Accounting: Definition

The American Institute of Certified Public Accountants (AICPA) published perhaps the most comprehensive definition of accounting:

Accounting is the art of recording, classifying, and summarizing, in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof.

Accounting: Explanation

To explain and understand the above definition clearly, let’s consider it in parts.

The first thing to note about accounting is that it is an art, not a science. It is a practical subject concerned more with doing things than theorizing about them.

Accounting is the art of recording, classifying, and summarizing transactions and events. In the first place, we maintain the records of transactions by writing various accounting books like journals and ledgers, etc.

These records are then classified into suitable headings and groups. This classification is important because all information must be seen in a proper perspective to be meaningful.

After the basic records have been suitably classified into groups, the information provided by the groups is summarized into accounting statements (e.g., statements showing the calculation of profit and loss or the business’s financial position).

The preparation of such summarized financial statements is frequently the ultimate aim of keeping records and classifying them.

Another important fact is that such records, classifications, and summaries are made for both transactions and events.

A transaction is any business dealing or activity in which a business unit (or a person) is involved that causes a change in its financial position (e.g., purchase or sale of goods).

An event, on the other hand, is an occurrence to which a business unit may not be a direct party, but may still be affected by it.

An example is the devaluation of a currency. An importer or an exporter is usually affected by devaluation without being directly involved in the decision to devalue the currency.

If an event has a financial implication for a business unit, it must make a record of such an event.

Again, the records, classifications, and summaries are made for only those transactions and events that are of a financial nature or character. All accounting records are basically financial records.

If a transaction or an event does not have a financial implication, it will not be recorded in the accounting books.

For example, placing a purchase order is a transaction but it has no financial implication until the goods are actually delivered by the supplier to the buyer.

Hence, accounting records are made only after the goods have been physically received. As a case in point, the devaluation of the US dollar may have no financial implication for a small trader who has no import or export dealings.

Therefore, in this case, no record of the event must be maintained.

All records are made in a significant manner and in terms of money. It is important that these records must be made in a significant (i.e., organized and methodical) manner in order to be of any real use to a business unit.

Again, all accounting records are made in terms of money—not in terms of quantity or weight.

While additional or subsidiary records may be kept by some businesses in terms of quantity, the basic accounting records are all kept in terms of money.

Thus, a motor vehicle account will show the value of a motor vehicle owned by a business, not its make or mileage, etc. Similarly, in the purchase account, we show only the monetary value of purchases, not the quantity, type, etc. of goods purchased.

The last part of the definition from the AICPA shown above is concerned with the interpretation of the results made available by accounting records and summaries.

Financial statements must be explained to the people concerned so that they can understand the contents and the message conveyed. This is, therefore, an important aspect of the accounting process; without it, records would have limited, if any, value.

For the purpose of interpreting and explaining the accounts, a number of tools or techniques can be utilized.

Need for Accounting

A business exists to earn a suitable return (or profit) on the investment allocated to it. It is so because money obtained from shareholders and long-term creditors comes at a cost.

The cost for shareholders’ money is to be equated with their expectations. A business will, therefore, aim at a return that satisfies the shareholders’ expectations as well as the legal requirements of the creditors.

The expenses incurred to run a business and the income earned is recorded in accounting. Accounting converts business transactions in money terms, classifies and records transactions in the books of accounts, and summarizes transactions.

This shows the profit earned (or loss sustained) during a period. It also shows the company’s financial position (in terms of assets, liabilities, and proprietor’s interest) at the end of the period.

Without accounting, a business cannot identify how much has been spent, why it has been spent, and what results have been achieved in the form of earnings made through increasing these expenses.

Accounting, therefore, serves as the eyes and ears of a company. With accounting information, businesses can evaluate the direction they are heading in and, accordingly, determine whether the journey will lead to a happy or sad end.

True is a Certified Educator in Personal Finance (CEPF®), contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, his interview on CBS, or check out his speaker profile on the CFA Institute website.