The first step to understanding accounting is to understand what it is and how it works. You may think its maintaining receipts, using an accounting software, or writing transactions down in a paper ledger. All ideas are correct, but they are not the full picture.
Accounting is the process of recording all financial transaction to a general ledger. This can be done in an accounting software or in a general ledger book. A general ledger is a list of accounts, called the chart of accounts, with a dollar balance. The chart of accounts should be tailored to fit your normal business activities. Some accounts, such as advertising, are common for nearly every firm. Other accounts depend on the type of business you are in and your own preferences for financial reporting.
For example, say you are in construction and you spend a lot of money on concrete, you may want a concrete account so you can more closely track what you spend on concrete. If you were to put it into a standard supplies and materials then it would be mixed with all other supplies and materials the business uses and thus would be harder to track. Customizing the chart of accounts is critical to effectively managing your business because it determines how the business’s activities will be reported on the financial statements.
The next step in accounting is to review that all data was recorded into the correct account and in a consistent manner. After the review the accountant should perform reconciliations on key accounts, like the bank account, credit card accounts, and any other accounts management deems to be very important. A reconciliation is comparing the beginning balance, activity, and ending balance to a third-party statement, like a bank statement. After the reconciliations and any adjustments are made, the accountant may choose to review the data again.
Once all transactions are entered in the general ledger and the key accounts are reconciled, you can produce financial statements. The standard statements are the Income Statement, Balance Sheet, Cash Flow Statement, Statement of Owners Equity. In subsequent articles we will discuss each statement in depth. The financial statements are where the real power lies. They are a reflection of all business activities and thus allow management to analyze performance and identify issues and opportunities.
Accounting is an ongoing process. The books can be updated as frequently as daily or infrequently as annually. In general, it is the best practice to update the accounting transactions weekly and produce monthly financial statements. For key accounts a business owner may want to review reports on them weekly.
You may wonder if you need an accountant or a bookkeeper. The two roles are very similar, almost synonymous. However, a bookkeeper is a limited role. All accountants can do bookkeeping, but not all bookkeepers are accountants. Bookkeeping at its core is data entry. Accountants can provide a wider range of services like financial analysis and tax strategizing. If s/he is a CPA, they can also provide assurance if you need to get a loan and tax preparation services. That said, there are very talented bookkeepers and some charge more than a CPA for their services.
In summary, accounting is organizing and maintaining your business financials. I recommend using an accounting software, such as QuickBooks Online, because it can automate a lot of the data entry, easier to review, and compile financial statements. It is the best practice to update your books weekly, or at the least monthly. A bookkeeper or accountant can perform these functions, and I strongly suggest contracting or hiring one so that you can focus on what you are in business to do.
Thanks for joining me for this segment of accounting 101. Next we will start learning the terminology, principles, and various frameworks.