Accounting, often considered the "language of business," is one of the earliest recorded human activities and may be the origin of writings. It was extremely important to keep records of who owed how much, what kind of transactions one was involved in, etc.

Accounting is a system of keeping records and is in its essence a language of business. Accountants classify and measure information coming from businesses or other economic entities, track it in accounting books (now a computer ledger), and display it in financial statements.

Since accounting is a record-keeping business, correct accounts can be displayed in various forms in financial statements that help people to understand, what has happened or is happening to the business.

3 main uses of accounting

1. Financial health check

Financial health is displayed in financial statements. Those are compiled regularly for different reasons by accountants and submitted to managers and owners. There you can see if a company is making a profit, how much they own, or how much they owe. There are several ratios that can help you determine if the business is doing well or struggling and banks very often require detailed financial statements to do exactly that and to determine if they can loan to the company.

2. Decision making

Decision-making is helped by planning and analysis, which is a separate branch of accounting. It essentially forecasts the effect of future decisions on the financial statements. For example, will closing a branch increase or decrease an overall profit? Can the business sustain R&D operations until it can be commercialized? Is it possible to pay bonuses to employees this year?

3. Compliance and regulatory needs

Compliance and regulation are a pain point for any business, especially for small businesses. We are not talking only about taxes and tariffs but other compliance forms you have to submit to the state (information on employees, on R&D, on employing disabled persons, ESG metrics...). More often than not, this information is connected to information already recorded in your accounts and regulatory needs are therefore usually covered by accounting departments.

Who is the user of accounting information?

Official financial statements are used by top management, owners (investors), debt holders (banks), competitors (if they can get their hands on them) and suppliers and customers to gain information on how well the company is doing. Sometimes even employees want to know if the company is growing in revenue and generating profit because it can influence their decision on asking for a raise or staying with the company. Governments use that information for tax purposes.

Other custom reports from accountants are used by management for managing specific projects and departments or solving problems. They are used for forecasting the impact of business decisions, planning future costs, and determining if departments stay within their budget. Custom reports are used to determine bonuses, for example increase in revenue can determine bonuses company-wide, sales made by a specific person can improve their commission and average cost per unit can determine the bonus of a specific department. All in all, everyone should be interested in having competent accountants for a company.

Basic accounting terms

Balance sheet

A balance sheet is a document displaying what a company owns and who has a claim on it (creditors and owners). Assets are owned by the company, they might be fixed assets such as a factory, intangible assets such as intellectual property, financial assets like bonds, cash in the bank, or accounts receivable (promise of payment from customers)

On the other side, there are debts to the government (unpaid taxes), employees (unpaid wages), banks (revolving and other debts), and suppliers (unpaid invoices). All those debts are called liabilities. The difference between assets and liabilities is known as equity, which is the owner’s residual interest in the business, calculated using the equation: Equity = Assets - Liabilities.

Profit and Loss statement

Companies usually generate sales. To generate sales, they have to incur some expenses (wages, materials, energy, rent). If you subtract expenses from sales, you have gross profit, if you subtract taxes, you get net profit, which can be redistributed back to owners. If you do not pay dividends, this profit becomes new equity back on the balance sheet.

Double-entry accounting

From the 14th century, Europe used double-entry accounting systems. There you have a charter of accounts all representing either asset, liability, income, or expense. Every transaction has to affect two accounts, for example, if you buy an inventory of phone cases, you either have a new box of phone cases and less cash than before or you have an invoice to pay. Therefore we can assume that every transaction impacts a balance sheet in one of those ways:

  • Increase in one asset (inventory), decrease in other (cash)
  • Increase in assets (inventory), increase in liabilities (accounts payable)
  • Decrease in assets (you pay cash), decrease in liabilities (for an invoice/accounts payable)
  • Decrease in liability (accounts payable), increase in liability (bank loan)
  • Increase in assets (you issue invoice - accounts receivable), increase in equity (profit)
  • Increase in liability (accounts payable), decrease in equity (new expense, lower profit)

Double-entry accounting was formalized by Luca Pacioli and made famous by Medici bank a hundred years later. The main advantage lies in a more detailed account of transactions, where you can see each account separately and also check for errors more easily.

Final checks

External users of any financial information often require external verification. With accounting records, there is a financial audit. In a financial audit, an auditor goes through the records with the sole purpose of verifying, that the statements are truthful, balances correspond with actual amounts and there are no "material misstatements" - that is an accounting jargon for "there are no errors whose correction would change your assessment of the business". While there are countless high-profile cases where the audits were done poorly or didn't find any problems even though a company was indeed misrepresenting its financial position, the assurance given is mostly satisfactory.

Conclusions

Accounting is very important for running a business and understanding history. You can learn more on Coursera or Wikipedia. For personalized accounting support, I am here to provide expert guidance and complex accounting activities from day-to-day bookkeeping and preparing financial statements with accordance with Czech GAAP to strategic financial planning.