Why Do Companies Need Accounting?
The owners and managers of any business need records of monetary transactions. These records are useful to measure the amount of money invested or spent during a given period of time. Also these records inform the readers about the profit or loss resulting from the operations during a given period of time. Accounting helps in summarizing vital details that are used in planning and strategizing future course of actions for a business organization.
Meaning of Financial Accounting
Accounting is the science of recording, classifying and summarizing monetary transactions & events of financial nature and interpreting the results thereof. A brief diagrammatic presentation of an accounting process is as follows:
The Basic Accounting Equation
- Assets = Capital + Liabilities or
- Capital = Assets – Liabilities
In order to understand the science behind this equation let us discuss each of its variables one by one.
- Assets are what the firm owns.
- Liabilities are what the firm owes.
- Capital is the net of what the form owns minus what the firm owes.
Types of Assets
Fixed Assets are Long term Assets
Examples: Land, Building, Machinery, Furniture etc.
Current Assets are Short term Assets.
Examples: Inventory, Cash, Receivables etc.
Types of Liabilities
Long term Liabilities
Examples: Capital, Reserves & Surplus, Long term loans etc.
Current Liabilities are Short and Medium Term Liabilities
Examples: Short term loans, payables etc.
The accrual system of accounting records transactions as and when they take place. Income and expenses accrue over a given period of time and therefore shown as assets (accrued income) or liabilities (accrued expenses) in the balance sheet of the company.
When we refer to the term Corporate Financial Statements, we are referring to three documents namely;
[I] Balance Sheet
[II] Income Statement (Profit & Loss Statement)
[III] Cash Flow Statement
[I] Balance Sheet – As the name suggests, this is a sheet of balances. This is a statement of a company’s assets and liabilities. This statement gives the reader a snapshot of how much a company owns and how much it owes as on a particular date. Balance Sheets are therefore a good way to assess a company’s financial health. When a company’s liabilities are too high against the value of its assets, the investors and owners get a clear signal that it has been borrowing more than it can repay.
[II] Income Statement or Profit & Loss [P&L] Statement – This is a document which presents the summary of how profit got generated or loss got incurred by a company during a particular financial year. In other words P&L statement records incomes and expenses of the company for a financial year. Once again, when a company’s profits see a falling trend the investors and owners get a signal that the business is not performing up to the mark.
[III] Cash Flow Statement – A Cash Flow Statement gives a snapshot of how and where a company spends its cash and bank balance during a financial year on operating, investing and financing activities of company. It shows both inflows and outflows of cash in order to give the investors and owners a clear picture of what is leading to rise or fall in cash balances over the years.
To conclude, we must learn the art and science of reading financial statements of companies to be able to take a calculated risk of investing our hard earned money in a company.
About the author: Prof. Anil Kshatriya works as Assistant Professor in the area of Finance at Institute of Management Technology, Nagpur. His teaching and research interests include Managerial Accounting, Management Control Systems and Strategic Management. Prof. Kshatriya is a professional accountant (CMA India) having associate memberships of Institute of Cost Accountant of India (ICAI) and Chartered Institute of Management Accountants (CIMA UK). His industry experience includes working as cost accountant with the Auto Sector at Mahindra Group. Prof. Kshatriya teaches courses in Accounting and Strategy at IMT.