What is Accounting? Why it is Important and How Works with Examples

Yarab A |Updated on: September 13, 2022

• What is accounting?
• Objective of accounting
• Users of accounting information
• Accounting system
• Example of double entry accounting system
• Accounting rules

Introduction to accounting

With the growth of trade and commerce, accounting plays is a key role in determining the financial stability of the business. Accounting is essential for almost every business irrespective of the business size. Accounting is the language of the business used to communicate to internal stakeholders and external stakeholders. The history of accounting can be traced back to the dawn of the commerce and with some evidence to claim that accounting existed as early as 2600 BC.

What is accounting?

The term ‘Accounting’ referred as ‘the art of recording, classifying, and summarizing, in a significant manner and in terms of money, transactions, and events which are part of a financial character and interpreting the result thereof’. This is the bookish definition or meaning of accounting.

Confused! Let us break the meaning of accounting in a simpler way.

Accounting is the process of collecting, classifying, and recording all the financial data or financial events of the business in a book so as to determine the financial performance of the business as an end objective.

Here, financial data or events are nothing, but the financial transactions of the business and these transactions are recorded in the ‘Books of accounts’

Hundreds of thousands of these accounting transactions recorded in the books of accounts are summarized to prepare various financial statement such as cash flow statements, balance sheet, income statements etc.

Objective of accounting

Accounting is the steppingstone for business decisions. Accounting business transactions provides invaluable information to the people who have a direct or indirect interest in the business. The following are some of the reasons why accounting is required.

• Recording business activities in a systematic manner
• Evaluate the performance of the business in terms of profit
• Know the financial position of the business
• Business control and decision making
• The primary source of information to various stakeholders of the business.

Users of accounting information

Accounting is often coined as the language of the business since accounting considers all the financial transactions in communicating the financial performance of the business to internal stakeholders as well as outside word. The following are the primary users of accounting information.

• Internal users: Internal users of accounting information are management, employees, Owners etc.
• External users: Regulatory, tax authorities, banks, unions etc.

Generally accepted accounting principles (GAAP) in accounting

Generally accepted accounting principles’, commonly known as ‘GAAP’, sets the protocol for summarizing and preparing the financial statements. Generally Accepted Accounting Principles (GAAP) can be defined as a set of accepted principles, standards, assumptions, procedures etc. that business follows in preparing the financial statements.

Accounting system

As the definition of accounting states, it is a systematic way of managing the business transactions, there are defined system of recording or accounting the business transactions in the books of the accounts. Among the various accounting system, the most common and widely adopted accounting system is ‘Double Entry System’.

Under the double entry accounting system, every transaction is recorded with two aspects – Debit aspect and Credit aspect. This implies that every accounting transaction should be recognized into two accounts, one debit account and the other credit account. Thus, for every accounting transaction, debit will always be equal to the credit. To sum up, for every benefit you receive, there always an outgoing aspect of the business.

Example of double entry accounting system

If you have paid 5,000 towards electricity bill using cash, you will debit electricity expenses and credit cash account. To make it simple, the double entry system of booking requires you to answer two aspects for a given transaction. These statements will help you understand better.

• To Whom you have paid (Vendor, Customer etc.) and How (Cash or Bank)?
• Towards what you have paid (Expenses) and How (Cash or Bank)?
• How you have received (cash or Bank) and from Whom/why (Income)

Similarly, when start applying this type of logic for other transactions, you will be in a better position to know the two aspects (accounts) of the accounting transactions which needs to be considered.

Accounting rules

Once you know the ledger accounts which needs to be accounted, the next question will be the ledger account which needs to be debited and the one that needs to be credited. From the given transaction, you need to consider the ledger account which is affecting the financials of the business and apply the following accounting rules. These rules famously referred to as ‘Golden Rules of Accounting’.

There are three Golden Rules of accounting. All the accounts of financial transactions are classified into three kinds of accounts.

Personal account

The personal account relates to persons with whom a business deal. A person can be a natural person or a legal person. For example, customer, supplier. The accounting rule for a personal account is mentioned below:

Real account

The real account relates to property which may either come into the business or go from the business. For example, cash, goods, machinery, furniture & fixtures, equipment. The accounting rule for a real account is given below:

Nominal account

Nominal accounts are the accounts that relates to business expenses, gains, income and losses. Examples of nominal account are rent, salaries, interest, telephone expenses, conveyance, interest on deposits. The accounting rule for a real account is given below

Why Accounting is Important for Business?

Accounting is a critical element in tracking the economic standpoint of a business. It helps businesses manage and track income and expenditures, assures compliance, thereby improving business decisions.

Different types of accounting

Here are the types of accounting - financial accounting, managerial accounting, cost accounting, auditing, tax accounting, forensic accounting, public accounting, governmental accounting

FAQs

What is a simple definition of accounting?

Accounting refers to the process of tracking, documenting and managing financial transactions.

What are the types of accounting?

Here are the 8 types of accounting - financial accounting, managerial accounting, cost accounting, auditing, tax accounting, forensic accounting, public accounting, governmental accounting

What are advantages of accounting?

Here are some of the benefits of accounting:
Helps maintain transaction records
You can compare your economic standpoint
Improves decision making
Helps stay compliant

Learn More

Capital Lease, Life Cycle Costing, Budgeting vs. Forecasting, Royalty in Accounting, Auditing Process, External Audit