The Core of Accounting: Its Function, Importance, and Link to Business

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The Core of Accounting: Its Function, Importance, and Link to Business

Business Essentials · Chapter 20: Accounting FundamentalsSection 20.1 · lesson 86 of 10511 min · free with a free account

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In this lesson

Its function, its importance, and its link to business.

  • Define accounting and the accounting equation
  • Distinguish financial from managerial accounting
  • Explain cash versus accrual, and why profit is not cash
  • Describe the profession, audits, and accounting ethics

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Everything said in the video, section by section (1,614 words). Read along, or search it.

Accounting Fundamentals

The Core of Accounting

A landscaping business has a profitable quarter. Its owner still can't pay her supplier. That's not a mistake in the books. It's the books working exactly as designed. This section is educational, and isn't accounting, tax, legal, or financial advice. A business with a specific accounting question should consult a qualified accountant. We'll start with what accounting is, and the one equation everything rests on. Then the two branches, financial and managerial, and the difference between bookkeeping and accounting. Then cash and accrual, and why profit and cash are different things. And we'll close with the profession, what an audit really tells you, and the ethics behind it all.

What Accounting Is

A Language, Not a Set of Sums

Accounting is the process of recording, classifying, summarizing, and reporting the financial effects of a business's activities. It's worth reading that definition slowly. Most people picture accounting as arithmetic. That misses what it's for. Accounting is better understood as a language. A language for describing what a business did, in financial terms. Think about what a language does. It lets someone who wasn't there understand an event they never saw. Accounting does the same for a business's transactions. People who weren't present can see what happened to it financially over a period. And they can see where it stands at a single point in time. Crucially, they see it in a standard form, so one business can be compared with another.

Why It Exists

What Direct Observation Can't Supply

So why does accounting exist at all? Because a business's owners, lenders, managers, and regulators all need three answers. What does it own? What does it owe? And is it making money? None of them can simply observe the business and get reliable answers. An owner who isn't there every day can't see the financial position by walking through it. A lender deciding whether to extend credit can't judge repayment by touring the premises. A regulator overseeing many businesses can't rely on impressions at all. Accounting fills that gap. It supplies, in a structured and comparable form, what direct observation never could.

The Foundation

The Accounting Equation

Everything in accounting rests on one structural relationship, the accounting equation. Assets equal liabilities plus owners' equity. An asset is something of value the business owns or controls. That includes cash, equipment, and amounts its customers owe it. A liability is an amount the business owes someone else, like a loan, or a bill from a supplier. Owners' equity is the owners' residual claim, what's left of the assets once the liabilities are subtracted. It represents what the owners invested, plus what the business has earned and kept. The intuition is simple. Every asset had to come from somewhere. Either the business borrowed it, which creates a liability. Or the owners put it in, or the business earned it, and that's equity. Since every asset came from one of those two sources, the two sides must always be equal.

Staying In Balance

Every Transaction Leaves It Balanced

The equation stays in balance after every single transaction. That's the discipline that makes accounting checkable. The source traces three transactions for a fictional business, using illustrative amounts. Here's the pattern, using the kinds of transaction from this section's exercises. When the owner contributes cash, assets rise, and equity rises by the same amount. When the business takes out a loan, assets rise, and so do liabilities. When it pays cash for equipment, one asset falls and another rises. Neither liabilities nor equity move. Each transaction changes something. None of them breaks the balance. That's not a coincidence of these examples. It's built into how every transaction is recorded. Which is why a system that doesn't balance tells you something specific. An entry has been made incorrectly, somewhere.

Table 20.1.1

Financial and Managerial Accounting

Accounting splits into two broad branches, by audience and purpose. Financial accounting produces statements for external users, like investors, lenders, and regulators. It follows a common set of rules, covered in subchapter twenty point three, so businesses can be compared. Managerial accounting produces information for decisions inside the business. No external rules govern its form, because only the business itself uses it. Timing differs too. Financial accounting reports a completed period, after the fact. Managerial accounting is as current as the decision requires, and is sometimes a forecast. Financial accounting summarizes the whole business. Managerial accounting may focus on one product, or one department. One is a historical record. The other supports a decision that hasn't been made yet. Here's the common mistake. Managers expect one branch to do the other's job. Managerial accounting is not a simplified version of financial accounting. It's a different discipline, and a business needs both.

Recording And Interpreting

Bookkeeping Versus Accounting

Next, a distinction people blur all the time, bookkeeping versus accounting. Bookkeeping is recording the business's transactions in its accounting records. Accounting is interpreting them. A bookkeeper enters transactions accurately and consistently. An accountant uses those records to prepare statements, and applies judgment to estimates. And the accountant explains what the numbers actually mean. In a small business, one person often does both jobs. The distinction is still useful, for one reason. Accurate recording is a precondition for reliable interpretation. But it's not a substitute for it. Perfect records can still be badly read.

When To Record

Cash Basis and Accrual Basis

When exactly is a transaction recorded? There are two bases. Under the cash basis, revenue is recorded when cash comes in, and expenses when cash goes out. Under the accrual basis, revenue is recorded when it's earned. That means the business has done what it needs to do to be entitled to it. And expenses are recorded when they're incurred, when the resource is used, whenever the cash moves. Why bother? So a period's results reflect that period's actual business activity. A sale made in one month but paid the next belongs to the month it was made. That's when the business did the work of earning it. Now the crucial consequence. Under accrual accounting, profit and cash are different things. A business can report a profit and still end the period with less cash than it started with. Its earned revenue may not be collected yet, or its expenses may already be paid. The reverse can happen too. This one point confuses more new business owners than perhaps any other accounting idea.

The Profession

Branches of Accounting

The accounting profession has several branches. Public accounting serves many clients from an independent firm. It includes audit, which examines a business's statements and expresses an opinion on them. It includes tax, preparing returns and advising on tax matters. And it includes advisory, a broad category of consulting on business and financial matters. Management accounting works inside one business, producing the managerial information we just described. Government and non-profit accounting serves public bodies and non-profit organizations. They follow reporting frameworks suited to their distinct purposes and sources of funding. Forensic accounting investigates financial records, typically over a dispute or suspected wrongdoing. Internal audit is an ongoing function inside a business. It tests whether the business's own controls and processes are working as intended.

Audits

What an Audit Does and Doesn't Provide

The audit is routinely misunderstood, so it's worth stating plainly what it does. An audit is an independent examination of a business's financial statements. It ends in an opinion on whether they're fairly presented, under the applicable accounting framework. It provides reasonable assurance. That's a high level of confidence, but not an absolute one. The assurance is that the statements are free of material misstatement. And it's reached by examining evidence on a test basis, not by checking every transaction. Now what an audit doesn't provide. It isn't a guarantee against fraud. A well-concealed fraud can escape even a properly conducted audit. And it says nothing about the business's prospects, its management, or its worth as an investment. Those matters are entirely outside its scope. So an owner or investor who reads a clean opinion as a certificate of safety has misread it.

Ethics And Literacy

Trust, and What a Manager Needs

Accountants work under professional obligations of integrity, objectivity, and competence. Those obligations are heightened by how much others rely on their work. A supplier extending credit, a lender approving a loan, and an investor committing capital all act on it. They act on information they didn't prepare, and generally can't confirm for themselves. That's precisely why the integrity of whoever prepared it matters so much. So what does a manager who isn't an accountant actually need? Not the ability to prepare statements. The ability to read them with understanding. That means knowing what each statement shows, and recognizing when a number rests on a judgment or estimate. It means asking an accountant a sensible question when something is unclear. And it means understanding that accounting reflects choices and estimates. It isn't a mechanically objective photograph of the business. This chapter is built to give you exactly that level of working literacy.

Case Vignette

Profitable and Unable to Pay

Back to the landscaping business. Marisol is in her third year, and her quarter shows a solid profit. Yet she can't pay an overdue invoice from her mulch and soil supplier. She doesn't understand how a profitable quarter has left her short of cash. Her accounts are kept on an accrual basis. A large share of the quarter's revenue came from several big jobs, finished near the end of the period. The invoices are out, but the clients haven't paid yet. That revenue is properly recorded as earned, because the work was done. So it counts toward profit. But it hasn't arrived as cash. Meanwhile, she's already paid for the materials, fuel, and labor those jobs needed. She can't force her clients to pay early, and her supplier expects prompt payment. Once the accrual basis is explained, her reasoning becomes clear. Profit measures what she earned in the period. Cash measures what actually moved. Under accrual accounting, those are different things by design. How to manage that gap, and the statement that reveals it, comes in subchapter twenty point five.

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FAQ

Questions students ask us

About The Core of Accounting: Its Function, Importance, and Link to Business

What is the accounting equation?
The accounting equation states that assets equal liabilities plus owners' equity. Assets are things of value the business owns or controls, such as cash, equipment, and amounts customers owe. Liabilities are amounts owed to others, like loans or supplier bills. Owners' equity is the residual claim: what owners invested plus earnings kept. Every asset is financed by borrowing or by owners, so both sides stay equal after every transaction.
What is the difference between financial accounting and managerial accounting?
Financial accounting produces statements for external users such as investors, lenders, and regulators, following common rules so businesses can be compared. Managerial accounting produces information for decisions inside the business, with no external rules on its form. Financial accounting reports a completed period for the whole business, while managerial accounting can be current or a forecast and may focus on one product or department. A business needs both.
Why can a profitable business run out of cash?
Under accrual accounting, revenue is recorded when earned and expenses when incurred, whenever the cash actually moves, so profit and cash differ. A company that finishes large jobs near the end of a quarter counts that revenue toward profit even though clients have not paid yet, while it has already paid for materials, fuel, and labor. The result can be a solid reported profit alongside too little cash to pay suppliers.
Does a clean audit opinion mean a company has no fraud?
No, an audit provides reasonable assurance, a high but not absolute level of confidence, that financial statements are free of material misstatement and fairly presented under the applicable framework. Auditors examine evidence on a test basis rather than checking every transaction, so a well-concealed fraud can escape a properly conducted audit. An audit also says nothing about a business's prospects, the quality of its management, or its worth as an investment.

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Business Essentials (Business 100) carries a NCCRS credit recommendation for 3 semester credits. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.
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