Why Is Accounting Important for Businesses?

Why Is Accounting Important for Businesses? | Accounting Smarts
Charles Hall

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Charles Hall

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May 21, 2021

Everyone seems to understand that all businesses have accountants, but not why accounting is so important for businesses.

Everyone seems to understand that all businesses have accountants, but not why accounting is so important for businesses. They’re everywhere; from local start-ups to large corporations like Google and Amazon, accountants are an inseparable business component, and for good reason.

Accounting is important for businesses because it helps owners keep track of income and expenses. Accounting keeps business owners knowledgeable of profit and loss to better inform them in decision making. Accounting also provides investors with valuable financial information.

Accounting can look different for many businesses—be it management accounting or financial accounting—but it’s crucial in every way. In this article, we’ll cover why this practice is so important, and the types of benefits these forms of accounting can offer companies.

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Accounting Helps with Important Business Decisions

Typically, when people think of accounting, the notion of keeping track of numbers and money immediately comes to mind. However, beyond that, there exists a form of accounting called management accounting, and it’s crucial for a business.

Management accounting, while related to financial accounting, is about using financial information to make management decisions. 

Management accounting is about making long term decisions instead of the day-to-day tallying of costs and profits that a business inevitably accumulates. It offers businesses important financial feedback and helps businesses make decisions.

The following are just some of the types of decisions accounting can help with:

Cost-Benefit Estimates for New Products

Management accountants develop cost estimates of ideas developed by designers. They can give a range of what something is likely to cost for the company to create, which is essential; this usually includes projections of the investments needed to create and launch a new product.

Management accountants are helpful in meetings between the product development team and senior management; they help frame the cost-benefit discussion of adopting new products between the two business entities. Important factors that must be considered, such as costs to the manufacturer, distributor, customer satisfaction, and other costs, are thrown into any discussions.

Determining the Release Date for New Products

Timing product launches is crucial for the success of businesses. Products need to be released when customers are most in need of the product's features and benefits.

For instance, movies are typically released on Fridays throughout the year; this is done to capitalize on their audience’s free time and to pay multiplex owners fewer fees. Management accounting seeks to strategically time their products with factors like this in mind. They want to maximize the customers they attract and the revenue the business earns.

Determining the Price for New Products

Management accounting also helps decide the price of products that a business puts out, which is crucial to business success. The ideal price should allow the business to make money on their profits. If the price is too high, no one will buy, and the business will lose money for production. If the price is too low, the business won’t gain enough profits to cover production costs.

Accounting Keeps Businesses Organized

Numbers can feel abstract and infinite; however, money is not. When large quantities of money are being made and spent, it can be disarmingly easy to lose track of where the money is coming from and where the money is going. Without that knowledge, business owners can make financially poor decisions.

For example, it’s jarring when you try to buy something from the grocery store only to get your card declined. Business owners can experience this on a much larger scale, with grander consequences.

As businesses grow in size, the complexity of their business transactions also increases. Products can be sold on credit, campaigns can be launched that provide steady streams of revenue over lengthy periods, and companies can incur losses over time.

Without accounting, it’s challenging to tell how much you can buy, how little you should spend, which customers haven’t paid yet, etc. This is impossible to keep track of on memory alone, so accounting offers a way to reduce the cognitive load of managing cash flow.

Benefits of Accrual Accounting

Accountants aid in the organization by using an accounting method known as accrual accounting, which emphasizes revenues and expenses being recognized in the same period. With accrual accounting, business owners have more insight into their company’s spending habits and revenue to determine whether it’s worth purchasing or creating a product to sell.

Accounting Manages a Business’s Budget

In business, a budget is an estimation of revenue and expenses over a period of time and is periodically examined and reevaluated by accountants. Management accounting is responsible for using performance reports to evaluate any deviations from the budgets and see if anything can be done to get back on track.

Budgets allow business owners to be less bogged down by the day-to-day problems that arise, such as not making enough money on a product. It grants business owners the ability to focus on the bigger picture. Budgets allow money to be allocated towards goals that support business growth and help everyone understand the business's priorities, for better or worse.

Without the proper budget management accounting provides, businesses could suffer from financially running in circles, putting out one fire only for the next fire to show up without ever understanding why. Additionally, business owners can find that when bills are due, they don’t have enough money to pay them, thus putting a preventable strain on their business.

Accounting Aids Inventory Management

Management accounting is responsible for inventory turnover analysis, which refers to a company’s measurement of how fast a company sells inventory compared to industry averages. The speed at which a company can sell its products is crucial in determining its overall performance.

Inventory turnover is crucial for businesses that work with perishable and time-sensitive goods. For example, an excess of milk, eggs, or meat could result in unsold inventory and ultimately lost profits, which no business wants at the end of the day.

  • Low turnover is usually indicative of weak sales and potentially too much of a product. Business owners will find that there are costs to the items being “held.” Holdings are unattractive to businesses because fewer consumers will have reasons to return for that specific product over time.
  • In contrast, a high turnover rate is usually indicative of either strong sales or simply insufficient inventory.

Insufficient inventory is a death sentence for a business, as it could result in the complete loss of sales; management accountants do their best to prevent this from happening by building in safety margins. 

Safety margins calculate the difference between actual sales and break-even sales. It’s a number that accounts for all costs relating to a product. Accountants utilize this by determining just how much losses can be taken without any drastic effects. It provides a cushion from unpredictable factors in the market that result in lower sales, such as running out of a product or having too much of it.

Accounting Can Optimize Staffing

Everything in business costs money. It costs money to keep an accountant on staff, and it certainly costs money to hire employees for the company. Businesses have to make decisions all the time regarding hiring staff and where to set wages, and it can be incredibly stressful to make these decisions if you’re unfamiliar with the numbers.

There can be disastrous consequences on the business if you make an employee's salary too high. If an employee is making excess when the business can’t afford it, something somewhere will break (financially speaking).

Hiring the wrong person can result in a lot of costs, too. Typically when people think of costs, they think of just financial costs. Accountants have to also consider the costs of replacing a departing employee, which includes advertising and recruiters. Termination payouts also tend to be considered as well.

Management accountants let you know just how much you can afford to spend on staffing new people and how much money you can expect to make a return on based on the new personnel. They also encourage hiring the right person, so the payoff is worth it.

Accounting Facilitates Business Transactions

Financial accounting is another specific branch of accounting that’s useful in the longevity of businesses. It involves recording, summarizing, and keeping track of numbers/transactions that are accrued over time. The transactions that a business accumulates over time can be summarized in various financial statements that the accountant can prepare.

Accounting Makes Businesses Credible

Financial accounting needs to be used by a company. It has to be easy to understand, use the same format as other companies, and—most importantly—it needs to be credible. Financial accounting follows the generally accepted accounting principles (GAAP) to do this.

GAAP Benefits

The GAAP is predicated on some fundamental principles in the accounting world. They can be referred to as general rules that make up the foundation for the more detailed and legalistic accounting rules. The GAAP offers a business many benefits:

  • The GAAP keeps a business credible. Without the GAAP, accounting errors and omissions are much more likely. These hurt the company's validity in the eyes of creditors, lenders, and investors who rely on accurate financial statements.
  • The Securities and Exchange Commission (SEC) view companies that use the GAAP favorably. While it’s not impossible to accurately report financial statements using other accounting systems, mistakes can be costly, and your business could be fined if it does not follow GAAP.  

The “generally accepted accounting principles” (GAAP) are made up of three specific rules:

  1. The first is the basic accounting principles and guidelines, which are the rudimentary building blocks that make up the more advanced rules.
  2. The second is the extensive, detailed rules issued by the Financial Accounting Standards Board (FASB) and Accounting Principles Board (APB).
  3. The last consists of the accounting industry’s accepted practices and techniques.

The GAAP ensures that companies who distribute their financial statements to the public follow a universal format. It standardizes accounting definitions, creating consistency every year in companies' methods in preparing their financial statements.

These financial accounting principles aren’t mandatory, but they help alleviate any potential miscommunications of a company’s financial health.

Accounting Can Help Achieve Loans and Manage Debt

Businesses will typically need loans for expansion opportunities without eating into any operational funds.

Financial accounting is a huge component of whether creditors are willing to offer loans to a business. Financial statements outline not just all the assets of the business but any short-term and long-term debt. With this information, lenders get an excellent grasp of the company’s creditworthiness. 

Creditors rely on accounting ratios such as the debt-to-equity ratio taken from a company’s financial statements to determine its creditworthiness. Once the risk level is understood, lenders can decide how much money to lend and what interest rates to charge.

After receiving the loan, accounting can keep business owners accountable for their debt. Even if the loan was used in an asset, accountants do their best in ensuring that the creation of this asset can cover the costs of the loan. 

Accounting Manages Liquidity

A common reason for businesses going bankrupt is the mismanagement of cash. If you spend more than you earn, it’s common knowledge that you’ll be in a deficit. Chances are you’ll owe money to someone as well, which will eat into your profits. For this reason, accounting helps determine the amount of liquidity your business has. 

Liquidity refers to how transferrable your money is, or your business's ability to cover any immediate and short term financial debts and obligations. Accountants can calculate your company's liquidity by tracking the different ratios of the company’s assets and liabilities.

If you owe money, then you’re going to need money that’s easily transferable to pay off financial commitments. Knowing this information on hand can significantly reduce the chances of a business owner’s worst fear: bankruptcy.

By using accounting to compare your business's liquidity ratios month to month and year to year, you’ll be more likely to spot financial liabilities before they get any worse. You can then decide whether you’ll need to liquidate any assets to cover short-term debts.

Accounting Influences Major Investing Decisions

Public companies all have financial statements that are reported according to the financial accounting standards set by the Financial Accounting Standard Board (FASB); this specifically includes information about how well or poor a business is doing in the quarter.

Business owners will find that investors and analysts will use that information about their company from the financial statements to make decisions about their company's creditworthiness and credibility, allowing investors to determine if a stock’s price is valuable or not.

When companies go public, they allow the public to secure shares of equity. Stocks help the corporation quickly secure a lot of capital, which is essential for the growth and expansion of any business. If the information provided by financial accountants weren’t available, investors wouldn’t understand the financial health of the stock and business.

Investing in a company that doesn’t release its financial statements would inherently be a risky investment. There would be no way to know if the company is worth staking in, thus reducing the chances of public or private investment. Businesses want investments so they can increase profits. If no one invests, profits can only reach so far.

Accounting Helps Businesses Avoid Legal Trouble

When you become a business owner, it becomes pertinent to work within the realms of the law. When organizations start amassing large quantities of money, the possibility of breaking fiscal laws becomes more apparent. Accounting keeps businesses accountable—it makes sure that they remain in adherence to the law and aren’t in any preventable trouble. 

IRS Audits  

Everyone has to pay taxes, especially businesses. When businesses pay taxes, if certain expenses and deductions are unaccounted for, there’s a chance that the business will experience the dreaded IRS Audit for preventable mistakes when filing taxes. This comes with the potential danger of monetary penalties, seized assets, and even prison time in severe cases.

Accounting prevents errors and omissions in financial statements. When the financial reports are done right, you eliminate the risk of being audited by the IRS. Accountants keep businesses clean; they make sure that all money is accounted for, and no dollar goes missing.

Equity Laws

Many states have implemented laws about closing the gaps in pay between co-workers of the opposite gender. These laws prevent various behaviors. For example, employers can’t use a candidate’s pay information to decide on their employment offer. While this is a human resources problem, its relation to pay connects this issue with internal bookkeeping.

The requirements mandated by equity laws make it crucial to have all salaries within a hierarchal group of jobs conform to the same standard. There shouldn’t be any surprises about how much an employee is making, and recruits should be able to refer to the market value of their positions to adequately assess the value of their job without breaking any equity laws by asking about compensation history.

Not only do accountants have to be aware of state laws regarding pay, but they also have to stay up to date on the accounting industry’s generally accepted accounting practices (GAAP). 

While not technically a law, these are accounting principles that are updated periodically. If not followed correctly, inaccurate reporting could be the least of your business’s problems. Lenders may not want to work with you, thus lowering your credibility.

Fraud Prevention

Businesses are particularly vulnerable to fraud, especially small and midsized businesses. Because of the business's size, the effects of being targeted by fraud can be so much more damaging and harder to come back from.

Businesses generally experience one of three types of fraud: theft, financial statement fraud, and asset misuse.

Theft

Theft is usually done by directly stealing cash, claiming fictitious expenses, or stealing property and assets. Surprisingly, theft is usually done by employees.

Accountants can deter this by implementing checks and balances in the workplace to ensure that no one person has control over a financial transaction. For example, if one person writes a check, then a different person has to sign it.

Financial Statement Fraud

Financial statement fraud has to do with inaccurate reporting and general corruption in which employees financially benefit from violating their responsibility to the company.

To deter fraud, businesses often hire at least two people to handle the financial functions of the business interchangeably, keeping track of the handling of cash.

Accountants also have the opportunity to view the account activity of statements at a moment’s notice, making sure that paper-based statements in the office haven’t been manipulated or aren’t hiding any information. They look out for unknown payment recipients, checks that were signed over to a third party, and anything that reveals intentions to remain anonymous.

Asset Misappropriation

Asset misuse, or misappropriation, tends to get confused with theft, but it isn’t necessarily the same. Asset misuse could look like billing schemes, check tampering, using company computers after hours, and more.

It involves company assets being used at inappropriate times, thus cutting into the costs of the company. It’s typically less costly but important nonetheless because it can frequently happen unless disincentivized.

Because asset misuse and other types of fraud result from employees accessing assets through a lack of control, accountants can establish proper internal controls for their business to prevent this. Internal controls promote accountability and prevent fraud in businesses.

Accountants establish preventative and detective internal controls:

  • Preventative controls deter asset misappropriation in the first place. For example, having computers be used by logging in users and recording their time spent working can deter employees from logging in extra hours.
  • Detective controls find instances of fraud or asset misuse once they’ve already happened. Accountants establish this by necessitating internal audits or physical inventory counts.

Accounting Provides Key Information for Stakeholders

Financial information often needs to be communicated to external parties. Businesses will always have stakeholders, both external and internal. These are people who’ve either purchased shares of the company and have invested their money in the company's future or people directly involved with the company.

External Stakeholders

External stakeholders are individuals or entities outside of a business who have a reason to care about the business's performance. They’re usually customers, regulators, banks suppliers, or—most important to businesses' profits—investors. Accounting mandates the task of digging up and revealing the numbers involved in the company's financial prospects to external stakeholders, which can seem like an intimidating process.

However, communicating the financial prospects of a company can attract the eyes of investors. Ultimately, everyone wants to make money. If investors find out that a company is doing well financially, they’ll be motivated to invest in the company, hoping that they’ll eventually get a significant return on investment (ROI).

The law mandates public companies to publish their financial performance information every year for interested parties to look at. Financial analysts can use this information to calculate a company’s strength in relation to competitors.

Additionally, sometimes accountants need to provide information about a business’s credit because it's necessary to get a bank loan to commence with specific projects.

Internal Stakeholders

Not only is it necessary to communicate with external stakeholders, but internal stakeholders are just as important in sharing financial prospects as well. Internal stakeholders are usually entities within a business that are significantly impacted by the performance of the business. They are employees, managers, the board of directors, and anyone who works for and with the business.

It’s essential to keep in mind that internal stakeholders are often people who work for and with the company, meaning that they can influence the company's growth if motivated. Internal stakeholders are not just responsible for doing work but are also capable of giving valuable input on how the company could be run for maximum investment return.

Because internal stakeholders are usually employees or related to the company, accountants communicating financial prospects can actually motivate their behavior. 

They can help create bonuses—such as profit-sharing or stock-based compensation—that help with the team's productivity and morale. With this compensation, teams can feel as though they’re making progress towards an identifiable goal instead of feeling like their work is meaningless.

Final Thoughts

Accounting for businesses is separated into two types of accounting: management and financial. Both are important for businesses by ensuring their longevity.

Management accounting is concerned with the long term prospects of the company. They encourage wise spending and ensure that the products being sold are ultimately in the company's best interest.

Financial accounting makes sure that all the work done for the business is in unity with the GAAP. It worries more about the day-to-day finances of the company. It’s responsible for the business's financial statements and tries to ensure that the company isn’t making any omissions in financial documents. They prevent laws from being broken, keep stakeholders for the business happy, and allow the business to stay on top of problems.

A business requires enormous amounts of data to be collected and analyzed over time to best proceed with future decisions, and accounting is the most effective way to do that.

Charles Hall

Charles Hall

Charles has spent 25 plus years in the world of accounting and business. His experience includes working as a CPA/Auditor international accounting firms. He has worked as a controller and as a COO for small to medium sized companies.

Learn more about Charles Hall