In simple terms, accounting is the process of recording and summarizing transactions for the purpose of generating reports relevant to decision-making. Regardless of the business size, it is an important business function to ensure that all of the owners’ resources are used efficiently and effectively. Many certified public accountants (CPAs) and business executives define accounting as the language of business. It’s the primary tool that business owners, managers, and decision-makers use to make objective and informed decisions regarding the business.
Basic Terminologies in Accounting
| Term | Definition |
|---|---|
| Assets | These are resources that the company owns. Assets can be current or noncurrent. Current assets are assets convertible easily into cash within a year. Otherwise, assets are classified as noncurrent assets. |
| Liabilities | These are obligations that your company owes to customers, creditors, and employees. They can also be classified as current and noncurrent. Current liabilities are liabilities with maturities of less than a year, such as accounts payable (A/P) and salaries, whereas noncurrent liabilities have maturities due more than a year, such as long-term debt. |
| Equity | This is the residual amount of assets left to the business owners after paying all liabilities. Since assets are not always stated at their fair market value, the equity of the company is not a measure of the value of the company. |
| Journal Entries | These are used to record and enter transactions in the company’s accounting records. Every journal entry must at least have one debit and credit entry. |
| Chart of Accounts | It is a list of all accounts used in a company’s accounting system. |
| General Ledger | The GL provides a detailed list of transactions within each account. |
| Subsidiary Ledger | A subledger groups transactions from the general ledger by something of interest, like customer, vendor, or inventory. |
| Cost of Goods Sold (COGS) | It is the total cost of inventory transferred from the inventory account to the income statement as a result of a sale. COGS are direct costs, such as purchase costs and manufacturing costs, attributed to the product or services sold. |
| Fixed Assets | These are physical or tangible assets used in the course of business with useful lives beyond one year such as buildings, machinery, and equipment. |
| Depreciation | It is the allocation of a fixed asset’s cost over its useful life as a result of usage in business operations. |
| Debits & Credits | These represent the left (debit) and right (credit) side of the accounting equation. |
| Revenues | These are inflows of economic benefits or enhancement of assets that pertain to the business’ primary operations, such as product sales of a convenience store. |
| Expenses | These are outflows of economic benefits or incurrences of liabilities that pertain to the business’ primary operations, such as COGS of a convenience store. |
| Accrual Basis of Accounting | This principle dictates that all revenues and expenses are recorded when earned or incurred, not when cash is received or paid. Read our cash basis vs accrual basis guide to know the significant differences between the two methods. |
| Intangible Assets | These are noncurrent assets that lack physical substance but can still bring future economic benefits to a company. Examples of these assets include goodwill, patents, copyrights, trademarks, franchises, trade names, and other intellectual properties. |
| Income From Operations | This summarizes the net income coming from the business’s principal operations. |
| Other Income & Expense | These represent increases or decreases in equity that come from peripheral, incidental, or unusual transactions that are not part of the business’s principal operations, such as interest expense and gain from the sale of a fixed asset. |
| Net Income or Profit | This item shows the total net income after considering other income and expenses and the effect of taxes. |
| Generally Accepted Accounting Principles (GAAP) | GAAP refers to a common set of rules, standards, and procedures used in preparing financial statements. |
| Costing | It is the process of assigning or allocating costs to a product, service, or element of a business. |
The Financial Statements
The financial statements are the result of accounting. In the financial accounting cycle outlined below, it is the seventh step before wrap-up procedures. You can create financial statements on a monthly, quarterly, or annual basis—as long as it is cost-effective to prepare them. If you use small business accounting software, preparing them is easier—and your bookkeeper or accountant can generate them quickly with just a few clicks.
Profit & Loss
This financial statement shows the revenues, expenses, and net income or loss of the business. You can use the profit and loss statement (P&L) to evaluate business performance and predict future cash flows. The income statement can be prepared as many times as you like—even without preparing the other financial statements. If you’re using small business accounting software, you can generate an income statement within seconds easily.
Owner’s Equity
Owner’s equity is the residual amount left to the owner after paying all liabilities. The owner’s equity statement shows the movement of capital accounts as a result of earning net income and distributing profits to the owners. While the terms used in the statement of owner’s equity will vary depending on the form of the business, it should always include the following items:
- Beginning owner’s equity that matches the amount shown on the beginning balance sheet as owner’s equity
- Net income for the period that agrees to the P&L statement
- Distributions to the owners during the period
- Additional owner contributions during the period
- Other equity transactions such as purchases of treasury stock by corporations
- Ending owner’s equity that matches the amount shown on the ending balance sheet
Essentially, the statement of owner’s equity reconciles the beginning balance sheet, P&L statement, and ending balance sheet.
Balance Sheet
The balance sheet (US GAAP name) or the statement of financial position or International Financial Reporting Standards (IFRS) name) shows a snapshot of the business’s financial condition at a point in time. You can use it to assess the liquidity position of your company. By analyzing assets and liabilities, you can determine if the business can stay afloat with present asset levels as liabilities come due.
Cash Flows
The cash flow statement presents the inflows and outflows of cash in the operating, investing, and financing activities of the business. This financial statement can provide insight into the business’s sources and uses of cash. You can also assess the business’s ability to generate cash flow to fund daily operations and pay liabilities as they come due.
Trailing 12 Months
Trailing twelve months is a way of preparing a financial statement in an annualized format even if the current calendar or fiscal accounting period hasn’t ended. This method of financial statement preparation uses previous year’s data with current year data to generate financial statements that are on a 12-month basis.
Types of Accounting
Small businesses often think that they only need bookkeeping to keep records organized and ready for tax compliance. However, there are four types of accounting that small businesses can rely on for important information.
Financial accounting is the process of collecting, identifying, and measuring business transactions for the purpose of preparing financial statements. The objective of financial reporting is to provide information about the business that is intended for business owners, creditors, and other external stakeholders. Financial statements are based on past information and used to evaluate past performance and potentially estimate future performance and value.
Since financial statements are intended for external users, financial accounting complies with the United States GAAP, a set of accounting standards promulgated by the Financial Accounting Standards Board (FASB). Standards are important to ensure that financial statements are comparable, verifiable, timely, and understandable across industries.
Tax accounting is the process of compiling income and deductions for the purpose of filing a tax return. It differs from financial accounting because the timing of recognizing income and deductions vary greatly between the two. The primary user of tax accounting information is the IRS and state taxing authorities.
Companies that follow GAAP for their financial statements will often start with those numbers and make a series of adjustments to arrive at taxable income. Smaller companies that don’t follow GAAP will often calculate taxable income directly and report that information for both tax and financial accounting purposes.
Cost accounting is a branch of accounting that provides information to owners and managers about the cost and profitability of particular products, services, or departments. Unlike financial and tax accounting, cost accounting has very few strict rules and can be designed to provide whatever information an owner or manager deems useful.
Since the goal of a business is to earn revenue and profit, controlling costs are important because they determine net profit. With cost accounting, managers and small business owners can determine areas of improvement and bottlenecks in producing goods or providing services.
The types of cost accounting include:
- Normal and actual costing
- Standard costing
- Activity-based costing
- Job order costing
- Process costing
- Joint cost allocation
- By-product and scrap accounting
- Backflush costing
- Absorption costing
- Variable costing
- Throughput costing
- Cost of quality
- Target costing
- Kaizen costing
Managerial accounting is the process of using information from both financial and cost accounting to make economic decisions in planning, organizing, and monitoring business operations. Unlike financial accounting, it isn’t standardized.
Its reports are based on current and future information and are intended for internal users like managers and business owners. These reports aren’t meant to be distributed to external stakeholders and are solely for decision-making purposes and internal evaluation.
The types of managerial accounting include:
- Cost behavior analysis
- Cost-volume-profit or breakeven point analysis
- Master budget preparation
- Profit planning
- Variance analysis
- Performance evaluation
- Differential analysis
- Responsibility accounting
- Capital budgeting
- Financial ratio analysis
- Quantitative techniques in business, such as expected value analysis, PERT-CPM, linear programming, learning curve theory, simplex method, decision tree analysis
The 7 Steps of the Financial Accounting Cycle
The ultimate goal of financial accounting is to generate financial statements but, before you can do that, you have to follow the seven steps of the accounting cycle.
Step 1: Analyze & identify Transactions
In an accounting information system, every transaction is recorded in an account. The listing of all accounts in the business’s books is in the chart of accounts. Before recording transactions, you must first analyze and identify them to determine what accounts they affect. In double-entry bookkeeping, every transaction must at least affect two accounts.
The easiest way to analyze transactions prior to recording is by going back to the accounting equation. You must first check how the transactions affect assets, liabilities, or equity before looking at the specific accounts to adjust. Hence, familiarize yourself with the accounts and their descriptions to analyze transactions faster.
Step 2: Make Journal Entries
Recording journal entries is the first activity in the bookkeeping process and is how accounting data are entered into the accounting information system. Today, most small business accounting software does away with journal entries. Users would instead record bills and invoices as if filling out a form—and the accounting software will write the journal entries “behind the scenes” automatically.
Be sure to have supporting source documents when recording journal entries. However, journal entries are still useful for making year-end adjustments or recording unusual transactions. In making a journal entry, always remember the rules of debits and credits. The debit–credit equality is one of the basics of accounting.
Step 3: Post in the General Ledger
In old manual accounting systems, every journal entry had to be manually recorded in a ledger. The ledger would then be totaled at the end of the period to determine the total account balance. In a computerized system, entries are posted to ledgers automatically. You can view all the activity in an account’s ledger by viewing a general ledger report.
Step 4: Prepare the Unadjusted Trial Balance
Bookkeepers and accountants use the trial balance to test the equality of debits and credits. But if you’re using small business accounting software, the possibility of getting out of balance is remote or even impossible because accounting software features can detect inequalities in debits and credits at the time of entry easily. However, if you’re using a manual accounting system, creating a trial balance can help check if all entries and postings are correct.
In addition to testing that debits equal credits, the unadjusted trial balance is useful because it provides a simple list of all accounts and their period-end balances. An accountant will use this list to review the account balances and determine if any period-end adjusting entries need to be made.
Step 5: Make Adjusting Entries
The adjusting process is a result of the application of the accrual basis of accounting. Since transactions are recorded when earned or incurred, adjustments must be made at the end of the period to update accounts. The five adjusting entries are:
- Accrued revenues: These are revenues already earned but not yet paid by the customer, such as purchases on account and accounts receivable.
- Deferred revenues: These are revenues not yet earned but already paid by the customer, such as unearned revenue and advance payment of customers.
- Accrued expenses: These are expenses already incurred but not yet paid by the business, such as interest expenses on loans that are payable only at the maturity date.
- Deferred expenses: Also called Prepaid Expenses, these are expenses already paid but not yet consumed by the business, such as annual fire insurance of a building.
- Depreciation: This is a systematic allocation of a fixed asset’s cost to profit or loss of the period that benefited from the use of the fixed asset.
Step 6: Prepare the Adjusted Trial Balance
The adjusted trial balance shows the updated balances of accounts. We need to perform this step to test the equality of debits and credits before generating the financial statements. But if you’re using an accounting software program, debits and credits should always be equal.
The adjusted trial balance might still be useful to view because it will show the unadjusted balances, followed by the adjusting entries made, and then finally the adjusted balances. This is a good place to review whether all the necessary adjustments have been made. Learn more about the adjusted trial balance.
Step 7: Generate the Financial Statements
The purpose of accounting is to produce financial statements for internal and external users. It is easy to generate them in small business accounting software. In manual accounting, you have to get account balances one by one from the adjusted trial balance. Step seven is the culmination of the accounting cycle.
Role of Accounting in the Business
Accounting plays a significant role in keeping business transactions organized. Many small business owners think of it as a “necessary evil” for tax preparation and filing. However, it can do more than just provide information for tax compliance, as it can be an invaluable tool that can help grow your small business. Below are three major roles of accounting in a small business:
- Provide information to managers for decision-making: Accounting is an information system. Raw data, such as bills and invoices, entered in an accounting information system will be processed using certain rules, such as accounting principles and GAAP, to generate useful information in the form of reports. These will help business managers make decisions in any aspect of the business.
- Assess business performance and continuity: Accounting information can provide insights into the financial or quantitative aspect of business performance. As a business owner, it is important to consider the qualitative and quantitative aspects to have a bird’s eye view of business performance. For example, sales increased by 15% but net income decreased by 7%. This scenario could mean that the business took extra measures to boost sales at a greater expense. Now, it’s up to the business owner to decide if this technique is worth it in the long run.
- Offer information to external stakeholders of the business: External stakeholders refer to suppliers, creditors, government agencies, customers, and shareholders. Since these people don’t see the daily operations and decision-making frameworks of the business, they rely on financial statement information to assess if the business is in good shape or if their investment is growing over time. Government agencies can also use accounting information to verify the accuracy of income and deductions declared for tax purposes.
The Role of the Accountant
An accountant is a general term for someone who knows and accepts accounting work. They can be a bookkeeper or CPA.
A bookkeeper is an accounting professional who is responsible for keeping and organizing the books. They don’t need to take a licensure examination to perform bookkeeping. However, if you’ll be hiring one, we recommend choosing a candidate with certifications from AIPB or NACPB.
Meanwhile, a CPA is a state-certified accountant who passed all parts of the licensure examination for CPAs. They can also do bookkeeping tasks and can extend their services by providing management advisory and consultancy, tax compliance, and attestation services. They can also interpret the financial statement and provide financial advice to their clients or employer.
In a small business, a CPA is not required if your goal is to keep the books updated and organized. You can instead hire a bookkeeper. You’ll only need a CPA if there’s a need for audited financial statements when applying for a bank loan or bidding on a contract. Even you as a small business owner can perform daily bookkeeping, then at tax time, you can hire a CPA to arrange your tax returns.
Accounting vs Bookkeeping
In the financial accounting cycle, bookkeeping is only the first two steps. Bookkeepers record invoices, bills, and payments; can reconcile bank statements; and follow up on customer accounts. However, accounting focuses more on providing information to business owners for decision-making.
Another way to think about accounting vs bookkeeping is that accounting deals with organizing and interpreting the output of the system, whereas bookkeeping deals with inputting information into the system. For a more detailed discussion, read our accounting vs bookkeeping comparison guide.
Accounting vs Finance
Accounting focuses on keeping the business’s resources accounted for by updating accounts and documenting transactions. In accounting, the end goal is to generate financial statements.
On the contrary, finance focuses on the management of a business’s capital. Its main role is to generate more capital and allocate capital to profitable projects. The end goal of finance is to maximize the owner’s wealth. Finance also uses accounting information but with tweaks using financial models.
Bottom Line
Accounting is a business function that can help your business grow and address challenges, and accounting information helps you make informed decisions. With the popularity of small business accounting software, accounting tasks become easy for small business owners without accounting experience.
