Accounting is the process of recording, classifying, and summarizing financial transactions to provide information that is useful in making business decisions. It is the language of business, providing a clear and concise way to track financial performance and assess risk. Accounting also helps businesses comply with government regulations.
There are two main types of accounting: bookkeeping and financial accounting. Bookkeeping is the process of recording day-to-day financial transactions, while financial accounting provides an overview of a company’s overall financial position. Financial statements show how a company’s assets, liabilities, and equity have changed over time. These statements are used by investors, creditors, and other interested parties to make informed decisions about a company’s health and prospects. Generation of financial statements has become much more efficient with advancement of tools like Quickbooks, Xero, SAP and Auditproo.
The most important financial statement is the balance sheet, which shows a company’s assets, liabilities, and equity at a specific point in time. The income statement measures a company’s profitability over a period of time, while the cash flow statement shows how much cash has flowed in and out of the business. These statements are all interconnected; for example, changes in a company’s equity can be explained by its income or cash flow.
It is important to understand these concepts if you want to invest in or creditor companies. By understanding accounting, you can make more informed decisions about where to place your money and what risks to take. In the long run, this can lead to greater financial stability and success. So, how does accounting protect your business, gauge its health, and help you make decisions? In short, why is accounting important in business? Let’s count the ways.
Recording transactions
Accounting is concerned primarily with record keeping, reporting and analysis of financial data. There are many benefits to having an accounting system in place, including the ability to run any type of business, keeping track of expenses and revenue and automating accounting processes. Through its accounting system, a business records the transactions that take place during its activities. These transactions include everything from buying supplies or equipment to selling products or services, borrowing money, paying employees and many other activities. Through accounting, the business tells others how it spends the money it takes in, what it owns and what it owes. The financial data is used to satisfy the business’ legal requirements (by the government), inform internal decision-making (by the business’ owners) and inform external parties (potential investors, suppliers and other businesses).
Business performance
Accounting naturally becomes a quantitative practice when you are running a business. Accounting helps your business in multiple ways, such as by generating information about how well the business is doing, and also to prevent frauds and/or errors in your organization. Apart from that, accounting information generated can help in knowing how well different areas of the business are performing and it helps in boosting performance in those areas which are underperforming according to the expectations. It tracks financial values for individual items of income and expenditure for keeping a check on expenses and making plots for saving money. These savings can then be invested back into the business to boost the performance of the company. Accounting keeps company leaders informed on how the company is performing. Accounting information enables a business to compare actual performance against the budgeted performance, as well as assess whether it is meeting its planned sales and profitability targets. Tracking profitability is essential for any business that wants to be successful and increase its profits.
Financial position
Accounting helps a business determine its financial position. This business function provides important insights on operating costs, competitive expenses and the performance of the company’s management team. These factors help company decision-makers decide on factors to improve the business’ financial health. In this way, if a business is starting to fail, then an owner can act quickly before the entire entity becomes insolvent and goes under. Accounting establishes the financial position of a company at a particular point in time by measuring its assets, liabilities, and owners’ equity. Accountancy is a plan for acquiring and using resources to achieve business goals and objectives. A business has to determine its financial position periodically. The results are shown in balance sheets and profit and loss accounts.
Liquidity
The liquidity of a company determines whether it is able to meet its short-term obligations or not. There are certain ways to ensure liquidity and they include determining the security components ratio, current ratio, the ratio of the quick and current assets, and the inventory turnover. To ensure the liquidity of business by determining the security components ratio must be concerned with any company desiring growth and profits, in order to enhance this liquidity and meet the needs of creditors upon demand, especially the short-term debts holders, because they are more important to ensure that their debt is paid.
Liquidity refers to the ability to pay back debts as they come due and ensure adequate cash flow in a firm. The current ratio is an indicator of a firm’s liquidity. If a firm uses too much debt, then there may not be enough earnings to pay off creditors, even though the firm has many assets. A higher current ratio is always better than a lower current ratio. You can use the current ratio to determine the liquidity in your business by dividing the current assets by current liabilities and comparing the results with industry averages.
The current and quick ratios are two ways to analyze liquidity. Quick assets include cash and items that can be converted quickly into cash, such as accounts receivable. Current liabilities are those owed within one year, such as accounts payable, accruals and short-term loans.
Liquidity is concerned with the day-to-day operations of your business. If you want to ensure liquidity, it would be ideal for you to conduct an inventory turnover analysis. Inventory turnover analysis is a method that companies use in order to keep track of their stock and sales, Ultimately, this will provide you with a clear estimation of how many days it normally takes for all the products on your store’s floor to get sold.
Legal requirements and obligations
Accounting is crucial in ensuring that a business meets its legal requirements and obligations. Accuracy, clear documentation and proper storage of all financial transactions are important to avoiding costly fines from the tax office or worse, potential legal action. A business can ensure it meets its regulatory and legal requirements by choosing an accounting software package in line with their business goals as each country have different legislative requirement for companies to comply with. A good accountant knows the state and federal laws, including tax laws, that govern a specific type of business. For example, certain types of businesses have more tax reporting requirements than others. An accountant can spot these sorts of things and ensure the business is compliant with all relevant laws. An accountant can also handle government agencies that may come knocking with questions about how a business is reporting income or expenditures.
Decision-making
Rational decision making is a multi-step process for making choices between alternatives. Accounting supplies information – financial and non-financial – to managers so they can make decisions. The role of accounting in decision making is to provide financial information that managers and owners need to make informed decisions. Accounting information gives business leaders the data necessary to plan for their company’s future, improve finance management strategies, assess the current state of finances, understand their customer base and optimize their marketing strategy.
The decision making depends on various items of financial information provided by the accountant which can be elaborated further by discussing the following points:
- The auditor’s report – This can be obtained from a qualified and independent auditor who certifies that the information communicated is free from any material misstatements whether caused by fraud or error.
- A trial balance and the income statement – The balance sheet gives information about purchase, sale, and inventory transactions through an accounting cycle.
- A cash flow statement – It shows all the cash-inflows and cash outflows for a particular period of time in a logical format and summarizes the cash balance at a given date.
- Depreciation schedule – This is based on depreciation which provides cost allocation instead of full expense to the year of acquisition.
- Stocktaking schedules – Stocktaking is conducted periodically to insure that no errors in computation or theft have occurred during the audit period.
Reasons why accounting is important
While there are many reasons why accounting is important, here are three key reasons:
Reason #01: Accounting is the Language of Business
As mentioned earlier, accounting is the predominant language of business. In fact, most business transactions are recorded in terms of money and numbers. If you don’t understand accounting, it will be difficult to make sense of financial statements, track expenses, or manage your company’s finances.
Reason #02: Accounting Helps You Make Smart Financial Decisions
A strong understanding of accounting can help you make smart financial decisions for your business. By understanding how profits and losses are calculated, you can more effectively manage your cash flow, budget for future growth, and identify areas where you may be able to reduce costs.
Reason #03: Accounting Provides Insight into Client Finances
When dealing with clients, it is important to have a good understanding of their financial situation. By reviewing a client’s financial statements, you can get an idea of how healthy they are financially and make decisions accordingly.
In today’s business world, financial literacy is an essential skill for success. Whether you’re an entrepreneur, a small business owner, or a corporate executive, if you don’t understand the basics of accounting and finance, you will likely find yourself at a disadvantage.
