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What is Accounting?
Accounting is a process of accumulating, summarizing and communicating financial
information. Financial information can be of different types and serve different purposes,
but it all comes from the same function – accounting.

Types of Accounting
Accounting provides information to several groups of people and for different purposes.
As a result, there are several kinds of accounting:

 Financial accounting provides information to external users. Such external users

can be investors, creditors, banks, regulatory bodies (i.e., Securities and Exchange
Commission, Internal Revenue Service, etc.). The information is usually in the
form of financial statements (see more on the financial statements below).

 Managerial accounting provides information to internal users. Such internal

users include a company’s managers and employees. The information
accumulated and presented by managerial accounting function includes sales
figures, gross margin analysis, cost information broken down by product line, etc.
As a rule, managerial accounting information provides more detail than the
financial accounting information and sometimes includes confidential data not
available to external users.

 Tax accounting can be distinguished as another kind. Tax accounting deals

mainly with calculation of taxes (i.e., income taxes, sales and use taxes, etc.).
Because rules regulating calculation of taxes are different from those governing
financial statements preparation and presentation, tax accounting should be
performed separately and in parallel to financial and managerial accounting.
Usually, there is a tax department with a company that deals with tax accounting,
but works closely with the financial accounting department.

See more on Accounting.

Cash vs. Accrual Accounting

Two approaches to recording accounting events and transactions exist.

One approach is based on cash flows and therefore called cash-basis accounting. Cash
basis accounting implies that any transaction should be recorded in accounting records
when cash movement (i.e., payment or receipt) takes place. For example, when a
company sells a product on account, no transaction is recorded in accounting books.
Only when cash is received from the customer, will the company record the sales
transaction. Cash-basis accounting is not permitted under the US Generally Accepted
Accounting Standards (US GAAP), which are rules for financial accounting and
reporting. However, cash-basis accounting is generally permitted by the Internal
Revenue Service for tax accounting purposes (with some exceptions which are beyond
this introductory accounting lecture).

The other approach is based on the time a transaction takes place regardless of when cash
related to the transaction is exchanged. This approach is called accrual-basis
accounting. Returning to the example of a sales transaction, the revenue will be
recognized by the company when the goods are delivered to the customer and not when
the customer pays for the goods. The accrual-basis accounting is required by the US
GAAP in preparing financial statements.

T-Accounts, Debits, Credits and Journals

All transactions are recorded in accounts. Accounts have three parts – header, left side
and right side. Because the accounts resemble the letter T, they are called T-accounts.
The left side of a T-account is called debit and the right side is called credit.

T-accounts are sometimes drawn to understand the relationship between different

accounts. Most of the time, however, accounting information is posted directly to
accounting journals that accumulate information about specific types of transactions. For
example, a journal where all sales are recorded is called a sales journal.

See more on T-Accounts, Debits, and Credits.

Bookkeeping, Accounting, and Financial Statements

The accounting process starts when transactions are posted to the accounting records
called journals. The recording process may be manual or automated.

The manual process means that a bookkeeper records transactions into paper journals as
they occur or at the end of a day, week, or month, depending on frequency. The manual
process is not used widely any more.

The automated process involves use of the accounting software, where a bookkeeper
can enter all transactions, again daily, weekly, and monthly or as needed. Due to the
efficiency increase with the automated process, it is the most used nowadays.

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The process of entering the transactions into journals (whether on paper or in accounting
software) represents bookkeeping.

The next step in the process is summarization and presentation of the financial
information. Again, this may be completed manually or automatically with help of
accounting applications. This process is known as accounting.
Note that there is no definite separating line between bookkeeping and accounting.
Bookkeeping mostly relates to entering and recording transactions, while accounting
means preparing the information for presentation of financial statements or other reports.

Once all transactions for a period have been posted, the financial statements are prepared.
There are four basic financial statements in financial accounting (in the order of
preparation):

 Income Statement (Profit and Loss Statement)

 Equity Statement (Statement of Owners’ Equity)
 Balance Sheet (Statement of Financial Position)
 Cash Flow Statement (Statement of Cash Flows)

The Income Statement shows the profit or loss for the period. It includes revenues and
expenses, which provide the net result for the period. This statement is prepared for the
period, meaning it includes all transactions that took place during the period.

The Equity Statement shows the capital and other equity accounts of the company and
how such accounts changed during the period.

The Balance Sheet shows the company’s assets, liabilities and equity as of the end of the
period. This statement is prepared as of a date, and not for the period, like the Income
Statement.

The Cash Flow Statement shows the cash movements during the period. Such cash
movements include all cash receipts and expenditures.

Accounting for Small Businesses

Accounting for small businesses has its peculiarities. Due to the small size of such
companies, there may only be one or several people in the accounting department.
Therefore, the same people can deal with financial, managerial and tax accounting. In
addition, most small businesses don’t have complicated transactions that occur in larger
public companies, such as transactions related to stock options accounting, accounting for
derivatives, etc.

The best way to maintain accounting records in a small business is to use one of the
accounting packages available in the market. For example, QuickBooks and MS
Accounting are the ones I can recommend. Somebody in the company can take care of
the entire bookkeeping > accounting > financial statements process. Alternatively, the
bookkeeping can be performed in-house by the owner(s) or employees, while accounting
and financial statements preparation can be outsourced to a CPA who will perform such
work for a reasonable fee.

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