WHAT USE IS ACCOUNTING?

Before we can discuss what use Accounting is, we must first understand what Accounting is. So, let’s ask Wiki:

‘Accounting or accountancy is the measurement, processing, and communication of financial information about economic entities.’

While this is a good definition, the order is a little out. Why? Because the processing of the transactions is necessary before the measurement — of performance and position — can be achieved. So, let’s discuss them in the appropriate order.

Processing

This refers to how the transactions a business enters into are processed. What’s a transaction? Well, for example, if we pay for something the cash moves out of our bank account. That movement, that payment, is a transaction.

There are, of course, lots of types of transactions. For example, every Sale we make is a transaction. How? Well, when we sell goods the items move from our store to the Customer’s premises. If it’s a sale of an electronic item, the item (or, at least, a copy of it) move to the Customer’s computer. If we are selling services, then the sale, the transaction, comprises a transfer (= movement) of value to the Customer.

Needless to say, when the Customer pays our invoice this is also a transaction. Why? Because the funds transfer/move to our bank account.

No prizes for guessing where to next! ….. You got it when we purchase an item — electronic or otherwise — or a service, this is also a transaction. Once again the item/the value transfers/moves — this time to us (from the Supplier). And, of course, when we pay — transfer/move funds to the Supplier — this is also a transaction.

Your accountant will, from time to time, enter a journal entry to your accounts. These are also transactions. In this instance, there is no transfer/movement of value from you to someone else, or from them to you. With a journal entry, the transfer is between two accounts within your accounts. For example, the Accountant might choose to move the cost of some printing you had done at your stationers to your Advertising expense from your Stationery expense account.

You might think that’s all, but there are other transactions, too.

Firstly, there’s Salaries and Wages. By now the movement should be easy to spot. Yes, funds are transferred to your Employees — that’s the transaction. Simple, you say! Ah, but, then there’s the payroll and other taxes and deductions to pay. At the time the Salaries/Wages are paid a Liability (Creditor) comes into being — mostly being payments owing to Infernal Revenue (everybody’s friend!) on those Salaries/ Wages. Once again, when the payment of these items is made to whomever they are owed this is a transaction — again a movement of funds.

Further transactions include receiving loans (funds transferred from the lender to us), repayments made on those loans (funds transferred back, including interest), and payment of bank fees (okay, the bank just takes those, but the funds do move out of our account). And then, there are further payments to the various Government authorities, for whatever purposes — Customs, Income, and other Taxes. Once again, payment for each of these items is a transaction.

Measurement

This also involves the balancing of accounts — which is why the Statement of Financial Position used to be called the Balance Sheet. That said, it is only possible to generate the financial statements once a Trial Balance has been completed. These days, the trial balance is maintained on an ongoing basis by accounting software. But, back in the not-too-distant past (i.e. before computers), this was a task in itself.

Going further back in history, this balancing involved settling the account with other parties. So accounting also has the connotation of settling things with someone. Settling scores, if you like. This involves checks and balances, as the saying goes — i.e. your records and their records must be agreed.

As you can see, the underlying foundation of accounting is facts. Financial facts. So, the outcome of accounting — which is, in any case, an ongoing process, and therefore not having one end-of-process outcome — is, yes, a set of financial statements based on facts.

But it’s more than that. These financial statements must be prepared according to the standards prescribed by an international standards-setting body. These standards spell out not only how transactions are to be accounted for, but also how the financial statements are to be presented. Why’s this? So, they can be understood because they are presented in a defined/expected way.

Communication

Communication implies a shared understanding, and this necessitates a shared language. That language? Accounting!

As Warren Buffet says:

Charlie Munger takes this further:

Yet, this too is not the whole outcome of accounting. While the Wiki definition includes ‘communication’, I would suggest it should go further, in that accounting should lead to a full understanding of that financial information. And deliberate decision-making about what should be done going forward as a consequence of that information.

So, accounting should lead to the viewers of the Statement of Financial Performance getting a good grasp of:

• How the organization has been performing against expectations:
• Budget/Forecast
• Last year
• Where problems have been faced, and what can be done about them.
• Where things are going well, and what can be done to capitalize on this, or replicate it.

Accounting should also inform interested parties, via the Statement of Financial Position:

• How the organization is placed financially, including answering questions like:
• Has it sufficient cash to pay its creditors?
• Is it holding too much stock?
• Are customers being allowed too much credit?
• Has too much borrowing been done?
• What can be done about the answers to the above questions.

The combination of these two statements also enables readers to determine the return on equity — whether the organization is delivering sufficient return on the funds put into it.

There are other statements included within a set of accounts, including especially the Cash Flow statement, and a number of very useful key performance indicators (financial KPI’s) can be derived from the statements. All of these — the statements and the financial KPI’s — must be used in conjunction with other, non-financial (KPI) data to inform the decision-making process.

They also enable appraisal of the management team! Robert Kiyosaki sums it up like this:

So, what use is Accounting? It’s a process of recording and reporting on the financial results of an organization in order that decision-makers can make informed decisions to take the organization forward, and be held accountable for those decisions/results.