Accounting is like the language of business in that it can communicate how a business is doing financially. Accounting is a process that tells us how much money is involved in certain business and financial activities. In accounting, there are two types of users: external users and internal users. External users, such as banks and the IRS, use accounting information to make decisions about a particular entity. This external accounting is called financial accounting. Internal users, such as accountants, treasurers, and managers, use accounting information to make decisions for the entity they work for. This internal accounting is called managerial accounting.
The Rules
The Financial Accounting Standards Board (FASB) is a governing body that sets rules that all accountants and accounting practices must follow. The main principles that must be followed by all publicly traded businesses are the Generally Accepted Accounting Principles (GAAP) to ensure that everyone is reporting transactions in the most informative and transparent way necessary. This prevents publicly traded companies from engaging in tricky reporting that makes their profits look better or worse for an inaccurate gain.
So why is accounting necessary? Any investor would answer that by saying that seeing the financial reports of businesses provides information that helps them make investment decisions. GAAP ensures that financial information is consistent, relevant, reliable, and comparable.
Basic Principles
The basics of accounting boil down to the following principles: the reliability principle, the cost principle, the going concern concept, and the stable monetary-unit concept.
The reliability (objectivity) principle dictates that information must be reasonably accurate, as in it must report what actually happened. The information must also be free from bias such that different parties would arrive at similar conclusions using the same data.
The cost principle states that assets must be recorded at their actual cost when acquired. For example, something is bought on a discount, the asset must be recorded at the discounted price, not the original price.
The going concern concept is to define an entity that will continue to operate in the future, meaning it will remain in business long enough to use its resources.
Finally, the stable monetary-unit concept makes the assumption that the purchasing power of the dollar is relatively stable. This assumes relatively stable inflation rates, meaning that what a dollar buys today, a dollar can also buy tomorrow.
The Balancing Equation
Perfectly balanced, as all things should be.
Thanos, Avengers: Infinity War
The accounting equation is Assets = Liabilities + Owner’s Equity. In accounting, this equation will always be true so if it is unbalanced, it may be a mistake but if not a change must be made. Assets are basically anything a company owns that has value. For example, cash, buildings, inventory, and property are assets because they have value and can be owned. However, employees are NOT assets because, although they have value, they cannot be owned. Liabilities describe anything that a company owes. These could be things like debt payments or things purchased on account (like with a credit card). The owner’s equity is a claim of the remaining (assets) after liabilities are paid off. Revenue and owner’s investment increase owner’s equity while expenses and owner’s withdrawals from a business decrease owner’s equity.
This equation is most useful for creating a balance sheet. A balance sheet is a financial document that compares assets to liabilities and owner’s equity. Balance sheets are useful for personal finance because it can help you find net worth, or book value. Net worth is found by subtracting liabilities from assets. This would be the value of your assets that you have at your disposal after all liabilities are paid off.
Conclusion
Accounting is essential for both businesses and personal finance. Understanding the rules, principles, and applications of accounting, as described in this article is helpful for keeping track of your personal financial standing.
About the author
I write about accounting, economics, and the intersection of finance and technology. I am a rising high school senior who is committed to increasing financial literacy rates.
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