Mind the GAAP! Definition of Accounting For Non-Accountants

What is accounting? It’s a generally used term, but it's an extremely important part of the health and well-being of any business or firm, large or small.

You’ve probably heard the term accounting thrown out in general conversation, and you’re probably wondering what the term accounting means? Or moreover, what does it mean for businesses and organizations?

The Webster dictionary defines accounting as, “the system of recording and summarizing business and financial transactions, and analyzing, verifying, and reporting the results”. Accounting is also a separate discipline from finance, accounting focuses on the day-to-day flow of cash into and out of a business, while finance is a broader term for management and planning.  

But what does that mean? What kind of business and financial transactions? Where do accountants record and summarise these transactions? And finally, where do you do the “analyzing, verify, and reporting”?

Let’s start with the “business and financial transactions”. Any transaction that any business makes has to be recorded, whether that be an outgoing or incoming payment. Next, these transactions are recorded in the general ledger. 

The general ledger encompasses all the financial data of a business. There are a couple of major parts of the general ledger, but we’re going to focus on two for this article: 

• Income Statement 

• Balance Sheet  

The Income Statement shows you all a company’s income and expenses. It shows the profit and loss of a company for a given period. By looking at this, accountants and bookkeepers can get a pretty good idea of the health and financial well-being of a company. This can be looked at like a common measurement for accountants to gauge a company's overall financial health.

The Balance Sheet is a financial document that lists three things: assets, liabilities, and equity. 

Assets are everything that the company owns, whether that be cash, factories, machines, etc. There are two types of assets, current and non-current. Current assets are expected to be sold soon, like cash or stocks. On the other hand,non-current, or long-term investments aren’t expected to be sold within the next year, like factories, machinery, intellectual property, etc. 

Liabilities are the things that the company owes. There are two main types: current and non-current. Some examples of current liabilities would be a short-term loan or accounts payable. Non-current liabilities would be something like a long-term loan or even long-term leases. 

Finally, there’s what’s called equity, or the shareholders’ stake in the company. There are a lot of complex aspects of equity, so we won’t go too much into detail in this article. But, equity is a way for a business to raise funds, or capital, for its activities.

Normally this comes in two forms, either by borrowing through things like loans or bonds, or raising money through stocks. This is particularly interesting for investors because it allows them to share in the company’s profits, through something called dividends. 

Dividends are a sum of money regularly paid out to its shareholders from its profits. Owning equity also allows shareholders to make decisions and take part in business decisions, like voting on corporate actions or elections for board directors. 

Equity is fairly easy to calculate, it’s Total Assets - Total Liabilities.    

Note: There are two types of people who take care of the ledger, bookkeepers and Chartered Certified Accountants or CPAs. A bookkeeper's job is to record every individual transaction in the ledger. A Certified Accountant’s job is to analyse that data and offer financial advice. 

One can become a Certified Accountant through the Institute of Chartered Accountants of England and Wales, or your specific institute if you live in Scotland or Northern Ireland. 

Now while accountants all start from the same starting block, that being the general ledger and its financial data, different kinds of accountants do different things with that data. For example:

• Financial Accounting: The job of a financial accountant is to compile and keep track of all the relevant financial data during a given period. A financial accountant handles financial accountability and is thus responsible for things like budgeting, managing tax payments, and performing internal audits. 

• Managerial Accounting: Management accountants analyse and make sense of the financial data. They then communicate that to managers, so that they can make wise financial decisions. 

• Cost Accounting: As the name implies, cost accountants keep track of and analyse cost expenditures. They’re the ones that review expenses, and then make recommendations on what a business should or should not be spending money on. 

Different countries have different accounting regulations/principles and ways of reporting accounting results. While there are a lot of similarities between them, the UK abides by the UK GAAP, or Generally Accepted Accounting Principles, and IFRS, or the International Financial Reporting Standards, which is accepted worldwide. These principles provide accountants and interested parties with a sort of standard, so that different financial statements from various accountants aren't vastly different. 

Within the UK GAAP, there are five principles that each accountant needs to use and abide by, those principles are:

1. The Accrual Principle: This principle tells accountants two things, first they should recognize income when it’s earned, instead of when you receive it. Secondly and similarly, recognize expenses when you incur them, not when you pay them. For example, a company that does business with a customer who pays at a later date, after the initial transaction, would record the income at the initial transaction date, not when they actually receive the money.
2. The Matching Principle: This principle tells accountants to align revenues and expenses. For example, a company buys a piece of machinery, and uses it over the next 20 months. They would then spread that cost out by recording the cost over the 20 months, not all at the initial sale date.
3. The Historic Cost Principle: This states that transactions must be recorded at their historical, or original, cost. For example, your company buys a factory or piece of land, then that land appreciates significantly in value over the next ten years. Should you write the new, appreciated price in your financial statements? Or keep the original one? Well, according to the historic cost principle you must keep recording the original price.
4. The Conservatism Principle: Accountants aren’t supposed to predict future transactions. That’s why the Conservatism Principle states that accountants should only state and record potential gains in the books when they happen. Conversely, accountants should recognize anticipated costs or losses, even if they haven’t happened yet.
5. The Principle of Substance over Form: Substance over form is the idea that financial statements and related filings should reflect the reality of the transactions. In short, accountants should not intentionally try to mislead readers of financial statements while recording transactions. 

As we laid out a little before, accounting plays a gigantic role in the health and wellbeing of any business or organisation. Accounting allows a business to: 

• Keep track of income and expenditures 

• Ensure legal and regulatory compliance with local regulations 

• Provide management and investors with relevant financial data, so they can make appropriate financial decisions

• Check employees’ performance

• Prevent mistakes or fraud

Yet, the arguably most important facet of accounting is providing management with financial information. Imagine trying to make a decision without knowing how your company’s doing financially. It would be like trying to hit a moving target in the dark.

How would you know whether you could spend more money this quarter if you don’t know how much you owe from the last quarter? Accounting allows managers, and investors, to be confident in their decisions. 

Modern-day businessmen weren’t the only ones to believe in the importance of accounting. In fact, accounting is so fundamental to our societies that its origins can be traced back to Mesopotamia, right around the times when writing, reading, and counting systems were first being developed, about 7,000 years ago. Mesopotamians, however, used it for very basic things, like keeping track of transactions involving livestock, crops, and animals. 

The first bookkeepers emerged before 2000 B.C., as a way to keep track of transactions, because at that time people traded through the barter system, not money. At the time, bookkeepers would write little entries that almost read like stories compared to the couple word entries we have today. All transactions were kept in separate ledgers, mostly to avoid disputes if there was a disagreement about what was promised and when. 

As the first forms of money and currency started to pop up, bookkeeping, and accounting evolved. They went from mostly tracking isolated trades between two people to keeping track of material wealth. Bookkeepers also started to be employed to keep track of a business or merchant’s transactions.

Just like before, the entries bookkeepers made were told in story-like form. These entries were very simple, today we would call this “single-entry” bookkeeping. An entry would include the date, whether an item was bought or sold, and then the amount. This process continued until the late 1400s. 

It might surprise you to hear that monks laid the groundwork for modern accounting. As a part of his scientific and philosophical research in the late 15th century, Italian monk Luca Pacioli published a textbook which introduced the “double-entry” system for the first time. 

His idea was to record transactions as separate debits and credits, effectively creating the first balance sheet. Instead of the basic, “single-entry” system, this made ledgers easier to understand and gave bookkeepers and merchants a better understanding of their financial position.       

The construction of the railroad and rise of corporations in the United States is what, according to most historians, pushed basic bookkeeping into the practice of accounting. The new form of transportation was the more powerful factor of the two, along with the railroad came things like distribution networks, shipping schedules, fare collection, and a lot more. To keep track of all of these things like financial statements, cost estimates, operating ratios, production reports, and more were invented. This allowed railroad companies to make informed decisions. 

 The increased access to easy, faster, and cheaper long-distance transportation also helped speed up the development of investment. Up until the 1800s, investment had been local. People would normally invest in a company because they had personal knowledge of the company or their friend or relative did. The shrinking of the country allowed people to invest in other cities and states, with relative ease.  

Fast-forward a bit, as corporations became bigger and more prevalent in American society, they started to publish financial statements such as their balance sheets, income statements, and cash flows statements to attract investors. These financial documents were proof of the profit-making ability of a company. 

However, over time the competition to attract investors increased dramatically, and transformed into a battle for higher profits and better metrics. Shareholders began to become sceptical over the validity of some financial claims, and demanded third-party and independent review.  

Accounting, although it might not seem like it, is essential to our businesses and to our society. As we said, accounting developed at the same time as writing, counting, and even money. 

It’s a key tool for any business to make coherent and smart financial decisions. Managers, investors, and internal and external stakeholders count on it, and the help of accountants, for the success of their businesses. By extension, we all count on it for the health and wellbeing of not just our businesses, but our overall economy.