How does accounting help businesses?
Businesses need cash to operate. They need cash to pay salaries, buy inventory and make large purchases -sometimes called capital purchases - like equipment in order to run their business.
Businesses get cash primarily from two sources:
The first source is banks. In accounting we call them creditors and in finance this is known as debt financing.
The second source is investors. You can think of the stock market as investors because stockholders are investors of large corporations, but an owner of a small business is also an investor of the small business. In finance this is known as equity financing.
So, how do investors and creditors decide who to invest or lending money to? This is where accounting comes into the picture. Accounting records the financial transactions of a business and communicates this information to potential investors and creditors.The output of the accounting process is the formal financial statements.
An income statement reports a business' profitability. A statement of changes in owner's equity is called the owner's equity statement. A balance sheet details the economic resources of a business and the claims on those resources. Finally a statement of cash flows summarizes the cash inflows and outflows for various business activities.
Businesses with good financial statements tend to get the money. Businesses with poor financial statements often do not. This is because cash , sometimes called capital in finance, is a scarce resource. Investors and creditors do not have an unlimited supply of cash so they have to choose who gets it and who does not. This concept is called capital rationing. This creates a dilemma for investors and creditors. How do they know that the accounting from one company to the next is done correctly and with the same procedures and guidelines? The accounting profession has a list of accounting standards that must be followed to ensure that all similar transactions are accounted for the same way. The standards are known as generally accepted accounting principles also known as GAAP. So GAAP are the accounting rules that tell us how to account for specific transactions. GAAP is the foundation of Financial Accounting.
In the United States the Security and Exchange Commission or SEC requires all companies whose stock is traded on a open markets, like a stock market, to prepare their financial statements in accordance to GAAP. Failure to do so would cause the company to go out of business and could possibly lead to accounting fraud. So all companies comply with this requirement. The SEC has deferred the creation of GAAP to a private non-government organization known as the Financial Accounting Standards Board or FASB.
Although this is an oversimplification you can think of it as the FASB creates GAAP for U.S. companies. For the rest of the world, there are different accounting principles and guidelines. The most common set of international accounting standards are known as International Financial Reporting Standards or as IFRS. IFRS is created by the International Accounting Standards Board or the IASB.
So to summarize, in the U.S. the FASB creates GAAP and internationally the IASB creates IFRS.
So why is this international stuff important, besides the obvious reason that we live in a global economy? The SEC wants GAAP and IFRS to merge or converge into one set of standards worldwide.
This process has been incredibly slow and began in 2002 but it does continue.