Overview: Accounting

What It Means

All businesses and organizations must keep accurate and current accounts of their financial information so they can make sound business decisions. The process of analyzing and interpreting financial information is called accounting. Accounting work is conducted by professional accountants, who are trained in statistics, economics, accounting law, and other disciplines. Accounting includes bookkeeping, which involves the creation of records and documents that show financial activity. An accountant may also prepare the information that is needed to file a federal income tax return (a report that shows the U.S. government the income a person or business has received over the course of a year so that the person or business can pay taxes to the government).

Accounting provides an organization with the information it needs so that the organization’s managers can responsibly decide how to use resources and set realistic goals. Accountants analyze records, estimates, and other information and communicate specific information to different audiences. For example, an accountant may give a manager information that helps the manager decide which ventures will be affordable for the business. Accounting done for the internal use of an organization is called managerial accounting. Accounting also serves the purpose of informing external parties, such as government groups, shareholders (people who own part of the company), and the public, about the financial health of an organization. Accounting done for external parties is called financial reporting.

For-profit businesses as well as government and nonprofit organizations use accountants. Accounting within governmental and nonprofit organizations, called nonbusiness accounting, covers the financial record-keeping and analysis for such organizations as independent schools or camps, hospitals, universities and colleges, and trade and government organizations.

Accountants also help individuals review their personal finances for various purposes. For example, an individual who inherits money or land might hire an accountant to review how the executor (the person assigned the duty of carrying out the instructions of the deceased person) has managed the finances of the deceased person. Individuals involved in a financial partnership, such as a small business, may hire an accountant to analyze each individual’s financial responsibilities within the partnership.

When Did It Begin?

The practice of bookkeeping dates back thousands of years to when ancient traders and merchants began keeping records of their financial transactions. The earliest examples of what is known as double-entry bookkeeping date from fourteenth-century Italy. In double-entry bookkeeping, which is an important part of modern accounting, each transaction is shown as a transfer from a source account (as a debit) to a destination account (as a credit).

During the Industrial Revolution, new accounting techniques were developed to address the mass production of goods and factory-based operations. Business practices grew increasingly more sophisticated during the nineteenth century, and the profession of accounting evolved to respond to the complexities of industry and corporate practice. The first public accounting agencies were opened in the late nineteenth century, and licensing requirements for accountants were established in the early twentieth century.

In the late twentieth century computer-based accounting grew prevalent. With the use of sophisticated data-processing software, accountants can present useful financial information to a wide range of parties who need this information to make business decisions, including managers, business owners, employees, customers, and government authorities.

More Detailed Information

The field of accounting includes several divisions: auditing, taxation, financial-statement analysis, and managerial accounting. An inspection of the accuracy and validity of financial statements is called an audit. An audit is usually conducted by an auditor who is trained in accounting. Large organizations sometimes employ full-time auditors to maintain the ongoing accuracy of the firm’s accounting information. Accountants are often responsible for providing a firm’s income tax returns, which can involve extensive work with the firm’s financial data as well as sufficient knowledge of corporate tax laws. Accountants who specialize in taxation are often employed by businesses to file annual tax returns. Financial-statement analysis is the process of using financial information to analyze the performance of a firm. Accountants who specialize in financial-statement analysis develop measures of a firm’s performance as it relates to other firms in the same industry. Accountants involved in managerial accounting compile the data that firms need to plan and make decisions. They examine the various costs of operating the firm, ensure the firm is operating within certain standards or rules, and create reports for the managers of the firm to use.

Accountants use two important financial tools: the balance sheet and the income statement. Sometimes known as the statement of condition, the balance sheet shows a company’s total assets (everything that the company owns), its liabilities (the amount of money the company is obligated to pay; its debts), and the value of shareholders’ equity (the amount of assets owned by a company’s shareholders). It is known as a balance sheet because the total assets must equal the liabilities combined with the shareholders’ equity. Stated another way, assets minus liabilities equals the shareholders’ equity.

Whereas the balance sheet shows a picture of a company’s condition at a given point in time, the income statement illustrates financial activity over the course of a specified time period, such as a quarter of a year or a full year. Sometimes an income statement is referred to as a profit-and-loss statement because the statement shows sales transactions or other revenue-generating activities as well as expenses or costs to the company for producing goods, such as costs for raw materials, facilities costs, and labor costs. Essentially, the income statement reviews the revenues and expenses for the company over a designated time frame. It also reflects any gains and losses from assets sold or acquired.

The balance sheet and the income statement play important roles in bookkeeping. Bookkeeping involves recording transactions in a journal. Most organizations use a double-entry system, in which both the debit and the credit side of the transaction are recorded. All of the information entered in the journal is also put into a book known as a ledger. When the bookkeeper transfers information from the journal to the ledger, this is known as posting. The ledger thoroughly illustrates the organization’s finances, and subsidiary ledgers illustrate specific accounts. For example, all the wages a company pays its employees may be shown in the ledger, and a subsidiary ledger may record each employee’s wages.

The information in ledgers forms the basis for the financial analysis that accountants perform. An accountant will take the information bookkeepers provide and prepare what are called adjustments. For example, an adjustment might show the cost of a piece of machinery as an expense spread out over the time it will be used by the company. An accountant makes adjustments before he or she prepares the balance sheet, the income statement, and other financial statements. These statements review the balances in the various accounts of the company.

Because accountants play a large role in managing and communicating the health of businesses, they are often relied on as decision makers. All accountants adhere to a general set of assumptions and principals that affect the decisions they make. For example, the disclosure principle requires that the financial statement an accountant creates provides the most useful amount of information relating to the firm at the time, meaning that no information is excluded in order to mislead the statements’ readers.

When accountants provide financial information to those inside a firm, they do not have to adhere to any regulations other than their responsibility to provide guidance to the firm and to rely on fundamental accounting concepts. However, numerous regulatory bodies set rules for accountants whose work is reported to the public. State governments are responsible for licensing certified public accountants (CPAs), who operate by a set of standardized principals of accounting. The U.S. government agency known as the Securities and Exchange Commission (SEC) regulates the public trading of stocks and bonds. The Internal Revenue Service (IRS) regulates taxation and collects taxes from businesses, nonprofits, and other organizations.

Recent Trends

In the early part of the twenty-first century the accounting profession came under intense scrutiny because of financial scandals within large corporations resulting from accounting fraud. Arthur Anderson LLP was the accounting firm responsible for auditing the financial records of the Enron Corporation, a Texas energy company. Through its accounting firm Enron led its investors and the public to believe that it had achieved record profits, when it had actually lost hundreds of millions of dollars from 1997 to 2001. Employees at Arthur Anderson LLP were caught shredding (destroying) documents relating to the Enron case and charged with obstructing justice in 2002.

Another corporate scandal involving the telecommunications corporation WorldCom shed further light on the crucial role of accounting in business. WorldCom’s accountants created false financial reports that excluded reports of billions of dollars in expenses and showed that the company had been extremely profitable. In fact, the company had lost 1 billion dollars over 15 months.

The result of these scandals was the passage of the Public Company Accounting Reform and Investor Protection Act of 2002, which created a board authorized to punish accounting firms that report on companies’ finances in misleading ways. The law also gave the board the legal ability to perform annual audits of accounting firms who work for large companies.

As a result of large corporate scandals and the growing interdependence of corporations in a global economy, many analysts and accounting industry leaders have called for the adoption of a set of global accounting rules. Such a set of rules would make it easier to evaluate financial information about different companies, no matter where they were located. Established in 1973, the nonprofit International Accounting Standards Committee (IASC) developed a set of international accounting standards, which many companies worldwide now voluntarily use.