The purpose of accounting

Book-keeping and accounting

Book-keeping is the recording of financial transactions in the books of account. It is detailed, routine and done as transactions happen.

Accounting uses those records to prepare financial statements, to analyse the results and to provide information for decisions. It comes after book-keeping and involves judgement.

A useful way to hold the difference: book-keeping asks what happened, accounting asks what it means.

Why measure profit

Profit is the difference between income and expenses for a period. Measuring it lets the owner:

• see whether the business is succeeding;
• compare this year with last year, and with other businesses;
• decide how much can safely be taken out as drawings;
• plan whether to expand, cut back or change what is sold;
• calculate the tax that is due;
• persuade a bank that a loan can be repaid.

Loss is measured for the same reasons. A business that does not know it is making a loss cannot act on it.

What accounting records provide

• A record of what the business owns (assets) and what it owes (liabilities).
• A record of how much the owner has invested (capital).
• The information needed to prepare an income statement and a statement of financial position.
• Evidence for the tax authorities.
• A check against errors and fraud, because everything is written down and can be traced.

The users and what they want

The mark comes from the second column. Naming a user without saying what they need from the accounts scores nothing.

Two of these need care. A supplier cares mostly about whether the business can pay in the short term, so they look at cash and current assets rather than at profit. A bank lending for ten years cares about long-term profitability and about what security is available.

The financial statements

Two statements do most of the work.

• The income statement covers a period, usually a year, and shows gross profit and profit for the year.
• The statement of financial position is at a single date, and lists assets, liabilities and capital.

The difference between a period and a moment is examined. The income statement is like a film of the year; the statement of financial position is a photograph taken on the last day of it.

Common mistakes

• Saying book-keeping and accounting are the same thing.
• Saying the purpose of accounting is only to work out the tax.
• Listing users without saying what each one needs.
• Saying the statement of financial position shows profit. It shows the position at a date.
• Saying the accounts show what the business is worth. They show recorded amounts, not market value.

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