What Is Accounting? the Basics, Explained
Accounting is the process of recording, cataloging, analyzing and reporting a company’s financial transactions. Proper accounting allows a company’s management to better understand the financials of its business. This is so they can strategically plan its future expenditures in order to maximize profit.
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NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.
What Are Accounting Principles?
Accounting principles are the rules and regulations companies are required to follow when creating their financial statements.
In the United States, these rules are set by GAAP. GAAP stands for “Generally Accepted Accounting Principles”.
GAAP was designed so that all businesses have the same set of rules to follow. GAAP defines accounting terms, assumptions and methods and sets policy for a wide array of topics, from assets and liabilities to foreign currency and financial statement presentation. This standardization makes it much easier for business owners, investors and government agencies to understand financial statements.
Most other countries, including Canada, Australia and Mexico, follow the rules set down by the IFRS (International Financial Reporting Standards) Foundation, which is headquartered in London, England.
For years, there has been a push to move the United States to follow IFRS, as IFRS is generally considered to be a better system than GAAP. This may have to do with the fact that the IFRS is more ‘principles-based’, while GAAP is more ‘rules-based’. However, progress is slow on that end and the transition may never happen.
What Is the Importance of Accounting?
The process of financial accounting is important because it deals directly with a company’s money, specifically all the expenses and income related to its day to day business operations and investments. That information can be recorded incorrectly, not at all, or improperly catalogued.
Every transaction needs to be recorded and accounted for properly so that a company’s financial statements are accurate. If not, a company could think it has more or less cash flow, or profits, than it actually has. Inaccurate reporting may later lead to serious problems for a company, meaning it may not be able to pay its debts, or money set aside for investing is not available.
Inaccurate reporting can also result in legal problems with external parties, such as investors or the IRS (Internal Revenue Service).
Where Do Accountants Work?
Accountants work for companies in every industry, enjoying careers at small businesses all the way up to very large companies. Most companies would not be able to operate without an accountant, as it’s an accountant’s job to report through financial statements the company’s economic health. Only through these financial statements can a company’s management make informed decisions about how to properly allocate resources to projects, by directing how to spend or invest the company’s money.
Accountants can also work for themselves, setting up their own small business and freelancing their services out. Technology in the form of accounting software and accounting apps makes it easier today for many small businesses to do their own accounting, however there is the human part of the equation to consider too, as the interpretation of the data often calls for a professional. There are no legal requirements or tests you must pass to call yourself an accountant, but ideally you would have an accounting degree from a recognized institution, and some work experience.
A CPA, or “Certified Public Accountant”, is recognized in the accounting field. It is a designation that is considered challenging to obtain, with exact requirements varying from state to state. All states do require the undertaking of a four-part exam. However, upon receiving the designation, a CPA is considered an expert in the field of accounting, and would typically enjoy a much higher salary than that of an accountant. For a breakdown on the differences between an accountant and a CPA, check out “Is a CPA the Same as an Accountant?”.
What Are the Three Types of Accounts?
Accountants deal with three types of accounts, when recording transactions:
Real accounts are all the assets of a company, plus liability and equity accounts. Here is a breakdown:
Assets - Tangible Items
Items you can actually touch, such as cash, inventory, equipment, land or a building.
Assets - Intangible Items
Items with no physical presence, such as stocks and bonds, patents and trademarks.
Liabilities deal with what the company owes, such as accounts payable, loans payable, mortgages and payroll.
Equity accounts deal with income or expenses not directly related to the products or services it provides, such as stocks or retained earnings (money to be invested back into a business).
Real accounts are permanent accounts, they are recorded in the balance sheet and are not closed at the end of an accounting year.
There are 3 types of personal accounts. Personal accounts represent people or companies:
Transactions with people.
Transactions with businesses, corporations or institutions.
Indirect transactions, such as staff owed wages paid through another company.
These are accounts related to a company’s expenses, losses, income or gains. Nominal accounts are considered to be temporary, they are reflected on a company’s income statement as net profit or loss, and are closed at the end of every fiscal year.
What Are the Golden Rules of Accounting?
The “Golden Rules of Accounting” are also referred to as the “3 Golden Rules of Accounting”. They relate specifically to the types of accounts listed above, and how transactions in these accounts are debited and credited.
Debits and credits are used in a company’s bookkeeping in order for its books to balance. Debits and credits are the very basics of accounting. They work like this: when recording a transaction, every debit entry must have a corresponding credit entry for the same dollar amount, or vice-versa. In this way, debits and credits balance each other out.
The golden rules help people to understand how debits and credits are applied to the three types of accounts.
The rules are:
Debit What Comes In, Credit What Goes Out (Real Accounts)
This rule is applicable to the assets of a business, such as cash, land, building, equipment, furniture, etc.
Debit the Receiver, Credit the Giver (Personal Accounts)
This rule is applicable to transactions involving people or businesses, for instance, a bank transaction.
Debit All Expenses and Losses, Credit All Income and Gains (Nominal Accounts)
This rule applies to expenses and income such as salaries, sales, purchases and commissions.