose all the relevant information. If firms were not required to follow these rules or principles, they could suppress specific details or choose to report inaccurate numbers.

Imagine for a moment that each company decided its own accounting rules. In this situation, banks and financial institutions would find it difficult to conduct a credit review. The IRS wouldn’t be able to determine a company’s taxable income, and investors would be clueless about the performance of the business in which they had deployed their funds.

So, which are the rules that company accountants are required to follow?

Public companies in the United States adhere to a set of standard accounting principles called GAAP (Generally Accepted Accounting Principles). These are accounting standards and procedures issued by the Financial Accounting Standards Board, an independent not-for-profit organization that establishes reporting standards. 

You can read more about GAAP in this post titled 24 Basic Accounting Principles Business Owners Must Have. 

Types of accounting

It’s important to realize that accounting records provide data that can be used in several different ways. In this section, we will describe three types of accounting and why each is important.

Financial accounting

Financial accounting is concerned with generating the five basic financial statements we listed in an earlier part of this post. Each financial transaction in an accounting period is summarized into the income statement, balance sheet, and cash flow statement. The statement of shareholder equity and the notes to financial statements are the other two key financial documents prepared using financial accounting records. These are used by bankers, lenders, government agencies, and investors to determine the company’s health. 

Managerial accounting

The objective of managerial accounting is to produce reports that are useful to company management. The company’s managers use these reports to evaluate the organization’s progress towards achieving its goals. The information in these reports also helps managers in the decision-making process. 

A key feature of managerial accounting is that it is meant for internal users. Financial accounting, on the other hand, is primarily for providing information to external parties.

Cost accounting

Cost accounting is a form of management accounting that focuses on the fixed and variable costs that a company incurs in producing goods. Cost accounting is used to monitor expenses and compare them with budgeted costs. It’s a management tool to control expenses and maximize profitability.

The bottom line

Accounting is the process of recording a company’s financial transactions. Additionally, it involves summarizing these transactions into statements and reports. These are used by various external parties like lenders, investors, and the IRS, as well as the company’s management. Every business organization needs to pay adequate attention to this essential activity.