Chapter 1. What is accounting?

1. What is accounting?

A definition

Accounting is the process whereby financial information is identified, recorded, classified and communicated to interested parties within a business in order to facilitate informed judgements and decisions being made by the various users of that information. This information pertains to financial activities, and in particular, how money flows in and out of a business as a result of various transactions.

Many of the decisions made within a business from day to day contribute in some way, large or small, towards the capital value, or worth, of the business at any given moment in time and the final net profit figure which appears on the profit and loss account at the end of a given period. Accounting exists to provide financial feedback about past decisions and to help a business optimise its future decisions.

Accounting is also required to provide answers to questions raised by a number of groups that interact with the business.

Users of accounting information

The table below lists the interested groups – both internal and external to a business – and the sorts of questions they will be hoping the accounting process can provide them with answers to:

The three stages of accounting

The accounting process can be divided into three stages as follows:

1. Identifying and recording financial transactions. Such transactions will include any flow of capital value in or out of the business, i.e. any changes in revenue, expense, assets, liability or general capital

2. Classifying and measuring the transactions identified and recorded in stage 1

3. Communicating and explaining these transactions, and their impact, to the relevant groups listed within the table above

The four branches of accounting

1. Bookkeeping

2. Financial accounting

3. Cost accounting

4. Management accounting

Branches 3 and 4 are concerned mainly with cost analysis, budgeting and forecasting. Cost and management accountants oversee the internal management of a business for the purposes of planning, controlling and making decisions. Cost and management accounting therefore exists to facilitate the collection and analysis of financial information for internal, and not external, users of this information.

Although important and useful fields of accounting in their own right, especially when it comes to quantifying projections and helping to influence decisions which improve the all-round efficiency of a business, I will not be covering branches 3 and 4 in this tutorial. Since the aim of my tutorial is to help you maintain accurate books and to provide you with the skills you need to successfully compose financial reports and submit accurate accounts, I will be concentrating only on branches 1 and 2, namely bookkeeping and financial accounting. Branches 3 and 4 are for advanced learners who would like to pursue a study of accounting in greater detail.

I will close this opening chapter to my tutorial with brief summary definitions of both the bookkeeping and financial accounting branches in order to provide you with a better idea of what you can expect to be seeing more of in upcoming chapters.

Bookkeeping

Bookkeeping lies at the heart of the first stage of accounting, which is concerned with identifying and recording financial transactions. As such, bookkeeping is very much the foundation of the accounting process.

A bookkeeper needs to ensure that the records of individual transactions are accurate, up-to-date and comprehensive so that the individuals and groups involved at later stages have all the information they need and a reliable foundation on which to build.

Bookkeeping entails recording transactions such as sales, purchases, bank, cash, wages, advertising and all other accounts.

Financial accounting

Financial accounting uses the information provided at the bookkeeping stage to classify, measure, explain and communicate financial information to answer the types of questions outlined in the table above and, in particular, to help managers make informed decisions.

The business will often need to publish two key accounting summaries or annual reports:

1. the trading profit and loss account (profit and loss or just TPLA for short)
2. the balance sheet

Reports 1 and 2 above provide essential information on a company’s profitability and capital worth respectively. A great deal of a financial accountant’s time within a business will be taken up with preparing these statements.

Financial accounting is concerned with organising the transactions gathered at the bookkeeping stage into accounts and reports which then enable this information to be presented and explained to interested parties in a meaningful way which answers questions about important financial aspects of a business such as its profitability, capital worth, revenue, expenses, assets and liabilities.