Definition and Overview of Accounting Functions
Accounting is a practice that dates back to the early days of human civilization. When people began to trade goods in large quantities, they soon realized that they needed a method for tracking their inventories, revenues, and overall costs related to business expense. In the mid 1400's, double-entry accounting was invented as a means for tracking not only incoming revenues but also expenses. Thus, it became possible to not only record how much an item sold for, but how much it cost to create, store, or process that item. In this way, profit margins were born. As businesses became more complex, the practice of accounting kept pace with intricate formulas and technological tools to help manage the increasing amounts of data.
Modern accountants use a codified set of tools, rules, and guidelines for reporting financial information to corporate executives, their shareholders, and governmental regulators. Though accountants perform a wide range of duties, some of the more common tasks include preparing and filing tax return documents to the IRS, incorporating small businesses, and securing all of their employer's or client's records.
Accountants can also specialize in areas such as:
- Accounts Payable
- Accounts Receivable
- Forensic Accounting
- Governmental Accounting
- Tax Accounting
- Managerial Accounting
- Financial Accounting
Accountants also work as auditors who make quantitative assessments of a corporation's financial and managerial health. Some even work in information technology and perform audits of those systems.
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How Does it Work?
Accounting works by aggregating financial data into spreadsheets and financial statements so that it can be analyzed and understood. While privately held entities can create their own standards for periodic accounting, public companies are mandated to report their financial position every three months, and then with an aggregated statement of accounts on their Annual Report. In either case, a thorough accounting helps executives and analysts better understand the company.
Thus, accounting is one of the core functions of any business' administration. Every business needs accurate records of how it is spending and making money. Even small one- or two-person businesses can benefit from generating an income statement, balance sheet, and cash flow statement. Those tools can help executives discover patterns that need amendment, or areas where they can improve.
For instance, the cash flow statement might reveal that the company has more cash reserves than previously thought, enabling the principal executives to make better decisions on how to spend, invest, or save that money.
In larger firms, accounting enables a company to share their information with potential creditors or investors. Often, a company needs to borrow money in order to spur a new period of growth. In those cases, creditors need to see a cash flow statement that reflects adequate liquidity and an ability to repay the loan. An accurate accounting of their operations can help a company demonstrate that it would be a good candidate for a sale, or it might entice a new round of public or private financing. In fact, if a company wishes to make a public stock offering, it must do a thorough accounting in preparation for scrutiny by the Securities and Exchange Commission (SEC).
The Accounting Basics
- Income Statement
A company's income statement is often termed the profit and loss statement as it details how well the company has performed in generating profits.
The fundamental formula of any income statement is:
Net Income = (Total Revenue + Gains) – (Total Expenses + Losses)
When applied to the statement itself, each part of the formula is broken out to distinguish non-core business income or loss generated as a direct result of the company's central mission. Thus, a toy company can delineate income generated from game sales vs. one-time revenue sources, such as the sale of equity investments. In this way, a company can describe for investors how a spike in gains or losses might have resulted from a one-time event or a surge in sales.
This statement is mandated for every publicly held corporation. Thus, public investors can retrieve any company's quarterly and annual income statements from the SEC to allow them to make an informed decision regarding any future investments. However, this statement only shows net income from a specific period.
If an investor is interested in a deeper analysis that includes the company's current worth or how it handles its cash flow, then they should consult the other mandatory statements: the balance sheet and cash flow statement.
- Balance Sheet
The balance sheet is a statement that demonstrates a company's overall worth: its total assets.
The core formula for any balance sheet is:
Assets = Liabilities + Equity
Assets include anything of positive, quantifiable value to the company. Items such as cash, accounts receivable, and investments. The company can include real estate, heavy equipment, and all inventories when aggregating the total assets.
When accounting for a company's liabilities, the accountants include any outstanding monies owed or regular payments. Thus, a company might include its debt and interest payments as a liability. However, the borrowed funds might also show up on the balance sheet in the form of cash on hand. In the discussion portion of that quarter's (or year's) statement, the accountants might reveal how that debt is being used to fuel research or to acquire other assets from which the company plans to profit in the future.
Ultimately, the balance sheet is used to encapsulate a company's present-day worth. No single balance sheet will be able to illustrate a financial pattern, but analysts often find it useful to compare a series of these statements to chart the company's relative value over time. When analysts track this data alongside information from the income and cash flow statements in the same periods, a deeper picture of corporate health will emerge.
- Statement of Cash Flows
In order to determine how a company manages its liquid assets, accountants generate a cash flow statement (CFS). This is one of the three financial statements that all publicly traded companies must file, as required by the SEC. Essentially, the CFS reflects cash generated from business operations, investments, and financing.
It is vital that companies take a hard look at their own CFS because it can reveal much about the company's day-to-day operations. For example, a highly profitable company might show great gains on its income statement, but then find that it has poor cash flow due to excessive expenditures or the fact that customers have not yet paid for their goods. The company might be extending too much credit and thus be liable to fall short on its own payments, such as rent, loan obligations, or even taxes.
The cash flow statement is also vital when seeking a new line of credit. Creditors need to see that the company has enough cash on hand to pay its debts, as well as the managerial acumen to translate stellar data from the income statement into real-world liquidity.
- Generally Accepted Accounting Principles (GAAP)
The GAAP, or the Generally Accepted Accounting Principles, is a set of guidelines that all accountants are taught and then apply to their accounting practices. Just as a newspaper employs a style guide that codifies a set of standards for its writers, the GAAP sets a standard that helps accountants work with and understand one another. Furthermore, when all accountants work in accord with the GAAP, analysts and investors have an easier time understanding their filings and financial statements.
The GAAP includes ten basic tenets that accountants should heed when preparing financial statements.
Those tenets are:
- Principle of Regularity: Ensures that accountants follow all GAAP guidelines
- Principle of Consistency: Ensures that the same rules are followed throughout the accounting process
- Principle of Sincerity: Ensures accuracy with regard to the company's finances
- Principle of Permanence of Methods: Maintains consistency in accounting methods
- Principle of Non-compensation: Ensures full disclosure of positives and negatives
- Principle of Prudence: Ensures that speculation is eradicated
- Principle of Continuity: Accountants assume that the company will continue its operations
- Principle of Periodicity: Ensures that all revenues, etc. are recorded according to when they were received
- Principle of Materiality / Good Faith: Ensures that accountants exercise full disclosure when reporting financial information
- Principle of Utmost Good Faith: Ensures honesty and fair dealing with regard to accounting
Most state governments and their school districts are either fully, mostly, or somewhat compliant with the GAAP. However, a full fourteen states are not GAAP compliant at all, equal to the number of full-compliance states. The United States federal government, on the other hand, requires that all publicly traded corporations file their financial statements according to GAAP guidelines.
Areas of Accounting
This all-important area of accounting is concerned with preparing a company's tax documents and then filing them with the IRS. Generally speaking, a Certified Public Accountant is required to assess the filings and then sign them for filing. Tax accountants have a thorough knowledge of the United States Internal Revenue Code.
Tax experts thus know what sorts of items can be deducted from a company's tax filings and how to apply tax credits. Accountants need to have full access to a company's books so that they can assess what sorts of income are taxable, and then what parts of the tax code applies. A similar process applies to expenditures, debt, and depreciation.
Even tax-exempt organizations such as charities or trusts must employ a tax accountant. Every corporate body or financial entity must file an annual accounting for the IRS. Tax-exempt organizations need to demonstrate how their money was generated and spent in order to maintain their status. Most tax-exempt entities cannot record profit.
For larger corporations, it is vital to employ a payroll accountant. In fact, there are Fortune 500 companies who make their profits by providing payroll services to their clients.
This form of accounting must take into account each employee's tax status, their benefit packages, and types of income, among other items. Employees will have a range of dependents on their tax document, will make individualized payments to 401(k) accounts, and require other deductions from pre-tax pay to cover health insurance.
Further, there may be some employees who receive a standard rate of pay with commissions or bonus payments added on top of that.
- Accounts Payable
Accounts payable are short-term debts that companies generally pay off within 30 days, or some other short-term arrangement. Items on the AP ledger can include office supplies, payroll expenses, income taxes, bridge loans, and travel expenses. Both AP and long-term debts are recorded on the balance sheet. However, AP is recorded under the heading of current liabilities. Long-term debt is not part of AP and includes items such as lease obligations, mortgages, and long-term loans.
When a company purchases an item on full or partial credit, the unpaid amount of the transaction is recorded as an account payable. There is a contract to represent the future payment, but that payment is not yet recorded in the books. AP is recorded as a debit on the balance sheet but is not recorded on the cash flow statement because the company still has the relevant cash on hand.
- Accounts Receivable
AR is a part of accounting and bookkeeping that records the all the monies due the company. These items are recorded on a company's balance sheet but are neither a part of the income statement nor the cash flow statement. AR represents funds not yet realized from contracts that extend credit to a customer. Though the funds have not yet reached a company's accounts, they are considered assets because the agreement implies that payment is forthcoming. Thus, they hold value.
AR is generally handled by a team of bookkeepers who may be managed by either a bookkeeper with more experience or an accountant. In a larger corporation, AR will receive ultimate oversight from a CPA at the Vice President or C-level.
This is the basic entry-level point in the accounting world. Bookkeepers are charged with recording transactions in a ledger for later use by an upper-level accountant. When recording transactions, a bookkeeper must know how and where to make the entry. They should understand that, when making an AP entry, the debit should also be credited as an expense to the specific part of the business in question. For example, a small innkeeper might record a payment for new bedding as a debit to accounts payable, but then credit the expense to housekeeping supplies. Thus, the bookkeeper's accuracy and professionalism is vital to the long-term financial well-being of the firm.
- Analysis (for decision making)
Financial analysis is a position that does not always require an accounting degree or CPA license. However, financial analysts generally have received intensive training in the world of finance.
Financial analysis is required when a company is seeking to open a line of credit, receive investment, or put itself up for sale. The analyst will review the company's balance sheet, income statement, and cash flow statement from multiple reporting periods. The aim is to determine trends and patterns from which a financial decision can be made. It's common for an analyst to review the most recent 10-K (annual report) and the previous three 10-Q (quarterly) statements, each of which contain the three key financial reports as well as other information.
In the case of a corporate merger or acquisition, the analyst might review comparable companies to ascertain the company's value in the market. They might also review other SEC filings that reflect any material change to the company's financial standing.
When companies have extended credit to customers and the customers have failed to pay, the debt can go to a collections department. If the non-payment period extends past what the company finds tenable, they might aggregate their delinquent accounts receivable and sell the debt to a collection agency for a percentage of the principal amount.
Debt collectors are often unskilled, or semi-skilled workers whose task is to contact errant customers in hopes of receiving payment on the debt. They may have basic bookkeeping skills. Collections professionals might also be skilled at helping debtors restructure their loans or find ways to begin making payments. However, in small companies, initial collection proceedings may be carried out by the controller of the accounting group or a number of team members who report to the controller. Collections is a vital part of any business, as it gives you the best chance to recoup losses from clients or customers who have fallen behind in payments and makes it easier to track these losses.
Accounting has long relied on technology to help manage the math and to sort data. In the past, accountants have used primitive abacuses, adding machines in conjunction with paper ledgers, then digital calculators. However, this has changed in many ways as technology continues to improve.
Like most other professions, accounting is now rife with technology that automates tasks in a way that saves much time. Not only do accountants need technology to compile data and apply formulas, but they need secure storage for their records. This means that accountants must be well-versed in many areas of information technology including enough cyber security to understand how to maintain their company’s and their client’s/customer’s privacy.
At a minimum, an accountant should have expert-level skills with spreadsheet software. The most common spreadsheet package is Microsoft Excel, but others exist including Google Sheets and Libre Office Calc. Accountants should be able to set their spreadsheets up with macros, which are small programs that will apply financial models or simple formulas to the data. In fact, some highly successful firms have made hundreds of millions of dollars based on financial models they apply in spreadsheet applications.
There are also full-service accounting programs that will handle items including, but not limited to payroll, taxes, invoices, and inventory control. Depending on the specific maker, these packages might not provide much room for customization. Thus, these applications are often best used for simpler data-entry tasks performed by bookkeepers or businesses who have a smaller scope of operation on top of a limited technology budget.
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Should You Get into Accounting?
Accounting is a highly diversified field. Professional accountants take on jobs such as Controller, Financial Analyst, Tax Accountant, Risk Manager, and Forensic Accountant. The very top of the field, the Certified Public Accountant is considered one of the most well-prepared professionals in accounting.
While each state has its own set of parameters for its CPA licensure, most follow a common pattern. That is, you need to graduate with a four-year degree in accounting from an accredited college, pass all four parts of the CPA exam, and submit a background check. The CPA exam is so difficult that many people are able to land top-paying jobs after only passing one of the four parts.
If you have a desire to pursue a career in business, accounting is certainly a valid choice. It requires rigorous analytical thinking, top mathematical abilities, and a meticulous attention to detail. If you are up to the task, accountants receive handsome compensation packages. At the lower end, bookkeepers and other accounting clerks are said to receive a median salary of $40,240, but the Bureau of Labor Statistics shows that growth in that field is nominal through 2026.
On the other hand, the BLS notes that accountants and auditors should see an occupational growth of 10% in the same time frame, which is faster than average, according to the agency. The median salary for accountants and auditors was $70,500 in 2018. However, if you have achieved certifications in the field, including a CPA license, you could take jobs such as financial manager or investment banker, that rely on accounting skills but can pay well into six figures.
Thus, if you are interested in finance and accounting, and have the requisite skills, you should consider pursuing accounting. After all, nearly every business, government agency, and non-profit organization relies on its accountants to file taxes, analyze operations, and provide many other services. When you have accounting skills, you can apply them to nearly any sort of managerial position. Thus, if you have a passion for a certain industry you’ll almost definitely find a position if you know how to put together financial statements.