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Running a business

The definition of accounting and how to master the basics

By Ken Boyd

Published on June 13, 20246 min read

Accounting is the process of gathering information on business activities, posting transactions and producing financial statements. And a well-managed accounting system can keep your business running each day.

Accounting functions to keep track of all business transactions, protect assets from loss or theft, and report financial results to stakeholders. Managing a small business is challenging. But if you can produce accurate financial information, you can make better decisions and grow your business.

Why is accounting important for small businesses?

Often, small businesses operate on slim profit margins, and their access to cash may be limited. These businesses have less room for errors, but accounting information can help the business owner stay on track.

You can protect assets from theft

Assets are resources—vehicles, machinery, equipment, etc.—you use to generate sales and profit. As such, businesses must invest in asset purchases and maintenance. Without assets, businesses can’t operate.

Accounting tasks protect assets from loss and theft. A retail store, for example, should perform an inventory count each month. They should confirm that each item in the accounting records is on store shelves. If an item is missing, the owner can investigate quickly.

You can report financial results to stakeholders

Business owners may keep stakeholders informed for a variety of reasons. Stakeholders include employees, investors, creditors, regulators, and suppliers. Investors want to know if the business is generating profit and that the value of the business is increasing. Creditors need to know if the company is generating enough cash to repay a loan. Suppliers want to know if the business will continue to order goods and services and that the business can pay invoices on time. If you can provide reliable financial statements, you’ll maintain good relationships with the stakeholders.

How accounting methods impact business results

The accounting industry maintains generally accepted accounting principles (GAAP) so businesses can produce financial statements comparable to other companies. Your stakeholders expect you to follow the GAAP so that you can compare your results with other businesses in your industry.

Companies can use accrual basis accounting or cash basis accounting. The GAAP require businesses to use the accrual basis because it presents a more accurate picture of the company’s profitability.

Why you should use the accrual method

The accrual method of accounting requires a business to post revenue when they earn it and expenses when they incur them. This method applies the matching principle, which matches revenue with the expenses that relate to the revenue. This method ignores the timing of cash inflows and outflows when computing the profit. Here’s an example that explains the accrual method:

Seaside Home Furnishings builds custom furniture. When a customer orders a dining room table, Seaside tracks the accounting activity related to the sale.

Seaside paid $1,000 cash for the wood, metal and other materials on 30 January.
Seaside paid $600 in cash for labour costs on 20 February.
Seaside shipped the completed table on 5 March, and the customer paid the retail price of $2,300 on 5 March.

Using the accrual method of accounting, Seaside posted revenue of $2,300 on 5 March, along with the material and labour costs. The revenue matches the expenses incurred, generating a $700 profit.

Seaside can calculate the profit accurately because the timing of the costs is not important. It’s more important to match the revenue with the expenses incurred to generate the revenue.

On the other hand, the cash basis method distorts a business’s true profit.

Why cash basis accounting can be misleading

What if you used your chequebook activity to post your revenue and expenses? When a client pays you cash, you increase your revenue. And you post expenses when you pay cash.

That’s how the cash basis method works. Using the dining table example, Seaside would post the material expenses in January, wage expenses in February, and revenue in March. And they would base each transaction on the cash inflow or outflow. The cash basis wouldn’t match the revenue with the related expenses. As a result, the business owner wouldn’t know their true profit from that sale.

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How to use the accounting cycle to create financial statements

The accounting cycle represents the tasks that a business must perform to post transactions into the accounting records and generate accurate financial statements. The accounting cycle has six parts.

A source document: a source document is generated when an event happens in your business. Source documents include purchase receipts and client invoices.
A financial impact: accountants or business owners can decide how the event impacts their accounting records. For example, if a business owner purchases $3,000 of inventory with cash, the inventory account increases and cash decreases.
A journal entry: the accountant or business owner records the event using a journal entry.
A general ledger: the general ledger is a record of every transaction an accountant or business owner posts to the accounting records. Review the general ledger frequently to verify that you posted transactions correctly.
A trial balance: the trial balance lists each account and the current account balances. After reviewing the general ledger, the accountant generates a trial balance.
A financial statement: accountants or business owners use the trial balance to generate financial statements like balance sheets, income statements and cash flow statements.

How accountants differ from bookkeepers

A bookkeeper handles the most basic accounting tasks for a business. They gather source documents and post transactions into the accounting system. But they can perform additional tasks to keep a business running smoothly. For example, a bookkeeper can monitor the accounts receivable balance and help manage cash collections.

Accountants, on the other hand, review the bookkeeper’s work and post any necessary adjustments to the financial statements. They generate the trial balance and produce financial statements.

When someone opens a business, they may take on all accounting responsibilities. As the number of accounting transactions increases, the owner may hire a bookkeeper and act as the accountant. Eventually, the owner may hire a full-time accountant.

How financial statements can help you make better business decisions

Business owners use financial statements to make better business decisions. If a business owner is considering a business loan, a new product line or an expensive piece of equipment, they may analyse their financial statements.

Business owners should generate a balance sheet, income statement and statement of cash flows at the end of each month.

Balance sheets monitor assets and liabilities

The balance sheet summarises a company’s financial position as of a specific date. It’s a financial statement that subtracts assets from liabilities to determine equity:

Assets – liabilities = equity

Imagine that you sell all of your business’s assets for cash. Then you use the cash to pay off all of your accounts payable balances and your long-term debts. Any cash remaining is your equity, which is the true value of your business.

Income statements assess profitability

An income statement reports a business’s profit or loss over time—typically, a month or year. It’s a financial statement that subtracts revenue from expenses to determine net income or profit:

Revenue – expenses = net income

Net income increases equity in the balance sheet. Many business owners focus on the balance sheet and income statements. But the cash flow statement is equally important.

Cash flow statements show cash generated for business operations

The statement of cash flows reports the cash inflows and outflows over time. Accountants or business owners can separate cash flow into three activities: operating, investing and financing. The ending balance in the cash flow statement must equal the cash balance in the balance sheet.

Make decisions that help your business grow

If you set up an effective accounting process and understand the basics, you’ll produce useful information that you can analyse quickly. Use the financial statements to make more informed decisions and to grow your business.

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