In a typical day, your small business will generate upwards of 1,000 economic transactions. These include the most basic activities such as pumping gas into a vehicle to the more complicated transaction such as the borrowing money from a bank. Think about a small construction company, they have several employees and they record their time on a job, there are purchases of materials, the use of subcontractors, and small cash transactions like purchasing pizza for the guys. All of these transactions generate a source document such as a receipt, a bill to the company, a vendor contract, and sometimes a paperless agreement (like a verbal work order from a customer).
Each of these transactions requires processing via a centralized office so that management is apprised of what is happening in the company. Information gathering is the first step in recording economic activity. Systems are implemented to get the paper documents to the office so they may be categorized and recorded. To resolve the gathering process, companies use the central office’s mailing address for bills, the payroll information is forwarded to the front office, and field personnel are required to drop off or mail in their respective source documents for record purposes. This is the first step in the accounting function of any business.
Categorizing the Economic Information
There a several sub areas of accounting, each with a different purpose. The most commonly understood area is financial accounting. This is the function of taking the information and turning the data into a monetary value. This value is recorded in the books of record for traditional financial outputs most notably the ‘Income Statement’ also known as the ‘Profit and Loss Statement’. But there are other areas of accounting. These include cost accounting which addresses production management; internal auditing which deals with managing information, preventing theft and misinformation; compliance accounting which addresses governmental reporting (taxation, payroll, asset reporting, etc.) and public accounting reporting (audited financial statements, public records submission, and capital creation). Each of these areas of accounting has national standard setting boards or governmental bureaus to establish rules and guidelines. The most notable organization is the Internal Revenue Service.
Depending on the area of accounting the gathered information is categorized to comply with the rules and guidelines of the respective sub area of accounting. For most small businesses, the information is grouped (often referred to as ‘Classed’) to comply with financial accounting restrictions. In general there are five overall classes of information in financial accounting comprising assets, liabilities, equity, revenue, and expenses. The data is further refined to particular sections of each class such ‘Cost of Goods Sold’, ‘Wages & Salaries’, ‘Fixed Assets, ‘Accounts Payable’ and so on. If the organization is utilizing other areas of accounting such as cost accounting, the data may be classed to a project and a function of the project. Therefore, one economic transaction may be categorized for one or several; if not all the areas of accounting.
Recording the Transactions
Once the transaction is categorized it is then recorded in the respective books of record. Typically accounting software is used to record the data. Small business accounting software includes QuickBooks, Sage (formerly Peachtree) and a multitude of other programs. As businesses grow and prosper, their software needs change and can get quite expensive. Large publicly traded companies spend several hundred million dollars just for the software to properly record the data.
The goal of accounting goes beyond just recording the economic transactions, the accounting function generates reports for management. For the small business operation, these reports include accounting statements such as the ‘Profit and Loss’ and the balance sheet. Other standard reports include cash flow statements, changes in equity statements and even reconciliation statements for respective accounts (most often the Bank Reconciliation – Fundamentals ). The other categories of accounting generate dynamic reports for management including control reports, production reports, inventory, and labor utilization. All of these reports are sourced from input documents such as bills, receipts, timecards, meter readings, measurements and more. The key is accounting is a measurement process and the source documents provide the basis for data input and data output in the form of reports.
Analyzing the Data
The best part of accounting is analyzing the data. The reports provide valuable feedback to the readers of financial and non financial progress. With good information in, the system can create the best opportunity to generate good information out for analysis. Remember the primary goal of accounting is to measure economic activity. The outcome of this measurement activity is reports for review. The most common analysis tool is comparing prior periods to the current period to evaluate changes. Ideally, management seeks improvement. Any discrepancies can be further broken down into more detail to identify the core problem(s). Then management can make changes to systems, processes or the employment in the business to affect the needed change. Then the process begins anew. This is referred to as the feedback loop.
Human Skill Sets
All of the above process is performed by various individuals with different talents and backgrounds. The following are the four most common types of accounting personnel that provide these services. For each, I describe their job and their background.
Most bookkeepers are self-taught or become bookkeepers after working under an accountant for several years. Mostly the bookkeeper manages the source documents that come into the office and load the information into the database or accounting software. They perform the more mundane and ongoing function of accounting such as entering the bills, processing payroll, cutting checks for bill payments, receiving payments from customers and sometimes making general journal entries. The latter is more uncommon with bookkeepers and is usually performed by someone with a bit more education in accounting due to the nature of general journal entries.
To be classified as an accountant, the individual should have formal education in accounting as a part of their background. The formal education doesn’t have to be a degree in accounting but for the most part there should be no less than 2 full years of education from college with the bulk of classes in accounting. This way the individual truly understands the concept of the ‘Dual Entry’ system of accounting. In addition, accountants understand the reasoning for a balance sheet and how the equity section of the balance sheet is structured. For this reason, general journal entries are entered by accountant level individuals or higher level accounting positions. If you desire to have a basic understanding of the balance sheet read the following: How to Read the Balance Sheet – Simple Format.
These types of accountants have formal education and are typically experts in certain areas of accounting. Fields of expertise include internal accounting, cost accounting, fraud examination, human resources benefit management and so on. You will rarely if ever see these types of accountants in the really small business world. All of them have formal degrees in accounting and many have advance degrees in their fields of expertise. Some have passed advanced national exams for their respective area of expertise. A good example is a Certified Fraud Examiner which is an accountant that examines source documents for compliance purposes or in the investigation of a possible fraudulent act. Often the goal of this level is to provide information back to management related their area of expertise and recommend modifications to improve corporate performance or reduce risk.
Certified Public Accountants
Considered the top level of expertise in the field of accounting, Certified Public Accountants (CPA) provide the premier level of services for business. The most common level of service is tax preparation and performing audits for businesses or organizations. They are revered due the formal education and the taking of a national exam considered one of the most difficult if not the most difficult business related exam in the world. Currently CPA’s must have completed the equivalent of an advanced degree in accounting before taking the exam.
Summary – Accounting
Accounting is the function of recording economic activity for a business. It includes the process of gathering information, categorizing the economic information, recording the transactions, generating reports and analyzing the data outputs. This spectrum of information processing is performed by various individuals with different levels of education and experience. The most common position in accounting is the bookkeeper and with more education and experience come the higher levels of expertise. Accountants have some formal education and the managerial experts have full formal educations in their respective fields of accounting. The most widely accepted expert is the Certified Public Accountant.
From the above, the reader should understand that accounting is an overall process to record business activity and report that information to management. Act on Knowledge.