What is Accounting? Definition, Equation, Methods, Examples
Every business irrespective of its size (small, medium, or large businesses) requires accounting. Although businesses assign accountants to handle their accounting load, it is a good practice for business owners to be aware of accounting basics.
Accounting is a vast field with multiple types, terms, and systems. The thought of learning and understanding a variety of accounting concepts can be discouraging. However, if you take out time to familiarize yourself with the basic accounting concepts, you will discover it is not as difficult as you anticipated.
You may be wondering why you need to familiarize yourself with the basics of accounting. The answer is that you need it to run your business efficiently. Even if you do not need it now, it will come in handy for you in the future.
As a small business owner, with a small or no accounting team, gaining an accounting education can boost your productivity and overall contribution to your business.
In this article, you will learn how accounting works, types and the major principles of accounting, accounting terms, accounting methods, and the best accounting software.
Let’s get started.
What is Accounting? A Short Definition
Accounting in its simplest form refers to the way an individual or a business records, organizes and interprets its financial information.
According to Investopedia, “Accounting is the process of recording financial transactions pertaining to a business.”
The Merriam Webster English Dictionary defined accounting as “the system of recording and summarizing business and financial transactions and analyzing, verifying, and reporting the results.”
Think of accounting as a gigantic device in which you throw raw financial information (such as your taxes, expenses, income, and any other transactions). The gigantic device then grinds and cooks the financial information and spits it out in an easy-to-understand answer. It is this cooked end product that reveals the financial state of your business.
Accounting is what shows you whether you are making a profit or loss, reveals your cash flow, assets, and liabilities. It points you to areas of your business that are performing and areas that are underperforming.
How Accounting Works
Accounting is an essential function of almost any organization. The accounting workload is the task of a bookkeeper or an accountant at a small business. For large organizations, accounting is the responsibility of a sizable financial/accounting department with a sizable number of employees.
The bookkeeper handles basic accounting tasks. On the other hand, the accountant is a professional responsible for recording, processing, interpreting, and keeping business transactions on behalf of a company.
Accounting reports generated by the accountant or accounting department are invaluable resources that guide the company’s management to make informed decisions. Accounting involves cost planning and measurement of financial performance.
There are two essential types of accounting, managerial accounting and cost accounting. Managerial accounting helps companies make better business and financial decisions. Cost accounting helps companies determine the selling price of a product.
Professional accountants are responsible for preparing financial statements for the company. They follow a set of standards to produce these financial statements known as the Generally Accepted Accounting Principles (GAAP).
GAAP refers to a common set of accounting principles, rules, and standards that every company irrespective of its size adheres to. Public companies in the US must use GAAP for their financial statements.
GAAP is designed to govern corporate accounting and financial reporting in the US. It was developed jointly by the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA).
There are ten primary principles of GAAP. They include
- Principle of Regularity,
- Principle of Consistency,
- Principle of Sincerity,
- Principle of Permanence of Methods,
- Principle of Non-Compensation,
- Principle of Prudence,
- Principle of Continuity,
- Principle of Periodicity,
- Principle of Materiality, and
- Principle of Utmost Good Faith.
The equivalent of the US GAAP is the International Financial Reporting Standards (IFRS). Over 120 countries follow the IFRS guidelines for accounting.
Advanced accounting functions are beyond the scope of a bookkeeper or an ordinary accountant. Accountants best fit for this task have to undergo rigorous examinations and have considerable and practical accounting experience.
If your business is located in the United States, you need to hire a Certified Public Accountant (CPA) or Certified Management Accountant (CMA) for your advanced accounting needs.
In Canada, there are three accounting designations—the Chartered Accountant (CA), Certified General Accountant (CGA), and Certified Management Accountant (CMA).
Types of Accounting
Accounting does not just involve the preparation of taxes, this is just one type of accounting. There are several types of accounting, with accountants specializing in one or more of these different types of accounting.
1. Financial Accounting
Financial accounting is a type of accounting that tracks, records, and reports financial transactions through financial statements. It is a type of accounting performed to conform to external regulations and not for internal use.
In the United States, financial accounting must be done using the Generally Accepted Accounting Principles (GAAP) standardized principles and guidelines.
GAAP is set by the Financial Accounting Standards Board (FASB). The primary reason why GAAP is compulsory is to ensure consistency in the financial statement reporting process between companies.
For companies with international transactions, their financial statements must abide by the International Financial Reporting Standards (IFRS).
Financial accounting has its focus on past performance, unlike management accounting which has a more futuristic outlook. It tracks the business performance over some time and produces accurate reports in the form of financial statements.
The completed financial statements are for external use. They are issued to stakeholders such as investors and relevant financial institutions. A financial accountant must have the ability to pay attention to details to sufficiently convey the current financial state of the company to external sources.
Financial accounting is made up of two types: cash and accrual accounting. Cash accounting involves focusing only on corporate transactions involving cash. Small businesses often use this method.
Accrual accounting does not just focus on the cash transactions only but all other transactional data involved in the corporation’s operations. It contains the cash accounting method and more. Large businesses and publicly traded companies use this method.
Both accrual accounting and cash accounting make use of the double-entry accounting method to accurately record financial transactions.
2. Management Accounting
Management accounting is a type of accounting that provides financial information about the business for its internal management team. It focuses on providing the necessary information needed by management to make high-level decisions. It is a popular accounting type used globally.
The difference between financial accounting and managerial accounting lies in their audience. Financial accounting is designed for external use and stakeholders. Management accounting on the other hand is exclusively for sharing with appropriate employees in an organization.
Management accounting has a forward-looking approach, intending to find more productive ways to run the business finances. It provides the company's management team with the right tools and resources to make beneficial policies. The use of management accounting eliminates the need for an uninformed guess.
There are three popular forms of management accounting used by companies. They include strategic management, performance management, and risk management. There is no rule that forces you to use a limited amount. Based on the circumstances of your company’s needs, you can choose to use one, two, or all of them simultaneously.
Management accounting involves these accounting areas: budgeting and forecasting, financial analysis, cost analysis, past business decision reviews, and more.
3. Governmental Accounting
This type of accounting is similar to financial accounting in the sense that they both have a standardized framework that they must abide by.
Governmental Accounting is governed by the Governmental Accounting Standards Board (GASB) which sets consistent accounting procedures and standards applicable to all levels of government.
The accountants that perform this type of accounting operations are known as government accountants. They perform the roles of managing and planning for the allocation of resources to different departments within the three tiers of government (local, state, and federal).
Governmental accounting performs the all-important role of tracking a government’s budget and judiciously allocating funds to the appropriate quarters. Government accounting is a different playing field compared to corporate accounting. Accountants that specialize in this area usually stay within the field for their entire careers.
Unlike financial accounting that uses a single account for tracking income and expenditures, governmental entities use separate accounts.
For example, if a county awards a road repair project to a contractor, all the tracking of expenses and possible income from the pocket are done in a capital project fund.
This unique tracking method helps the government to track the performance of each fund or program. It makes it easy to show how the government is spending public money entrusted to it.
The government uses five types of funds. They are the General Fund, Permanent Fund, Capital Projects Fund, Special Revenue Fund, and Debt Services Fund. Each fund requires separate tracking to provide an all-encompassing report on the performance, spending, and balance of government funds.
4. Public Accounting
Public accounting is a type of accounting in which an accounting firm or accounting offers its services to the general public. They are businesses that provide accounting advice and services to their clients. The public accountant is the title for those who practice public accounting.
Unlike the previous three types of accounting, accountants practicing public accounting do not work as internal employees for a business or government. Public accountants run their own accounting firms or work for one.
The job description of a public accountant includes auditing, tax returns and filings, and legal counsel on accounting and financial matters. They also provide consultation for the installation and use of accounting software, payroll software, and inventory management software.
Public accounting firms serve a vast range of clients. There are no limits on which clients they can provide accounting services to. Some fields they cover include service businesses, retailers, governmental organizations, manufacturers, nonprofit organizations, and even individuals.
Preparation of financial statements and analysis are also roles performed by public accounting firms. They provide consultation services for businesses on issues around mergers, acquisitions, strategies, and internal accounting systems.
The Certified Public Accountant (CPA) is an accountant that acts as a consultant on many business issues such as accounting and taxes. They are trusted financial advisors used by both businesses and individuals to plan and attain their financial targets. They are in high demand.
Public accounting firms can also perform other accounting services that a typical accountant does. They may help their clients to perform simple bookkeeping activities, payroll services, accounting management, and others.
5. Cost Accounting
Cost accounting is a form of management accounting that aids managers in making decisions. It is an accounting type used in industries where there is a lot of cash and resources to manage such as the manufacturing industry. Some service businesses also use it. Cost accounting assesses the company’s internal operations.
This type of accounting is all about recording and analyzing costs. It takes into consideration the company’s fixed and variable costs. Fixed costs are the unchanging and constant costs such as rent, while variable costs are the changing costs such as shipping charges.
The accounting type that looks at the actual cost of doing business is cost accounting. Cost accounting is about how the company’s fixed and variable costs affect a business and helps determine how to manage these costs better. An individual who practices cash accounting is called a cash accountant.
Cash accountants perform the function of documenting, reviewing, and presenting costs. They ensure that both the variable and fixed costs are not beyond what the company can afford. Cash accountants work hand in hand with managers to help make future projections and decisions about cost management.
6. Forensic Accounting
Forensic accounting is an accounting type that involves reconfiguring a company’s financial information to find missing information. A person who studies forensic accounting is called a forensic accountant.
Companies invite a forensic accountant when some of their financial information is missing or unavailable for review. A forensic accountant gathers all the available documentation a company has and comprehensively reviews all the transactions (credit, debit, and cash) in financial statements.
Forensic accounting uses accounting, investigating, and auditing techniques to arrive at its goal. Professionals who specialize in this area work in legal cases that involve claims, disputes, and fraud. They work in the insurance industry, legal support, auditing firms, or accountant consulting firms.
Financial investigations on the suspicious activities of individuals and companies require forensic accounting. Banks, businesses, attorneys, and police departments use forensic accounting frequently to examine financial records.
Fraud and embezzlement cases require forensic accountants to get to the root of the matter. Forensic accounting uses data collection, preparation, analysis, and reporting techniques and methods to investigate these cases. They frequently have to testify in courts to offer a professional explanation of their findings.
Businesses also use forensic accountants to help reconstruct or recreate the business financial data. Forensic accounting is more of a consultation service since only a few businesses require them and its services are not needed regularly.
7. Tax Accounting
Tax accounting is a form of accounting that deals with tax calculations and filings. The Internal Revenue Code (IRC) regulates tax accounting. IRC ensures that businesses, individuals, and nonprofit organizations follow all the current tax rules and regulations.
An individual who practices tax accounting is a tax accountant. Tax accountants help businesses stay in compliance with tax rules and regulations. You need a tax accountant to help you follow strictly the annual tax codes when you file your taxes annually.
Tax accountants help businesses plan for future tax returns, avoid tax burdens, and better understand the implications and benefits of tax decisions. They are tax specialists that every company or organization needs to hire to avoid running into tax complications.
Small businesses do not always have a tax accountant in-house because of their smaller tax needs and calculations. However, these businesses may opt to hire one on a consultation basis or assign the role to the business’s in-house accountant.
Large organizations hire a tax accountant because of their larger tax needs. They have more complicated financial records and need the services of a professional to help navigate the complexities and accurately file their taxes.
Tax accounting requires accountants to be updated about the latest tax changes that happen yearly. Tax accountants work with companies, individuals, and nonprofit organizations to plan their taxes and minimize taxes due.
Auditing is different from accounting. Accounting involves tracking and reporting all the business financial activities. Auditing on the other hand focuses on providing an independent analysis of the business’s financial activities to ensure that the business stays compliant with the various compulsory standards, rules, and frameworks.
There are two main types of auditing: internal and external auditing. Auditing falls under public accounting.
Internal auditing focuses on the effectiveness of the company’s internal accounting processes. It involves evaluating how a business structures its accounting duties, the policies and procedures the business has in place. The individual who performs internal auditing is an internal auditor.
The benefit of internal auditing for businesses is that it helps identify fraud, mismanagement, and waste. Internal auditors also spot and fix potential weaknesses in business procedures and policies.
Internal auditing involves reviewing management policies, employee responsibilities, and other procedures in a company. The reports and feedback provided by the internal auditors are extremely useful for companies. Companies use it to enhance their profitability and efficiency.
External auditing refers to the examination of a company’s financial statements by an independent third party to ensure that the company stays compliant with GAAP (Generally Accepted Accounting Principles).
The difference between external auditing and internal auditing is that external auditing is performed by independent accountants while internal auditing is performed by in-house accountants. The individual who specializes in external auditing is called an external auditor.
Types of Audits
Internal auditors and external auditors perform a variety of audits.
- Compliance Audit examines the procedures and policies an organization uses to determine if the organization is compliant with regulatory standards.
- Financial Audit analyzes a company’s financial statements to ensure it is accurate. It is the most popular and frequently used audit.
- Investigative Audit examines the financial statements and records of an organization or company to determine if there is any manipulation in its accounting records. It is frequently the first step taken in a financial crime case.
- Tax Audit examines the accuracy of a company’s tax return. It is carried out by the IRS (Internal Revenue Service).
Assets, Liabilities, Equity: Understanding the Accounting Equation (Including Examples)
The accounting equation is a basic principle of accounting and is considered the foundation of the double-entry accounting system. It is the relationship between the business’s assets, liabilities, and equity.
By using the accounting equation, you are in a good position to know if your company’s assets are financed by business funds or debt. On the balance sheet, the accounting equation ensures that the company’s assets are equal to its shareholders’ equity and the company’s liabilities. The accounting equation is referred to as the balance sheet equation or the basic accounting equation.
Understanding the Accounting Equation
All businesses whether large or small have their financial position assessed based on three components of the balance sheet: assets, liabilities, and equity (owner or shareholder equity). The accounting equation shows the relationship between these three components.
Assets refer to all the valuable resources under the control of the company. Liabilities refer to the obligations that the company owes. Equity refers to what is left after the liabilities are removed from the company’s assets.
Equity and liabilities are a reflection of how the company finances its assets. On the balance sheet equation or basic accounting equation, when a company finances its assets through debt, it falls under liability. When it finances it by issuing equity shares, it falls under equity.
The accounting equation is a balance and check system that helps companies determine whether their business transactions are properly and accurately recorded in their books and accounts.
Assets refer to the total value of the property that a company possesses which it owns. It may be in the form of cash, cash equivalents, or liquid assets such as certificates of deposit and treasury bills.
Examples of assets include cash, inventory, prepaid expenses, accounts receivables, and equipment. Accounts receivables refer to the money that customers owe a company or business as a result of purchasing a product or service.
Liabilities refer to the money that a business or company owes or needs to keep the company afloat. Examples of liabilities include accounts payable, notes payable, deferred revenue, and any form of debt such as rent, salaries, wages, taxes, utilities, and dividends payable.
Equity refers to what is left when the company’s total assets get subtracted from its total liabilities. It can either be shareholders’ equity or owners’ equity.
Shareholders’ equity refers to the sum of money paid to shareholders if the company’s assets are liquidated, and only after the company pays off its debt. Owners’ equity refers to the amount of money that would be returned to the company’s owner after the company’s liabilities are removed from its assets.
Examples of equity include dividends and retained earnings. Retained earnings are the sum of shareholders’ earnings that have not yet been paid as dividends to shareholders. It is a part of shareholders’ equity and a type of savings.
The Accounting Equation Formula and Calculation
The formula for the accounting equation is
Assets = Liabilities + Equity
The balance sheet contains the basis of the accounting equation. The company’s assets, liabilities, and equity are on the balance sheet for the period in question. Assets are on a separate listing on the balance sheet distinct from liabilities.
Locate the total equity on the balance sheet and add it to the company’s total liabilities. The sum of the liabilities and total equity must be equal to the company’s total asset.
Here is a good example. Let’s assume that in the fiscal year 2020, a leading sports betting company reported the following on its balance sheet.
Total Assets: $200 million
Total Liabilities: $120 million
Total Equity: $80 million
The accounting equation is Assets = (Liabilities + Equity). In this example, the total liabilities are $120 million and total equity is $80 million. When you sum the liabilities and equity together, you must arrive at a figure equal to the company’s asset.
Assets = (Liabilities + Equity)
Assets = ($120 million + $80 million)
Assets = $200 million
The assets arrived to match the value of the assets reported by the company.
The Double-Entry System
The accounting equation is the basis of double-entry accounting. It is the best representation of the complexities on the balance sheet. The balance sheet is based on the accounting equation or the double-entry accounting system where the company’s total assets are equal to its total liabilities and total equity.
Every single business transaction that a company performs is represented in at least two of its accounts on the balance sheet. For a company to record accurate accounts, it has to balance every transaction through this double representation method.
For instance, if a company takes a loan from a bank, the money borrowed will enter into the balance sheets under two columns, assets and liabilities. As a result, the company's total assets and liabilities will rise. The money entered into the two columns has to be equal.
Another example is a company purchasing raw materials for production by paying cash. This transaction will enter into double columns. It will enter as inventory (putting it under assets) and reduce the cash capital available.
Two or more accounts get affected by every transaction that a company undertakes. For this reason, this accounting system is called double-entry accounting.
The double-entry accounting system keeps the accounting equation balanced, ensuring that both the left side value and right side value of the equation are equal. To put it more simply, the total assets will always be equal to the sum of liabilities and equities.
All over the world, there is a global adherence to the double-entry accounting system. The benefit of using the double-entry accounting system is that it makes accounting easier, fool-proof, and more standardized.
The accounting equation maintains a relationship between assets, liabilities, and equities. Companies use the accounting equation to vet the records entered into the books and records.
Limits of the Accounting Equation
The accounting equation may always balance out the information on the balance sheet but it still has its limitations. One of the most noticeable limitations of the accounting equation is that it does not provide insights into the company’s performance.
Company executives and investors have to interpret the numbers and decide whether the company is performing well or not. Investors have to estimate from the accounting equation if the company has too many or too few assets, liabilities, and equity.
Another limitation of the accounting equation is that it does not guarantee that fraud or mistakes are eliminated.
Accounting Equation Examples
You start a small business selling tote bags. You contribute $5,000 to your small business. According to the accounting equation, the $5,000 will reflect in your business’s assets and owner’s equity and increase by similar amounts.
The formula for Accounting Equation is Assets = (Liabilities + Equity)
$5,000 Assets = Liabilities + $5,000 Equity
If your small business needs to buy equipment and raw materials to manufacture the tote bags. You take a $1,500 loan on credit to fund the equipment. As a result, you gain assets but also incur liabilities of the same amount.
Your assets and liabilities will increase by $1,500. Here is the representation of the accounting equation for this transaction.
$1,500 Assets = $1,500 Liabilities + Equity
If you get an order for 50 tote bags from a customer, and each tote bag is worth $10, your small business gains $500. Your assets and owner’s equity will increase by $500.
$500 Assets = Liabilities + $500 Equity
Financial Statement Analysis for Beginners
Financial statement analysis is the process of analyzing and evaluating a company’s financial information through its various financial documents. It helps managers make informed business decisions.
It is an essential tool used by analysts, managers, internal decision-makers, and investors to better understand a company’s performance, growth potentials, and financial position.
Financial statement analysis involves the analysis of balance sheets, cash flow statements, income statements, statements of shareholders’ equity, and other essential financial statements.
Financial statement analysis is the process of analyzing and evaluating a company’s financial information through its various financial documents. It helps managers make informed business decisions.
It is an essential tool used by analysts, managers, internal decision-makers, and investors to better understand a company’s performance, growth potentials, and financial position.
Financial statement analysis involves the analysis of balance sheets, cash flow statements, income statements, statements of shareholders’ equity, and other essential financial statements
There are three essential financial statements you need to perform a comprehensive financial statement analysis for your business or company. They are the balance sheet, income statement, and cash flow statement.
There are other financial statements used by analysts, internal decision-makers, and investors to determine a company’s financial position and performance. They are not as essential as the three financial statement types that will be discussed below.
1. The Balance Sheet
The balance sheet is a type of financial statement that provides insight into a company’s financial position at a given timeframe. It is also known as the statement of financial position.
On the balance sheet, it is where you find and record the company’s assets, liabilities, and shareholder’s equity. It shows you the available assets the company has to work with, the amount it owes, and what shareholders own of the company’s assets.
2. The Income Statement
The income statement is a type of financial statement that highlights the company’s revenues, gains, expenses, and losses over a timeframe. It is also known as the profit and loss statement.
Companies and businesses use the income statement to analyze and determine their financial positions, performance, and overall efficiency. This financial statement compares the performance of the company or business to other competitors in its industry.
3. The Cash Flow Statement
The cash flow statement is a type of financial statement that summarizes the cash flow (inflow and outflow). It is also known as the statement of cash flows. Companies use the cash flow statement to help them identify the sources of the company’s cash flow and what it is used for.
In a typical company, cash is useful for running operations, investments, and other business financings. The cash flow statement measures how well or badly a company manages its cash position over a given period.
Essential Financial Statements in Details
1. Balance Sheet
Balance sheets are essential financial statements that highlight the company’s financial position and performance over a given period. It offers valuable insights into the company’s assets (what the company owns), liabilities (what the company owes), and equity (shareholders’ or owners’ profit).
Analysts, investors, and other decision-makers use the valuable insights provided by the balance sheet to determine if investing in the company is going to be profitable.
What to Look for on the Balance Sheet
A balance sheet contains several pieces of information. The most important items worth paying attention to during a balance sheet analysis are assets, liabilities, and shareholders’ equity.
Assets refer to all the economic resources that a company owes. Although every input under assets is important, there are certain variables or items that you will want to give extra attention to. They are cash, account receivable, and inventory.
Cash is one of the essential items to look at in the balance sheet. It is a reflection of the company’s ability to get sales and manage its financial obligations such as purchases and debts. The amount of cash a company has on its balance sheet can help predict how well equipped it is to handle unexpected downturns and repay debts.
However, the amount of cash available is not suitable for all types of companies. It is best used to analyze heavily cash-reliant companies such as those in the manufacturing industries. Some businesses do not need or rely on a huge amount of cash to operate efficiently, instead, they reinvest the cash to boost the business’s future earnings.
Accounts receivable refers to money that is owed to the company and its ability to collect it. If account receivables decrease each year and sales remain stable or increase, the company is performing a great job at collecting the money it is owed. If account receivables increase each year, the company may be struggling to collect the money it is owed.
Inventory refers to a company’s raw materials, works in progress, and completed inventory. Proper inventory management is essential for measuring the cost of goods sold (COGS), inventory turnover rate, and other inventory metrics used to determine efficiency and profitability.
Note that the inventory section in the assets column of the balance sheet does not take into consideration spoilage, shrinkage, and obsolescence of the items provided.
Liabilities refer to all the financial obligations that a company owes to external parties. Companies that have fewer liabilities compared to their assets attract investors. Other items to pay attention to on the liabilities side of the balance sheet are accounts payable, short-term debts, and long-term debts.
Accounts payable refers to the money that the company owes its suppliers or vendors. It includes both short-term debts and long-term debts. Inventors and analysts pay attention to accounts payable to understand how well a company balances its credit and cash purchase.
Short-term debt refers to the debt that a company owes which it has to repay within a year. This type of debt includes accounts payable, taxes, short-term loans, salaried owed, and leased payments.
Another name for short-term debts in a company is operating debts. Analysts, investors, and creditors use short-term debts to gauge the company’s ability to meet its financial obligations in the short term and its liquidity.
Long-term debt refers to the money a company owes that is not due until at least after a year. Examples of long-term debt are bonds, loans, lease obligations, mortgages, and others.
Another name for long-term debts in a company is financial debts. Long-term debts are incurred to raise more capital for the company. Analysts and investors use it to examine the company’s long-term financial commitments.
Shareholders’ equity refers to what is left for the shareholders to share after the company’s debt has been paid. Mathematically, shareholders’ equity is the difference between the company’s assets and its liabilities.
If a company gets liquidated, the money left after the payment of all debts is called shareholders’ equity. Investors pay attention to shareholders’ equity before deciding to invest in a company.
Retained earnings refer to the amount of income accumulated and leftover after shareholders receive their dividends. The company can decide to reinvest it, hold it as cash, or use it to handle a portion or all of its liabilities.
Depending on how the company manages its profit, the retaining earnings value can be positive or negative. Retained earnings reflect the company’s financial stability. It is an important section that analysts, lenders, and investors use to get more insights into how the company manages its cash flow and growth.
Paid-in capital refers to money that a company gathers from selling ownership in the form of stocks directly to investors. It also covers any fund the business receives from the sale of common stock or preferred stock. Stock exchanges that happen between investors do not count as paid-in capital.
Investors can choose to pay additional paid-in capital, which is an extra sum of money paid for stocks above their value.
The Balance Sheet Equation
The balance sheet equation is a simple accounting equation where the left side of the balance sheet (assets) must be equal to the right side of the balance sheet (liabilities and shareholders’ equity).
The formula for the balance sheet equation is:
Assets = Liabilities + Equity
2. Income Statement
An income statement is a reflection of the company's gains, losses, revenues, and expenses in a given timeframe. Investors and analysts use the income statement to analyze and gauge the performance, efficiency, and profitability of a company.
There are three components of an income statement that investors and analysts pay extra attention to. They are net income, operating expenses, and gross profit.
Net income refers to the total profit or loss a company generates over a given period. Another name for net income is net earnings. Investors and analysts use it to determine if a company is profitable or not.
In any income statement, the net income is one of its most essential components. It is the amount of money that a company earns after accounting for its expenses. Net income is useful for calculating earnings per share, retained earnings, and net profit margin.
The net income is always on the last line of any income statement. The formula for net income is:
Net Income = Total Revenue – Total Expenses
Operating expenses refer to all the expenses that a company incurs through its business activities such as inventory costs, administrative fees, payroll, and rent. The operating expenses refer to the total money that a company needs to operate effectively.
Investors and analysts use the operating expenses to get insights into the company’s efficiency and profitability. It is also used to calculate a company’s operating income.
Gross Profit refers to the sum of all the revenue a company generates from sales deducted from the cost of attaining those sales. It shows the company’s profit after the deduction of the cost of goods sold.
Mathematically, the gross profit is sales minus the cost of goods sold.
Gross Profit = Sales – Cost of Goods Sold (COGS)
Some of the goods deducted from the gross profit include the cost of labor, shipping, transaction fees, equipment, administrative fees, and marketing costs. Analysts and investors check the gross profit in the income statement to measure the company’s efficiency.
3. Cash Flow Statement
A cash flow statement is the measurement of a company’s liquidity, turnover, solvency, and financial health. It provides insight into how the company generates its revenue and manages its spending over a given time. It is an important consideration that investors and analysts use to make a decision.
A thorough financial statement is not complete without taking into consideration the cash flow statement. According to the cash flow statement, the company cash activities are split into three categories: operating activities, investing activities, and financing activities.
Operating activities are the summary of all the company’s cash inflows and outflows that come from its normal business activities. It represents the primary source of cash for a company, and as a result, it is an essential section of the cash flow statement.
Positive cash flow is when the inflow exceeds the outflows, while negative cash flow is when the outflow exceeds the inflow. When there is a positive cash flow from the operating activities, it is a signal that the company’s operation is in a good state.
Investing activities refer to the company’s cash inflows and outflows as a result of the company’s investments. Some of these investments include payments for company acquisition, sale of assets, purchase of assets, repaid loans, and others.
This section of the cash flow statement leans massively towards cash outflow because the company spends cash to acquire or purchase investments. Cash inflow occurs when the company sells investment and receives cash for it.
Analysts and investors can not use the company’s investing activities alone to determine the company’s financial health. However, a healthy investment portfolio is a sign that the company is performing well enough to afford to invest in its future growth.
Financing activities refer to any cash inflows or outflows that involve equity, dividends, and debts. It is the summation of all transactions that contribute to the funding of the company.
Tracking the financing activities of a company provides insights into the cash movement between the company and its owners, investors, creditors, and lenders. It reveals the impact of borrowing on the company’s cash flow.
Cash flow from financial activities can either be positive or negative. A positive cash flow means the company receives cash through issuing stocks and other streams. On the other hand, a negative investment means that the company pays out cash by making dividend payments.
Financial Statement Analysis Doesn’t Always Show the Full Picture
Financial statement analysis helps investors, analysts, and internal managers make more informed decisions. It is way better than any uninformed guess. However, it is not a science, and even the projections and factors on which it is based do not always show the full picture.
If you are new to financial statement analysis, it is best to conduct your own initial research to familiarize yourself with the bulk of the concepts. Another alternative is to hire accounting experts to analyze your financial statements before you make any critical business or investment decision.
Major Accounting Principles for Modern Accountants
Irrespective of the type of business you operate, the basic principles of modern accounting guides its operation. These major accounting principles for modern accounting became popular in the 1800s, although they originated back in ancient Mesopotamia.
Accounting took a modern turn with the publishing of the treatise of bookkeeping by Luca Pacioli in 1494. The treatise of bookkeeping was published in a book titled “Summa de Arithmetica, Geometria, Proportioni et Proportionalita.”
Five major accounting principles form the foundation of modern accounting practices.
1. The Revenue Principle
The revenue principle refers to the condition or points in time when the bookkeeper or accountant may record a transaction as revenue in the accounting book.
According to the principle, revenue for a company is earned and recorded at the sale, which is when the buyer takes possession of the product or service purchased. Another name for the revenue principle is the revenue recognition principle.
Many businesses tend to go against the revenue recognition process by waiting for the customer to make the cash payment before recognizing it as revenue.
2. The Expense Principle
The expense principle refers to the point in time or condition in which a bookkeeper or accountant may log a transaction as an expense in the accounting book. Another name for the expense principle is the expense recognition principle.
According to this principle, an expense occurs when the business accepts goods and services from another source. It does not matter when the business gets billed or pays for the transaction initiated. As long as it receives the goods or services, an expense has taken place.
A good practice for recording a company’s expenses is to record it in the accounting book immediately. Procrastinating the recording of these expenses can cause complications. The expense principle does not take into consideration when and how the billing takes place.
3. The Matching Principle
The matching principle is an accounting principle that states that a bookkeeper or accountant should match an item of revenue with an item of expense.
Let’s assume a company is selling orange juice, you count the expense it incurs in purchasing the plastic bottles, oranges, and sugar. You match the expense of the orange juice ingredients with the revenue earned from the sale of orange juice.
The application of the revenue principle, expense principle, and the matching principle means a company is operating under the accrual accounting method. The matching principle helps businesses to match and balance their revenues and expenses.
Whenever you sell a product, you incur some expenses along the way. The matching principle covers the selling expenses, administrative expenses, and manufacturing expenses.
4. The Cost Principle
The cost principle states that you use the historical cost of an item to record it in the books instead of the resell cost. To understand this principle, you have to first understand the meaning of historical costs.
The historical cost of an item refers to the value of the item at the time when the item was first purchased or acquired. It measures the value of fixed assets guided by the provisions of GAAP (Generally Accepted Accounting Principles). The current prevalent market price is the opposite of the historical cost.
According to the cost principle, you have to record the cost of any item in your accounting book using its historical cost and not the resell cost.
For example, if you own a real-estate business, every time you sell a property, you record it with the historical cost in the accounting book. The resale value or what it is currently trading in the market is not what you record.
Another example is a company that sells vehicles. Every time you sell a vehicle, you record it with the historical cost of the transaction in the accounting book instead of resale value.
The benefit of recording your company’s assets using the historical cost is that it helps keep your company’s expenses in order. A company needs to record the acquisition price of any item it spends money on to enable it to properly record the depreciation of these items.
5. The Objectivity Principle
The objectivity principle is an accounting principle for modern accountants that supports only the recording of factual and verifiable data in the accounting books. Subjective measurement of values takes less value, and should not be used even if it seems like the better option. Verifiable data is the foundation of the objectivity principle.
In accounting, the accounting data need to remain consistent, accurate, and independent of personal opinions.
Any accounting data you want to record should be supported by evidence. Some of the common evidence types are vouchers, invoices, and receipts. Having an objective viewpoint helps you produce and trust the financial results.
For example, if an accountant worked in a company before, the accountant cannot be an auditor for it because of concerns over the accountant’s relationship with the company. Such a relationship can skew the accountant’s work.
The objectivity principle states that when you enter data into your accounting book or your small business accounting software, you only enter verifiable and factual data. Avoid entering data into your accounting software or books that are subjective or based on estimates.
Accountants and bookkeepers have to operate under these five major accounting principles for modern accountants. They help keep your business from making misleading financial information and decisions. It helps businesses from falling short of the required standards that auditing authorities require.
Accounting Oversight and Regulations
Accounting oversight and regulations refer to those principles that guide the accounting process for uniformity and standardization. Talking about the accounting oversight and regulation is not complete without explaining these three entities:
- Financial Accounting Standards Board (FASB)
- Generally Accepted Accounting Principles (GAAP)
- International Financial Reporting Standards (IFRS)
Financial Accounting Standards Board (FASB)
The Financial Accounting Standards Board (FASB) is an independent nonprofit organization that sets accounting and financial reporting standards and rules binding on public and private companies, and nonprofits in the US. FASB follows the Generally Accepted Accounting Principles (GAAP) which will be extensively discussed shortly.
In 1973, FASB was created to replace and take over the responsibilities and missions of the Accounting Principles Board based in Norwalk, Conn. FASB works closely with the International Accounting Standards Board (IASB) to set up compatible rules and standards worldwide.
How the Financial Accounting Standards Board (FASB) Works
FASB is the body that has the power and authority to interpret GAAP in the US for public and private companies, and even nonprofits.
The Securities and Exchange Commission (SEC) recognizes it as the standard accounting practice that all public companies have to comply with. FASB enjoys numerous recognition by state accounting boards, organizations, and the American Institute of Certified Public Accountants (AICPA).
The mission of the FASB is to improve financial accounting and reporting standards so that investors and other interested parties can access standardized and useful information about a company’s finances. FASB also involves itself in educating others about how best to use its standards.
Generally Accepted Accounting Principles (GAAP)
GAAP refers to the collection of accounting principles, procedures, and standards set by the Financial Accounting Standards Board (FASB). In other words, GAAP is the guidelines set by FASB.
All public companies in the US have to comply with GAAP when compiling their financial statements. Accountants are well aware of this principle. GAAP combines guidelines set by policy boards and traditionally acceptable ways of recording and reporting financial statements.
GAAP aims to make the communication of financial information across companies clear, consistent, complete, and comparable. GAAP makes it easy for investors and other interested parties to analyze and extract key information about the company’s financial health from the company’s financial statements.
The equivalent of GAAP is the International Financial Reporting Standards (IFRS) used by over 120 nations.
GAAP helps govern the accounting world by setting general rules and guidelines applicable to all. It focuses on topics like balance sheet classification, materiality, and revenue recognition.
General Concepts of Generally Accepted Accounting Principles (GAAP)
10 general concepts guide accountants and help them stay within the GAAP framework.
- The Principle of Regularity occurs when the accountant follows the GAAP rules and regulations in recording and preparing the company's financial statements.
- The Principle of Consistency means that the accountants have to follow the same standards when preparing reports, even for different periods. Any change the accountant makes has to be properly updated in the footnotes of the financial statements.
- The Principle of Sincerity means that the accountant has to commit to reporting accurate and impartial records of the company’s financial health.
- The Principle of Permanence of Methods means using consistent procedures for financial reporting to make it easy to compare and interpret the company’s financial information.
- The Principle of Non-Compensation means that accountants should report both the positives and negative sides of the account, and not hide any detail. Reports should be transparent and without expecting debt compensation.
- The Principle of Prudence means that the financial report must be free from speculation but rather a representation of fact-based financial data.
- The Principle of Continuity means that the accountant should assume that the business will continue its operation while it is recording and analyzing its financial records.
- The Principle of Periodicity means that the financial reports should be reported and distributed in the relevant accounting period.
- The Principle of Materiality means that the company has to disclose all its financial and accounting information in its reports.
- The Principle of Utmost Good Faith is a principle that assumes that all parties are honest and straightforward in all their financial and accounting transactions.
International Financial Reporting Standards (IFRS)
IFRS refers to the common rules that accountants and companies must follow to keep their financial statements transparent, consistent, and comparable according to global standards. The body responsible for issuing the International Financial Reporting Standards (IFRS) is the International Accounting Standards Board (IASB).
IASB specifies the rules that companies must follow in maintaining and reporting their accounts and transactions. It is the common accounting language that companies and businesses use to remain consistent in their financial statements irrespective of the geographical barrier.
Despite the “international” title in its name (IFRS), it is not universally used by every country, with the U.S using GAAP and some other countries adopting other accounting oversight and regulatory frameworks.
Standard IFRS requirements influence the following reports:
- Statement of Financial Position
- Statement of Comprehensive Income
- Statement of Changes in Equity
- Statement of Cash Flows
Companies operating under IFRS also have to provide a summary of all their accounting policies.
Accounting Methods: Cash Accounting vs Accrual Accounting
Accounting methods are the various rules that a company adheres to when reporting its revenues and expenses. There are two types of accounting methods: cash accounting and accrual accounting.
Cash Accounting Method
Cash accounting is a relatively simple and straightforward accounting method that records cash inflow and cash outflow, that is when cash is spent or recovered. Small businesses generally use this accounting method. Another name for cash accounting is cash-basis accounting.
With the cash accounting method, a sale is recorded at the point you receive payment, and an expense is recorded at the point when you pay the bill. It is suitable for recording personal finances.
According to the Internal Revenue Service (IRS), businesses that generate an average gross receipt worth more than $25 million in the last three years cannot use the cash accounting method. They can only use the accrual accounting method.
The reason why large companies with a large inventory do not use cash accounting is that it can cause misleading financial positions.
Example of Cash Accounting
If a logistics company receives $10,000 for delivering packages to another company on May 1, the sale will be recorded to have taken place on the 1st of May. The other company may have placed their order on April 12, but it does not count in the cash accounting method on that date.
If the same logistics company buys three new trucks from another company on May 25 and pays the invoice on June 7. The expense is recorded on June 7 because it is when payments are made.
Accrual Accounting Method
The Accrual accounting method measures a company’s performance by recognizing economics regardless of when the transaction takes place. It is based on the matching principle which seeks to accurately match the timing of the revenue and expense recognition.
The true financial condition of a company can be best viewed with the accrual accounting method. Transactions under accrual accounting are recorded when payments and expenses are incurred rather than when they are paid. In other words, companies record sales when customers order for a product and not when payment is made.
Examples of Accrual Accounting Method
If a logistics company receives $10,000 for delivering packages to another company on May 1 but got the order on April 12, the sale will be recorded to have taken place on the 12th of April.
If the same logistics company buys three new trucks from another company on May 25 and pays the invoice on June 7. The expense is recorded on the 25th of May because it is when the transaction was incurred.
Accrual Accounting vs Cash Accounting
One difference between the two types of accounting methods is who uses them. Accrual accounting is used by companies while cash accounting is used by individuals.
Another difference is that accrual accounting records and reports financial transactions as they are incurred and earned. Cash accounting on the other hand records and reports revenues and expenses as they are paid and received (cash inflow and cash outflow). Generally Accepted Accounting Principles (GAAP) uses accrual accounting.
Important Steps in the Accounting Cycle
The accounting cycle refers to the whole process of recording and processing the company’s financial transactions from when they occur to financial statements and the closing of the accounts. It is a guide for the successful recording, analyzing, and reporting of a company’s accounting and financial activities.
Bookkeepers and accountants must know about the accounting cycle. They keep track of the cycle from its inception to its end. Every year, the accounting cycle repeats itself as long as the business remains operational.
The accounting cycle is all-encompassing and used for one full reporting period. It consists of all the accounts, debits and credits accounts, journal entries, and adjusting entries that record the accounting activities over a full cycle.
Accounting cycle periods vary from one company to another based on their reporting needs. Some companies report it on a monthly, quarterly, or annual results
There are eight steps in the accounting cycle. These steps are also the responsibilities of bookkeepers. Many companies use accounting software to automate many of these steps. However, accountants need to know all these steps, especially small business accountants.
Understanding the 8-Step Accounting Cycle
The 8-step accounting cycle starts with the recording of the company’s transactions and ends with the reporting of the company’s transactions in a given timeframe. A lot of companies use accounting software to automate their accounting cycle.
Bookkeepers and accountants provide from the use of accounting software. They enjoy less financial burden and have more time for productivity. Accountants can set the accounting software to a fixed cycle date and receive automated reports.
Every company has its system which may permit some level or a high level of technical automation. The accountant or bookkeeper may need to step in at various points in the accounting cycle.
Companies modify the eight-step accounting cycle to fit their company’s business model and accounting procedures.
There are eight steps of the accounting cycle. They include identifying transactions, recording transactions in a journal, posting to the general ledger, the unadjusted trial balance, the worksheet, adjusting journal entries, financial statements, and closing the books.
1. Identify Transactions
The first step in the accounting cycle is to identify the transactions. Many transactions happen in companies during the accounting cycle. It is essential for companies to properly record their company’s books. Without proper recordkeeping, the accounting cycle does not kick-off.
2. Record Transactions in a Journal
The next step in the accounting cycle is the recording of transactions in a journal. Companies use point of sale technology to automate the first and second steps of the accounting cycle. The type of accounting method your company uses will determine when your transactions are officially recorded.
The accrual accounting method requires companies to match and record their revenues and expenses at the time of sale. Cash accounting requires companies to record revenues and expenses at the point when cash is either paid or received.
The journal must be organized chronologically for better accounting. For single-entry bookkeeping, a bookkeeper will enter an incoming transaction in the debit ledger and an outgoing transaction in the credit ledger.
For double-entry bookkeeping, a bookkeeper will list two transactions for each entry in the debit and credit ledgers. The double-entry bookkeeping system ensures that every entry must be equal and balanced.
3. Posting to the General Ledger
After recording the transaction in a journal, the next step is to post it in the general ledger account. The general ledger is where accountants record the breakdown of all accounting activities.
Bookkeepers and accountants can easily monitor the financial positions of the company by its various accounts. The most referenced account in the general ledger is the cash accountant. Bookkeepers use it to provide details on the company’s cash position.
4. Unadjusted Trial Balance
The fourth step of the accounting cycle is the unadjusted trial balance. At the end of the accounting period, companies are required to calculate a trial balance. Depending on the company’s preference, the accounting period can be monthly, bi-monthly, quarterly, or even yearly.
Companies calculate their trial balance to test the accuracy of their credit and debit entries. Both sides have to be equal for double-entry bookkeeping. If there are unadjusted balances in any account, the trial balance tells the company where it occurs.
5. Adjust Trial Balance (Worksheet)
Adjusting the trial balance is the fifth step of the accounting cycle. It is only needed when the debit and credit ledger on a trial balance is unequal. The bookkeeper or accountant has to adjust entries, spot the errors, and track them on a worksheet.
If the company uses the accrual accounting method, it may need to adjust entries for revenue and expenses.
6. Adjusting Journal Entries
The sixth step involves adjusting journal entries to correct errors where necessary. It is an opportunity for bookkeepers to account for accruals and deferrals.
Accruals refer to the revenue or expenses that a company incurs but were not originally recorded. Deferrals refer to receipts of upcoming expenses or advanced payments.
7. Financial Statements
Financial statements are prepared last in the accounting period. They are made or extracted from the balances from the adjusting journal entries and trial balance. Examples of financial statements include cash flow statements, income statements, balance sheets, and statements of retained earnings.
Cash statements detail the cash inflow and output of the company. Income statements show the company’s profit and loss. The balance sheet is a summary of the company’s assets, liabilities, and equity. These statements are a good measurement of a company’s performance over the accounting period.
The output or summary of the accounting process that is useful for both internal and external parties is the financial statements.
8. Closing the Books
The eighth and last step of the accounting cycle is closing the books at the end of the accounting cycle or period. It is also called closing statements. Closing statements are reports that summarize and analyze the company’s performance over the accounting period.
After closing the books, the accounting cycle starts afresh with a new accounting period. Closing the books is a good time to file paperwork, prepare for the next reporting period, and review the just-concluded accounting cycle.
Important Accounting Terms You Should Know
Small business accounting software makes it easy for companies to manage their accounting without having extensive knowledge of the field. However, it is valuable to acquit yourself with the essential accounting terms for more fruitful results.
- Accounting Period refers to a specific time frame covered in the company’s financial statements. It can be monthly, bi-monthly, quarterly, or annually depending on the company’s preference.
- Accounts Payable (A/P) refers to the money a company owes for its purchase of goods and services. Examples of accounts payable include utility bills, office rent, and raw materials from vendors.
- Accounts Receivable (A/R) is the opposite of accounts payable. It refers to the money that is owed to a company for goods and services provided.
- Accrual Accounting is a method of accounting in which transactions get recorded when they occur rather than when payments are received.
- Allocation refers to the accounting process or procedure of assigning funds to several accounts or periods.
- Asset refers to everything of value that the company owns. They include cash, land, building, inventory, vehicles, A/R balances, and intangible properties such as trademarks and copyrights.
- Bank Reconciliation is the process of making your general ledger balance equal to your ending bank balance every month.
- Capital refers to the financial assets that a company needs to operate efficiently.
- Cash Accounting is a method of accounting in which transactions get recorded when they are received and not when they are incurred.
- Certified Public Accountant (CPA) is an accountant who meets the education and experience requirements set by the American Institute of Certified Public Accountants (AICPA).
- Cost of Goods Sold (COGS) is the cost a company incurs in producing or purchasing goods for sale.
- Credit is an accounting entry made on the right side of the accounting ledger.
- Debit is an accounting entry made on the left side of the accounting ledger.
- Depreciation refers to the usage of a particular asset over a period. Types of depreciation include straight-line depreciation, declining balance, double-declining balance, and sum-of-the-year digits.
- Dividends refer to the portion of the company’s earnings a shareholder receives.
- Expenses refer to the cost a company incurs while doing business. To earn revenue, businesses have to incur expenses first. Examples of expenses include rent, salaries, commissions, and advertising.
- Equity refers to the owner’s stake in a company.
- Financial Statements refer to reports of the company’s financial performance used by auditors, creditors, and investors to analyze the company’s financial health. There are three types of financial statements: balance sheet, income statement, and cash flow statement.
- Generally Accepted Accounting Principles (GAAP) are common accounting rules, principles, procedures, and standards set by the Financial Accounting Standards Board (FASB) to ensure uniformity of reports across companies. It is used by publicly traded companies in the United States
- General Ledger (G/L) is the full record of all accounting transactions made by your business or company.
- Gross Profit refers to the revenue left after deducting expenses such as the cost of goods sold.
- Inventory refers to goods that a company owns. There are three stages of inventory: finished goods, work-in-progress goods, and raw materials.
- IRC is an acronym for the Internal Revenue Code. It is the sum of tax rules set by the federal government.
- IRS is an acronym that stands for Internal Revenue Service. This federal agency is responsible for administering the IRC.
- Journal Entry refers to the recording of business transactions in the accounting book. A proper journal entry must have a date and be put in the right account.
- Lender refers to an individual or firm that gives out money to a borrower with the expectation of receiving it back at a fixed period, usually with an interest.
- Leverage refers to the judicious use of borrowed money to make more profit.
- Liability is the money or financial obligation that a company owes. Examples of liability include accounts payable, payroll, and accrued expenses.
- Liquidation refers to the closure of a company where it has to sell its assets to settle its debts.
- Liquidity refers to the cash a company has in hand to settle its bills and take care of its needs and other obligations.
- Market refers to a public place where the buying and selling of goods and services take place either directly or through intermediaries.
- Market Capitalization refers to the value of a company that is traded on the stock exchange market.
- Net Profit/Loss refers to profit or loss that a company incurs after deducting all expenses.
- Not-for-Profit are organizations that exist for charitable, educational, or humanitarian purposes, and not for the primary reason of making a profit.
- Objectivity is the ability to separate your reflection or feelings from the reality of a thing.
- Obligations refer to money your company owes which has to be paid at a future time.
- Overhead Cost refers to the cost of doing business that is not directly linked to production. They are administrative costs such as utilities, office rents, and insurance.
- Profit is the money left after deducting the selling price of your products or services from the cost of production.
- Qualitative Analysis refers to analysis dealing with unmeasurable factors that are important.
- Quality refers to the ability of a company’s product or service to satisfy the customer.
- Quantitative Analysis refers to the analysis of important measurable factors.
- Revenue refers to the income that a company generates from its business activities.
- Report refers to a written accounting statement that reflects the financial health of the company.
- Return on Investment (ROI) refers to the profit that a company makes on its investment.
- Review refers to the process of evaluating accounting reports to check the reliability and accuracy of the financial information provided.
- Sale refers to the exchange of goods or services for monetary gains.
- Sales Tax refers to any tax levied on the sale of goods and services by the government.
- Securities and Exchange Commission (SEC) is a federal agency in the United States responsible for regulating financial reporting practices and standards for publicly traded companies.
- Self Employment Tax refers to tax that is paid by self-employed individuals for running business activities. Self-employment does not come with the tax withholdings that employers are required to do on employee’s earnings, although the self-employed still have to calculate their taxes and pay them.
- Solvency refers to a deployable state of a company where it is unable to meet its financial obligations at the due date.
- Spreadsheet refers to any accounting or bookkeeper software or application that automates and makes the accounting cycle easier.
- Stockholder refers to any individual that owns shares in a company.
- Tax refers to a compulsory financial contribution to government revenue charged on income, wealth, consumption, and others.
- Taxable Earnings refer to the portion of an employee or company earnings that is subject to tax.
- Trade refers to the act of buying or selling goods and services among organizations, states, and even nations.
- Trademark refers to a distinctive symbol, motto, or name that clearly identifies a company, product, or service.
- Trader refers to anybody who buys and sells goods and services intending to make a profit. Other names for a trader include a dealer or merchant.
- Transaction refers to any business exchange or activity recognized by an entry in the company’s accounts.
- Turnover refers to the number of times a company sells a particular product and restocks it within a given period.
- Variable Costs refers to change in total cost as a result of changes in productive outputs.
- Variable Manufacturing Costs refer to the rise or fall of manufacturing costs as a result of changes in the number of manufactured units.
- VAT is an acronym for Value-Added Tax. It is a tax charged on the value added to a product at the manufacturing stage and the purchase stage.
- Velocity refers to the rate of money turnover or spending in a given period.
- Vendor refers to anyone that supplies goods and services to a company or business. A vendor can be a manufacturer, wholesale distributor, or importer.
- Volatile refers to a state of rapid or extreme fluctuations.
- Wage refers to money earned by employees for the services rendered to the company or business.
- Wholesale refers to the act of selling goods in large quantities, usually to a retailer who plans to sell them in smaller quantities.
- Wholesaler is the middleman or distributor who buys goods in large quantities from the manufacturing company and sells it in smaller quantities to the retailer. The retailer in turn then sells it in even smaller quantities to the consumer.
- Withholding refers to the amount that an employer withholds from employee salaries for tax payment to the appropriate authority.
- Work in Progress refers to inventory that is not yet at a finished stage and still awaiting completion.
- Working Papers refer to records that the auditor keeps that show how he or she carried out the audit. It contains the procedures applied, information obtained, test performed, and the conclusion reached.
- Yield means the return on investment that an investor receives as interests or dividends.
Best Accounting Software to Automate Accounting Processes
Best Cloud Financial Management Solution for Large Businesses and Enterprises.
NetSuite is more than accounting software, it also offers Enterprise Resource Planning (ERP) software solutions. The company was established in 1999 and was bought by Oracle in 2016.
Managing your business and automating your finances is easy with the system of integrated applications NetSuite gives you access to. The cloud-based software performs project management, inventory management, CRM, and even eCommerce management tasks.
NetSuite performs all the vital tasks that your company needs. They include cash management, expense tracking, payroll management, fixed asset management, tax management, and compliance checks, invoicing, recurrent billing, fraud detection, and others.
The cloud-based accounting software allows users to customize their workflows. Users enjoy accurate reports with real-time metrics and role-based dashboards to help improve the company’s financial performance.
Best Accounting Software and Invoice Generator for Small Businesses and Freelancers.
QuickBooks is one of the most popular accounting software used by businesses of all sizes to automate their accounting needs. Whether you are a freelancer, small business owner, medium-sized business owner, QuickBooks offers multiple features for you.
With its extensive list of accounting and bookkeeping features, the cloud-based software is the go-to accounting solution for small businesses. There is a free mobile app available which makes the software even more accessible to users.
Some of the key features of QuickBooks include tracking your cash flow, tax management, invoice generator, managing your bill payments and receipts, and more. It also serves as payroll software.
QuickBooks is an easy-to-use platform that any small business owner can easily operate with little directions. With its Live Bookkeeping Service feature, businesses can get a virtual bookkeeping expert to navigate them through the whole accounting and bookkeeping process.
The cloud-based accounting software for small businesses integrates with third-party applications such as Shopify, Square, PayPal, and others. You can use its time tracking software feature to track employee time and billable hours.
Best Budget-friendly Accounting Software for Medium-Sized Businesses.
FreshBooks is one of the best accounting and invoicing software for businesses, especially medium-sized ones. It was founded in 2003 and started as invoicing software, but added other accounting features over the years.
The accounting software is popular among solopreneurs, small and medium-sized businesses. FreshBooks offers numerous accounting features such as invoices, expense tracking, time tracking, project management, payments, and reporting. It also serves as a task management software for accounting.
FreshBooks has a free mobile app that makes it easy for users to access their accounting information from anywhere in the world.
The QuickBooks alternative integrates with over 100 applications to help businesses and individuals streamline their other work-related applications. Some of these third-party integrations include Bench, Slack, Gmail, Stripe, Fundbox, and MailChimp.
Best Free and Powerful Accounting Software for Small Businesses
Wave is the best free accounting software with multiple features for small businesses. If you do not have a budget to pay for an accounting software subscription, Wave is 100% free and helps businesses and individuals achieve their financial goals.
Despite its free service and limitations, it still offers powerful accounting features at zero cost. It supports double-entry accounting and allows users to connect their bank accounts to the app. You can balance your books, sync your expenses and prepare your taxes quickly with Wave accounting software.
The cloud-based software helps businesses automate their invoices and recurring bills. However, if you need payroll and time tracking features, you have to look elsewhere.
5. Sage 50cloud
Best Accounting Software for Accountants, Accounting Firms, and Medium-Sized Businesses
Sage 50cloud is a reliable desktop and cloud-based accounting software for medium-sized businesses, accountants, and accounting firms. It was formerly known as Peachtree Accounting.
There are over 400,000+ users of the Sage 50cloud software, making it one of the most popular accounting software in the market. You can connect your bank account to the software so that it can easily track your receipts, expenses, sales records, and cash flow.
The powerful accounting software helps businesses manage multiple payment options, and get more accurate records of their transactions. It has one of the best credit card processors.
Sage 50cloud provides real-time reports showing you your profit and loss so you can easily track your business performance. Even if you are not an accounting expert, the software has built-in step-by-step guides to show you how to do your month and year-end processing.
Sage Drive is a handy tool for collaborating with accountants. The drive allows you to share your accounting data in real-time with your accountants and helps you to see what changes they make to your books.
Best Accounting Software for Medium-Sized to Large Businesses
Xero is a popular cloud-based accounting software from New Zealand that boasts of having over 2 million users and 15,00 accounting firms.
The software is a perfect solution for the accounting needs and problems of business owners. With the cloud-based software, business owners spend less time working on their accounts thanks to its automated features.
Some of the top features of Xero accounting software include payroll management, cash flow management, bank reconciliations, project tracking, accepting payments, paying bills, and others.
There are over 500+ integrations available on Xero. It can serve as a robust project management software by providing simple financial oversight into projects.
Enjoy using the Xero app to access your business accounting records from any location as long as there is an active internet connection. The Xero app is available in the Apple Store and Google Playstore.
Biggest Accounting Scandals of the Last 30 Years
The world has experienced so many accounting scandals that there is no book large enough to contain them. Accounting scandals happen when there is deliberate manipulation of financial statements for the benefit of the manipulator.
Here are some of the biggest corporate accounting scandals that sent shockwaves throughout the world.
1. The Waste Management Incorporation Fraud Scandal, 1998
The Houston-based publicly traded waste management company was a famous company with over 20 million customers across North America. Established in 1894, the company felt like one of those honest companies with a long tradition of winning.
However, 1998 was the year the massive financial scandal that was perpetuated in the background came to the limelight. The company connived with a large independent auditing firm, Artur Andersen, to overlook its fraudulent activities.
The company’s new CEO, Maurice Meyers, discovered the company’s fraud of reporting over $1.7 billion in fake earnings!
Once the news came into mainstream media, the company lost 33% of its share value, resulting in over $6 billion loss for shareholders. The company had to pay $457 million to settle shareholders, while the Securities and Exchange Commission (SEC) prosecuted the auditor, Arthur Andersen, which had to pay $7 million.
2. Enron Scandal, 2001
Another Housed-based corporation, the Enron Scandal is one of the biggest accounting scandals of all time because of its global repercussions.
The Enron bankruptcy of 2001 sent shockwaves to the American society and the world at large. At different points, Enron was considered America’s most innovative company. It was a huge U.S energy trading firm that dominated the U.S electricity industry.
Enron exploited accounting loopholes of the period to book assets as profit without it having any actual value. The company kept huge debts off its balance sheets. CEO Jeff Skilling and former CEO Ken Lay were the major players in this scandal.
An internal whistleblower Sherron Watkins suspected the scandal and alerted the authorities. Also, its high stock prices caused external suspicions.
The U.S trading firm employed a big auditing firm, the same Arthur Andersen which was instrumental in the Waste Management Incorporation Fraud Scandal in 1998 to audit its books. Arthur Andersen covered up some of the scandals but the company’s debt could not be hidden.
Once the debt was revealed, the company collapsed, shareholders lost $74 billion, and thousands of employees lost their jobs and pensions. Arthur Andersen was found guilty of fudging Enron’s accounts and folded after this episode. CEO Skilling got 24 years in prison while his partner in crime Lay died before he could serve his time.
Before the scandal blew open, Fortune Magazine named Enron as America’s most innovative company for six years consecutively.
3. WorldCom Scandal, 2002
WorldCom was a telecommunication company run by CEO Bernie Ebbers that fraudulently inflated the company assets by about $11 billion. Investors lost over $180 billion as a result of this scandal while 30,000 jobs got lost.
The scandal was uncovered by the company’s internal auditing department. CEO Bernie Ebbers was sentenced to 25 years in prison for his role in the scandal, the CFO was sacked, and the controller resigned. WorldCom now MCI filed for bankruptcy as a result.
Few weeks after the scandal, Congress swung into action and passed the Sarbanes-Oxley Act, a powerful set of business regulations to prevent the scandal from repeating itself.
4. American International Group (AIG) Scandal, 2005
The multinational insurance corporation perpetuated a series of accounting frauds rising to the tune of $3.9 billion. Other crimes AIG committed included stock price manipulation and bid-rigging.
CEO Hank Greenberg played a central role in the fraudulent activities of the company. He booked loans as revenue and used traders to inflate AIG stock prices. The SEC got wind of these activities and investigated the company.
At the end of the investigations, the company had to pay fines to the SEC in 2003 and 2006, $10 million and $1.64 billion respectively. Greenberg lost his job and luckily did not have any criminal charge for his role in the whole scandal. AIG paid $115 million to a pension fund in Louisiana and $725 million to three similar funds in Ohio.
Despite posting the largest ever quarterly loss in the history of $6.17 billion, the company executives paid themselves bonuses over $165 million. The public was outraged as it was taxpayers’ dollars that bailed the company out.
5. Lehman Brothers Scandal (2008)
Lehman Brothers was one of the largest investment banks in the US. The investment bank hid over $50 billion in loans during the 2008 financial crisis and disguised them as sales.
SEC investigation into the bank revealed how it sold toxic assets to banks in Cayman Island with an agreement to pay them back. This move gave the impression that the company had $50 billion in cash more than it did.
The main players in the Lehman Brothers scandal were the bank’s executives and its auditors, Ernst & Young. Lehman Brothers were forced into the largest bankruptcy recorded in U.S history. The SEC could not prosecute the key players because of the absence of substantial evidence.
6. Bernie Madoff Scandal, 2008
Bernie Madoff, an American stockbroker, was the brain behind one of the largest accounting scandals and biggest Ponzi scheme in history. Through his company, Bernard L. Madoff Investment Securities LLC, he scammed investors to the tune of over $64.8 billion.
How did Bernie Madoff carry out this act? Instead of paying investors from the profits of the company, he paid them out of their own money or that of other investors. He got caught when he told his sons about the Ponzi scheme and they informed the SEC.
Madoff was not the only one behind these huge accounting scandals and Ponzi schemes, his accountant David Friehling, and his second in command, Frank DiPascalli assisted him.
The SEC filed charges against him and his two accomplices. They all got prison sentences, with Madoff the ringleader getting a prison sentence of 150 years and a gigantic restitution fine of $170 billion.
The basics of accounting are divided into three categories: the system of record-keeping, transactions, and reporting. Without knowledge of these basics of accounting, business owners will not understand how accounting works.
The first basic of accounting is the system of record keeping. Every business or individual has to set up accounts where it will store financial information. Accounts fall into the following classifications: assets, liabilities, equity, revenue, and expenses.
The second basic of accounting is transactions. It refers to the business’s financial activities (buying and selling). Examples of transactions include purchasing materials and services, selling goods and services to customers, receiving payments from customers, and paying employees.
The third basic of accounting is reporting. After all the business transactions are completed and recorded, the next step is to aggregate the information for reporting. There are three documents used for reporting, and they are collectively called financial statements. They include income statements, balance sheets, and statements of cash flows.
In addition to your accounting degree or certifications, you need to add soft skills for accounting success. They include time management, strong written and oral communication, analytical and problem-solving skills, critical thinking, organization and attention to detail, mathematical and deductive reasoning, adaptability, interpersonal skills, innovation, and integrity.
There are also specialized and technical accounting skills you can learn if you want to major in the field of accounting. They include financial reporting, analysis and account reconciliation, and the use of accounting and accounting-related software.
Some of this software include financial statements and tax preparation software, project management software, database reporting software, enterprise resource planning software, and spreadsheet software.
Accounting is important for investors for several reasons. Companies provide investors with their financial statements which contain the details of the company’s performance in the accounting period.
A basic understanding of accounting will help investors better interpret the document and evaluate the company’s financial health.
Knowledge of accounting helps investors determine a company’s assets’ value, calculate its profitability, and learn how the company finances its operations.
Investors can use their knowledge of accounting to accurately estimate the profits and risks involved. It saves investors from making knee-jerk decisions and helps them understand the full picture of a company’s financial state before investing.
An accountant job can be stressful. When you are in charge of something with a magnitude of importance as a company’s finance, there is bound to be pressure. The cost of you making a mistake can have huge repercussions for the company.
The more accounting tasks you handle and the more important, the more stressed you will be. If not carefully handled, it can harm your health.
Thanks to the influx of accounting software, you can automate many of the recurrent and stressful accounting tasks. This accounting software helps reduce the stress that comes with the job. It saves you time and energy by handling many of your accounting tasks on your behalf.
Accounting certifications are designed to improve the skills and expertise of accountants.
The best accounting certifications recommended for accountants include Certified Public Accountant (CPA) certification, Certified Financial Analyst (CFA) designation, Certified Management Accountant (CMA) certification, Enrolled Agent (EA) Certification, and Certified Internal Auditor (CIA) Certification.