July 11, 2018 0

Importance of Accounting: Basic Financial Concepts to Know

Importance of Accounting: Basic Financial Concepts to Know

Businesses run on money, and anything that involves money has to be kept a record of. Someone has to dedicatedly monitor the flow of money in and out of an organisation, which, inarguably, plays an important role in determining how well the business is performing. This is where the accounting department and the seasoned accounting professionals step in.

“Accounting is the language of business efficiently communicated by well-organised and honest professionals called accountants.”

Why is Accounting Important?

Companies spend huge amounts of money on hiring accounting experts, which explains how important the accounting business function is for organisations. Maintaining a strong accounting framework is the right way for businesses to grow. As rightly said, accounting is the financial backbone of all enterprises, and without finances, there will be no business.

There is not one but several reasons why accounting is the most crucial function of all business functions. We have consolidated a list of the top reasons for you.

Also Read: Top 10 Questions to Ask your Accountant

To seek Assistance from Creditors and Banks

To seek financial assistance from any financing firm or a bank, companies have to provide detailed information about their finances. Records in the accounting book, paid taxes, assets, liabilities, etc. are meticulously studied before a loan is granted to any company. If the company’s accounting records do not suggest a healthy financial position, there is a chance it may lead to disqualification from receiving a loan.

To attract Investors

Companies focus on attracting investors to raise capital, expand their business and building wealth. For investors to be interested in a company’s stake, the accounting numbers should look promising.

To plan the Budget

Budgets are planned to decide on a company’s financial undertakings over a period of time. They may involve decisions such as planning business expansion and deciding policies. Budgets may also set off warnings to suggest the company expenditure is increasing and propose solutions to fix this. All budgets are planned on the basis of the data available in the accounting systems.

To Conform to Global and Regional Accounting Compliances

Accounting practices across the world are regulated by compliances and laws that have to be strictly followed. It is essential for companies to comply with the country’s statutory guidelines and audits. During audits, the accounting books are carefully studied to ensure companies have not evaded taxes or put forward incorrect numbers. Maintaining clear and up-to-date accounts will help companies retain consistency and error-free records of all financial transactions, which will help them stay away from legal troubles of all kinds.

Some basic Financial Concepts Everyone should know about

Accounting as a systematic way of maintaining financial records has been around for a long time. However, with the advent of modern technologies, the ways of accounting have transformed immensely, as new software and tools have hit the market. These accounting tools have made accounting easier by automating most of it. However the concepts and principles on the basis of which accounting was established, have not changed much. We’ve listed down the top basic financial concepts in accounting that everyone should be aware of.

Also Read – Why Should Accountants Specialize?

Financial Accounting

Financial accounting is focussed on assembling accounting data and information into financial reports and statements. Financial accounting is concerned with the overall financial results of a company; it reports on the financial status and profitability of the company. Financial accounting information is made available to the public, including stakeholders, customers, stockholders, creditors and regulatory bodies. It offers insights into the overall financial health of companies and provides details about their profits and losses. The financial accounting data in companies has to comply with various accounting standards and industry regulations.

Management Accounting

Unlike financial accounting, management accounting handles data that is not made available to the public, such as employee salary data, the cost of produced goods, customer demographics and profit targets. Management accounting information is usually distributed within the organisational boundaries. It collects and manages information required for internal use, thereby reporting on a more detailed level. While financial accounting reports on the profits/losses of an organisation; management accounting sheds light on the various factors contributing to the profits/losses and also suggest solutions to fix the identified issues. As the data in management accounting is generated for internal consumption, it does not need to comply with any industry or market regulation.

Checkout hereHow much do accountants charge?

Asset, Liability, Net Worth and Balance Sheet

An asset is a company-owned item that has value and can provide future economic benefits. Cash, accounts receivable, investments, sales inventory, land and equipment are a few examples of assets. On the other hand, liabilities are money or services that a company owes to others. Liabilities define the obligations of companies and may include the accounts payable, taxes owed, bank debts and pending wages, among others. The net worth of a company is calculated by subtracting the liabilities from the assets. A positive net worth indicates a healthy financial posture, whereas a negative net worth suggest hardships in finances. A balance sheet is the summation of a company’s assets, liabilities and the net worth during any given period. It helps evaluate the financial status of a company. On a balance sheet, the total asset value of a company should always be equal to the total value of its liabilities plus the total net worth.

Debit, Credit and the Double-Entry Bookkeeping System

All business transactions are recorded as debits or credits. According to the double-entry bookkeeping system, any transaction impacts at least 2 accounts: one account to receive the credits (on the right side) and the other to receive the debits (on the left side). For a journal entry to be valid in the account ledger, the total debits must be equal to the total credits. In other words, the total entries on the left-hand side of the double-entry bookkeeping system must be equal to the total entries on the right-hand side. Sometimes, multiple debits and credits may be entered for a transaction to match both the sides of the journal entry.

Accrual and Cash

Cash-based accounting is used by businesses wherein they recognise a revenue only when cash has been received and an expense post it has been paid. Small companies prefer using cash-based accounting, as it is simple and doesn’t require maintaining the accounts payable and receivable. The cash method assists in tracking how much cash a company actually has at any given period. Transactions are not recorded until cash has been received or paid, thus, the company’s income isn’t taxed until it reaches the bank.

As opposed to cash accounting, accrual accounting deals in accounts payable and receivable. It records expenses and revenues when they are incurred, irrespective of when the money is paid or received. This method of accounting is more commonly used, as it gives a complete financial overview of a company’s accounts. However, it says nothing about the cash flow. A company have a healthy accrual account, though in reality, its cash flow may be running meagrely.

Generally Accepted Accounting Principles (GAAP):

GAAP is an accounting standards, rules and compliance framework on the basis of which enterprises put together their financial reports and statements. GAAP was established with the intent of forming a standardised set of uniform accounting compliances that would apply to all organisations, regardless of their size or sector. Companies following GAAP have to create their financial statements as per the specified rules, which makes it easier for investors to compare information between two or more companies.

Financial Statements

Financial statements consolidate the data related to a company’s financial activities and present it in the form of financial reports. These financial reports are shared with the external public, including stakeholders, creditors, investors and customers. Financial statements highlight a company’s financial growth over a period of time. These statements have three major types of reports—the balance sheet, the income statement and the statement of cash flow.

Also Read: How to Raise Capital for a Small Business?

Conclusion:

There are several financial concepts in the accounting industry, and the list is endless. Governments and regulatory bodies across the globe are continually introducing new standards to ensure transparency in the accounting processes of enterprises. However the basics need to be strong enough to be able to get acquainted with any new standard and processes. Having said this, it is also true that just theoretical concepts don’t help and in-depth knowledge can only be gained by practical real-time scenarios. As the ‘legendry investor Warren Buffet’ said, “You have to understand accounting and you have to understand the nuances of accounting. It’s the language of business and it’s an imperfect language, but unless you are willing to put in the effort to learn accounting – how to read and interpret financial statements – you really shouldn’t select stocks yourself”.

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