What is accounting?

Accounting is the process of identifying and recording financial transactions and generating financial statements and other reports. Accurate and timely financial information helps business owners make informed decisions while providing stakeholders, like creditors, investors, and regulators, with the data they need to assess a company’s financial health.

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What is the accounting cycle

Accounting tasks are completed in a specific order, and this process is defined as the accounting cycle. This involves repeatable steps that businesses follow to keep their financial records accurate and organized. 

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Companies go through the cycle each month, quarter, and year to produce reliable financial statements.

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A small business may complete most of the steps using a bookkeeper and outsource the preparation of financial statements to a CPA firm. Larger companies with an accounting staff perform all of the steps in-house.

• Step 1. Collecting and analyzing financial data: This involves gathering invoices, receipts, and other records to understand the details of each transaction.
• Step 2. Recording transactions in journals: Each transaction gets recorded in a journal with all the necessary details, like dates, descriptions, and debit/credit amounts.
• Step 3. Posting transactions to the ledger: Once recorded, transactions are posted to the general ledger, where they are organized by account for a clear overview of financial activity.
• Step 4. Preparing a trial balance: A trial balance helps you check that everything adds up by listing all account balances and ensuring debits equal credits.
• Step 5. Posting adjusting entries: Adjusting entries capture anything that might’ve been missed, like revenue earned but not yet recorded or expenses that haven’t been billed yet.
• Step 6. Preparing an adjusted trial balance: After adjustments, you’ll create an updated trial balance to make sure everything is accurate and balanced.
• Step 7. Preparing financial statements: The adjusted trial balance is used to prepare the financial statements, including the income statement, balance sheet, and statement of cash flows.
• Step 8. Closing entries: At the end of the period, revenue and expense accounts are zeroed out, and the net income or loss is moved to equity accounts.

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To see these steps in action, consider how a sporting goods manufacturer handles a $20,000 sale of hiking boots:

1. Gather the sales invoice, shipping documents, and verify the $12,000 production cost.
2. Create entries for the $20,000 sale and $12,000 cost of goods sold.
3. Move the sale and cost entries to their respective account categories in the general ledger.
4. List all accounts to verify the $32,000 in total debits match total credits.
5. Record the $500 March bank interest and any other end-of-month adjustments.
6. Generate a new trial balance that includes the $500 interest.
7. Create financial reports showing the $20,000 sale, $12,000 cost of goods sold, and $8,000 profit.
8. Reset revenue and expense accounts, transferring the $8,000 profit to retained earnings.

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Accounting financial statements

The financial records produced during the accounting cycle are used to generate the balance sheet, income statement, and statement of cash flows.

Balance sheet

The balance sheet, or the statement of financial position, shows your company's financial position on a specific date. It follows this formula:

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Assets - Liabilities = Equity

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Assets are resources that generate revenue, including cash, inventory, and accounts receivable. Liabilities are claims on assets, such as accounts payable and long-term debt. The difference between assets and liabilities is equity, and equity is the actual value of a business.

Income statement

You generate an income statement for a specific period (month or year) using this formula:

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Revenue - Expenses = Net Income (profit)

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Income statement accounts are adjusted to zero during each monthly close, and the net income balance is posted to the balance sheet.

Statement of cash flows

The cash flow statement tracks money movement over a specific period in three categories:

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• Cash flow from operating activities: Cash activity related to day-to-day operations, including customer deposits, inventory purchases, and paying for marketing costs.
• Cash flow from investing activities: Cash used to purchase assets or received from selling assets.
• Cash flow from financing activities: Cash inflows from issuing common stock or cash outflows to repay principal on a loan are considered financing activities.

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Beginning cash balance + Cash inflows – Cash outflows = Ending cash balance

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Stakeholders, like creditors, regulators, and investors, depend on this accurate financial data to make informed decisions about the business.

Types of accounting

Your accounting staff may work on different accounting issues as your business grows and becomes more complex. Accounting professionals often develop expertise in one or more of these disciplines.

Financial accounting

Financial accounting follows the accounting cycle to prepare standardized reports like income statements and balance sheets for external users, such as investors and regulators. Financial accounting follows strict rules to ensure financial statements are consistent with prior periods and comparable across businesses.

Managerial accounting

Managerial accounting produces reports for internal use. As a result, the reports can be customized to meet a particular manager’s needs. An e-commerce business owner may want a report summarizing customer conversion rates or a report listing pricing changes by product sold.

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Accountants in this field may obtain a Certified Management Accountant (CMA) designation.

Cost accounting

Cost accounting tracks and assigns all expenses incurred to operate a business to individual products or services. This helps identify wasteful spending and maximize profits.

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A 2023 Morning Consult study reports that nearly 6 in 10 survey respondents don’t feel confident about their organization’s ability to measure wasted spending. Cost accounting provides the tools to assign costs, identify wasteful spending, and increase profits.

Forensic accounting

Forensic accountants use tools to investigate fraud, theft, and other financial crimes. They often work closely with legal teams, examining transactions to uncover irregularities.

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For example, if fraud is suspected in the cash account, a forensic accountant might analyze every cash transaction within the suspected period.

Auditing

Auditors review financial statements to ensure they are free from material misstatements—errors significant enough to impact a user’s understanding of the data. Auditors often test samples of transactions and evaluate a company’s internal controls over financial reporting.

Tax accounting

Tax accountants assist with tax planning, helping businesses understand the tax implications of major decisions, such as acquiring a competitor or selling a division. They also prepare tax returns and handle communications with the IRS and state tax authorities.

Accounting regulatory bodies

The accounting industry is governed by various organizations and standards to ensure accuracy and compliance. Accountants and CPAs must adhere to these regulations, and CPAs are also required to complete continuing education annually.

AICPA 

The American Institute of Certified Public Accountants (AICPA) supports the accounting profession by providing research, industry news, and training resources. It is also responsible for creating and administering the CPA exam. To become a Certified Public Accountant (CPA), candidates must register with a state board of accountancy, meet educational requirements, and pass the CPA exam.

Generally Accepted Accounting Principles (GAAP)

Generally Accepted Accounting Principles (GAAP) is a set of standards that businesses follow to produce accurate and consistent financial statements. For example, GAAP requires the use of accrual accounting to ensure comparability across companies. Adhering to GAAP is essential for producing financial reports that align with industry norms.

International Financial Reporting Standards (IFRS)

IFRS is a global set of accounting standards aimed at harmonizing financial reporting internationally. The accounting industry is attempting to align GAAP and IFRS standards to simplify compliance. However, there are some differences between the standards.

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If your company has operations outside the US, you may need to generate financial reports that comply with GAAP and IFRS.

Internal Revenue Service (IRS)

The Internal Revenue Service (IRS) enforces tax laws in the United States by administering the Internal Revenue Code and collecting taxes. It provides detailed publications to help businesses understand tax regulations and reviews all submitted tax returns for compliance.

Accelerate your accounting workflow

Businesses rely on accounting data to make better decisions faster, create budgets, forecast performance, and evaluate their financial health. Also, stakeholders, such as investors and creditors, depend on accurate financial information to assess a company’s performance and potential. So, quick access to accurate financial information helps you see opportunities and stay competitive.

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Accounting software transforms how you handle financial data by automating manual tasks and providing real-time insights. Your accounting team saves time and reduces errors by automating data entry, while cloud-based systems eliminate paper files and give you secure access to financial records from anywhere. This shift from manual to automated processes means your team can focus on strategic tasks like analyzing profit trends, identifying cost-saving opportunities, and developing financial strategies.

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The best accounting platforms integrate seamlessly with other business processes, including purchase orders, employee expenses, travel management, inventory, and payroll. This integration creates a single source of truth for all financial data, making it easier to track and manage your company's finances across departments.

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As your business grows, accounting software helps you process more transactions efficiently, maintain compliance, and generate detailed financial reports without adding staff. A 2022 Forrester study found that 51% of finance leaders struggle to automate finance and accounting