What is Accounting?
Accounting is crucial to the healthy functioning of your business. But what exactly is it?
Getting your head around the jargon and process of modern accounting can be pretty painful (which is why you should probably hire an accountant to do it for you). But the fundamentals of the field are surprisingly easy to understand.
Here’s the simplest way we can explain it.
A simple definition of ‘accounting’
Accounting is the practice of recording, organizing, and understanding a business’s financial information.
You can think of accounting as a big machine that you put raw financial information into—records of all your business transactions, taxes, projections, etc.—that then spits out an easy to understand story about the financial state of your business.
Accounting tells you whether or not you’re making a profit, what your cash flow is, what the current value and state of your company’s assets and liabilities is, and which parts of your business are actually making money.
The accounting cycle
The process of accounting begins the moment you enter a business transaction—any activity or event that involves your business’s money—into your company’s ledger.
Recording business transactions this way is called bookkeeping. And bookkeeping is the first step of what accountants call the “accounting cycle”, a long and complicated series of rules designed to take in raw financial information and spit out accurate and consistent financial reports.
The accounting cycle is comprised of five major steps:
- Analysing business transactions (looking over invoices, bank statements, etc.)
- Recording these transactions in a journal (according to the rules of double-entry accounting)
- Posting journal entries to your business’s ledger accounts
- Preparing a trial balance (this involves listing all of your business’s accounts and figuring out their balances)
- Preparing financial statements (using those balances you calculated in step 4)
Most of these rules and processes are automated by accounting software, so we’re going to skip over the gritty details of the accounting cycle and define the most important types of accounting.
Financial accounting is the process of generating a company’s major annual financial statements.
Financial statements—like the statement of profit and loss, balance sheet, statement of cash flows, and statement of retained earnings—provide a yearly snapshot of a company’s financial health and trajectory.
Financial accounting is the primary way investors, lenders, government agencies, potential buyers, and anyone else outside of your company can learn more about your company’s financial state.
Generally accepted accounting principles (GAAP)
Every company is different, but in order to make accurate financial comparisons between companies, we need a common language to describe each of them with. That’s what generally accepted accounting principles (GAAP) are: a series of standards and procedures that accountants at all companies must adhere to when preparing financial statements for public consumption.
GAAP are set by a nongovernmental body called the Financial Accounting Standards Board, and there are no laws enforcing them, but most lenders and business partners in the United States will require that you adhere to GAAP.
Managerial accounting is a lot like financial accounting, with two important exceptions:
1. The statements produced by managerial accounting are for internal use only.
2. They’re generated much more frequently—often on a quarterly or monthly basis.
If your business ever grows to the point where you need to hire an accountant full-time, this will comprise the bulk of their work: producing reports that provide regular updates on the company’s financial health, and helping management interpret those reports in order to make informed decisions about how the business spends money.
When your accountant is providing recommendations on how to get the most out of your tax return, that’s tax accounting.
If managerial accounting is for a company’s internal management team, and financial accounting is for external companies and lenders, then tax accounting is for the one other group of people that is interested in your company’s financials: the government.
Tax accounting is regulated by the Internal Revenue Service (IRS), and the IRS legally requires that your tax accounting adhere to the Internal Revenue Code (IRC).
If financial accounting is all about communicating the financial health of your company to the public, and managerial accounting is all about helping you make good internal business decisions, tax accounting is all about making sure that you don’t pay more tax than you are legally required to by the IRS.
When you’re trying to figure out how to increase your margin, or trying to figure out if raising prices is a good idea, you’ll probably do some cost accounting.
Cost accounting involves analyzing all of the costs associated with producing an output (whether it be a physical product or service) in order to make better decisions about pricing, spending and inventory.
Cost accounting feeds into managerial accounting, in that managers use cost accounting reports to make better business decisions, and it also feeds into financial accounting, because costing data is often required when compiling the inventory part of a balance sheet.
Credit accounting involves analyzing all of a company’s unpaid bills and liabilities and making sure that a company’s cash isn’t constantly tied up in paying for them.
Credit accounting can be one of the most difficult kinds of accounting to do well, because it often involves telling someone something they don’t want to hear (like your accountant telling you that you should be borrowing less).
What kind of accounting you, a non-accountant, will do
These days, a lot of the work around recording and organizing a business’s financial information has been automated by software—things like recording transactions and producing simple financial statements.
Something that software hasn’t been able to automate yet, and something you might have trouble with on your own, however, are the many subjective decisions that accountants must make when analyzing, interpreting and presenting financial information.
What an accountant does
A skilled, experienced accountant will save you time by communicating your company’s financial state to you jargon-free while anticipating your financial needs, rather than simply reacting to them.
They can also provide you with knowledge and insight that is simply inaccessible to non-accountants. For example, information about tax deductions that you didn’t even know you qualified for, tax rules you didn’t know you were breaking, and best practices picked up while working as an accountant for other companies in your industry.
If those are things you think your business can benefit from, it might be time to hire an accountant.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.