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Accounting has been defined as “the language of business” because it is the basic tool keeping score of a business’s activity. It is with accounting that an organization records, reports, and evaluates economic events and transactions that affect the enterprise. As far back as 1494 the importance of accounting to the success of a business was known. In a book on mathematics published that year and written by the Franciscan monk, Luca Paciolo, the author cites three things any successful merchant must have. The three things are sufficient cash or credit, an accounting system to track how he is doing, and a good bookkeeper to operate the system.

Accounting processes document all aspects of a business’s financial performance, from payroll costs, capital expenditures, and other obligations to sales revenue and owners’ equity. An understanding of the financial data contained in accounting documents is regarded as essential to reaching an accurate picture of a business’s true financial well-being. Armed with such knowledge, businesses can make appropriate financial and strategic decisions about their future; conversely, incomplete or inaccurate accounting data can cripple a company, no matter its size or orientation. The importance of accounting as a barometer of business health—past, present, and future—and tool of business navigation is reflected in the words of the American Institute of Certified Public Accountants (AICPA), which defined accounting as a “service activity.” Accounting, said the AICPA, is intended “to provide quantitative information, primarily financial in nature, about economic activities that is intended to be useful in making economic decisions— making reasoned choices among alternative courses of action.”

A business’s accounting system contains information relevant to a wide range of people. In addition to business owners, who rely on accounting data to gauge the financial progress of their enterprise, accounting data can communicate relevant information to investors, creditors, managers, and others who interact with the business in question. As a result, accounting is sometimes divided into two distinct subsets—financial accounting and management accounting—that reflect the different information needs of the end users.

Financial accounting is a branch of accounting that provides people outside the business—such as investors or loan officers—with qualitative information regarding an enterprise’s economic resources, obligations, financial performance, and cash flow. Management accounting, on the other hand, refers to accounting data used by business owners, supervisors, and other employees of a business to gauge the enterprise’s health and operating trends.

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Generally Accepted Accounting Principles

Generally accepted accounting principles (GAAP) are the guidelines, rules, and procedures used in recording and reporting accounting information in audited financial statements. In order to have a vibrant and active economic marketplace, participants in the market must have confidence in the system. They must be confident that the reports and financial statements produced by companies are trustworthy and based on some standard set of accounting principles. The stock market crash of 1929 and its aftermath showed just how damaging uncertainty can be to the market. The results of U.S. Senate Banking and Currency Committee hearings into the 1929 crash caused public outrage and lead to federal regulation of the securities market as well as a push for the development of professional organizations designed to establish standardized accounting principles and to oversee their adoption.

Various organizations have influenced the development of modern-day accounting principles. Among these are the American Institute of Certified Public Accountants (AICPA), the Financial Accounting Standards Board (FASB), and the Securities and Exchange Commission (SEC). The first two are private sector organizations; the SEC is a federal government agency.

The AICPA played a major role in the development of accounting standards. In 1937 the AICPA created the Committee on Accounting Procedures (CAP), which issued a series of Accounting Research Bulletins (ARB) with the purpose of standardizing accounting practices.

This committee was replaced by the Accounting Principles Board (APB) in 1959. The APB maintained the ARB series, but it also began to publish a new set of pronouncements, referred to as Opinions of the Accounting Principles Board. In mid-1973, an independent private board called the Financial Accounting Standards Board (FASB) replaced the APB and assumed responsibility for the issuance of financial accounting standards. The FASB remains the primary determiner of financial accounting standards in the United States.

Comprised of seven members who serve full-time and receive compensation for their service, the FASB identifies financial accounting issues, conducts research related to these issues, and is charged with resolving the issues. A super-majority vote (i.e., at least five to two) is required before an addition or change to the Statements of Financial Accounting Standards is issued.

The Financial Accounting Foundation is the parent organization to FASB. The foundation is governed by a 16-member Board of Trustees appointed from the memberships of eight organizations: AICPA, Financial Executives Institute, Institute of Management Accountants, Financial Analysts Federation, American Accounting Association, Securities Industry Association, Government Finance Officers Association, and National Association of State Auditors. A Financial Accounting Standards Advisory Council (approximately 30 members) advises the FASB.

In addition, an Emerging Issues Task Force (EITF) was established in 1984 to provide timely guidance to the FASB on new accounting issues.

The Securities and Exchange Commission, an agency of the federal government, has the legal authority to prescribe accounting principles and reporting practices for all companies issuing publicly traded securities. The SEC has seldom used this authority, however, although it has intervened or expressed its views on accounting issues from time to time. U.S. law requires that companies subject to the jurisdiction of the SEC make reports to the SEC giving detailed information about their operations. The SEC has broad powers to require public disclosure in a fair and accurate manner in financial statements and to protect investors. The SEC establishes accounting principles with respect to the information contained within reports it requires of registered companies. These reports include: Form S-X, a registration statement; Form 10-K, an annual report; Form 10-Q, a quarterly report of operations; Form 8-K, a report used to describe significant events that may affect the company; and Proxy Statements, which are used when management requests the right to vote through proxies for shareholders.

On December 20, 2002, the SEC proposed a series of amendments to the rules and forms that it imposes on companies within its jurisdiction. These changes were mandated as part of the passage of the Sarbanes-Oxley Act of 2002. This law was motivated, in part, by accounting scandals that came to light involving firms as well known as Enron, WorldCom, Tyco, Global Crossing, Kmart, and Arthur Andersen to name a few.

Accounting System

An accounting system is a management information system responsible for the collection and processing of data useful to decision-makers in planning and controlling the activities of a business organization. The data processing cycle of an accounting system encompasses the total structure of five activities associated with tracking financial information: collection or recording of data; classification of data; processing (including calculating and summarizing) of data; maintenance or storage of results; and reporting of results. The primary—but not sole— means by which these final results are disseminated to both internal and external users (such as creditors and investors) is the financial statement.

The elements of accounting are the building blocks from which financial statements are constructed.

According to the Financial Accounting Standards Board (FASB), the primary financial elements directly related to measuring performance and the financial position of a business enterprise are as follows:

  • Assets—probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.
  • Comprehensive Income—the change in equity (net assets) of an entity during a given period as a result of transactions and other events and circumstances from non-owner sources.

Comprehensive income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.

  • Distributions to Owners—decreases in equity (net assets) of a particular enterprise as a result of transferring assets, rendering services, or incurring liabilities to owners.
  • Equity—the residual interest in the assets of an entity that remain after deducting liabilities. In a business entity, equity is the ownership interest.
  • Expenses—events that expend assets or incur liabilities during a period from delivering or providing goods or services and carrying out other activities that constitute the entity’s ongoing major or central operation.
  • Gains—increases in equity (net assets) from peripheral or incidental transactions. Gains also come from other transactions, events, and circumstances affecting the entity during a period except those that result from revenues or investments by owners. Investments by owners are increases in net assets resulting from transfers of valuables from other entities to obtain or increase ownership interests (or equity) in it.
  • Liabilities—probable future sacrifices of economic benefits arising from present obligations to transfer assets or provide services to other entities in the future as a result of past transactions or events.
  • Losses—decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions, events, and circumstances affecting the entity during a period.

Losses do not include equity drops that result from expenses or distributions to owners.

  • Revenues—inflows or other enhancements of assets, settlements of liabilities, or a combination of both during a period from delivering or producing goods, rendering services, or conducting other activities that constitute the entity’s ongoing major or central operations.

Financial Statements

Financial statements are the most comprehensive way of communicating financial information about a business enterprise. A wide array of users—from investors and creditors to budget directors—use the data it contains to guide their actions and business decisions. Financial statements generally include the following information:

  • Balance sheet (or statement of financial position)— summarizes the financial position of an accounting entity at a particular point in time as represented by its economic resources (assets), economic obligations (liabilities), and equity.
  • Income statement—summarizes the results of operations for a given period of time.
  • Statement of cash flows—summarizes the impact of an enterprise’s cash flows on its operating, financing, and investing activities over a given period of time.
  • Statement of retained earnings—shows the increases and decreases in earnings retained by the company over a given period of time.
  • Statement of changes in stockholders’ equity— discloses the changes in the separate stockholders’ equity account of an entity, including investments by distributions to owners during the period.

Notes to financial statements are considered an integral part of a complete set of financial statements. Notes typically provide additional information at the end of the statement and concern such matters as depreciation and inventory methods used in the statements, details of long-term debt, pensions, leases, income taxes, contingent liabilities, methods of consolidation, and other matters. Significant accounting policies are usually disclosed as the initial note or as a summary preceding the notes to the financial statements.

Accounting Profession

There are two primary kinds of accountants: private accountants, who are employed by a business enterprise to perform accounting services exclusively for that business, and public accountants, who function as independent experts and perform accounting services for a wide variety of clients. Some public accountants operate their own businesses, while others are employed by accounting firms to attend to the accounting needs of the firm’s clients.

A certified public accountant (CPA) is an accountant who has 1) fulfilled certain educational and experience requirements established by state law for the practice of public accounting and 2) garnered an acceptable score on a rigorous three-day national examination. Such people become licensed to practice public accounting in a particular state. These licensing requirements are widely credited with maintaining the integrity of the accounting service industry, but in recent years this licensing process has drawn criticism from legislators and others who favor deregulation of the profession. Some segments of the business community have expressed concern that the quality of accounting would suffer if such changes were implemented, and analysts indicate that small businesses without major in-house accounting departments would be particularly impacted.

The American Institute of Certified Public Accountants (AICPA) is the national professional organization of CPAs, but numerous organizations within the accounting profession exist to address the specific needs of various subgroups of accounting professionals. These groups range from the American Accounting Association, an organization composed primarily of accounting educators, to the American Women’s Society of Certified Public Accountants.

Accounting And The Small Business Owner

A good accountant is the most important outside advisor the small business owner has, according to the Entrepreneur Magazine Small Business Advisor. “The services of a lawyer and consultant are vital during specific periods in the development of a small business or in times of trouble, but it is the accountant who, on a continuing basis, has the greatest impact on the ultimate success or failure of a small business.”

When starting a business, many entrepreneurs consult an accounting professional to learn about the various tax laws that affect them and to familiarize themselves with the variety of financial records that they will need to maintain. Such consultations are especially recommended for would-be business owners who anticipate buying a business or franchise, plan to invest a substantial amount of money in the business, anticipate holding money or property for clients, or plan to incorporate.

If a business owner decides to enlist the services of an accountant to incorporate, he/she should make certain that the accountant has experience dealing with small corporations, for incorporation brings with it a flurry of new financial forms and requirements. A knowledgeable accountant can provide valuable information on various aspects of the start-up phase.

Similarly, when investigating the possible purchase or licensing of a business, a would-be buyer should enlist the assistance of an accountant to look over the financial statements of the licensor-seller. Examination of financial statements and other financial data should enable the accountant to determine whether the business is a viable investment. If a prospective buyer decides not to use an accountant to review the licensor-seller’s financial statements, he/she should at least make sure that the financial statements that have been offered have been properly audited (a CPA will not stamp or sign a financial statement that has not been properly audited and certified).

Once in business, the business owner will have to weigh revenue, rate of expansion, capital expenditures, and myriad other factors in deciding whether to secure an in-house accountant, an accounting service, or a year-end accounting and tax preparation service. Sole proprietorships and partnerships are less likely to have need of an accountant; in some cases, they will be able to address their business’s modest accounting needs without utilizing outside help. If a business owner declines to seek professional help from an accountant on financial matters, pertinent accounting information can be found in books, seminars, government agencies such as the Small Business Administration, and other sources.

Even if a small business owner decides against securing an accountant he or she will find it much easier to attend to the business’s accounting requirements if a few basic bookkeeping principles are followed. These include maintaining a strict division between personal and business records; maintaining separate accounting systems for all business transactions; establishing separate checking accounts for personal and business; and keeping all business records, such as invoices and receipts.

Choosing An Accountant

While some small businesses are able to manage their accounting needs without benefit of in-house accounting personnel or a professional accounting outfit, the majority choose to enlist the help of accounting professionals.

There are many factors for the small business owner to consider when seeking an accountant, including personality, services rendered, reputation in the business community, and expense.

The nature of the business in question is also a consideration in choosing an accountant. Owners of small businesses who do not anticipate expanding rapidly have little need of a national accounting firm, but business ventures that require investors or call for a public stock offering can benefit from association with an established accounting firm. Many owners of growing companies select an accountant by interviewing several prospective accounting firms and requesting proposals which will, ideally, detail the firm’s public offering experience within the industry, describe the accountants who will be handling the account, and estimate fees for auditing and other proposed services.

Finally, a business that utilizes a professional accountant to attend to accounting matters is often better equipped to devote time to other aspects of the enterprise. Time is a precious resource for small businesses and their owners, and according to the Entrepreneur Magazine Small Business Advisor, “Accountants help business owners comply with a number of laws and regulations affecting their record-keeping practices. If you spend your time trying to find answers to the many questions that accountants can answer more efficiently, you will not have the time to manage your business properly. Spend your time doing what you do best, and let accountants do what they do best.”

The small business owner can, of course, make matters much easier both for his/her company and for the accountant by maintaining proper accounting records throughout the year. Well-maintained and complete records of assets, depreciation, income and expense, inventory, and capital gains and losses are all necessary for the accountant to conclude her work; gaps in a business’s financial record only add to the accountant’s time and, therefore, her fee for services rendered.

The potential management insights that can be gained from a study of properly prepared financial statements should not be overlooked. Many small businesses see accounting primarily as a paperwork burden and something whose value is primarily in helping to comply with government reporting requirements and tax preparations. Most experts in the field contend that small firms should recognize that accounting information can be a valuable component of a company’s management and decision-making systems, for financial data provide the ultimate indicator of the failure or success of a business’s strategic and philosophical direction.