What is Accounting and Why Does it Exist?
Accounting is the systematic process of identifying, recording, measuring, classifying, and communicating financial information. It is the language of business — a universal system that translates every economic event into numbers that decision-makers can act on.
Two core purposes drive it: to measure profit and to support decisions. Accounting also underpins compliance, sustainability reporting, and public trust in markets.
Who uses accounting information?
| User | Type | Decision they make |
|---|---|---|
| Managers & Employees | Internal | Planning, budgeting, performance evaluation |
| Investors & Shareholders | External | Buy, hold, or sell equity in the business |
| Banks & Creditors | External | Whether to lend money and on what terms |
| Tax Authorities | External | How much tax is owed by the entity |
| Customers & Suppliers | External | Whether the business is stable and reliable |
| Regulators & the Public | External | Compliance, sustainability, social impact |
The Accounting Equation
Every business transaction keeps this equation in balance.
The Conceptual Framework (FASB)
The FASB Conceptual Framework provides the theoretical foundation for all accounting standards. Its objective: provide information useful to investors, lenders, and creditors in making resource-allocation decisions.
Qualitative Characteristics
Could make a difference in a user's decision — has predictive or confirmatory value.
Complete, neutral, and free from material error. Depicts economic reality.
Similarities and differences can be identified across companies and periods.
Same accounting methods applied period to period for meaningful trends.
Independent observers using the same methods reach the same conclusions.
Available before it loses its capacity to influence decisions.
Elements of Financial Statements
| Element | Definition | Statement |
|---|---|---|
| Asset | Economic resources controlled by the entity expected to provide future benefit. | Balance Sheet |
| Liability | Present obligations to transfer economic resources as a result of past events. | Balance Sheet |
| Equity | Residual interest in assets after deducting liabilities (net assets). | Balance Sheet |
| Revenue | Inflows from ordinary business activities that increase equity. | Income Statement |
| Expense | Outflows consumed in ordinary activities that decrease equity. | Income Statement |
Key Assumptions
Four assumptions underpin all of GAAP and are taken as given unless stated otherwise.
Going Concern
The business is assumed to continue operating indefinitely — not planning to liquidate. This justifies recording assets at cost and spreading depreciation over useful lives.
e.g. A company depreciates machinery over 10 years because it expects to still be operating in a decade.
Economic Entity
The business is treated as separate from its owners. Only business transactions are recorded in the entity's books — personal transactions are excluded.
e.g. The owner's personal mortgage is never recorded as a business liability.
Periodicity
Financial performance is reported at regular intervals — monthly, quarterly, or annually — enabling meaningful comparison and trend analysis.
e.g. A company closes its books on December 31 every year for meaningful year-over-year comparison.
Monetary Unit (Stable Dollar)
Only transactions measurable in a stable monetary unit are recorded. The currency is assumed reasonably stable — historical costs are not adjusted for inflation.
e.g. Land purchased for $300,000 in 2005 stays on the books at $300,000 even if now worth $700,000.
Key Principles
Principles guide how accountants record and report specific types of transactions.
Revenue Recognition
Revenue is recognised when earned (performance obligation met) — not when cash is received. Under ASC 606: when control transfers to the customer.
e.g. A law firm wins a case in December, invoices the client — revenue is December even though payment arrives in January.
Matching Principle
Expenses are recorded in the same period as the revenues they helped generate, regardless of when cash is paid. Ensures net income reflects the true cost of earning revenue.
e.g. Cost of goods sold is matched against the sale in the same period, even if inventory was purchased months earlier.
Historical Cost
Assets are recorded at their original purchase price, not current market value. Provides an objective, verifiable basis. Exceptions exist for financial instruments and impaired assets.
e.g. A building bought for $800,000 ten years ago stays at $800,000 (less depreciation) even if the market value is now $1.5M.
Full Disclosure
All material information that could affect a user's decision must be disclosed — in the statements or in notes. Nothing significant should be hidden or omitted.
e.g. A company discloses a pending $5M lawsuit in the notes even though no loss has yet been recorded.
The Four Financial Statements
Every set of financial statements tells a different part of the same story. Prepared in order because each feeds into the next — together they give a complete picture of a business's financial health.
For the period ended…
“Were we profitable?”
- Covers a period of time
- Result is Net Income or Net Loss
- Revenues and expenses on accrual basis
For the period ended…
“How much profit did we keep?”
- Bridges Income Statement and Balance Sheet
- Shows retained earnings change for the period
- Dividends reduce retained earnings
As at [date]…
“What do we own and owe?”
- Reports position at a single point in time
- Assets: what the business controls
- Equity = Assets − Liabilities (net worth)
For the period ended…
“How did cash move?”
- Tracks actual cash — not accrual estimates
- Three sections: Operating, Investing, Financing
- Ending cash ties to the Balance Sheet
Accrual vs Cash Basis Accounting
Cash Basis
- •Revenue recorded when cash is received
- •Expenses recorded when cash is paid
- •Simple — used by small businesses and sole traders
- •Not GAAP/IFRS compliant for most entities
Accrual Basis
- •Revenue recorded when earned
- •Expenses recorded when incurred
- •More complex but more accurate picture
- •Required by GAAP & IFRS for most entities
Worked Example — Bright Spark Consulting, December 2024
| Transaction | Cash | Accrual |
|---|---|---|
| Completed project; client pays in January ($8,000) | $0 | $8,000 |
| Received $3,000 advance for January work | $3,000 | $0 (Unearned) |
| Received $5,000 from client for November work | $5,000 | $0 (already recognised) |
| Paid December rent in cash ($1,500) | ($1,500) | ($1,500) |
| December wages accrued, not yet paid ($2,000) | $0 | ($2,000) |
| December Net Income | $5,900 | $4,500 |
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