Accounting 101: A Beginner’s Guide to Accounting Basics

Accounting is the foundation of financial health for every business. Without it, your business could experience numerous financial problems, including losing money, failing to repay debts, exceeding budgets, and disappointing your investors.

To succeed in business, it’s essential to understand the importance of healthy accounting practices and take them seriously. Otherwise, the consequences can be dire.

In this article, we’ll discuss what accounting is, why accounting matters for businesses of all sizes, and the accounting basics you should know. We’ll also explore the best accounting software and how you can utilize it in your business.

Key Takeaways

  • The purpose of accounting is to provide relevant and useful information about the financial performance of companies, nonprofits, governments, and even individuals.
  • Accounting produces three major financial statements: the income statement, the balance sheet, and the statement of cash flows.
  • Accounting is regulated by the Financial Accounting Standards Board (FASB) in the US and the International Accounting Standards Board (IASB) globally.
  • Every business uses accounting in some form, whether it’s simple bookkeeping or complex financial accounting.

What Is Accounting?

You’ve probably heard about accounting in some form or another during your life. But do you understand how it works?

Accounting is the process of recording and summarizing financial transactions related to a business, nonprofit, or government. The purpose is to provide relevant and useful information relating to the organization’s financial performance. Standardized accounting is the foundation of financial markets around the world, and without it, financial markets would collapse.

Accounting produces three major financial statements: the income statement (also referred to as a profit and loss statement), the balance sheet, and the statement of cash flows.

Investors and banks use these financial statements to make investment decisions. Similarly, executives and the board of directors use these statements to make decisions about their organization’s future.

Every business needs to understand the basics of accounting to some degree (whether they want to or not). Familiarizing yourself with accounting basics will help you understand the financial health of your business and how you can best utilize your financial resources.

Common Accounting Terms

There are several simple, foundational accounting terms that all business owners should seek to understand.

You’ll encounter these terms often in your business, as well as when you’re investing in the stock market. You can use these terms to organize your financial transactions into different accounts, plus they’ll help you gain a better understanding of your financial performance and current financial position.

Term Description Examples
Revenue Revenue (also known as income) is the money received by a business from selling goods or services. Sales of products or services, interest income, dividend income, and capital gains.
Expenses Expenses are the costs incurred by a business to generate revenue. Cost of goods sold (COGS), rent, salaries, utilities, office expenses, supplies, interest expense, dividend expense, depreciation, and taxes.
Assets Assets are the resources owned by a business that have economic or monetary value. Assets can be either tangible or intangible. Tangible assets include cash, accounts receivable, inventory, property, equipment, office supplies, and vehicles. Intangible assets include intellectual property, software, and brand value.
Liabilities Liabilities are the debts or financial obligations owed by a business to others. Liabilities can be either short-term (due less than a year) or long-term (due in a year or more). Short-term liabilities include accounts payable and accrued expenses. Long-term liabilities include loans and mortgages.
Equity Equity is the owner’s claim on the assets of a business after liabilities are subtracted. It represents the net worth of the business. Equity that stays in the business (and is not removed as dividends) is called “retained earnings.” Investments by founders, shares purchased on the stock market, and retained earnings.
Accounts Receivable (A/R) Money owed to your business by customers for goods or services already provided but not yet paid for. Accounts receivable covers all sales that the customer hasn’t paid off yet, including sales on credit and payments due in the future (see Net X).
Accounts Payable (A/P) Money your business owes to suppliers or vendors for goods or services you’ve already received but haven’t paid for yet. Accounts payable covers all supply or inventory purchases that you haven’t paid off yet, including purchases on credit and those due in the future (see Net X).
Net X e.g. 10, 15, 30, or 60 Used to specify that the full payment is due within 10, 15, 30, or 60 days after the invoice date. Allows buyers to purchase goods or services on account without immediate payment. If an invoice is issued with Net 30 terms on April 1st, the payment from the customer is expected by April 30th. Similarly, for Net 60 terms issued on the same date, payment would be due by May 30th.

Bookkeeping and Accounting

Accounting and bookkeeping, while often used interchangeably, are distinct roles with different focuses within the financial world.

Every business needs someone to act as a bookkeeper, and the larger or more complex a business becomes, the more likely they are to need accounting services as well.

Here’s a breakdown of the key differences between bookkeepers and accountants:

Bookkeeping

  • Focus: Recording and organizing financial transactions.
  • Responsibilities: Collect financial data, enter it into accounting software, and produce basic financial reports. Bookkeepers are also often responsible for reconciling bank statements, managing accounts payable and receivable, and some payroll tasks.
  • Education/Certification: Professional bookkeepers typically must undergo some form of vocational training or an associate’s degree. Bookkeepers can also earn certifications and become Certified Bookkeepers (CB) or Certified Public Bookkeepers (CPB).
  • Who can perform this work? Anyone can perform bookkeeping tasks—no certification is required for small businesses. Education and certifications are typically only required if someone wants to become a professional bookkeeper for hire.

Accounting

  • Focus: Analyzing and interpreting financial data and preparing complex financial reports and financial statements.
  • Responsibilities: Analyzing financial performance, budgeting and forecasting, tax planning, regulatory compliance, and preparation of financial records.
  • Education/Certification: Accounting experts are required to have a bachelor’s degree in accounting and must be either an Enrolled Agent (EA) or a Certified Public Accountant (CPA).
  • Who can perform this work? Anyone can perform the accounting functions for their own small business. However, if a business is publicly traded, its accountant(s) must have a bachelor’s degree and be either an EA or a CPA. Similarly, if someone wants to become a professional accountant for hire, they must have a bachelor’s degree and be either an EA or CPA. In addition, if your business has loans from a bank, they might require you to hire an EA or CPA to produce professional financial statements as part of the loan agreement.

Both bookkeeping and accounting are important parts of smooth functioning businesses. They play significant roles in helping businesses understand their financial performance and position, which results in better financial decision-making. But not all accounting is the same—let’s explore the two main types below.

Types of Accounting

There are two major types of accounting: financial accounting and managerial accounting. Financial accounting is the one people interact with when they invest in the stock market, while managerial accounting is only used by an organization’s internal decision-makers.

Both are important, but they differ in terms of the information they provide, their target audience, and how (or if) they’re regulated.

Financial Accounting

Financial accounting is the most well-known and widely used form of accounting. Everyone who invests in stock markets or bond markets utilizes financial accounting information at some point. This type of accounting produces the standardized and regulated financial statements that we’re used to seeing, allowing the entire financial market to function smoothly.

Let’s take a closer look at financial accounting:

  • Focus: With a focus on past performance, detailed financial records show managers, executives, regulatory agencies, auditors, debt holders, and investors where a company has been and how it arrived at its current financial situation.
  • Target audience: Anyone who invests in the stock market through their brokerage accounts, retirement accounts, financial apps, crypto platforms, and so on utilize financial statements. Even observers who simply read financial blogs and news, either for work or as a hobby, interact with financial accounting information.
  • Regulation: Financial accounting produces publicly available financial statements that affect the entire stock market. Therefore, strict accounting rules are enforced by the SEC and FASB (Financial Accounting Standards Board).

Managerial Accounting

In contrast to financial accounting, managerial accounting focuses on the future, providing the organization’s internal decision-makers with the financial information they need to guide their organizations.

Let’s take a closer look:

  • Focus: The financial information supplied by managerial accounting is used by an organization’s decision-makers to help predict the company’s trajectory, inform their strategic choices, and understand their strengths, weaknesses, opportunities, and threats.
  • Target audience: Financial statements from managerial accounting practices are used by an organization’s managers, partners, executives, and boards of directors, as well as any significant investors or debt holders—hence the term, “managerial.” Financial statements produced by managerial accounting aren’t released to the public, so it’s very uncommon to see this information shared on financial websites or blogs.
  • Regulation: Financial reports produced by managerial accounting aren’t regulated by any US government agency. This is largely because they aren’t made public and don’t directly affect the larger financial markets. Therefore, managerial financial statements can include whatever information is most useful to the organization’s decision-makers.

Now that we understand what accounting is, let’s explore what financial statements are and what the three major financial statements are used for.

What Are Financial Statements?

Financial statements are records of an organization’s financial activities and financial position. As with everything financial, organizations must adhere to strict accounting rules when producing financial statements for public use.

There are three major types of financial statements: the income statement, the balance sheet, and the statement of cash flows. Below, we’ll discuss all three, as well as a fourth, more detailed financial document called the general ledger.

Income Statement

An income statement summarizes income, expenses, gains, and losses over a certain period—usually either a calendar year or the organization’s fiscal year. The income statement is used by investors, debt holders, and managers to better understand where income is coming from, where expenses are going, and how profitable the company has been for the last year.

The basic formula for an income statement is:

Income – Expenses = Net Income or Loss

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Balance Sheet

A balance sheet is a record of an organization’s assets, liabilities, and owner’s equity as of a specific point in time. Assets can include things like cash, accounts receivable, property, plant, and equipment (PP&E), vehicles, computers, and more. Liabilities include credit card debt, loans from banks, accounts payable, and more.

Owner’s equity represents all investors in the organization, including common and preferred shareholders. The balance sheet is called a “balance” sheet because assets minus liabilities must always equal the owner’s equity (they must balance).

The basic formula for a balance sheet is:

Assets – Liabilities = Owner’s Equity

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Statement of Cash Flows

A statement of cash flows, also known as a cash flow statement, is a financial statement that tracks the inflows and outflows of cash over a specific period.

Specifically, it tracks three main categories of cash flows organized by activity type. These include operating activities, investing activities, and financing activities.

The net inflows or outflows from each of these activities show how good the organization is at earning cash. Let’s define each activity type:

  • Operating activities: Cash flow from operating activities tracks cash flows from the organization’s core activities. The net inflows or outflows can be used as an indicator of the business’s financial health.
  • Investing activities: Cash flow from investing activities tracks the cash inflows and outflows related to long-term financial investments, as well as investments in property, plant, and equipment (PP&E).
  • Financing activities: Cash flow from financing activities tracks the cash flows to and from the organization’s shareholders and debtors. Cash from stock sales and cash from loans appear in this section of the statement of cash flows.

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General Ledger

A general ledger is a financial document that includes all transactions in all accounts throughout the entire year. It’s used as the basis for the three major financial reports and is generally only used by internal decision-makers within the organization.

Transactions include ordinary income, interest income, capital gains, and more, as well as expenses like COGS, rent, equipment and supplies purchases, dividend payments, tax payments, and more.

While the general ledger is not shared with the public, it can be a useful tool for internal teams. It lists everything from the stapler a company purchased to the office space(s) they rent to the income they received from their largest clients.

Though the general ledger is too detailed to be the most useful financial statement, it can still be utilized by managers and executives to better understand the details of the organization’s financial choices.

So, now that we understand some useful accounting terminology, as well as the main financial statements, let’s discuss the accounting cycle and how it works for businesses.

What Is the Accounting Cycle?

The accounting cycle is a structured, step-by-step process that organizations use to track, record, and analyze their financial activity over a specific period for income statements, or as of a certain point in time for balance sheets.

The accounting cycle usually covers financial information for an entire year, but the periods can also be monthly or quarterly, depending on the organization’s reporting requirements and if its debt obligations call for more frequent financial disclosures.

The goal of the accounting cycle is to ensure that financial transactions are recorded accurately, comprehensively, and completely.

It consists of eight steps:

  1. Identify transactions: Identify and document every financial transaction that affects the business, such as sales, purchases, other expenses, and more.
  2. Record transactions: Each transaction identified in the first step should be recorded in a chronological record of financial transactions called a “journal.” Accounting journals include details like a description of the transaction, relevant accounts involved, and the transaction amount and date.
  3. Post to the general ledger: All recorded transactions should be included in the general ledger, which is the main record book of all financial activity.
  4. Prepare the trial balance: A trial balance is a list of all accounts and their current debit or credit balances. The trial balance ensures mathematical accuracy in the system, and it acts as a rough draft for the financial statements.
  5. Make adjusting journal entries: At this point, accountants would make adjusting journal entries to correct any issues with the trial balance. Adjustments are often made to account for accruals, deferrals, depreciation, amortization, contra accounts, and other factors not yet included in the financial statements.
  6. Prepare the financial statements: The now-adjusted account balances are used to generate the three main financial statements: the income statement, the balance sheet, and the statement of cash flows. These financial statements paint a picture of the organization’s financial performance and position.
  7. Close the books: In this step, temporary income statement accounts, such as revenue and expenses, are “closed” by transferring their ending balances to permanent balance sheet accounts, such as owner’s equity and retained earnings. This sets the accounting system up for the next period.
  8. Create a post-closing trial balance: This step is not always required, but it can be useful for verifying the completeness and accuracy of the account closing process. Because of this, many organizations will do this step. This is essentially a second trial balance (like the one from step four) that verifies all accounts balance, the adjusting journal entries were appropriate, and the closing process was effective and should be used again.

This eight-step process is used by every public company in the US, and it’s the foundation of the standardized, verifiable, and trustworthy financial statements that allow the financial markets to function smoothly.

This process also allows for an organization’s financial statements to be comparable with other organizations in the same industries and in the market in general, which makes analyzing financial information much simpler for investors and debt holders.

Next, let’s discuss the financial statement assertions that help keep organizations and accountants honest.

What Are Financial Statement Assertions?

Financial statement assertions (also known as accounting assertions or management assertions) are the implicit or explicit claims made by organizations about their financial statements.

Auditors use these assertions when determining if financial information is accurate and reliable. Accounting assertions are the foundation for trustworthy financial records, and they’re designed to force companies to take responsibility for their financial statements.

There are two main types of accounting assertions: transaction-level assertions and balance-level assertions.

Transaction-level assertions deal with income statement transactions, such as income, expenses, dividend payments, and tax payments. Balance-level assertions deal with balance sheet items such as assets, liabilities, and owner’s equity. Let’s explore them in more detail below.

Transaction-Level Assertions

  • Occurrence: Ensures that all transactions recorded in the financial records actually occurred and that none were fabricated for financial reasons.
  • Completeness: Verifies that all completed transactions are recorded in the financial records and that none are left out.
  • Accuracy: Confirms that transactions are accurately reflected in the financial records. The accounts, amounts, dates, and descriptions should all be accurate and should accurately reflect the transactions that occurred.
  • Cut-off: Ensures that transactions are recorded in the correct accounting periods (in the year, quarter, or month that the financial records relate to).
  • Classification: Verifies that transactions are properly classified and categorized and ensures these categories are accurately reflected on the financial statements.

Balance-Level Assertions

  • Existence: Confirms that the reported balances exist and are not fraudulent or fabricated.
  • Completeness: Verifies that all relevant account balances are included and none are hidden or excluded.
  • Rights and obligations: Ensures that the organization has legal rights (either an owner or a lessee) to all assets, as well as legal obligations for all liabilities.
  • Accuracy and valuation: Confirms that account balances are accurate and the accounts are properly valued.
  • Presentation and disclosure: Ensures appropriate presentation and disclosure of all information in the financial statements.

To summarize, financial statement assertions play an important role in ensuring financial records are accurate and honest, and these assertions help establish truth and fairness in financial reporting throughout the financial markets.

Who Regulates the Accounting Industry?

Because financial accounting impacts financial markets—and as a result, the economy at large—the industry is regulated heavily, both in the US and abroad.

The US accounting industry is regulated by the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB), while international financial accounting is mostly regulated by the International Accounting Standards Board (IASB).

Who Regulates the US Accounting Industry?

The US accounting industry is regulated by the Financial Accounting Standards Board (FASB), a non-governmental, non-profit organization that manages the creation and implementation of financial reporting standards in the US.

The FASB does this by establishing US Generally Accepted Accounting Principles (GAAP), which constitute the standards, principles, and procedures that govern all financial accounting within the US. The FASB’s head office is located in Norfolk, Connecticut.

Generally Accepted Accounting Principles only affect organizations based in the US. GAAP is effectively the rules of the road for financial reporting (in the US), governing how companies implement their accounting practices and standardizing how financial statements are prepared and organized.

Goal

The goal of GAAP is to standardize financial reporting while also improving the comprehensiveness and transparency of financial information for shareholders, debtors, and stakeholders.

Benefits

GAAP creates a predictable and reliable financial environment for accountants, executives, investors, debt holders, and more to exist within. Additionally, standardized accounting practices improve market efficiency, allow for informed financial decision-making, and increase trust in the financial markets.

Without standardized accounting practices, many believe that modern financial markets couldn’t exist.

Drawbacks

There are some drawbacks to GAAP, with the greatest issue being its complexity. Accountants are always finding new ways to make their financial statements look as attractive to investors as possible, while governments create new laws to ensure companies are being honest.

The result is a complex web of laws, legal loopholes, and loophole-closing laws.

Most public companies employ teams of certified public accountants (CPAs) to manage their accounting processes and the generation of their financial statements. This can lead to significant costs for the organization.

Another issue is the inflexibility of GAAP. Often there’s one prescribed method of calculating a financial value, and no other method is acceptable. This can result in financial reporting processes that may benefit some organizations while hindering others.

For example:

  • Inventory valuation methods could be either FIFO (first in, first out), which benefits companies with rising inventory costs, or LIFO (last in, first out), which could hurt the financial statement efficacy of companies with volatile inventory costs.
  • Companies that use both a subscription revenue model and the accrual method of accounting benefit from recognizing revenue before cash is received, while companies with upfront costs and delayed revenue streams might be hurt by either the accrual or cash accounting methods.
  • Accounting standards for leases aim to recognize all leases on the balance sheet, potentially benefiting lenders by showing higher assets, while companies with significant operating leases might see increased debt on their balance sheets, impacting borrowing capacity, investor sentiments, and credit ratings.

Who Regulates the International Accounting Industry?

The international accounting industry is regulated by the International Accounting Standards Board (IASB), a non-profit international regulatory organization not unlike the FASB in the US.

The IASB manages the creation and implementation of the International Financial Reporting Standards (IFRS), which are similar to US GAAP. The IASB’s head office is located in London, UK.

Goal

The IASB is an independent standard-setting body that issues authoritative pronouncements, including International Financial Reporting Standards (IFRS). The goal of these standards is to ensure that financial statements are consistent, transparent, and comparable worldwide.

National and Regional Authorities

In addition to global standard-setting entities, various national and regional bodies regulate the accounting profession in smaller ways.

These authorities cover areas such as:

  • Accounting
  • Education
  • Ethics
  • Service quality and best practices
  • Enforcement of accounting standards

They offer training opportunities, administer professional examinations (such as the CPA exam), and help oversee compliance with accounting standards.

An organization’s accountants will be familiar with regional, national, and international accounting authorities, and their financial reporting processes should reflect the standards set by these authorities.

Accounting Software

Accounting is utilized by every organization in every country on earth in some form or another, and as a result, the accounting software industry is massive.

There are numerous forms of accounting software catering to businesses of different types, industries, sizes, and more. Some software solutions are designed or custom-made for large corporations, while others target small businesses, specific industries, or sectors.

Here are some of the best accounting software programs:

  • Small business accounting software: Used to track business transactions and balances, create invoices, and manage billing cycles and payments. This type of accounting software is fairly scalable; businesses as small as one person and as large as dozens of people can use it effectively. Examples include Quickbooks (desktop or online), Xero, Zoho Accounting, Freshbooks, Bonsai, Sage, Wave, and more.
  • Custom accounting software: Custom accounting software offers tailored solutions created specifically for unique business needs. This type of accounting software is generally more expensive than off-the-shelf software, but it can help streamline the accounting process for large businesses. Examples include ScienceSoft, Diceus, and Mobindustry.
  • Billing and invoicing accounting software: This type of software focuses on creating invoices, managing billing cycles, and tracking payments. Most accounting software available today will include this functionality. Almost all businesses use some form of billing and invoicing software, from freelancers to large businesses. Examples include Quickbooks (desktop or online), Xero, Zoho Books, Freshbooks, Striven, Sage, and Wave.
  • Payroll accounting software: This type of accounting software is specifically designed to manage payroll tasks like paying employees and managing tax withholdings, employment benefits, time off, hiring and termination, and more. Payroll software is usually used by human resource (HR) departments. Examples include Quickbooks (desktop or online), ADP, Gusto, OnPay, Melio, Rippling, and Paychex.
  • Enterprise resource planning (ERP) software: ERP software integrates various business processes, including accounting, inventory, sales, and procurement into a single comprehensive system. The goal is to streamline these processes and allow the organization to manage them all in one place. Examples include Oracle, Microsoft Dynamics 365, Sage, Odoo, Acumatica, Katana, SAP Business One, and ERPNext.
  • Spreadsheet software: While spreadsheet software is not technically accounting software, spreadsheets are widely used for basic accounting tasks. They can be used to track simple transactions, create basic financial records, calculate financial formulas, and more. Examples include Microsoft Excel, Google Sheets, OpenOffice Calc, LibreOffice, and Zoho Sheet.
  • Tax preparation software: Most people are familiar with this type of accounting software, as millions of people use it every year to file their taxes. This software can either be web-based or a downloadable program. Examples include TurboTax, TaxSlayer, TaxAct, H&R Block, FreeTaxUSA, Liberty Tax, and Jackson Hewitt.
  • Outsourced accounting services: These are designed for businesses that don’t want to hire a full-time accountant or bookkeeper to manage accounting tasks. Outsourced accounting services allow business owners to take a hands-off approach, delegating accounting responsibilities to a third party so they can focus on their core competencies. Examples include Merritt Bookkeeping, Bookkeeper.com, InDinero, Bench, and Bookeeper360.

Each of these solutions serves a specific purpose, and some serve multiple purposes simultaneously.

Almost all businesses will use at least one, and many businesses will use several of them or an ERP that combines multiple software programs. It all depends on the size of the business, its budget, and the complexity or uniqueness of its accounting needs.

To learn more about accounting software and which might be right for you, check out our guide to the 10 best accounting software programs for 2024.

Conclusion

Understanding the basics of accounting helps to secure the financial foundation of your business, allowing you to increase your revenue, manage your expenses, and pursue your goals.

Taking ownership of your bookkeeping and accounting processes is not only possible but relatively straightforward with easy-to-use software programs catered to your specific needs.

With the information in this article, you can master the basics of accounting, utilize healthy accounting practices, maintain the three big financial statements, and use your newfound accounting terminology to keep your finances healthy and thriving.

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Robbie Mizzone
Editor

Robbie holds a BSc in Accounting and Finance from Centenary University, New Jersey. He's worked for banks and private companies alike, including Kering (Gucci, Balenciaga), focusing on financial reporting, account reconciliation, and complex accrual analysis. An avid explorer and jack of all trades, Robbie's garnered experience in luxury hospitality, carpentry and construction, and is now backpacking solo around the world.