We live in a world of credit. Without some form of accounting record, indecision and confusion would result. Not only is it business-like to keep accounts as a check on suppliers and credit customers, but the financial statements made up from these accounting records keep management informed, from time to time, of the progress of their businesses.
The financial statements are scrutinized and verified when:
- a business is sold, or a new partner is admitted to an existing firm
- the company needs a bank loan or a substantial overdraft
- Governments enquire into a business's tax liability.
There are three Main Types of Financial Statements
Balance Sheet: A balance sheet lists a company's assets, liabilities, and equity at a specific time. It is used to calculate the company's net worth.
Income Statement: An income statement shows a company's revenue and expenses over a period of time. It is used to calculate the company's net income.
Cash Flow Statement: A cash flow statement shows a company's cash inflows and outflows over a period of time. It is used to calculate the company's free cash flow.
Purpose of Accounting
Accounting is the process of recording, classifying, and summarizing financial transactions to provide helpful information in business decisions. The three main types of financial statements are the balance sheet, income statement, and cash flow statement.
The purpose of accounting is to provide valuable financial information in business decisions. Accounting information can be used in financial planning, risk management, performance management, and decision-making.
Why is Accounting needed
Business transactions involving all aspects of services, production, trade and distribution are varied and voluminous in every town and village. The bulk of these transactions is on credit, with payment for the goods bought or services used often being delayed for a few days or weeks. There must be electronic or written evidence of the original terms, and monetary values agreed upon between producer and consumer, vendor and credit customer, or the professional service provider and the client.
In double-entry bookkeeping, the money values of all transactions with suppliers of goods on credit (the creditors, also known as accounts payable) and the sales to credit customers (the debtors, also known as accounts receivable) are recorded. The details of all money received and paid, whether by cheque or in cash, are also recorded in a manner that, with practice, becomes routine and easy to comprehend.
Some simple terms have different meanings when used in the accounting sense.
Assets refer to the property and possessions of a business, which may be owned by an individual (a sole trader or one-person business), a firm or partnership, or perhaps a limited company.
- – Fixed assets (also known as non-current assets) are those assets that are retained for the benefit and permanent use of the business, such as premises, machinery and plant, vehicles, fixtures and fittings. These assets are not for resale in the trading sense.
- – Current or circulating assets change their form during trading, typical examples being stock of goods for sale, the trade debts of customers (called accounts receivable), money in the bank and office cash.
Liabilities are the debts and obligations of the business, the external and trade liabilities falling into two main categories:
- – fixed or non-current liabilities such as a mortgage or a long-term loan, not due within 12 months.
- – current liabilities comprise outstanding accounts owing to trade and expense creditors (accounts payable) and sometimes a bank overdraft, payable within 12 months.
In addition to the external debts and obligations of the business, there is generally a large internal debt owed by the company to its proprietor under the heading of capital. This is sometimes called the owner's 'equity' in the business.