Generally accepted accounting principles, or GAAP, specify the natural balance of accounts and tell companies whether a specific account should have a credit or debit balance. Financial accounts run the gamut from assets and liabilities to equity items, revenues and expenses. The U.S. Securities and Exchange Commission identifies account balancing as a central feature of sound financial reporting.
In accounting, assets and expenses typically have a debit balance, meaning a corporate bookkeeper debits them to increase account amounts. Revenues, equity items and liabilities have a credit balance, so the bookkeeper credits these accounts to increase them. Any change to this normal order of things produces inaccuracies in the record-keeping process and could lead to error-laden financial statements. For example, if a bookkeeper mistakenly credits the insurance expense account to record a premium payment, that entry understates the amount of insurance expense reported in the statement of profit and loss. Understating means representing as less significant or reducing the amount of an accounting item.
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To earn the trust of the public and investors, a company must properly record transactions and report performance data at the end of a given period, such as a quarter or fiscal year. Accurate reporting requires a thorough review of account balances. A complete set of financial reports includes a statement of changes in shareholders’ equity, a statement of income, a statement of cash flows and a statement of financial position, also known as a balance sheet.
External auditors delve into a company’s records to evaluate the accuracy of performance numbers, paying attention to each master account to ascertain its balance. Corporate reviewers look at sub-accounts from the inside out and also from the outside in to understand transactions that made it into the master account. For example, an auditor may look at the accounts payable account in the balance sheet and identify all journal entries that led to the account’s balance. This represents an “outside in” approach. In this scenario, an “inside out” review would take the opposite analytical journey.
In the corporate context, personnel who ensure that accounts have accurate balances include bookkeepers, accountants and financial managers. Cost controllers and budget supervisors also help with record-keeping and reporting.
Marquis Codjia is a New York-based freelance writer, investor and banker. He has authored articles since 2000, covering topics such as politics, technology and business. A certified public accountant and certified financial manager, Codjia received a Master of Business Administration from Rutgers University, majoring in investment analysis and financial management.