What is Accounting?

Accounting is how a person or company keeps track of money. It is a way to record financial transactions and information. Accounting helps individuals and businesses understand how much money they have, how much they owe, and how much they are making or losing.

The Basics of Accounting

At its core, accounting is a system for tracking money as it flows in and out. When a person or business earns money, that is considered “income” or “revenue.” When they spend money, that is an “expense”. The difference between total income and expenses is the “profit” or “loss.” If income is higher than expenses, there is a profit. If expenses are higher than income, there is a loss.

Accountants record all of these financial transactions in a systematic way using a standardized system of “accounts.” Each type of income or expense has its own account. For example, a business might have separate accounts for sales revenue, employee salaries, rent, marketing costs, and so on. Organizing transactions into these accounts makes it easier to see the complete financial picture.

The Accounting Cycle

Accounting is an ongoing process, often called the “accounting cycle.” This cycle typically follows these key steps:

1. Recording financial transactions as they occur in a journal
2. Posting those journal entries to a ledger
3. Preparing a trial balance to check that debits equal credits
4. Making adjusting entries at the end of a period
5. Preparing financial statements like the balance sheet and income statement
6. Closing the books for that period and starting the cycle again

This cycle ensures that all financial activity is accounted for properly. Following this standard process, accountants maintain accurate and reliable financial records.

The Different Types of Accounting

There are a few main branches or types of accounting, each with a different focus:

Financial Accounting

Financial accounting centers on reporting a company’s financial information to external stakeholders like investors, creditors, and regulators. Financial accountants prepare critical financial statements that are shared publicly, such as the balance sheet, income statement, and cash flow statement. The goal is to provide a clear and accurate picture of the company’s financial position and performance to those outside the company.

Managerial Accounting

Managerial or management accounting is more inward-focused. It involves providing financial information to a company’s managers to help them make decisions. Managerial accountants often prepare budgets, cost analyses, and performance reports. The goal is to give managers the information they need to control costs, improve efficiency, and make strategic business decisions.

Tax Accounting

Tax accounting involves planning for and preparing tax returns and payments. Tax accountants ensure that individuals and companies pay the correct amount of taxes and follow all tax laws and regulations. They also look for ways to minimize taxes legally. Tax accounting requires specialized knowledge of the always-changing tax code.

Auditing

Auditing is a specific activity within accounting focused on reviewing and verifying financial records for accuracy and compliance with laws and regulations. Auditors examine financial statements to see if they are a fair representation of the transactions they claim to represent. Audits can be conducted internally by a company’s accountants or externally by an independent firm. External audits provide an essential oversight role.

The Importance of Accounting

Accounting is often called the “language of business.” Here’s why it matters so much:

Tracking Financial Health

Accounting allows a person or business to monitor its financial health and position. By carefully tracking income and expenses, accounting helps answer critical questions like: Are we profitable? How much cash do we have on hand? Can we afford to hire more employees or buy new equipment? What is our financial position compared to last year? The financial statements produced by accounting, like the balance sheet and cash flow statement, provide a vital snapshot of economic well-being.

Making Informed Decisions

Business leaders rely heavily on accounting information to make all kinds of decisions. Should we launch that new product line? Should we buy out our competitor? Can we cut costs without hurting our operations? Accounting doesn’t give leaders a crystal ball, but it does give them valuable data to inform their choices. Especially for critical decisions involving large amounts of money and risk, businesses need solid accounting to guide them.

Securing Financing

For most businesses, borrowing money is a regular part of operations. Companies need to show their financial information, whether applying for a small business loan or selling stock to investors. Banks and investors want to see a track record of financial performance before they commit their funds. They analyze financial statements to assess a business’s stability and potential for growth. Solid accounting is essential for securing the financing a business needs.

Complying with Laws

Businesses also have significant obligations regarding financial reporting. Publicly traded companies are required to file audited financial statements regularly. All businesses have to pay taxes, and most have other financial reporting requirements as well. Accurate accounting is critical for meeting these legal obligations. Mistakes or improprieties in accounting can lead to significant legal issues, including fines and even criminal charges in severe cases.

The Evolution of Accounting

While the fundamental principles of tracking income and expenses, maintaining balanced books, and reporting financial information have been around for centuries, accounting continues to evolve:

Technological Advances

The rise of computers and accounting software has dramatically changed day-to-day accounting work. Many manual tasks have become automated. Accountants can analyze much larger sets of data much more quickly. Cloud computing allows real-time financial information that can be accessed anywhere. Accounting information systems are increasingly sophisticated and integrated with other business operations. Technology has made accounting more efficient and dynamic.

Changing Regulations

Accounting is significantly impacted by constantly evolving laws and regulations. Major accounting scandals in the early 2000s led to the Sarbanes-Oxley Act, which increased requirements for financial reporting and internal controls. The global economic crisis led to additional regulations around mark-to-market accounting and loan loss provisions. Accountants have to adapt to this changing regulatory landscape continually.

Globalization

As business has become more global, accounting has had to adapt. Multinational companies must navigate the complexities of differing accounting standards, tax laws, and financial regulations across countries. Significant effort has been made to harmonize accounting standards globally, but much complexity still remains. Accounting today requires a much more global perspective.

Expanded Roles

Accountants today are business advisors and strategic partners, not just number crunchers. With their deep understanding of a company’s finances, accountants contribute to a broader range of business decisions. They provide assurance services that go beyond traditional auditing. They are more involved in risk management, business valuation, and forensic analysis. The role of accounting has significantly expanded.

To finish off

At its heart, accounting is a system for telling a person or organization’s financial story. By recording financial transactions, accounting turns raw financial data into useful information. That information is critical for understanding financial performance, making informed decisions, reporting to stakeholders, etc. While the tools and regulations continue to change, the core purpose of accounting remains constant. Accounting will be an essential function as long as people and businesses deal with money.