Definition of accounting and how it works in businesses

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What is accounting? Accounting can be defined as an information system that provides report to stakeholders about the economic activities and condition of a business. Accounting also is the process of recording, summarizing, analyzing, and interpreting financial (money-related) activities to permit individuals and organizations to make informed judgments and decisions. Accounting often is referred to as "the language of business" because of its role in maintaining and processing all relevant financial information that an entity requires for its managing and reporting purposes.

When did accountings start? Accounting began because people needed to record business transaction, to know if they were being financially successful, and know how much they owned and how much they owed. Accounting was born before writing or numbers existed, some 10,000 years ago, in the area known as Mesopotamia, later Persia, and today the countries of Iran and Iraq. Around 3500B.C there is also evidence of accounting being practiced in ancient times in China, Greece, and Rome. Evidence suggests that double entry bookkeeping developed in Italy around 1200B.C. The first book written on double entry bookkeeping was written by Luca Pacioli and published in Venice in November 1494.

Financial accounting and managerial accounting are most common in the accounting field. Financial accounting is comprised of information that companies make available to the general public:  stockholders, creditors, customers, suppliers, and regulatory commissions. Managerial accounting is the use of economic and financial information to plan and control many of the activities of the entity and to support the management decision-making process. Other fields include cost accounting, internatio0nal accounting, not-for-profit accounting, and social accounting.

Three Type of business entities that use accounting to make decision:

Sole trader is a business only one owner and he has the final word taking all decisions by himself. This means that the owner has unlimited liability

Partnership is owned by two or more individuals. Like sole trader, small local business such as automotive repair shops, music stores, beauty salons, and clothing stores may be organized as partnerships.

Company is organized under state or federal statutes as a separate legal entity. The ownership of a corporation is divided into shares of stock.

User of accounting information falls into two categories that are external users and internal users. External users, including financial accountant from outside of the business they may be potential investors or tax inspectors who use this information for making decision. Internal can be divided into two classes one is internal managers who use this information for making routine decisions in the short term planning and controlling operations. Another class is internal manager who use this information for making non-routine decisions in the long term planning and to formulate overall policies. The types of information used include income statements, owner's equity statement, balance sheets and statements cash flow.

Accountings are important this is because accounting letting people and organizations know:

-How much they have earned this year;

- How much they earned during the last year;

- Is business improving;

- How much cash do they have;

- How much money they owe;

- How much they owe to someone else.

The accounting equation represents the basic equation associated with double-entry accounting. Essentially, the accounting equation establishes the formula for representing the relationship that exists between assets, liabilities, and owner's equity. As the most common of all balance sheet equations, the accounting equation is also fundamental to learning how to properly read and utilize a balance sheet.

Assets = Liabilities + capital

This equation is known as accounting equation. It is usual to place liabilities before owner's equity in the accounting equation because creditors have first rights to the assets.

Capital = Assets - Liabilities

The ownership interest is the residual claim, after liabilities to third parties have been satisfied. The equation expressed in this form emphasizes that residual aspect.

Another way of thinking about an equation is to imagine a balance with a bucket on each end. In one bucket are the assets minus liabilities. In the other is the capital. When the assets increase then the capital must also increase. In other way, when the profits increase capital then the assets will increase or liabilities will decrease. Every financial transaction that is accounted for will cause a change somewhere in the accounting equation, and the equation will remain in balance after every transaction.

In the accounting equation consist of two relationships that are positive relationship and negative relationship. A positive relationship exists between assets and owner's equity. For example, increase in capital by cash injection. A negative relationship exists between liabilities and owner's equity such as accrued expenses.

Accounting equation shows the financial position of a business entity at a particular date. Using the accounting equation we can know how much the business owns and owes, and the owner's interest in the business. Is a useful rule which helps when assembling the balance sheet figure.


Income statement also called profit and loss statement. The income statement is a financial report that shows the income earned and the expenses incurred by a business for an accounting period, based on the matching concept. The income statement also report the excess of the revenue over the expenses incurred. This excess of the revenue over the expenses is called net income or net profit. If the expenses exceed the revenue, the excess is a net loss.

One of the most important uses of income statement is that of comparing the results obtained with the results expected. In the profit of calculation we can easily to see about how much profit is made, before deducting expenses, for every rm1 of sales revenue. The account in which profit is calculated is split into two sections one is gross profit, and net profit.

In the income statement it shows the relationship between revenues and expenses. That has two relationships between revenues, expenses and owner's equity. A positive relationship exists between revenues and owner's equity as revenue increases the value of the assets of a business entity. A negative relationship exists between expenses and owner's equity as expenses use up the assets of a business entity. Hence, the effect of revenue earned and expenses incurred during the month for Net Solutions were shown in the equation as increases and decreases in owner equity.

Balance Sheet is a financial report that shows the financial position of a business at a particular date and it shows the value of the assets, liabilities and owner's equity. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by the shareholders.

The balance sheet is split into two parts. One part is a statement of fixed assets, current assets and the liabilities. Another part is a statement showing how the Net Assets have been financed, for example through share capital and retained profits.

The Companies Act requires the balance sheet to be included in the published financial accounts of all limited companies. In reality, all other organisations that need to prepare accounting information for external users will also product a balance sheet since it is an important statement of the financial affairs of the organisation. This is because the balance sheet is a part of the annual report and other documents related by the company. It is used to ensure that the company is complying by the laws, tax rules and so on.

Income statement and balance sheet have many different. For an example, income statement describes the current year performance while balance sheet describes the overall position of company right from the starting year of business to current year. Not only that, income statement provide the current year net profit information while balance sheet provide information about the overall assets and liabilities of company applied in the business. Beside that, in the income statement it shows the relationship between revenues and expenses while balance sheet it shows the value of the assets, liabilities and owner's equity. Consequently, Income statement and balance sheet are totally different but both of the statement are important though the business organisation.

The following example shows some of the common elements of the Balance sheet:

Assets are possessions of value owned by a business because they bring future benefits to the business entity. Assets include land, buildings, equipment and anything else a business owns that can be given a value in money terms for the purpose of financial reporting. Assets are commonly divided into classes for presentation in the balance sheet. Two of these classes are fixed asset and current asset.

Fixed asset is an asset which is intended to be of a permanent nature and which is used by the business to provide the capability to conduct its trade. Examples for the fixed asset are premises, machinery, motor vehicles, office equipment, fittings and fixtures and furniture.

Current assets is cash and other assets that are expected to be converted to cash or sold or used up usually within one year or less, through the normal operations of the business. These can be seen in the operating or working capital cycle it is a process of buying goods until cash is received from the resale of the goods. The operating cycle show that cash is converted into stock when goods are bought. Stock is converted into cash when it is sold for cash and the amount owed by debtors is converted into cash when debts are settled. Examples for the current asset are cash in hand, cash at bank, debtors, stock and prepayments.

Liabilities are amounts owed by the business to outside parties. Examples for the liabilities are creditors, loans and outstanding expenses. Liabilities are business obligations that represent the claims by the external parties against the business assets. In the event of nonpayment, creditors can force the business to liquidate and be paid the amounts due to them before any claims by the owners. The most common classes of liabilities are current liabilities and long-term liabilities.

Current liabilities are liabilities that will be due within a short time and that are to be paid out of current assets. Examples for the current liabilities include bank overdraft, creditors and accrued expenses.

Long-term liabilities are amounts borrowed from banks or other institutions that will not be repaid within one year from the balance sheet date. Examples include bank loans, mortgages and debentures.

Capital also known as owner's equity. Owners' equity is the ownership right of the owner of the entity in the assets that remain after deducting the liabilities. Owners' equity also can define as investment made by the owner and it represents the owner's interest in the business. If the total revenues are greater than the total expenses the difference is the net income. A net loss is incurred if the total expense is greater than the total revenues. Transferring the net balance of the revenue and expense accounts will affect the owner's capital account.

Revenues > Expenses = Profit

Revenues < Expenses = Loss

The Accounting Cycle is a series of steps which are repeated every reporting period. That is the process begins with analyzing and journalizing transactions and ends with the post-closing trial balance. The most important is accounting cycle is the financial cycle.

The accounting cycle give structure to accounting or bookkeeping and has nine basic steps. 

First step in the accounting cycle is analyzing the transaction. Analyzing the transaction is to determine the transaction amount, which accounts are affected, and in which direction. Example: The invoice for the purchase of the paper is for a total of $100, on credit. We must then decide which accounts are affected accounts payable, inventory, supplies and cash.

The rules of debit and credit apply to accounts.

Second step in the accounting cycle is journalizing the transaction. Journalizing the transaction is recorded in the journal as a debit and credit. For an example, the increase in the asset, which is reported on the left side of the balance sheet, is debited to the cash account.

Third step in the accounting cycle is post the transaction to the ledger accounts. Each journal entry has to be posted to the ledger. A ledger is simply a collection of all accounts it shows all of the number detail about detail about a company's accounts. A simple form of ledger is a T-account.

Fourth step in the accounting cycle is preparing a trial balance. A trial balance is calculated to verify that the sum of the debits is equal to the sum of the credits. The information used in a trial balance comes from the ledger. The account balances from the ledger is used to create the trial balance.

Fifth step in the accounting cycle is journalizing adjusting entries. Adjusting entries are made for accrued and deferred items. The entries are journalized and posted to the T-accounts in the ledger. Adjusting entries involve bringing an asset or liability account balance to its proper amount and updating the corresponding revenue or expense account. Example: If there were any accrued interests or salaries that need to be adjusted this is the time to do it in preparation for the financial statements.

Sixth step in the accounting cycle is post adjusting entries to the ledger accounts and prepare an adjusted trial balance. After the adjusting entries have been posted, another trial balance, called the adjusted trial balance, is prepared. The purpose of the adjusted trial balances before we prepare the financial statements. If the adjusted trial balance does not balance, an error has occurred.

Seventh step in the accounting cycle is preparing the financial statements. The adjusted trial balanced is an aid in preparing the income statement, the statement of owner's equity, and the balance sheet. The financial statements must be prepared in a very specific order. This order is important because information provided in the income statement is used in the statement of owner's equity, and information from the statement of owner's equity is used in the balance sheet.

Eighth step in the accounting cycle is journalizing and post closing entries. Closing entries is a process that transfers the balances of the temporary accounts to owner equity. Examples for the temporary accounts are revenues and expenses. After the closing entries have been posted to the ledger and the balance in the capital account will agree with the amount reported on the statement of owner's equity and the balance sheet. In additional, the revenue, expense, and drawing accounts will have zero balances. A final trial balance is calculated after the closing entries are made.

The last accounting procedure for a period is to prepare a post-closing trial balance after the closing entries have been posted. The purpose of the post-closing trial balance is to make sure that the ledger is in balance at the beginning of the next period. The accounts and amounts should agree exactly with the accounts and amounts listed on the balance sheet at the end of the period.

The complete accounting cycle assures when done honestly and correctly a generally accepted snapshot of the financial situation of a company. It also helps regulators, investors and decision makers by providing a standardized tool that can be use in their duties.

In conclusion, accounting is important in our personal life, even though we may not become an accountant. Accounting can help us to make good personal and business decisions and in the accounting cycle let me know more details about the accounting process. Accounting is the conscious of the business world. Accounting is such an important aspect to any business is that accountants are responsible for determine the present and future economic stability of the organization.