What is accounting? Understanding the definition of accounting and the key concepts behind it can help you manage your small business's financials.
- Accounting is the language of small business. Without proper insight into your company's financial health, you're paralyzed as a small business.
- An accountant keeps track of your business's finances and profitability, and exactly how much money is coming in or going out.
- The three main types of accounting are financial, managerial and tax accounting.
- This article is for new business owners looking to improve their basic accounting skills and understanding of what accountants do.
What is accounting?
Accounting is how finances are tracked. As an individual, you may only ever use an accountant by way of an online form for submitting your taxes. Those are handled by certified public accountants (CPAs), who pass an exam to prove their mastery of accounting.
For businesses, though, tax collectors, regulators and other oversight agencies want to see thorough and proper accounting records. If your business ever seeks investors or other shareholders, these agencies will review your accounting paperwork. When you see a deal made on a show like The Profit or Shark Tank that later falls apart, it's almost always because of accounting problems.
Unless you are well versed in finance, your business will likely need to enlist the help of a professional accountant. Here's a breakdown of what accountants can do for your company.
What do accountants do?
The American Accounting Association defines accounting as "the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information." Accountants log a business's accounts payable, accounts receivable and other financial transactions, typically using accounting software.
"Accountants use the work done by bookkeepers to produce and analyze financial reports," said Stan Snyder, CPA. "Although accounting follows the same principles and rules as bookkeeping, an accountant can design a system that will capture all of the details necessary to satisfy the needs of the business – managerial, financial reporting, projection, analysis and tax reporting."
In the United States, most accountants abide by the generally accepted accounting principles to present a company's financial information to those outside the company in a format that everyone can understand. There are different sets of accounting standards for companies that operate overseas, as well as for local and state government entities.
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Harold Averkamp, CPA and owner of Accounting Coach, said accountants also give a company's internal management team the information it needs to keep the business financially healthy. Some of the information originates from the recorded transactions, and some consists of estimates and projections based on various assumptions, he said.
What are the different types of accounting?
There are tax accountants, financial accountants, public accountants, government accountants and more. Forensic accountants are employed by regulators and law enforcement to help track illegal activity. Diving even further, crypto accountants deal with cryptocurrency assets.
An accountant usually works for a person, a business or the government. However, accounting firms such as Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers are renowned for tracking and managing public and private financial data.
Here's a breakdown of the three main types of accounting:
- Financial accounting: This type of accounting is accomplished with investors in mind. It is used to assess the financial health of a business and helps management get an accurate idea of a business's finances. This type of accounting is essential for companies to be transparent about their financial health.
- Managerial accounting: This type of accounting is used to generate financial statements for companies, including product costings, cash flow reports, profit and loss statements, and business acquisition reports. This type of accounting is essential for business leaders, as it provides accurate financial data and can help companies make decisions about their money.
- Tax accounting: Tax accounting focuses on how your business works with the IRS. Accountants can help you understand your financial picture when filing your yearly or quarterly taxes. This is an essential service that all small businesses should utilize.
Accounting ratios help to uncover difficult-to-find conditions and trends by inspecting the individual components of the ratio. Formulas like this help accountants determine a company's status and projections. Accounting ratios are divided into five main categories:
- Liquidity ratios measure a company's liquid assets versus its liabilities.
- Profitability ratios measure an organization's ability to turn a profit after paying expenses.
- Leverage ratios measure total debt versus total assets and gauge equity.
- Turnover ratios measure efficiency by comparing the cost of goods sold over a period of time against the amount of inventory that was on hand during that same time.
- Market-value ratios measure a company's economic status against other companies in industry.
Many accountants choose to become CPAs, which they achieve by passing an exam and getting work experience. CPAs audit financial statements of public and private companies; serve as consultants in many areas, including tax, accounting and financial planning; and are well-respected strategic business advisors and decision-makers, according to the Pennsylvania Institute of Certified Public Accountants. Positions CPAs hold include accountant, controller, chief financial officer and financial advisor.
You can find more information on accounting careers at The Accounting Path.
Accounting vs. bookkeeping
While bookkeeping and accounting may seem like the same thing, they are actually very different. Bookkeeping is a record-based practice. It focuses on logging information, tracking important numbers and quantifying the important monetary aspects of your business. Accounting comes in when these numbers and reports are interpreted and extrapolated so you can make informed business decisions.
So, while bookkeeping – and having proper bookkeeping systems in place – is extremely important, it is only half the work for building a financially healthy business. You need accounting practices in order to make informed decisions about the future of your business. What good is data without proper interpretation? Generally, many accountants either manage or oversee bookkeeping within an operation to ensure its accuracy.
Basic accounting tasks
Here are some of accountants' main job duties:
- Record transactions: Depending on the volume of transactions, an accountant may record each transaction (e.g., billing customers, receiving cash from customers, paying vendors) daily or weekly.
- Document and file receipts: Accountants may copy all invoices sent, all cash receipts (cash, check and credit card deposits) and all cash payments (cash, check and credit card statements). They also may start a filing system that is easy to understand, track and maintain.
- Pay vendors and sign checks: Accountants may track accounts payable and have funds scheduled to pay suppliers on time and avoid late fees.
- Balance business checkbooks: Accountants may do this monthly to ensure that your business's cash transaction entries are accurate and that you are working with the correct cash position.
- Process or review payroll and approve tax payments: You need to meet payroll tax requirements based on federal, state and local laws at different times. Accountants make sure you withhold, report, and deposit the applicable income, Social Security, Medicare and disability taxes to the appropriate agencies by the required dates.
What is an accounting cycle?
An accounting cycle is the process your company has in place for recording and analyzing the various accounting-related events within your company. It's important to establish effective bookkeeping and accounting practices in order to manage the financial health of your company.
There are eight main steps in an effective accounting cycle:
- Identifying transactions: This is the basic step of establishing accurate and correct recordkeeping practices. Accounting software and POS systems can often assist with this.
Recording transactions: Much like step one, recording can be accomplished with cloud-based software systems. The key is for every transaction your business engages in to be recorded somewhere.
- Posting: When a transaction is recorded, it should be posted to a general ledger, which holds the total transactions of the entire business.
- Listing unadjusted trial balance: This is the review of your company's finances at the end of the accounting period – which could be quarterly, monthly or on another predetermined basis. Trial balances are established for each account within your business at the end of each period.
- Creating worksheets: These sheets identify where adjustments need to be made to each balance.
- Adjusting journal entries: Any necessary adjustments may be recorded as their own journal entries.
- Generating financial statements: Most businesses need an income statement, balance sheet and cash flow statement.
- Closing the books: The accountant wraps up the cycle with a closing entry, which resets the temporary account balances on the general ledger and serves as an overview of the given time period for future analysis.
Source interviews were conducted for a previous version of this article.