Accounting information is data about a business entity’s transactions. From buying inventory and machinery to entering into long-term building contracts, the events that occur in business operations almost always translate into accounting information. Accounting is a method of identifying and recording this data and using it to generate useful reports for a variety of users. These users are generally classified into two groups: internal users and external users. Because the needs of these users are so varied, accounting has two main perspectives. Managerial accounting is a forward-looking perspective geared toward internal users. Financial accounting relies on historical data and is standardized for external users. To understand these perspectives, you need to understand several underlying concepts that form the basis of accounting as the language of business.
TL;DR (Too Long; Didn't Read)
Accounting information is measurable, quantifiable information about the transactions and events involving a business entity.
What Is Accounting Information?
Accounting information is the information that arises from business transactions. Once identified, the information is then classified and recorded, and it eventually finds its way into various reports. For cash-basis accounting, this is relatively simple. Revenue is recorded in the books when cash is received, and expenses are recorded when cash is paid out. This method may be simpler, but it is only suited to smaller businesses with only a few owners or partners. However, businesses with more investors and businesses that have inventory find the accrual basis of accounting necessary. Additionally, publicly traded businesses are required by law to use accrual-basis accounting. Transactions in accrual accounting are recorded with respect to the accounting equation, where every transaction has a debit side and a credit side.
What Are the Three Basic Elements of Accounting?
The accounting equation is made of three elements: assets, liabilities and equity. Assets are things the business owns and can use. Assets can be tangible, like inventory items, machinery, buildings and supplies, or intangible, like patents and copyrights. Cash and cash-like instruments, such as bank account balances, are also considered assets. A business might also hold investments, which would be considered long-term assets.
Liabilities are amounts that the business owes to other entities. The business might buy inventory for resale on credit, for example. The amount they owe to their supplier would be a liability until it is paid. As the business pays employees and withholds taxes from paychecks, they will incur a liability in the form of tax withholdings owed to the government. The business might take out loans or lines of credit to pay for certain expenses. These loan balances would represent liabilities of the business.
Equity is a combination of amounts invested into the business by owners or shareholders and earnings of the business over the years. A sole proprietorship, partnership or LLC might start with having the members of the business each put a sum of cash into a bank account for the business to use. A corporation might start with a large group of investors all pooling money together. Either way, this investment represents their ownership interest in the business and is called the business’s equity. As the business operates, its profits and losses will increase or decrease equity.
These three elements combine in the accounting equation, which states that assets are equal to liabilities plus equity. As with any equation, the two sides have to remain equal. It is this concept that underlies the need for a debit and a credit side to every transaction. An increase in assets will always result in either an increase in liabilities or equity or a decrease in a different asset which was exchanged. For example, if your business buys inventory with cash, the transaction reduces the cash asset to increase the inventory asset. If your business instead buys the inventory on credit, your business has increased a liability, accounts payable, in order to increase the inventory asset account.
Why Is Accounting Important for Business?
Accounting information helps people make business and financial decisions. Their trust in the accuracy and reliability of this information is almost as important as the business’s actual financial results. Therefore, it is important to have a system that accurately captures the realities of a business’s operations and its financial standing and reports the information in good faith. There are many users of accounting information, each of whom has different concerns about the business.
Managers need to be able to forecast the potential results of different business decisions. Employees want to know that the business will continue to operate in a financially stable way. Investors want to know how a business utilized their money to turn a profit, and they need to be able to compare the business to other businesses in order to evaluate investment strategies. Suppliers and other creditors need to know about the financial performance of a business and whether or not the business has enough assets or is using too much credit. In a broad sense, these users can be divided into two basic groups: internal and external. As a result, accounting has two main branches: managerial and financial.
Financial accounting is the branch of accounting that focuses on standardized reporting to provide information to external users. Publicly traded companies, those that offer their stock for sale on various exchanges, are required to prepare financial accounting reports and file them with the Securities and Exchange Commission for public viewing. The Financial Accounting Standards Board sets the standards that govern how financial accounting is accomplished. These generally accepted accounting principles, or GAAP, serve as a framework for accountants to use when deciding how to measure and record financial information.
GAAP dictates that accounting information must have certain qualities: relevance, materiality, reliability, understandability and comparability. Relevant information is information that influences the decision at hand. Materiality means that something is significant enough to be noted. For example, a multi-million dollar business might not need to worry about precise reporting of a $200 transaction but would find a $20,000 transaction to be material. Reliable information is free of errors or manipulations. Understandability means that information is presented clearly and in an efficient manner to avoid misinterpretation. Finally, comparability means that the statements are created and presented by following the accepted accounting methods at the time. This allows users to compare one business to another because they know they are being told the information in the same way from business to business.
Fundamental Accounting Principles of Financial Accounting
Financial accounting is accrual based and uses the GAAP as its framework. Under GAAP, revenues are matched to the expenses used to create them. Revenue is considered earned when the business has delivered goods or provided services, whether or not cash is exchanged. Expenses are likewise recorded when goods or services are received. These transactions enter the books at their historical cost and are not revalued later. Historical cost is objective, while revaluation would be subjective and is to be avoided. These principles guide the creation of the financial statements.
The Major Financial Statements
In financial accounting, each accounting cycle results in three major financial statements: the income statement, the balance sheet and the statement of cash flows. From these three statements, users can analyze a wide variety of performance ratios to easily compare one business to another, even when the businesses are of different sizes.
The income statement shows the various income and expense accounts. Income is presented first. If inventory is involved, the cost of goods sold is generally deducted from income first, before moving on to itemizing expense categories. The cost of goods sold and expenses are deducted from income to get net profit or the “bottom line” of the income statement.
A balance sheet follows the accounting equation. It shows all of the asset accounts on one side and the liability and equity accounts on the other. When the books are closed at the end of an accounting period, the net income is shown in the equity accounts. A trial balance is prepared, adjusting journal entries are made and in the end, a balance sheet is prepared where assets equal the sum of liabilities and equity.
The statement of cash flows shows where the cash of the business went. Although accrual accounting means that transactions are recorded when obligations are fulfilled or taken on without regard to cash, it is still important to know what happened to the cash of the business. The statement of cash flows explains how cash came in and went out of the business. It breaks those flows down into different types of activities. For clearer analysis, cash flows from business operations will be shown separately from cash flows from investing or financing activities.
By contrast, managerial accounting is much more flexible. Management might need to see information in a variety of ways in order to evaluate a decision. They are free to use whatever report format is most useful to them. Managerial accounting reports are not to be shown to external users and therefore are not constrained by the use of GAAP.
Managerial accounting is often forward-looking and subjective. Managers might need to do cost-benefit analysis, find breakeven points, examine life-cycle costs or break down reports into different business segments than those required in the financial reports. The major benefit of managerial accounting, then, is the flexibility to manipulate reports so they are most useful to the decision at hand. The subjective nature of these reports defies GAAP, however, which is why they are not to be shown to external users.
Other Types of Accounting Information
Tax accounting and nonprofit accounting feature more specialized rules than those discussed here. When discussing tax accounting, you may hear the term “reconciling book to tax.” This means that the accountant is explaining the differences between what is shown in financial accounting reports and what results show up in the tax return. This is because the Financial Accounting Standards Board’s GAAP and IRS regulations differ in how certain transactions are treated. One example is the treatment of meals expenses. While you will likely reflect the entire cost of a meal in your business’s books, the IRS will only allow 50 percent of the expense in most cases. Your reconciliation would have a line item showing the other half of the expense as an explanation.
Nonprofit accounting is done in a very specific way because nonprofit businesses often have funds allocated in very specific ways. Grant issuers might have very specific constraints on how money can be used. For example, a grant might be made available to help low-skilled female workers obtain job training. The nonprofit will have to show that the grant funds were used in pursuit of this goal. They cannot use these grant funds for other projects, or they will have to pay the funds back to the issuer. Similarly, donors might donate to a specific project rather than to a nonprofit’s general fund. They will want to see that the project goals were met. Nonprofit accounting separates monies into various “funds” to accomplish this reporting.
Although the definition of accounting information seems simple, you can quickly see how the field of accounting has grown to include so many specialties. There are people who work in broad subject areas, but many more wind up in very specialized roles. An individual may deal solely in accounts payable, for example, ensuring that the business pays its bills on time so the lights stay on and the inventory keeps flowing smoothly. Another person might decide to work solely on a business’s tax information, ensuring accurate reporting and compliance with all tax entities’ regulations, whether federal or state, income, sales or payroll tax. One thing is certain: They will all record information about the business’s transactions and use them to report to various interested parties.