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What is Accounting? Everything You Need to Know

What is Accounting? Everything You Need to Know

What is accounting? In this article, we’ll explain how to get started with an accounting system for your small business. You’ll also learn about accounting, from basic definitions of the basic types to practical applications.

A small business owner must maintain records of financial transactions. What’s more, that small business owner must achieve an understanding of how the business transactions fit into the big picture of revenue and expenses. This is where a strong understanding of accounting principles becomes so important.

The Basics of Accounting

Accounting basics include these elements:

  • Assets: Resources owned by the business, such as cash, inventory, equipment, and property.
  • Liabilities: Debts or obligations owed by the business, including loans, accounts payable, and accrued expenses.
  • Equity: Represents the owner’s stake in the business, calculated as assets minus liabilities.
  • Income: Revenue generated from sales or services provided.
  • Expenses: Costs incurred in operating the business, such as rent, utilities, wages, and supplies.

The Definition of Accounting

Accounting is the systematic process of recording, summarizing, analyzing, and interpreting financial transactions of a business entity. It involves the preparation of financial statements to provide stakeholders with relevant information about the financial position and performance of the business.

The Purpose of Accounting in Business

Accounting has two main purposes in business:

Legal Compliance: Accounting ensures that businesses comply with financial reporting regulations and tax laws imposed by government authorities.

Business Management: Accounting provides valuable insights into the financial health of the business, enabling informed decision-making, budgeting, and strategic planning. It helps identify areas for improvement, monitor cash flow, and evaluate the profitability of operations.

A Brief History of Accounting

Accounting has its roots dating back to ancient civilizations, where rudimentary forms of record-keeping were used to track economic transactions.

The double-entry bookkeeping system, attributed to Luca Pacioli in the 15th century, revolutionized accounting by introducing the concept of debits and credits to record transactions accurately. Over time, accounting principles and practices evolved, influenced by industrialization, globalization, and advancements in technology.

The establishment of accounting standards and regulatory bodies, such as the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB) globally, has further standardized accounting practices and enhanced transparency in financial reporting.

Types of Accounting

There are three main types of tax accounting:

Financial Accounting

What is financial accounting? This type of accounting focuses on the preparation of financial statements for external stakeholders such as investors, creditors, and regulatory agencies. It involves recording and summarizing business transactions in accordance with generally accepted accounting principles (GAAP). Financial accounting provides a historical perspective on the financial performance and position of the business through reports like balance sheets, income statements, and cash flow statements.

Cost Accounting

What is cost accounting? This method is concerned with the analysis and allocation of costs to products, services, or activities within the business. It provides internal management with information for decision-making related to pricing, budgeting, and cost control. Cost accounting techniques include job costing, process costing, and activity-based costing, among others.

Managerial Accounting

What is managerial accounting? This style focuses on providing internal management with relevant financial information to support planning, controlling, and decision-making processes. Unlike financial accounting, managerial accounting is not bound by external reporting requirements and can utilize more flexible reporting formats tailored to the needs of management. Managerial accounting reports may include budgets, variance analyses, and performance metrics.

FeatureFinancial AccountingCost AccountingManagerial Accounting

Primary FocusPreparation of financial statements for external stakeholders.Analysis and allocation of costs to products, services, or activities.Providing financial information for internal management to support planning, controlling, and decision-making.

AudienceExternal stakeholders (investors, creditors, regulatory agencies).Internal management.Internal management.

Reporting StandardsGenerally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).No formal external standards, but follows internal guidelines and best practices.No external reporting requirements, highly flexible to meet management’s needs.

Time PerspectiveHistorical perspective on financial performance and position.Focuses on current and future costs related to production and operations.Often future-oriented, assisting in forecasting and planning.

Reports GeneratedBalance sheets, income statements, cash flow statements.Cost sheets, product costing reports, variance reports.Budgets, variance analyses, performance metrics, forecasting reports.

ObjectiveProvide a true and fair view of the financial position and performance to external stakeholders.Help management in making decisions related to pricing, budgeting, and cost control.Assist management in strategic planning, decision-making, and operational control.

Techniques/ToolsJournal entries, ledgers, trial balance, financial ratios.Job costing, process costing, activity-based costing, standard costing.Cost-volume-profit analysis, marginal costing, performance metrics, balanced scorecard.

There are additional styles that may appeal to certain businesses, like double entry accounting and accrual accounting, that some businesses may consider.

Financial Statements: The Backbone of Financial Accounting

Here are the basic components of tax accounting in financial statements:

  • Balance Sheet: Also known as the statement of financial position, the balance sheet provides a snapshot of a company’s financial condition at a specific point in time. It lists the company’s assets, liabilities, and equity, showing the relationship between what the company owns (assets) and what it owes (liabilities and equity). The balance sheet equation is Assets = Liabilities + Equity.
  • Income Statement: The income statement, also called the statement of profit and loss or P&L statement, summarizes the company’s revenues, expenses, gains, and losses over a specified period (usually a month, quarter, or year). It demonstrates whether the company has generated profit or incurred a loss during the period by comparing revenues to expenses. The basic format is Revenue – Expenses = Net Income (or Net Loss). There are also ways to dive deeper into specific expenses or revenue opportunities, like cost of goods sold.
  • Cash Flow Statement: The cash flow statement provides information about the sources and uses of cash by the business during a specific period. It categorizes cash flows into operating activities, investing activities, and financing activities. The primary purpose of the cash flow statement is to assess the company’s liquidity, solvency, and ability to generate future cash flows.

The Accounting Cycle: From Transaction to Statement

The accounting cycle is a series of steps that accountants follow in recording, analyzing, and reporting the financial transactions of a business. It typically involves the following accounting functions:

    • Identifying Transactions: This step involves recognizing and documenting business transactions, such as sales, purchases, and expenses.
    • Recording Transactions: Transactions are recorded in the accounting system using journals and ledgers, applying the double-entry bookkeeping method to ensure accuracy and balance.
    • Adjusting Entries: At the end of an accounting period, adjusting entries are made to update account balances for accrued expenses, prepaid items, depreciation, and other adjustments necessary for accurate financial reporting.
    • Preparing Financial Statements: Once all transactions are recorded and adjusted, financial statements (balance sheet, income statement, cash flow statement) are prepared to summarize the financial performance and position of the business.
    • Closing Entries: Temporary accounts, such as revenue, expense, and dividend accounts, are closed to retained earnings at the end of the accounting period to prepare for the next period.
    • Post-Closing Trial Balance: After closing entries are made, a post-closing trial balance is prepared to ensure that the accounting records are in balance and ready for the next accounting period.

Generally Accepted Accounting Principles (GAAP)

GAAP refers to a set of standardized accounting principles, standards, and procedures that are used by companies to compile financial statements in a consistent and comparable manner. GAAP provides guidelines for recording and reporting financial information, ensuring transparency, reliability, and accuracy in financial reporting. These principles are established by various standard-setting bodies, such as the Financial Accounting Standards Board (FASB) in the United States, and are updated periodically to reflect changes in business practices and regulatory requirements.

Why Accounting is Crucial for Small Businesses

Proper business accounting is crucial for small businesses for several reasons:

  • Financial Management: Effective accounting helps small business owners monitor cash flow, track expenses, and manage budgets, enabling better financial decision-making.
  • Compliance: Accurate accounting ensures that small businesses comply with tax laws, regulatory requirements, and financial reporting standards, reducing the risk of penalties, fines, or legal issues.
  • Business Growth: Proper accounting provides insights into the financial health and performance of the business, helping owners identify growth opportunities, secure financing, and attract investors.
  • Stakeholder Confidence: Well-maintained financial records instill confidence in stakeholders, including investors, creditors, and customers, enhancing the credibility and reputation of the business.

When Do You Need an Accountant?

Small business owners may consider hiring an accountant or seeking professional accounting services in the following situations:

  • Complex Transactions: When the business engages in complex financial transactions, such as mergers, acquisitions, or international expansion, requiring specialized accounting expertise.
  • Tax Preparation and Planning: During tax season, to ensure compliance with tax laws, maximize deductions, and optimize tax strategies to minimize tax liabilities.
  • Financial Analysis: When the business requires in-depth financial analysis, forecasting, or budgeting to support strategic decision-making and business planning.
  • Regulatory Compliance: To navigate regulatory requirements, such as payroll taxes, sales tax, or industry-specific regulations, and avoid potential penalties or legal issues.

The Future of Accounting

Some future trends in accounting include:

  • Automation and AI: Increasing adoption of automation, artificial intelligence (AI), and machine learning technologies to streamline accounting processes, improve efficiency, and reduce manual tasks.
  • Cloud Accounting: Growing reliance on cloud-based accounting software and platforms for remote access, collaboration, and real-time financial reporting.
  • Data Analytics: Utilizing advanced data analytics tools and techniques to extract insights from financial data, identify trends, and drive informed decision-making.
  • Sustainability Reporting: Rising focus on environmental, social, and governance (ESG) factors, leading to increased demand for sustainability reporting and integrated reporting frameworks.
  • Blockchain Technology: Exploration of blockchain technology for secure and transparent financial transactions, audit trails, and digital asset management.

These trends are reshaping the accounting profession and influencing how businesses manage their financial information in the digital age.

FAQs: What is Accounting

What is the difference between accounting and bookkeeping?

The difference between bookkeeping and accounting mainly lies in the type of record keeping and analysis. Here’s a deeper look into both.

Bookkeeping

Bookkeeping is the process of recording financial transactions, maintaining financial records, and organizing financial data. It involves tasks such as recording sales, purchases, receipts, and payments, as well as maintaining ledgers and journals. Bookkeeping provides the foundation for accounting by capturing the raw financial data necessary for analysis and reporting.

Accounting

Accounting encompasses a broader scope of activities than bookkeeping. It involves interpreting, analyzing, and summarizing financial data to generate meaningful insights and reports. Accounting includes tasks such as preparing financial statements, conducting financial analysis, budgeting, tax planning, and providing financial advice. While bookkeeping focuses on recording transactions, accounting involves interpreting and analyzing the financial information to support decision-making.

How often should a small business review its financial statements?

Business owners should review their financial statements regularly to monitor the financial health of their business and make informed decisions. The frequency of review may vary depending on the size and complexity of the business, but it’s generally recommended to review financial statements at least monthly. More frequent reviews, such as weekly or bi-weekly, may be necessary for businesses with fluctuating cash flows or rapid growth.

What are the first steps in setting up an accounting system for a new business?

The first steps to setting up your business accounting system include:

  • Define Financial Objectives: Clarify the financial goals and objectives of the business, such as maximizing profitability, managing cash flow, or reducing expenses.
  • Choose Accounting Method: Decide on the accounting method (e.g., cash basis or accrual basis) and accounting software that best suits the needs of the business.
  • Establish Chart of Accounts: Create a chart of accounts to categorize and organize financial transactions, including assets, liabilities, equity, income, and expenses.
  • Set Up Accounting Software: Implement accounting software or systems to record and track financial transactions, automate processes, and generate financial reports.
  • Design Internal Controls: Implement internal controls to safeguard assets, prevent fraud, and ensure accuracy and integrity of financial data.
  • Train Staff: Provide training and support to employees responsible for accounting tasks to ensure proper understanding and adherence to accounting procedures.

Is it necessary for a small business to adhere to GAAP?

While Generally Accepted Accounting Principles (GAAP) provide guidelines and standards for financial reporting in the United States, small businesses are not always required to follow GAAP if they are not publicly traded or subject to specific regulatory requirements. However, following GAAP principles is generally recommended for small businesses to ensure consistency, transparency, and credibility in financial reporting. Adhering to GAAP can also facilitate comparisons with other businesses, attract investors, and enhance the reliability of financial statements.

Can accounting software replace an accountant?

Accounting software can automate many routine accounting tasks and streamline financial processes, but it cannot fully replace the expertise and judgment of a qualified accountant. While the best free accounting software can handle data entry, transaction processing, and report generation, accountants play a crucial role in interpreting financial information, providing strategic advice, conducting financial analysis, and ensuring compliance with tax laws and regulations. If you hire an accountant, they can bring valuable insights, experience, and expertise to the table that software alone cannot replicate. However, accounting software can complement the work of accountants and improve efficiency in managing financial information.

Read More:

  • How to start an accounting business
  • What is accrual accounting
  • What is accounting profit

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