What is accounting?
Definition of accounting
The American Institute of certified public accountants has provided perhaps the most comprehensive definition of accounting.
“Accounting is 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 a financial character and interpreting the results thereof”.
To explain and understand this definition clearly, let us consider it in parts:
The first thing to note about accounting is that it is an art, not a science. It is a practical subject concerned more with doing things than theorizing about them.
It is an art of recording, classifying, and summarizing transactions and events. In the first place, we maintain the records of transactions by writing various accounting books like journals and ledgers, etc. These records are then classified into suitable headings and groups. This classification is important because all information must be seen in a proper perspective to be meaningful.
After the basic records have been suitably classified into groups, the information provided by these groups is summarized into a number of accounting statements. Examples of these statements include the statement that shows the computation of profit and loss, or the financial position of the business. The preparation of such summarized financial statements is frequently the ultimate aim of keeping records and classifying them.
Another important fact is that such records, classifications and summaries are made for both transactions and events. A transaction is any business dealing or act in which a business unit (or a person) is involved which causes a change in its financial position, for example, purchase or sale of goods. An event, on the other hand, is an occurrence to which a business unit may not be a direct party, but may still be affected by it.
An example is the devaluation of a currency. An importer or an exporter is usually affected by devaluation without being directly involved in the decision to devalue the currency. If an event has a financial implication for a business unit, it must make a record of such an event.
Again, the records, classifications and summaries are made for only those transactions and events that are of a financial nature or character. All accounting records are basically financial records. If a transaction or an event does not have a financial implication, it will not be recorded in the accounting books. For example, placing a purchase order is a transaction but it has no financial implication till the goods are actually delivered by the supplier to the buyer.
Hence, accounting records are made only after the goods have been physically received. Similarly, devaluation of Pakistani rupee may not have any financial implication whatsoever for a small scale trader who has no import or export dealings. He will therefore not need to make any record of this event.
All records are made in a significant manner and in terms of money. It is important that these records must be made in a significant (i.e., organized and methodical) manner in order to be of any real use to a business unit. Again, all accounting records are made in terms of money – not in terms of quantity or weight.
While additional or subsidiary records may be kept by some businesses in terms of quantity, the basic accounting records are all kept in terms of money. Thus a motor vehicle account will show the value of a motor vehicle owned by a business, not its make or mileage, etc. Similarly, in the purchase account, we show only the monetary value of purchases, not the quantity, type or other details of goods purchased.
The last part of the definition is concerned with the interpretation of the results made available by accounting records and summaries. Financial statements must be explained to the people concerned so that they can understand the contents and the message conveyed by these statements. This is, therefore, a very important aspect of the accounting process without which records would have limited if any, value. For the purpose of interpreting and explaining the accounts a number of tools or techniques.
Need for Accounting
A business exists for earning a suitable return or profit on the investment made in it. It is so because money obtained from shareholders and long term creditors have a cost. Cost for shareholders’ money is to be equated with their expectations. A business will thus aim at a return which will satisfy the shareholders’ expectations as well as the legal requirement of lenders of money.
The expenses which are incurred to run a business and the income which is earned is recorded in accounting.
Accounting converts business transactions in money terms, classifies and records transactions in books of accounts and summarises the transactions so as to exhibit profit earned (or loss sustained) during a period. It also shows financial position (in terms of asset liabilities and proprietor’s interest) at the end of the period.
Without accounting, a business cannot know how much amount has been spent, why it has been spent and which results have been achieved in the form of earnings made through increasing these expenses. Accounting thus serves as eyes and ears by means of which the businessmen can see where their business is going and whether the business journey will take the owners to a happy or sad end.