Accounting

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Updated August 30, 2020

What Is Accounting?

Accounting is the process of systematically recording, measuring, and communicating information about financial transactions. It’s a system of providing quantitative information about a business or person’s financial position.

A Simple Definition of Accounting?

A more simple definition of accounting is that it’s the process of tracking assets, liabilities, expenses, revenue, and equity.

Why Is Accounting Important?

Basic accounting knowledge is vital to understand investments, manage personal finances, and participate in the business world.

This information must be organized into the general ledger, or “books” of a company, which then provides the financial information used to report to tax authorities, investors, shareholders, regulatory agencies, and other possible stakeholders. 

Although many believe that accounting relies solely on mathematical skills, it also calls for shrewd business knowledge, prudent judgment, and strong oral and written communication skills.

What Is the Definition of an Accounting Job?

People who perform accounting functions may be called bookkeepers, accountants, or CPAs. The education, experience, and duties of each accounting role differs significantly. 

Companies may assign duties differently to each job title, but in general:

The differences between accountants, bookkeepers, and CPAs

Consider the differences between a bookkeeper and a CPA. Bookkeepers may earn a bachelor’s degree in accounting from an accredited college or university, or they may complete a specialized course after high school to learn accounting basics. 

A CPA must have a bachelor’s degree in accounting and meet state licensing requirements. These requirements typically include additional education, significant accounting experience, and passing the CPA exam. 

Keep in mind that all CPAs are accountants, but not all accountants are CPAs.

Who Uses Accounting?

Everyone uses accounting in some form. Individuals use accounting methods to maintain their personal budgets, reconcile their monthly credit card bills, and balance their checkbooks.

Every business – from a sole proprietor to a large multinational corporation – uses accounting methods to track revenues and expenses and analyze financial data. Although the size and scope of their accounting departments may differ, all must record transactions.

What Is Accounting Used for?

Accounting data is used for many purposes. These can include:

  • Communicating with managers - companies must communicate their financial position to managers through the use of accounting and financial data. Managers require detailed financial reports to estimate budgets and costs.
  • Paying taxes - accounting data is used to complete tax forms and schedules and determine federal, state, and local taxes (payable or owed)
  • Applying for loans - lenders accounting records to determine the creditworthiness of the applicant for credit
  • Satisfying regulatory bodies - some companies must provide detailed reports to regulatory bodies regarding their financial position. Accounting data provides the basis of thee reports
  • Updating shareholders - shareholders require detailed financial information derived from accounting records to understand the fiscal health of a company and – by extension – the potential of their investments
  • Informing capital markets - capital markets rely on accurate accounting and financial data, which in turn impacts stock prices.

How Many Types of Accounting Are There?

According to the University of Ohio, there are four types of accounting. Within each of these four major categories there are multiple specialities. For example, corporate accounting may be divided into for-profit and nonprofit accounting. Public accountants may provide auditing services or specialize in tax accounting. Government accounting may refer to employees of the IRS (who examine tax returns) or to local accounting departments who manage town, county, or state budgets. 

Some may include these specialty areas as unique types of accounting while others include them in the four types listed below.

Corporate Accounting

Corporate accounting deals with the financial needs of corporations. For example, corporate accountants record and file important financial records with federal and state authorities to record and pay taxes. They may also prepare financial statements for internal and external stakeholders such as managers, shareholders, and boards of directors.

Public Accounting

Public accounting refers to a type of accounting firm in which the accountants provide services directly to businesses and individuals. These accountants often consult with small business owners and help them manage their taxes and finances. They prepare financial statements, audit financial statements, and advise clients on matters pertaining to finance, accounting, and taxes.

Government Accounting

Government accounting refers to positions in the federal, state, or local governments who are responsible for financial reporting and auditing, taxation, and so on. Government accountants may examine tax reports and financial statements, prepare documents for the government or the general public, and assist with managing government funds.

Forensic Accounting

Forensic accounting is a branch of accounting that collects, recovers, and restores financial and accounting information as part of an investigation or court case. Such accountants may work with lawyers, police, or other law enforcement officials to provide evidence and testimony on matters of accounting or financial fraud or abuse.

What Are the 5 Basic Accounting Principles?

The 5 basic accounting principles include revenue recognition, expense recognition, matching, cost basis, and objectivity. All 5 principles should be applied consistently according to the accounting method chosen (e.g. accrual, cash basis). 

Note: Because most companies use accrual methods, the principles described below focus on accrual accounting definitions.  

The original 5 principles of accounting were established by the Accounting Principles Board, which is now called the Financial Accounting Standards Board (FASB). FASB continues to provide updates and guidelines to accountants today.

1. Revenue

Revenue refers to the gross amount received from the sale of goods or rendering of services. Transactions are recognized when their service is rendered or the goods are sold (regardless of when the payment is received).

Example of Revenue in Accounting

A medical equipment manufacturer receives an order for equipment to be shipped to a hospital. The order is placed on May 1 and the equipment ships June 1. Payment is received on August 1. The medical equipment manufacturer records the revenue on May 1 – the date the sales contract is received (or accrued) – rather than on August 1 when the payment is received.

2. Expense

The expense principle in accrual accounting holds that expenses are recorded when they are incurred. For example, the medical equipment company pays a commission to its salesperson for the order. It records the commission expense on May 1, even though the salesperson doesn’t receive the actual payment until August 1.

3. Matching

The matching principle states that revenue and expenses must be recorded at the same time period in which they occur. 

4. Cost

The cost principle states that assets must be recorded on the date they are acquired, and at the amount for which they were acquired (regardless of whether they change in value over time). For example, the hospital records the value of the purchased medical equipment at the precise value it paid for them on May 1, despite the fact that such equipment depreciates over time.

5. Objectivity

The fifth principle of accounting is the principle of objectivity. Objectivity means that accounts are backed up by evidence (e.g. sales receipts, invoices, purchase orders). The medical equipment manufacturer follows the standard of objectivity by maintaining copies of sales orders while the hospital maintains objectivity by providing their accountant with receipts for the purchase.

What Are Liabilities in Accounting?

Liabilities in accounting are financial obligations owed by a company or an individual. They may also be thought of as debts owed to others. Items often have the word ‘payable’ after them (e.g. income tax payable), indicating that the amount is owed to someone.

How Does the Accounting Cycle Work?

The accounting cycle is the process of recognizing and recording all of the financial transactions made by a business. It includes eight steps which are followed to identify, record, and reconcile entries.

The 8 Steps of the Accounting Cycle

The 8 steps of the accounting cycle

1. Identify Transactions

Transactions related to the business are identified and catalogued according to type. For example, sales orders may be set aside to record as income, while office supply receipts may be set aside as expenses.

2. Record journal entries

Journal entries are recorded in the appropriate category.

3. Post ledger entries

The journal entries are added to the general ledger.

4. Unadjusted trial balance

An unadjusted trial balance compares debits against credits. Debits and credits must balance for the accounts to be correct. The unadjusted trial balance shows whether they are equal. If they aren’t equal, there’s a mistake that must be identified and corrected. 

5. Adjusted entries

Entries are adjusted to add any income or expenses not captured at the end of an accounting period in steps 1 through 4. For example, bank interest statements may not arrive until after the close of the accounting period. An adjusted entry can be made to include interest.

6. Adjusted trial balance

Before taking time to create the financial statements in the next step, run an adjusted trial balance again to make sure there are no mistakes. Again, debits and credits must be equal. If not, go back and review your entries to find mistakes.

7. Financial statements

The correct balances can be used to create the income statement, balance sheet, and cash flow statement

8. Close the books

Revenues and expenses are closed, bank and credit card statements are reconciled, and the accounts are set up for the following month.

Accounting Software and the 8 Accounting Steps

If you use accounting software, it likely performs many of these steps automatically. Once income and expense items are identified and entered into the software, the system updates the accounts and general ledger. Users can run reports directly from the system. A quarterly or annual audit of the entire general ledger can reveal any accounts of out balance that must be corrected through adjusted entries.

Ask An Expert About Accounting Definitions

InvestingAnswers is on a mission to help consumers build and protect their wealth through education. That is why we have experts answering your pertinent questions at the end of each article.

What Is Financial Accounting?

Financial accounting is the branch of corporate accounting that identifies, records, and analyzes financial information for people outside of the company (such as investors). Information provided by financial accounting includes quarterly and annual income statements, balance sheets, and cash flow statements, and statements of retained earnings.  The standards of financial accounting differ whether under generally accepted accounting principles (GAAP) in the U.S. or the International Financial Reporting Standards (IFRS).

What Is Equity in Accounting?

Equity is the amount remaining to a company’s owners after all liabilities have been paid. You may see it referred to as stockholder’s equity or owner’s equity. Equity is calculated as assets minus liabilities.

What Is Goodwill in Accounting?

Goodwill is an intangible asset that arises when one company purchases another for an amount greater than the value of its assets acquired after accounting for the liabilities assumed. Examples of goodwill include an outstanding management team or a reputation for exceptional customer service. These things are by nature nearly impossible to quantify, though through the acquisition process it is possible to put a monetary value on them by considering the true value of the company including all tangible assets and net of any liabilities.

What Is Managerial Accounting?

Managerial accounting (also called management accounting) identifies financial information that helps managers run a company’s operations efficiently. Managerial accountants may analyze specific products, costs, or projects, and then provide this information to a company’s managers to enable them to make more informed judgements. Reports that managerial accountants provide to managers include cost analysis, constraint analysis, capital budgeting, trend forecasting, inventory analysis, and other types of product or project analysis, according to the industry in which the company operates. Managerial accounting is largely an internal system.

How Does Management Accounting Differ from Financial Accounting?

Managerial and financial accounting differ in matters of audience, reporting frequency, compliance, and accounting standards.

Audience

Managerial accounting provides reports for internal stakeholders, such as managers. Financial accounting may be shared internally but more often focuses on the financial information needs of  external stakeholders such as investors, shareholders, and boards.

Reporting Frequency

Managerial accountants provide internal stakeholders with reports on an ongoing basis. Financial accounting typically produces reports at the end of a given fiscal period (e.g. quarterly, annually).

Compliance and Accounting Standards

Financial accounting follows the rules established by FASB for companies in the US under the Generally Accepted Accounting Principles (GAAP). In addition, public companies must comply with requirements set by the Securities and Exchange Commission (SEC). Since it is shared solely with internal stakeholders, managerial accounting has more flexibility in its approach to accounting compliance and standards. Reports can be tailored to the needs of managers.