Just as French is considered the language of love, accounting is considered the language of business. In this lesson, you will learn exactly what accounting is. You will also learn the purpose of accounting, why it is important, and how it relates to the business world.
What Is Accounting?
Charlie has just opened his own hardware store. Even though he knows the basics of business management, he has no idea how to keep financial records. He decides to take a crash course in accounting.
Charlie walks into class on day one prepared to conquer accounting. The first thing that he notices when he walks in the room is three questions written on the board. The first question asks what accounting is and what its purpose is. The second asks how accounting is important. The last question asks how accounting relates to business.
‘Well,’ Charlie says to himself, ‘if I knew that I wouldn’t be here.’
Soon, a rather burly-looking old fellow comes in and leans on the podium. ‘Good morning class. I am Professor Potter. How many of you can answer the questions I have on the board?’ The room is silent. ‘Well, then, I guess we have quite a bit to talk about. I can’t promise miracles, but I can promise you that before you leave this room today, you will know the answer to all three questions!’
Professor Potter points to the first question. Speaking loudly, he says, ‘What is accounting? I know that you have all heard it before. So, tell me what the word ‘accounting’ means to you.’ Pointing at Charlie, Professor Potter says, ‘Go ahead, young man. I’m sure that you can give me some kind of answer.’
Charlie smiles and replies, ‘Accounting is just a bunch of numbers that get added or subtracted, depending on if you are making money or paying bills.’
‘Not a bad answer,’ Professor Potter says, ‘but accounting is really much more than that. The textbook definition of accounting is that it is the act of collecting, organizing. and interpreting financial data. In a nutshell, that’s true. However, to fully understand the entire concept of accounting, there are a few more things that we need to discuss.’
Basic Accounting Equation
‘How many of you know what aloe is?’ Professor Potter asks. Several people raise their hands. ‘I see that there are a lot of you that know what aloe is. Is aloe the stuff that you can put on a burn to make it feel better?’ Professor Potter sees several heads bobbing in agreement. ‘That’s true; aloe is a plant that is used to relieve the pain of burns. But, did you know that aloe has a place in accounting, too?’ Looking around, Professor Potter sees a room full of questioning faces.
He takes a piece of chalk and writes the word ‘ALOE’ on the board. ‘A-L-O-E, class, is an acronym for the most important piece of the accounting puzzle. ALOE stands for assets, liabilities, and owner’s equity. These are the components of the basic accounting equation: assets = liabilities + owner’s equity.’
‘Now that you know what ALOE represents, let’s talk about what each term means. Assets are items that are owned, have value, and can be turned into cash. Bank accounts, CDs, cars, property, and machinery are all examples of assets. Liabilities are what is owed. A loan to purchase an asset is a liability. Owner’s equity is the amount of money that a person has invested into an organization. The investment may be in the form of a stock purchase or a capital investment made by buying into a company. The most important thing to remember is that both sides of the accounting equation must be equal. If they don’t balance, then there is a problem.’
‘Let me see if I understand this correctly, Professor Potter,’ Charlie says. ‘I am opening up a hardware store in a building that I inherited. I know that I have to have $30,000 to purchase inventory, $15,000 to purchase shelving, and an additional $10,000 in the bank for beginning operating costs. I had $20,000 of my own money saved, and I borrowed $35,000 from the bank. If I’m looking at this correctly, then my assets are the $30,000 in inventory plus the $15,000 in shelves I bought and installed plus the $10,000 that’s in cash that is in the bank for beginning operations. That means my total assets are $55,000. I borrowed $35,000 to get the store going, so that’s what I owe, which is a liability. The $20,000 is what I personally invested in the business, so that is my owner’s equity. My assets equal $55,000, and the sum of my liabilities and owner’s equity equals $55,000. Both sides of the accounting equation are equal. So, I balance.’
‘You’ve got it, Charlie,’ Professor Potter says. ‘Does everyone understand the basic accounting equation?’ The entire class nods their heads. ‘Excellent, then we can move on.’
Purpose of Accounting
‘Now that you know what ALOE is in accounting, let’s talk about the entire purpose of accounting. Can anyone guess what the main purpose of accounting is?’ Professor Potter asks.
Charlie, feeling rather confidant since he has mastered the ALOE concept, decides he will respond to Professor Potter. ‘It seems to me that the purpose of accounting is so that a business knows how to classify its expenses,’ he says.
‘You are on the right track, Charlie,’ Professor Potter says. ‘But, let me explain this a bit further. Though there are many reasons why companies use accounting, the main reason is to be able to produce financial statements. In order to produce the financial statements, all the income and expenses of the company must be collected, classified, and entered into special accounting books called journals. Accounting is a step-by-step process that follows a specific pattern. The pattern resembles a circle and is called the accounting cycle. The accounting cycle usually takes 12 months to complete, but that’s not set in stone. A company can choose how long it wants its accounting cycle to be. Regardless of how long the accounting cycle is, one of the last steps in it is creating the financial statements.’
Importance of Accounting
‘Since I just told you what the purpose of accounting was, let’s talk about why it’s important. Do you remember being a child, and it seemed that as soon as you were given money it was gone?’ Professor Potter asks.
Looking around the room, he can tell by the smiles that everyone in the class remembers that time in their lives. ‘Now, can you imagine how well a company could run if they had no idea where their money went? I feel safe in predicting that the majority of companies out there would be in ruins and so would the entire economy. In order to even have a hope of success, a company has to know where their money is coming from and where it’s going out. That’s the importance of accounting and of the financial statements.’
Charlie is curious. He has heard the term ‘financial statements’ before, but he really doesn’t know what they are. ‘Excuse me, Professor Potter,’ Charlie says, ‘I really don’t know what financial statements are. Can you explain them?’
‘Charlie, good man, I am so glad that you asked. There are four main financial statements that are created in the accounting cycle. And just so you know, they are created in a specific pattern. The first financial statement is the income statement, which tells how much money was made or lost in a given time period. Next is the statement of retained earnings, which tells how much money that was made was reinvested into the company. The third statement is the balance sheet. The balance sheet is the financial statement that lists all the assets, liabilities, and owner’s equity of the company. It’s important to note here that the accounting equation is also known as the balance sheet equation. The last financial statement is the statement of cash flows, which tells how much money came in and was paid out in a specific time period.’
Accounting and Business
‘Okay,’ Charlie says, ‘so, now that we know what financial statements are, how does accounting and business really relate?’
‘You tell me, Charlie,’ Professor Potter says. ‘You’re a business owner, correct?’
‘Yes I am,’ Charlie replies.
‘Do you want to know how much money you are making, Charlie?’ Professor Potter asks.
‘Of course I do,’ Charlie answers.
‘Do you want to know where you are spending the most money at? Or even this – do you want to know what your assets are worth?’ Professor Potter asks.
‘It’s a wise business decision to know those things, Professor Potter.’ Charlie responds.
‘Do you hope to one day expand your business, Charlie? If you do, then do you think that you’ll have to borrow more money?’ Professor Potter asks.
‘Well, I hope that I am successful and can branch out. And yes, I will certainly need to have to borrow money at some point and time.’ Charlie answers.
‘Well then, Charlie, you will need to have your financial statements to give to your loan officer. He’ll want to see how well your business is operating and if loaning you money would be a good risk. I have one other question for you, Charlie. Do you want to be able to report accurate numbers to the IRS? After all, you have to let them know how much money they can tax you on.’
‘I want to report all my income and get as many deductions and credits as possible.’ Charlie answers.
‘Well, then, Charlie, I guess you know how accounting relates to business now, don’t you?’ Professor Potter says with a grin.
‘I guess I do.’ Charlie answers back.
‘Let’s review what we have discussed today, class,’ Professor Potter says. ‘The first thing that we talked about is what accounting actually is. It is the act of collecting, organizing, and interpreting financial data. Next, we talked about ALOE. ALOE is the acronym for the terms used in the basic accounting equation – assets, liabilities, and owner’s equity. Assets are what you own. Liabilities are what you owe. Owner’s Equity is what you have personally invested in a company. In accounting, the total assets must always equal the sum of the total liabilities and owner’s equity.’
‘We also talked about the purpose of accounting, which is ultimately to produce the financial statements of a company. The four financial statements that are used to paint the picture of financial health for a company are the income statement, statement of retained earnings, balance sheet, and statement of cash flow. The income statement tells how much money a company made. The statement of retained earnings tells how much of the money that was made was reinvested in the company. The balance sheet lists all assets, liabilities, and owner’s equity accounts and tells the balance of each account. The statement of cash flows tells the inflow and outflow of a company’s cash for a given time period.’
‘The last thing that we talked about was how accounting relates to business. Accounting is a business necessity for many reasons. One of the most important reasons is so that a company can know how much money they’re making, where it’s coming from, and where it’s being spent. Another reason accounting is a business necessity is because the financial statements generated during the accounting cycle are relied heavily on by potential investors and creditors. They use these statements to tell them whether the company is operating efficiently and whether entering into a financial venture with the company would be a wise decision. The last reason that accounting is a business necessity is because the government requires reporting financial data to the IRS for tax purposes. It’s very important that the dollar amount reported for both income and expenses be accurate. If you all recall, I promised that before you left class today you would all know the answers to these three questions. Now for my final question: do you?’
Professor Potter was pleased to hear the entire class answer in unison, ‘Yes we do!’
After finishing the lesson, students should be able to define accounting and relevant terminology in addition to understanding how accounting relates to business.