What Is Accounting?

Accounting is the process of recording financial transactions pertaining to a business. The accounting process includes summarizing, analyzing, and reporting these transactions to oversight agencies, regulators, and tax collection entities. The financial statements used in accounting are a concise summary of financial transactions over an accounting period, summarizing a company’s operations, financial position, and cash flows. 

How Accounting Works

Accounting is one of the key functions of almost any business. It may be handled by a bookkeeper or an accountant at a small firm, or by sizable finance departments with dozens of employees at larger companies. The reports generated by various streams of accounting, such as cost accounting and managerial accounting, are invaluable in helping management make informed business decisions. 

The financial statements that summarize a large company’s operations, financial position, and cash flows over a particular period are concise and consolidated reports based on thousands of individual financial transactions. As a result, all professional accounting designations are the culmination of years of study and rigorous examinations combined with a minimum number of years of practical accounting experience.

History of Accounting

The history of accounting has been around almost as long as money itself. Accounting history dates back to ancient civilizations in Mesopotamia, Egypt, and Babylon. For example, during the Roman Empire, the government had detailed records of its finances. However, modern accounting as a profession has only been around since the early 19th century.

Luca Pacioli is considered “The Father of Accounting and Bookkeeping” due to his contributions to the development of accounting as a profession. An Italian mathematician and friend of Leonardo da Vinci, Pacioli published a book on the double-entry system of bookkeeping in 1494.

By 1880, the modern profession of accounting was fully formed and recognized by the Institute of Chartered Accountants in England and Wales. This institute created many of the systems by which accountants practice today. The formation of the institute occurred in large part due to the Industrial Revolution. Merchants not only needed to track their records but sought to avoid bankruptcy as well.

Types of Accounting

Accountants may be tasked with recording specific transactions or working with specific sets of information. For this reason, there are several broad groups that most accountants can be grouped into.

Financial Accounting

Financial accounting refers to the processes used to generate interim and annual financial statements. The results of all financial transactions that occur during an accounting period are summarized in the balance sheet, income statement, and cash flow statement. The financial statements of most companies are audited annually by an external CPA firm.

For some, such as publicly-traded companies, audits are a legal requirement. However, lenders also typically require the results of an external audit annually as part of their debt covenants. Therefore, most companies will have annual audits for one reason or another.

Managerial Accounting 

Managerial accounting uses much of the same data as financial accounting, but it organizes and utilizes information in different ways. Namely, in managerial accounting, an accountant generates monthly or quarterly reports that a business’s management team can use to make decisions about how the business operates. Managerial accounting also encompasses many other facets of accounting, including budgeting, forecasting, and various financial analysis tools. Essentially, any information that may be useful to management falls underneath this umbrella.

Cost Accounting

Just as managerial accounting helps businesses make decisions about management, cost accounting helps businesses make decisions about costing. Essentially, cost accounting considers all of the costs related to producing a product. Analysts, managers, business owners, and accountants use this information to determine what their products should cost. In cost accounting, money is cast as an economic factor in production, whereas in financial accounting, money is considered to be a measure of a company’s economic performance.

Tax Accounting

While financial accountants often use one set of rules to report the financial position of a company, tax accountants often use a different set of rules. These rules are set at the federal, state, or local level based on what return is being filed. Tax accounts balance compliance with reporting rules while also attempting to minimize a company’s tax liability through thoughtful strategic decision-making. A tax accountant often oversees the entire tax process of a company: the strategic creation of the organization chart, the operations, the compliance, the reporting, and the remittance of tax liability.

The Accounting Profession

While basic accounting functions can be handled by a bookkeeper, advanced accounting is typically handled by qualified accountants who possess designations such as Certified Public Accountant (CPA) or Certified Management Accountant (CMA) in the United States.

In Canada, the three legacy designations—the Chartered Accountant (CA), Certified General Accountant (CGA), and Certified Management Accountant (CMA)—have been unified under the Chartered Professional Accountant (CPA) designation.

A major component of the accounting professional is the “Big Four”. These four largest accounting firms conduct audit, consulting, tax advisory, and other services. These firms, along with many other smaller firms, comprise the public accounting realm that generally advises financial and tax accounting.

Careers in accounting may vastly difference by industry, department, and niche. Some relevant job titles may include:

• Auditor (internal or external): ensures compliance with reporting requirements and safeguarding of company assets.
• Forensic Accountant: monitors internal or external activity to investigate the transactions of an individual or business.
• Tax Accountant: strategically plans the optimal business composition to minimize tax liabilities as well as ensures compliance with tax reporting.
• Managerial Accountant: analyzes financial transactions to make thoughtful, strategic recommendations often related to the manufacturing of goods.
• Information and Technology Analyst/Accountant: maintains the system and software in which accounting records are processed and stored.
• Controller: oversees the accounting functions of financial reporting, accounts payable, accounts receivable, and procurement.

The Accounting Rules

In most cases, accountants use generally accepted accounting principles (GAAP) when preparing financial statements in the U.S. GAAP is a set of standards and principles designed to improve the comparability and consistency of financial reporting across industries. Its standards are based on double-entry accounting, a method in which every accounting transaction is entered as both a debit and credit in two separate general ledger accounts that will roll up into the balance sheet and income statement.

In most other countries, a set of standards governed by the International Accounting Standards Board named the International Financial Reporting Standards (IFRS) is used.

Tax accountants overseeing returns in the United States rely on guidance from the Internal Revenue Service. Federal tax returns must comply with tax guidance outlined by the Internal Revenue Code (IRC). Tax accounts may also lean in on state or county taxes as outlined by the jurisdiction in which the business conducts business. Foreign companies must comply with tax guidance in the countries in which it must file a return.

Special Considerations

Accountants often leverage software to aid in their work. Some accounting software is considered better for small businesses such as QuickBooks, Quicken, FreshBooks, Xero, SlickPie, or Sage 50. Larger companies often have much more complex solutions to integrate with their specific reporting needs. This includes add-on modules or in-home software solutions. Large accounting solutions include Oracle, NetSuite, or Sage products.

The Accounting Cycle

Financial accountants typically operate in a cyclical environment with the same steps happening in order and repeating every reporting period. These steps are often referred to as the accounting cycle, the process of taking raw transaction information, entering it into an accounting system, and running relevant and accurate financial reports. The steps of the accounting cycle are:

1. Collect transaction information such as invoices, bank statements, receipts, payment requests, uncashed checks, credit card statements, or other mediums that may contain business transactions.
2. Post journal entries to the general ledger for the items in Step 1, reconciling to external documents whenever possible.
3. Prepare an unadjusted trial balance to ensure all debits and credits balance and material general ledger accounts look correct.
4. Post adjusting journal entries at the end of the period to reflect any changes to be made to the trial balance run in Step 3.
5. Prepare the adjusted trial balance to ensure these financial balances are materially correct and reasonable.
6. Prepare the financial statements to summarize all transactions for a given reporting period.

Cash Method vs. Accrual Method of Accounting

Financial accounts have two different sets of rules they can choose to follow. The first, the accrual basis method of accounting, has been discussed above. These rules are outlined by GAAP and IFRS, are required by public companies, and are mainly used by larger companies.

The second set of rules follow the cash basis method of accounting. Instead of recording a transaction when it occurs, the cash method stipulates a transaction should be recorded only when cash has exchanged. Because of the simplified manner of accounting, the cash method is often used by small businesses or entities that are not required to use the accrual method of accounting.

Imagine a company buys $1,000 of inventory on credit. Payment is due for the inventory in 30 days.

• Under the accrual method of accounting, a journal entry is recorded when the order is placed. The entry records a debit to inventory (asset) for $1,000 and a credit to accounts payable (liability) for $1,000. When 30 days has passed and the inventory is actually paid for, the company posts a second journal entry: a debit to accounts payable (liability) for $1,000 and a credit to cash (asset) for $1,000.
• Under the cash method of accounting, a journal entry is only recorded when cash has been exchanged for inventory. There is no entry when the order is placed; instead, the company enters only one journal entry at the time the inventory is paid for. The entry is a debit to inventory (asset) for $1,000 and a credit to cash (asset) for $1,000.

The difference between these two accounting methods is the treatment of accruals. Naturally, under the accrual method of accounting, accruals are required. Under the cash method, accruals are not required and not recorded.

Why Accounting Is Important

Accounting is a back-office function where employees may not directly interface with customers, product developers, or manufacturing. However, accounting plays a key role in the strategic planning, growth, and compliance requirements of a company.

• Accounting is necessary for company growth. Without insight into how a business is performing, it is impossible for a company to make smart financial decisions through forecasting. Without accounting, a company wouldn’t be able to tell which products are its best sellers, how much profit is made in each department, and what overhead costs are holding back profits.
• Accounting is necessary for funding. External investors want confidence that they know what they are investing in. Prior to private funding, investors will usually require financial statements (often audited) to gauge the overall health of a company. The same rules pertain to debt financing. Banks and other lending institutions will often require financial statements in compliance with accounting rules as part of the underwriting and review process for issuing a loan.
• Accounting is necessary for owner exit. Small companies that may be looking to be acquired often need to present financial statements as part of acquisition or merger efforts. Instead of simply closing a business, a business owner may attempt to “cash-out” of their position and receive compensation for building a company. The basis for valuing a company is to use its accounting records.
• Accounting is necessary to make payments. A company naturally incurs debt, and part of the responsibility of managing that debt is to make payments on time to the appropriate parties. Without positively fostering these business relationships, a company may find itself with a key supplier or vendor. Through accounting, a company can always know who it has debts to and when those debts are coming due.
• Accounting is necessary to collect payments. A company may agree to extend credit to its customers. Instead of collecting cash at the time of an agreement, it may give a customer trade credit terms such as net 30. Without accounting, a company may have a hard time keeping track of who owes it money and when that money is to be received.
• Accounting may be required. Public companies are required to issue periodic financial statements in compliance with GAAP or IFRS. Without these financial statements, a company may be de-listed from an exchange. Without proper tax accounting compliance, a company may receive fines or penalties.

Example of Accounting

To illustrate double-entry accounting, imagine a business sends an invoice to one of its clients. An accountant using the double-entry method records a debit to accounts receivables, which flows through to the balance sheet, and a credit to sales revenue, which flows through to the income statement.

When the client pays the invoice, the accountant credits accounts receivables and debits cash. Double-entry accounting is also called balancing the books, as all of the accounting entries are balanced against each other. If the entries aren’t balanced, the accountant knows there must be a mistake somewhere in the general ledger.

What Is an Accountant?

The term accountant refers to a professional who performs accounting functions such as account analysis, auditing, or financial statement analysis. Accountants work with accounting firms or internal account departments with large companies. They may also set up their own, individual practices. After meeting state-specific educational and testing requirements, these professionals are certified by national professional associations.

Understanding Accountants

Accountants are financial professionals who take charge of a series of accounts—either private or public. These accounts may be owned by either a corporation or individuals. As such, they may find work with corporations of different sizes—small to large—governments, different organizations like non-profits, or they may set up their own private practice and work with individuals who enlist their services.

They perform multiple accounting duties which vary based on where they work. Accountants perform account analysis, review financial statements, documents, and other reports to ensure they are accurate, conduct routine and annual audits, review financial operations, prepare tax returns, advise on areas that require more efficiencies and cost-savings, and provide risk analysis and forecasting.

An accountant’s duties often depend on the type of educational background and designation they receive. Most professionals in the field possess bachelor’s degrees and—if employed by a corporation—may require certification to move up within the firm. Certification requirements vary, with some roles requiring additional educational requirements above the bachelor’s degree and successful completion of rigorous examinations. Accountants can have more than one designation. But the most common accounting designations are the Certified Internal Auditor (CIA), Certified Management Accountant (CMA), and Certified Public Accountant (CPA). A Certified Internal Auditor doesn’t need to receive any license in order to practice, and neither do Certified Management Accountants.  

Many accountants choose to become CPAs because the designation is considered the gold standard in the accounting profession. In the United States, certification requirements for accountants can vary from state to state. But there is one requirement that is uniform in every state—the passing of the Uniform Certified Public Accountant Examination. This is an exam that is written and graded by the American Institute of Certified Public Accountants (AICPA).

Special Considerations

Accountants must abide by the ethical standards and guiding principles of the region where they practice, such as the International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP). The IFRS is a set of rules issued by the International Accounting Standards Board (IASB). These rules promote consistency and transparency in financial statements. GAAP, on the other hand, is a set of standards that accountants must adhere to when they complete financial statements for any publicly-traded companies.

Certified public accounts are legally and ethically responsible to be honest, trustworthy, and to avoid negligence in their duties. CPAs have real influence over their clients, which means their judgment and work can affect not just an individual but an entire company—including its employees, its board, and its investors. Accountants may be held liable for paying uninsured losses to creditors and investors in the case of a misstatement, negligence, or fraud.

Accountants can be held liable under two different types of law—common law and statutory law. Common law liability includes negligence, fraud, and breach of contract, while statutory law includes any state or federal securities laws. 

History of Accountants

The first professional association for accountants, the American Association of Public Accountants, was formed in 1887, and CPAs were first licensed in 1896. Accounting grew as an important profession during the industrial revolution. This was largely due to the fact that businesses grew in complexity and the shareholders and bondholders, who were not necessarily a part of the company but were monetarily invested, wanted to know more about the financial well-being of the companies they were invested in. 

After the Great Depression and the formation of the Securities and Exchange Commission (SEC), all publicly traded companies were required to issue reports written by accredited accountants. This change increased the need for corporate accountants even further. Today, accountants remain a ubiquitous and crucial part of any business.