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

1:44

Accounting

How Accounting Works

Accounting is one of the key functions for 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. 

Key Takeaways

  • Regardless of the size of a business, accounting is a necessary function for decision making, cost planning, and measurement of economic performance measurement.
  • A bookkeeper can handle basic accounting needs, but a Certified Public Accountant (CPA) should be utilized for larger or more advanced accounting tasks.
  • Two important types of accounting for businesses are managerial accounting and cost accounting. Managerial accounting helps management teams make business decisions, while cost accounting helps business owners decide how much a product should cost.
  • Professional accountants follow a set of standards known as the Generally Accepted Accounting Principles (GAAP) when preparing financial statements.

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 accounting designations are the culmination of years of study and rigorous examinations combined with a minimum number of years of practical accounting experience.

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 designations are Chartered Accountant (CA), Certified General Accountant (CGA), and Certified Management Accountant (CMA); however, all three will be unified under the designation Chartered Professional Accountant (CPA) in the near future.

The Alliance for Responsible Professional Licensing (ARPL) was formed during August 2019 in response to a series of state deregulatory proposals making the requirements to become a CPA more lenient. The ARPL is a coalition of various advanced professional groups including engineers, accountants, and architects.

Types of Accounting

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 into 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.

Requirements for Accounting 

In most cases, accountants use generally accepted accounting principles (GAAP) when preparing financial statements in the United States. 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.

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.

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 their 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 sometime between 1470 and 1517.

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.