What Is Accounting? The Basics of Accounting, Explained

The old saying “numbers don’t lie” rings true in the world of business. Numbers reveal a critical story, and accounting is the art and science of understanding the narrative.

Far from being a dull, back-office function, accounting is at the heart of any business endeavor, and it provides the insights needed for financial planning and, ultimately, a business’s success.

Learn more about the types of accounting and basic principles to help get you started.

What is accounting?

Accounting is the system of tracking a business’s money. It involves recording where money comes from and where it goes. Accounting is how you organize financial information to make data-backed business decisions. It provides a clear view of where you’re going, enabling you to keep an eye on your income and expenses, assess profitability, and manage cash flow. The system also ensures your business complies with tax laws, so you make the appropriate tax payments. Accurate accounting (in the form of accurate financial statements) offers a foundation for strategic planning.

Accounting vs bookkeeping

Accounting and bookkeeping may seem closely related, but they are actually two different parts of financial management. Bookkeeping is the process of recording all financial transactions—sales, purchases, invoice payments, receipts, and so on. A bookkeeper’s goal is to capture every financial detail on a regular basis, whether daily or weekly. Accounting, on the other hand, takes this financial data and analyzes it to help inform strategic business decisions.

Types of accounting

Every business has different facets, so there are different branches of accounting catering to a particular niche or purpose. A certified public accountant, or CPA, may specialize in one or more of these branches:

• Financial accounting. This branch focuses on performing accounting functions and routine accounting tasks, such as preparing financial statements (like income statements or balance sheets) for parties like investment firms, bank creditors, or regulatory bodies.

• Managerial accounting. Managerial accounting provides financial data and analyses to internal management to assist with making business decisions and evaluating company performance.

• Tax accounting. Tax accountants focus on tax preparation and ensuring your business is compliant with tax law. They may also help minimize tax liabilities, so businesses work with tax accountants during tax season. 

• Auditing. This is an independent examination of financial records to ensure they are accurate. Accounting professionals may also ensure a business adheres to established standards. Auditing is often performed when there is suspicion of fraud within the business.

• Forensic accounting. Forensic accountants combine accounting, auditing, and investigative skills to uncover financial crimes or resolve disputes.

• Governmental accounting. This deals with the financial reporting of governmental entities, like federal, state, and local governments.

• Cost accounting. Cost accounting focuses on the costs associated with production and operations. It helps management control expenses and increase the bottom line.

The basics of accounting 

When considering the role of accounting, it can be helpful to explore the processes of the overarching system. Doing so can help business owners better understand and analyze financial statements:

The fundamental formula of accounting

At the heart of all financial accounting practices is a simple equation enabling a business to determine its financial health: 

Assets = Liabilities + Equity

This formula, known as the accounting equation, represents the relationship between a company’s assets, the money it owes, and what is left after expenses have been paid.

Assets

Assets are resources a business has and expects to use in the future. This could be: 

• Cash in the bank

• Accounts receivable (money owed to you by customers)

• Inventory

• Land

• Buildings

• Equipment

• Patents

• Trademarks

Liabilities

Liabilities are part of a company’s financial health, as they represent its obligations. Some examples are: 

• Accounts payable (money you owe to suppliers)

• Loans from banks

• Wages payable to employees

• Deferred revenue (money received for services not yet rendered)

Equity

Equity, also called owner’s equity or shareholders’ equity, is what businesses are entitled to after liabilities are deducted. Examples include:

• Owner’s capital contributions

• Retained earnings (accumulated profits kept in the business)

• Common stock

Cash method vs. accrual method

Businesses will select one of two methods to record their financial transactions:

Cash basis

The cash method of financial accounting recognizes revenue when an invoice is paid and expenses when bills or expenses are paid. It’s straightforward and mirrors how a personal checkbook works. This is a popular method among small businesses and those with simple inventory, as it’s easier to manage and provides a clear picture of cash flow.

Accrual basis

The accrual method recognizes revenue when it has been invoiced or earned and expenses when they are incurred, whether or not they’ve been paid for. For example, under accrual, a sale on credit is recorded when the sale happens, not when the customer pays off that credit. This method helps offer an understanding of a company’s financial performance over time, regardless of the immediate cash flow.

The accounting cycle

Businesses should follow a series of steps, also known as the accounting cycle, to record and process financial transactions over a specified accounting period, such as a month or year. The steps below are relevant for using a general ledger. If you’re using accounting software like QuickBooks or Xero, many of these processes will be automated and enable you to store your accounting records digitally. This process is performed in managerial accounting, financial accounting, and other types as well.

1. Identify and analyze business transactions. Gather financial information, including every financial transaction that affects the business.

2. Record business transactions. Chronologically log each transaction in a general journal (also known as the book of original entry).

3. Post to the ledger. Transfer the debits and corresponding credits from the journal entries to their respective accounts in the general ledger.

4. Prepare an unadjusted trial balance. List all general ledger accounts along with their balances so you can ensure debits equal credits.

5. Prepare adjusting entries. Make adjustments at the end of an accounting period for revenues earned but have not yet been recorded. This includes expenses incurred but not yet paid.

6. Prepare an adjusted trial balance. Generate a new trial balance after all adjusting entries have been entered.

7. Generate financial statements. Use the adjusted trial balance to create common financial statements like income statements, statement of cash flows, statement of owner’s equity, and balance sheet.

8. Close the books. Close temporary accounts (revenues, expenses, and dividends/draws) to retain earnings or owner’s capital, preparing the books for the next accounting period.

9. Prepare a post-closing trial balance. Create a final trial balance to ensure all temporary accounts are zeroed out and the books are balanced for the start of the new period.

What are accounting standards?

To ensure that financial reporting is both transparent and consistent, accountants are required to adhere to established guidelines known as accounting standards. Globally, two main sets of standards dominate:

• Generally accepted accounting principles. Also known as GAAP, generally accepted accounting principles are a common set of accepted accounting principles, standards, and procedures that companies in the United States must follow when preparing financial statements. 

• International Financial Reporting Standards. IFRS is a set of accounting standards developed by the International Accounting Standards Board (IASB). Used in over 140 countries worldwide, IFRS created a global framework for financial reporting. 

Benefits of hiring an accountant

For many small business owners, managing accounting in-house isn’t the best use of time. Beyond saving you time, working with an accountant can offer a new point of view on your business’s strengths and weaknesses. When Roc Pilon, founder of the equipment and apparel company Gymreapers, shared his experience of building a seven-figure business on the Shopify Masters podcast, he emphasized the importance of working with an accountant.

At first, Roc handled all the bookkeeping and accounting, but he always found himself wanting to procrastinate.

“So, one of the first things I did was hire an outside accounting firm that does it specifically for ecommerce businesses,” he says. “I paid them somewhere between $300 to $800 a month.”

Although it seemed like a lot to him at the time, he says it granted him the ability to see which parts of his business were working and which weren’t.

“You can start to deductively analyze where the numbers drive your next business decisions,” says Roc. “And it’s better to start that when you’re small, because it’s not complex.”

Thorough accounting can help you identify your key revenue drivers, allowing you to focus investment on areas leading to growth. An accountant’s insights may help you identify which products perform best or determine where a new hire could best help you scale.

How to find an accountant for your business

A good accountant can meet you where you’re at and assist you as your business grows. If you’re looking to hire an accountant for the first time, consider the following avenues:

• Referrals. Consider asking colleagues, friends, family, and even vendors to recommend accountants. Referrals tend to be good leads because they have already been vetted by the individual who referred them.

• Services offered by your accounting software provider. Accounting software providers like QuickBooks and Xero offer access to a network of accountants and bookkeepers who maintain software certifications and have industry expertise.

• Online directories. Reputable accounting associations and some of the largest accounting firms often provide directories.

Most accountants offer an initial consultation. Use this time to assess their communication style, history of strategic planning, and whether they seem like a good fit for your business needs. Ultimately, the right accountant is one with whom you can build a partnership. Accountants are not simply number crunchers, but financial consultants who can play a pivotal role in your company’s success.