Accounting is a system of financial reporting that identifies, records, and communicates the economic events of an entity. What does this mean?
Identify: An accountant needs to be able to identify if an event is relevant to the accounting requirements of an entity, and whether or not it can be recorded. Some events are easily identifiable, such as sales or services rendered to a customer. Others, such as the depreciation of assets, are not as obvious and must be calculated using pre-determined criteria.
Record: Accounting provides a universal and structured framework for recording identified economic events. Uniform reporting across all entities allows for a more accurate estimate of an entity’s financial position, as well as meaningful comparisons between entities.
Communicate: The most important aspect of accounting, communicating financial information is what differentiates accounting from bookkeeping. Accounting provides a raft of tools, in the form of reports, with which interested parties can analyze the effect that economic events have had on an entity.
The process of communicating data about the economic performance of an entity allows an accountant to inform those who need to know. Stakeholders- including shareholders, board members, and employees- depend upon information communicated by accounting systems to understand economic performance of an entity, its present-day status, and the course upon which it should be set for the future.
Accounting requirements of internal and external users differ, and thus accounting can be divided into Managerial Accounting, which provides reports for internal users such as Managers and employees, and Financial Accounting, which provides reports for external users such as shareholders.
Reporting on the economic performance of an entity assumes that all information gathered is accurate and uncompromised. Unfortunately, this is not always the case in real world situations, and information may become tainted and inaccurate for a number of reasons. There are two major compromising influences on financial reporting: corporate governance and ethics.
Corporate governance, the management and control of entities, is an important influencing factor on financial reporting. It defines the short and long-term goals of an entity, its direction, and economic activities. This is an especially important consideration for entities where the owners (shareholders) are not actively involved in managing the entity, as in most modern, profit-motivated corporations.
Generally Accepted Accounting Principles (GAAP) are accepted standards and definitions that establish a ‘language’ of accounting, so that there is a common foundation that everyone adheres to and can understand.
Individual nations have individual GAAPs, often administered by specially established bodies. In Australia, for example, the Australian Accounting Standards Board set’s the standards, while in the USA several agencies have a hand in establishing the standards, including the Securities and Exchange Commission. GAAP varies from nation to nation but in recent times an effort has been made to set an internationally recognized set of standards through the International Accounting Standards Board that has issued the International Financial Reporting Standards (IFRSs).
Some of the more common accounting principles include:
1. Cost Principle
It is conventional for accountants to record assets at their cost price – known as the cost principle – in order to minimize errors associated with speculation. Valuing an asset at its cost price is reliable and minimizes errors associated with estimates of market value.
2. Monetary Unit Assumption
The conventions of the monetary unit assumption mean that only transactions that have a monetary component are relevant to the accounting process. While non-monetary factors may influence the performance of an entity, such as the morale of workers, if it is not possible to express them in monetary terms then are therefore excluded from the reporting process.
3. Economic Entity Assumption
An economic entity is an individual or collective in a society, and can be an individual person, a private corporation, charity, social club, or even government. The economic entity assumption assumes that the economic activities of an entity remain separate to those of its owner(s).
In accounting, the economic entity assumption generally deals with three types of business entities: Proprietorships, partnerships and companies.
Proprietorships are businesses owned and operated by one person. The owner is entitled to all profits, but is also liable for all debts incurred by the business.
Partnerships are businesses that have two or more owners who use some form of partnership agreement to establish how the business operates and profits are distributed. Individual partners may or may not be involved in the day-to-day operations of the business depending on the partnership agreement in place. Usually, each partner has unlimited liability for the debts incurred by the business.
Companies are businesses that are legal entities in their own right and have transferable shares to govern ownership. Shareholders are not usually involved in running the business, are usually entitled to a share of the profits when and if they are distributed, but have a limited liability and are not liable for the debts the business incurs.