Accounting — often called the language of business — is the process of recording, classifying, reporting and analyzing financial data. And while the accounting requirements of every business vary, all organizations need a way to keep track of their money.
Unfortunately, there's very little that's intuitive about accounting. Many small businesses hire accountants to set up and keep their books. Other companies use accounting software like QuickBooks, CheckMark Multi-Ledger and M.Y.O.B. Accounting and keep their accounting functions in house.
It's All about Balance
Using a system of debits and credits, called double-entry accounting, accountants use a general ledger to track money as it flows in and out of a business. They record each financial transaction on a balance sheet, which provides a snapshot of a business's financial condition. Accountants record every financial transaction in a way that keeps the following equation balanced:
Assets = Liabilities + Owner's Equity (Capital)
The Accounting Cycle
Accounting is based on the periodic reporting of financial data. The basic accounting cycle includes:
- Recording business transactions. Businesses keep a daily record of transactions in sales journals, cash-receipt journals or cash-disbursement journals.
- Posting debits and credits to a general ledger. A general ledger is a summary of all business journals. An up-to-date general ledger shows current information about accounts payable, accounts receivable, owners' equity and other accounts.
- Making adjustments to the general ledger. General-ledger adjustments let businesses account for items that don't get recorded in daily journals, such as bad debts, and accrued interest or taxes. By adjusting entries, businesses can match revenues with expenses within each accounting period.
- Closing the books. After all revenues and expenses are accounted for, any net profit gets posted in the owners' equity account. Revenue and expense accounts are always brought to a zero balance before a new accounting cycle begins.
- Preparing financial statements. At the end of a period, businesses prepare financial reports — income statements, statements of capital, balance sheets, cash-flow statements and other reports — that summarize all of the financial activity for that period.
The Importance of Financial Statements
At the end of a period — either annually or more frequently, depending on the length of a business's accounting cycle — accountants create financial statements that show the financial health (or decline) of a business.
Many people inside and outside a company use the information found in financial statements. Business owners and managers use the data in financial statements to chart the course of their companies, project revenues and expenses, monitor cash flow, keep tabs on costs and plan for the future. Present and prospective employees also want to see their employers' financial performance.
Stockholders and investors closely examine financial statements to check a company's performance. They want to compare a business's financial statements with those of other companies to guide their investment choices. Bankers look at a company's most recent financial statements when they make lending decisions.
Financial statements also make it easier to for accountants to prepare tax returns and report financial information to the Internal Revenue Service. In fact, so many business partners, investors, and other interested parties rely on your these documents that it's important to get a handle on all the common financial reports your business will be expected to produce.