According to the American Institute of Certified Public Accountants (AICPA), accounting is defined as 'the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof '.
Accounting is used to collect and report financial information regarding the performance, position, and cash inflow or outflow of a company. Apart from making major decisions related to future investments, fundraising, asset management, and dividend policies, these financial reports are also made available to tax authorities, investors, and creditors of the firm. Let us take a look at the basic purposes of accounting in the following paragraphs.
The aim of any business is to earn profit and remain solvent. Accounting helps the company keep track of its profits or losses. The main function of an accounting system is to prepare financial statements in a company, which helps them keep a record of their revenue and expenses. In order to bring worldwide uniformity in the accounting process, the statements are prepared according to the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). The four main financial statements that are prepared for accounting information are as follows.
- Balance Sheet
- Statement of Cash Flows
- Income Statement
- Statement of Retained Earning
A balance sheet is the most important financial statement of a company. The balance sheet contains the assets, liabilities, as well as the owner's equity, and is considered a snapshot of the company's business. Analysis of the balance sheet has many benefits such as:
- It gives a detailed report about the finances of a company at a certain point of time.
- A company takes asset management decisions after analyzing the balance sheet statement.
- Most creditors of any company analyze the previous year's balance sheet statements to know how financially solvent the company is.
Statement of Cash Flows
A cash flow statement presents the cash inflows and outflows of a company for a given period of time. Cash inflows are the revenues earned by a company in a specified period, while cash outflows are the expenses incurred during the same period. The basic purpose of a cash flow statement is :
- To present the liquidity and solvency of the company at a given time.
- To provide extra information about the liabilities, assets and owners equity.
- To provide details for future cash flows in a company.
It is also known as the Profit and Loss Statement. It is helpful as it shows whether the company has made a profit or loss in a given reporting period. It represents the difference between the revenues or gains of the business, and the expenses or losses of the business. Thus, the purpose of an income statement is:
- To provide the past performance records to investors and creditors of a company.
- To help in predicting the company's future performance.
- To assess the capability of a company in generating future cash flows through the incomes or expenses report.
Statement of Retained Earnings
Retained earning is used by companies to repay its own debt or reinvest in the company again. This statement shows the changes in the company's retained earning over a period of time. This is done by reconciling the beginning and ending retained earnings through the method of adding or subtracting items such as profits and dividends paid to shareholders. This statement is generally prepared for shareholders and creditors of the company. The formula to calculate retained earnings is:
Retained Earnings = Beginning Retained Earnings + Net Income - Dividends
Purpose of Accounting in Society
Apart from being quite useful and effective in the business sector, accounting has various uses in society as well.
Financial statements expose any fraud or wrong business practices of an organization, thus, investors can refrain from investing in organizations involved in malpractice.
For the Common People
A company proves its worth and fairness in the competitive market with the help of its financial statements. A fully detailed and fair report helps in creating goodwill for the company, thus helping the company to grow better.
For Government Agencies
The tax authorities can keep a check on the business practices of various organizations by analyzing and keeping a check on the financial statements. Government agencies, through the accounting statements, ensure that the funds being raised by the company are from legal sources and that the company is not cheating the shareholders, investors or the general public in any way.
The process of accounting starts with bookkeeping, that involves recording the transactions of the company. Once the financial statements are ready, accountants, investors, and financial analysts evaluate them and then use them for future financial decisions. Thus, for accounting to be beneficial, the financial reports should be timely, easy to understand, fair, and relevant.