What is accounting? We’ll cover how to start an accounting system for your small business. You’ll learn about accounting basics and how to apply them.
A small business owner needs to keep track of money. They must understand how transactions affect the business’s money. Knowing accounting is key.
The Basics of Accounting
Accounting basics include:
Assets: Things the business owns, like cash and equipment.
Liabilities: Debts the business owes, like loans.
Equity: The owner’s share of the business, calculated by subtracting liabilities from assets.
Income: Money made from sales or services.
Expenses: Costs of running the business, like rent and wages.
The Definition of Accounting
Accounting is about recording and analyzing business transactions. It helps make financial statements for stakeholders. This gives them important info about the business’s health.
The Purpose of Accounting in Business
Accounting has two main roles in business:
Legal Compliance: It helps businesses follow laws and report finances correctly.
Business Management: It gives insights into the business’s health. This helps with planning and making smart decisions.
A Brief History of Accounting
Accounting started with ancient civilizations. They kept simple records of money.
The double-entry bookkeeping system changed accounting in the 15th century. It made recording transactions easier. Over time, accounting has evolved with technology and global changes.
Standards and bodies like FASB and IASB have made accounting more consistent. This has made financial reports clearer.
Types of Accounting
There are three main types of accounting:
Financial Accounting
Financial accounting prepares statements for outsiders. It follows GAAP. It shows the business’s past performance and current state.
Cost Accounting
Cost accounting focuses on product or service costs. It helps with pricing and budgeting. It uses different methods to track costs.
Managerial Accounting
Managerial accounting gives info to management. It’s not for external reports. It helps with planning and decision-making.
Feature Financial Accounting Cost Accounting Managerial Accounting
Primary Focus Preparation of financial statements for external stakeholders. Analysis and allocation of costs to products, services, or activities. Providing financial information for internal management to support planning, controlling, and decision-making.
Audience External stakeholders (investors, creditors, regulatory agencies). Internal management. Internal management.
Reporting Standards Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). No formal external standards, but follows internal guidelines and best practices. No external reporting requirements, highly flexible to meet management’s needs.
Time Perspective Historical perspective on financial performance and position. Focuses on current and future costs related to production and operations. Often future-oriented, assisting in forecasting and planning.
Reports Generated Balance sheets, income statements, cash flow statements. Cost sheets, product costing reports, variance reports. Budgets, variance analyses, performance metrics, forecasting reports.
Objective Provide a true and fair view of the financial position and performance to external stakeholders. Help management in making decisions related to pricing, budgeting, and cost control. Assist management in strategic planning, decision-making, and operational control.
Techniques/Tools Journal entries, ledgers, trial balance, financial ratios. Job costing, process costing, activity-based costing, standard costing. Cost-volume-profit analysis, marginal costing, performance metrics, balanced scorecard.
There are additional styles that may appeal to certain businesses, like double entry accounting and accrual accounting, that some businesses may consider.
Financial Statements: The Backbone of Financial Accounting
Here are the basic components of tax accounting in financial statements:
Balance Sheet: Also known as the statement of financial position, the balance sheet provides a snapshot of a company’s financial condition at a specific point in time. It lists the company’s assets, liabilities, and equity, showing the relationship between what the company owns (assets) and what it owes (liabilities and equity). The balance sheet equation is Assets = Liabilities + Equity.
Income Statement: The income statement, also called the statement of profit and loss or P&L statement, summarizes the company’s revenues, expenses, gains, and losses over a specified period (usually a month, quarter, or year). It demonstrates whether the company has generated profit or incurred a loss during the period by comparing revenues to expenses. The basic format is Revenue – Expenses = Net Income (or Net Loss). There are also ways to dive deeper into specific expenses or revenue opportunities, like cost of goods sold.
Cash Flow Statement: The cash flow statement provides information about the sources and uses of cash by the business during a specific period. It categorizes cash flows into operating activities, investing activities, and financing activities. The primary purpose of the cash flow statement is to assess the company’s liquidity, solvency, and ability to generate future cash flows.
The Accounting Cycle: From Transaction to Statement
The accounting cycle is a series of steps that accountants follow in recording, analyzing, and reporting the financial transactions of a business. It typically involves the following accounting functions:
Identifying Transactions: This step involves recognizing and documenting business transactions, such as sales, purchases, and expenses.
Recording Transactions: Transactions are recorded in the accounting system using journals and ledgers, applying the double-entry bookkeeping method to ensure accuracy and balance.
Adjusting Entries: At the end of an accounting period, adjusting entries are made to update account balances for accrued expenses, prepaid items, depreciation, and other adjustments necessary for accurate financial reporting.
Preparing Financial Statements: Once all transactions are recorded and adjusted, financial statements (balance sheet, income statement, cash flow statement) are prepared to summarize the financial performance and position of the business.
Closing Entries: Temporary accounts, such as revenue, expense, and dividend accounts, are closed to retained earnings at the end of the accounting period to prepare for the next period.
Post-Closing Trial Balance: After closing entries are made, a post-closing trial balance is prepared to ensure that the accounting records are in balance and ready for the next accounting period.
Generally Accepted Accounting Principles (GAAP)
GAAP refers to a set of standardized accounting principles, standards, and procedures that are used by companies to compile financial statements in a consistent and comparable manner. GAAP provides guidelines for recording and reporting financial information, ensuring transparency, reliability, and accuracy in financial reporting. These principles are established by various standard-setting bodies, such as the Financial Accounting Standards Board (FASB) in the United States, and are updated periodically to reflect changes in business practices and regulatory requirements.
Why Accounting is Crucial for Small Businesses
Proper business accounting is crucial for small businesses for several reasons:
Financial Management: Effective accounting helps small business owners monitor cash flow, track expenses, and manage budgets, enabling better financial decision-making.
Compliance: Accurate accounting ensures that small businesses comply with tax laws, regulatory requirements, and financial reporting standards, reducing the risk of penalties, fines, or legal issues.
Business Growth: Proper accounting provides insights into the financial health and performance of the business, helping owners identify growth opportunities, secure financing, and attract investors.
Stakeholder Confidence: Keeping financial records up to date builds trust with investors, creditors, and customers. This boosts the business’s reputation and credibility.
When Do You Need an Accountant?
Small business owners might need an accountant in certain situations. This includes:
Complex Transactions: For complex deals like mergers or international growth, you need an expert.
Tax Preparation and Planning: During tax season, an accountant helps with compliance and saving money on taxes.
Financial Analysis: An accountant is key for detailed financial planning and budgeting.
Regulatory Compliance: They help with tax laws and avoid legal problems.
The Future of Accounting
Accounting is changing with new trends. Some include:
Automation and AI: New tech makes accounting faster and more accurate.
Cloud Accounting: Cloud software makes it easier to work together and get financial updates anytime.
Data Analytics: Advanced tools help find trends and make better decisions.
Sustainability Reporting: More focus on the environment and social responsibility in financial reports.
Blockchain Technology: It’s used for secure and transparent financial dealings.
These changes are shaping how we handle money in the digital world.
FAQs: What is Accounting
What’s the difference between accounting and bookkeeping?
Bookkeeping and accounting are different but related. Let’s explore them.
Bookkeeping
Bookkeeping is about keeping track of money. It includes recording sales and payments. It’s the first step in accounting.
Accounting
Accounting is more than bookkeeping. It’s about making sense of financial data. It helps with planning and advice.
How often should a small business review its financial statements?
Business owners should check their finances often. This helps with making smart choices. It’s best to do this at least monthly.
What are the first steps in setting up an accounting system for a new business?
Setting up an accounting system starts with:
Define Financial Objectives: Know what you want to achieve financially.
Choose Accounting Method: Pick the right accounting method and software for your business.
Establish Chart of Accounts: Organize your financial data with a chart of accounts.
Set Up Accounting Software: Use software to track and report your finances.
Design Internal Controls: Protect your assets and keep your data safe.
Train Staff: Make sure your team knows how to use the accounting system.
Is it necessary for a small business to adhere to GAAP?
Generally Accepted Accounting Principles (GAAP) guide financial reporting in the U.S. But, small businesses don’t always need to follow GAAP. This is true if they’re not publicly traded or under certain rules. Still, it’s wise for small businesses to follow GAAP. It helps keep financial reports clear, consistent, and trustworthy.
Following GAAP also makes it easier to compare with other businesses. It can attract investors and make financial statements more reliable.
Can accounting software replace an accountant?
Accounting software can make some tasks easier and faster. It can handle things like data entry and report making. But, it can’t replace the skills and knowledge of a good accountant.
Accountants are key for understanding financial data and giving advice. They also make sure everything follows tax laws. Hiring an accountant adds valuable insights and experience. But, software can help accountants work more efficiently.