Accounting

What Is Accounting?

Accounting is the process of tracking, organizing and reporting the money a business earns, spends, owns and owes. It turns a large volume of individual transactions, such as sales, purchases, payroll and loan payments, into a set of standardized reports. The people who prepare these records are called accountants, and the discipline rests on bookkeeping, the daily recording of transactions, along with the analysis and interpretation of the resulting data.

How Accounting Works

Most modern accounting uses double-entry bookkeeping, in which every transaction is recorded in at least two accounts so that the books always stay in balance. The core relationship is the accounting equation:

Assets = Liabilities + Equity

Assets are what a business owns, liabilities are what it owes to others, and equity is the owners' residual claim after liabilities are subtracted. Accountants summarize the recorded activity into financial statements. The three most common are the balance sheet, which shows financial position at a point in time; the income statement, which reports revenues and expenses over a period; and the cash flow statement, which tracks cash moving in and out.

Financial and Managerial Accounting

Financial accounting prepares reports for people outside the company, such as investors, lenders and regulators, and follows standard rules so that reports can be compared. In the United States those rules are generally accepted accounting principles, while many other countries use International Financial Reporting Standards. Managerial accounting serves internal decision makers and focuses on budgeting, cost analysis and performance measurement, and its reports need not follow external standards.

Why It Matters to Investors

Accounting information is the raw material for most investment analysis. Investors use reported earnings, assets, debts and cash flows to estimate what a company is worth and how well it is managed. Because managers have some discretion in how they apply accounting rules, many companies also have their statements examined by independent accountants through auditing. An audit does not guarantee that a company will perform well, but it adds a layer of outside review. Investors who understand the basics of accounting are better equipped to read annual reports critically and notice when the numbers do not tell a consistent story.