What is accounting: Types, examples, and FAQs

Whether you run a small business or an enterprise, accounting plays a key role in financial management. With accounting skills, you can set a budget, optimize tax returns, or forecast trends. Still, even after learning what an accountant does, you might still wonder what accounting is at its core. 

Anyone who maintains financial statements, files taxes, or manages spending becomes familiar with some form of accounting. To help manage your business finances, we'll explain accounting types, tasks, and frequently asked questions. 

You can read the entire article or jump to a section below:

• Accounting definition
• 4 main types of accounting
• Overview of how accounting works
• Examples of accounting tasks
• Common accounting FAQs
• Accounting for small business success

Accounting definition

Accounting is the process of recording, analyzing, and reporting financial transactions. Typically, accountants record transactions as journal entries in ledgers. By reviewing these entries, they can gauge a business’s financial health. While no definition of accounting sums up every task in a few sentences, it plays a vital role in:

• Business management
• Payroll laws and regulation
• Tax collection
• Personal finances

Why is accounting important?

Accounting helps businesses manage their finances and grow their accounts. Organized financial data guides leaders' decisions and priorities. Additionally, accounting helps chart a business’ growth and predict downturns. Finally, accountants help companies stay compliant with regulators and the IRS.

While anyone can improve their finances with accounting skills, businesses need them to expand. Accounting assists with:

• Business growth: Accountants shape financial decisions that lead to growth over time.
• Tax filing: Tax accountants file taxes, earn deductions, and dodge penalties. 
• Funding: Accounting sums up data that can attract funding from investors. 
• Payment management: Accountants organize transactions to track earnings and debts.
• Performance assessment: Financial statements reveal a company’s financial health.
• Financial projections: Accountants forecast economic changes affecting a business. 
• Legal compliance: Public companies must provide financial statements to regulators. 

Who needs an accountant or accounting department?

Any business looking for long-term growth needs an accountant. Not only will they manage tax payments and financial reports, but they also help meet legal requirements and sustain growth over time. Small businesses may roll their accountant and bookkeeper into one role with You can frame the difference between a bookkeeper vs. an accountant as:

1. Bookkeepers record day-to-day transactions.
2. Accountants organize this information into extensive reports and tax filings.

Enterprises and large corporations need an accounting department. Operating across states and offices calls for more financial insight. While a department isn't cheap, you can see a return on investment over time. 

Note: Live bookkeeping software can boost your staff’s productivity and help combine bookkeepers and accountants into one role.

Overview of how accounting works

A business’s financial well-being depends on accounting. To ensure the best performance, accountants adhere to standardized rules. Accounting success relies on generally accepted accounting principles (GAAP), up-to-date statements, and the accounting cycle. 

1. Use generally accepted accounting principles

Accountants follow GAAP when writing financial statements. GAAP outlines a set of principles to ensure consistency in reporting. It’s built on the foundation of double-entry accounting, a system in which you record each transaction in two book entries. The entries must equal one another for balanced books.

Double-entry accounting follows the principle that assets = liabilities + owners' equity. These accounts balance with journal entries that credit one account and debit another. Think of debits and credits like this:

• Debit entries increase asset and expense accounts.
• Credit entries increase liability and revenue accounts.

Beyond double-entry accounting, GAAP consists of four principles:

Historical cost principle

Businesses report assets and liabilities at the cost they paid to acquire them. On one hand, businesses may prefer to report at the market rate because that reflects current value. However, market rate can change and make an unreliable record. So, this principle ensures a consistent financial record. 

Revenue recognition principle

Businesses record revenue upon earning it, not receiving it. In many cases, an exchange of money and services won't occur at once. Revenue recognition organizes transactions to avoid confusion over this. 

For example, a supplier records revenue after sending goods and invoices to clients. This way, even if they aren’t paid at once, they can plan around incoming revenue. This principle forms the basis of accrual accounting, which involves:

• Accrued revenue: Income you earned but haven’t received. 
• Accrued expenses: Money you owe but still need to pay. 

Matching principle

In reporting, expenses match the revenue they generate. Instead of tying expenses to a product or service you offered, tie them into their return on investment. This principle highlights profitability over the rate of production. 

Note: If you can’t connect expenses with any revenue, you can charge costs to the current accounting period. 

Full disclosure principle

You must report all relevant information about your financial statements when sharing them. This way, readers aren’t misled by a lack of context. The full disclosure principle builds trust between a business and its shareholders, lenders, and partners. 

Other accounting guidelines

While GAAP covers most transactions in the US, it isn't the only rule set. Depending on their specialization, accountants may follow the:

• Internal Revenue Code (IRC): Federal tax guidelines issued by the IRS. Tax accountants follow these rules when managing federal returns. 
• International Financial Reporting Standards (IFRS): Accounting rules set by the International Accounting Standards Board. US businesses working overseas follow these guidelines.

2. Follow the standard accounting cycle

Accountants follow a standardized accounting cycle. This cycle organizes tasks into repeatable steps. This way, if you hire a new accountant, they’re familiar with their core tasks and workflow. The accounting cycle includes eight steps:

1. Identifying transactions: Collect details about the transactions in an accounting period. Note sales, payments, refunds, and other bookkeeping events.
2. Recording transactions: Record your transactions as journal entries. You record entries after making a sale or receiving an invoice. 
3. Posting transactions: Post journal entries to your general ledger. This ledger will break down all activities by account. 
4. Listing an unadjusted trial balance: Calculate a trial balance to ensure your credit and debit equal one another. 
5. Analyzing worksheets: Identify journal entries on your worksheet to find errors. If debits and credits aren’t equal, find the source of the mismatch.
6. Adjusting journal entries: Adjust your journal entries to remove errors and balance accounts. 
7. Generating financial statements: Create balance sheets, income statements, and cash flow reports based on the corrected ledger. 
8. Closing the books: Finalize revenue, expenses, and temporary accounts at the end of the period. 

3. Keep accounting documents up to date

Financial statements record your business's performance over time. Accountants update these forms to measure profitability or predict budgetary issues. Accurate reports let leadership and investors gauge a company's financial health. The main accounting documents include: 

• Balance sheets
• Income statements
• Cash flow statements
• Aging reports

4 main types of accounting (and some others)

The four main types of accounting are financial, managerial, tax, and cash accounting. Accountants typically have specialties you can’t boil down into a single category. Finding an accountant suited to your business needs will offer the highest ROI. To recap, the main accounting specialties include:

Financial accounting

Financial accountants review the performance of a business. You conduct this type of accounting by writing financial statements on transactions from a given period. These include:

• Income statements: A form highlighting income and expenses in a given period. 
• Balance sheets: A summary of a company’s assets, liabilities, and equity. 
• Cash flow statements: A document showing how income flows in and out of a business. 
• Aging reports: A form compiling debts owed to your business. 

Financial accounting keeps businesses transparent about their overall health. Investors review financial accounting statements to gauge their ROI. Auditors assess these forms to make sure businesses stay compliant. 

Managerial accounting

Managerial accountants create financial data for business leaders. This field covers a lot of the same ground as financial accounting. However, managerial accountants use this data for different ends. For example, they might recommend an online payroll service to cut overhead costs.

Business leaders rely on managerial accounting to make financial decisions. Specifically, these accountants guide:

• Financial forecasting
• Budgetary choices
• Product costs and their ideal ROI
• Investments in other companies

Tax accounting

Tax accountants minimize tax liability and keep you compliant with the IRS. Many businesses have to juggle quarterly and annual tax forms, and a tax accountant helps streamline these payments. Additionally, tax accountants avert IRS penalties and find deductions that save money. 

Note: Tax accountants have to juggle federal and state taxes. As a result, they may rely on different rulesets in each context.

Cost accounting

Cost accountants assess the expenses from running your business. Cost accounting tallies the charges from offering products and services. By keeping costs low, you can improve your financial health. Cost accounting may cover:

• Direct expenses: The cost of providing a specific product or service. 
• Indirect expenses: The general cost of running a business. 
• Fixed costs: Expenses that remain stable regardless of business activity. 
• Variable costs: Expenses that change based on business output. 

Note: Cost accounting is most common in manufacturing and service industries. However, all companies can benefit from cutting unnecessary charges.

Other types of accounting

Accountants can specialize in niche fields outside the four main categories. While less common, they still provide valuable services. The other types of accounting include:

• Forensic accounting: Monitoring transactions to investigate an entity. 
• Governmental accounting: Organizing funding and payments for government programs.
• Fund accounting: Tracking the money spent by non-profit organizations. 
• Auditing: Investigation of a business’s financial statements. 
• Accounting information systems: Systemizing financial reports' storage, retrieval, and use.
• Fiduciary accounting: Reporting on the activity of an estate or trust.

Examples of accounting tasks

After learning what accounting is and how it works, you can focus on accounting tasks. Each business hires accountants to meet its specific needs. While accounting software can streamline these tasks, a trusted expert will help you go the extra mile. We’ll break down a few standard accounting functions below:

Cash flow management

Accountants manage the flow of money in and out of your business. This complete financial picture simplifies reporting and decision-making. At its core, cash flows ensure more money goes into a business than it spends. As such, a healthy cash flow will keep your business in good standing. 

Cash flow software will help accountants go the extra mile. With extra tools and reports, your staff can assess cash flow in greater detail.

Financial forecasting

Even in stable markets, businesses need to plan ahead. Accountants can identify new opportunities or potential issues with forecasting. Small businesses depend on consistent performance to grow. With these forecasts, accountants lay out scenarios management can plan for. Proactive financial forecasting can:

• Reduce risk
• Prepare for future expenses
• Attract new investors
• Diagnose business problems
• Prove your profit model’s viability

Bill and invoice tracking

Hiring an accountant to manage bills and expenses will improve your bottom line. You can’t run a business without incurring a few expenses. An accountant can organize what you owe, ensure fast payments, and track expenses before they grow out of hand. 

On the flip side, accountants use invoicing software to help you get paid. Accountants can write custom invoices for different clients. With their oversight, cash will steadily flow in. 

Tax management

Effective IRS filing can make or break a business. By hiring a tax accountant, you can:

• Streamline filing
• Find new tax deductions
• Prevent mistakes that lead to audits
• Navigate federal and state tax policies

While many large businesses hire full-time tax accountants, small businesses don’t have to. You can work with a tax accountant during filing seasons to minimize costs. This small investment can pay for itself and impart valuable tax insights.

Gauging financial health with accounting ratios

Businesses rely on accounting ratios to measure their performance. While some ratios measure overall financial health, some focus on more minute details. Accountants run financial ratios to diagnose problems and suggest operational changes. The main ratios include: 

• Current ratio = current assets / current liabilities. The current ratio reveals if a business can meet its short-term obligations. 
• Quick ratio = (cash + securities + accounts receivable) / liabilities. Sometimes called the acid test ratio, this formula determines if a business can immediately pay off its debts. 
• Gross margin ratio = (net sales – the cost of goods sold) / net sales. This ratio compares revenue to the direct cost of selling a product or service.
• Debt to asset ratio = total debts / total assets. This ratio shows the relative proportions of your debts to assets. 
• Asset turnover ratio = net sales / average total assets. Asset turnover measures the efficiency with which your assets generate revenue.

Common accounting FAQs

Still have a few accounting questions? To help you out, we’ve answered a few common accounting FAQs. 

What is the difference between bookkeeping vs. accounting?

Bookkeeping records individual transactions while accountants report on the bigger financial picture. Accountants and bookkeepers use many of the same skills. They work together in a streamlined process where bookkeepers prepare financial data and accountants compile it into reports. 

Because their work is related, there’s no opposition between bookkeeping vs. accounting. In fact, many accountants perform bookkeeping tasks. These accountants can use bookkeeping software to save time.

What’s the cash method of accounting vs. the accrual method?

Cash accounting records transactions when money changes hands, but accrual accounting records income and expenses when they get incurred. As a result, cash-based accounting is more common. However, accrued accounting plays a vital role in some transactions. For example:

• Exchanging money for goods at a store is a cash expense. A bookkeeper can record the payment in real time. 
• If you order goods and receive an invoice, that’s an accrued expense. A bookkeeper will note what you owe before the payment comes in. 

Accrued accounting covers more complex transactions. It tracks what you owe and earn based on services tendered. While accrued accounting is more complicated, it paints an accurate picture of finances long-term.

How do you become an accountant?

There are no hard and fast legal requirements to become an accountant. Anyone with the right skills, training, or education can take on the job. That said, most employers prefer candidates with a degree in business, accounting, or economics. 

Earning a certified public accountant (CPA) license involves a few mandatory steps. Each state sets its requirements, but they usually cover: 

• Education: Most states require a bachelor’s degree in a relevant field.
• Work Experience: Obtain at least two years of public accounting experience.
• Examination: Pass all four sections of the CPA exam. 

What are the golden rules in accounting?

Accounting has three golden rules:

1. In nominal accounts: Debit all expenses and credit all income.
2. In a transaction: Debit the receiver and credit the provider.
3. In real accounts: Debit what comes in and credit what goes out.

At a glance, different types of accounts may look the same. In actuality, you can thank these rules for accounting consistency. Following these guidelines will ensure standardized bookkeeping.

Accounting for small business success

So, what is accounting at the end of the day? At its core, accounting is a money-management process that tracks and records expenses. Accountants analyze the flow of cash through your business to improve operations. A great accountant can improve profitability just by managing your finances.

Whether you’re looking to hire accountants or give them more tools, accounting software can help. These tools speed up report generation, tax filing, and payment management. With this software handling rote work, accountants can focus on their most important tasks.