Introduction to Accounting
Accounting is the process of recording, summarizing, and reporting financial transactions. It provides the information businesses, investors, lenders, regulators, and managers need to make sound economic decisions.
The Accounting Equation
Every financial transaction affects at least two accounts while keeping this equation in balance — the foundation of double-entry bookkeeping. The work of accounting ultimately produces three main statements: the balance sheet, the income statement, and the cash flow statement.
The Accounting Cycle
The accounting cycle is the repeating sequence of steps accountants follow to turn raw transactions into finished financial statements. It runs every accounting period — monthly, quarterly, or annually — and resets at the end so the next period can start clean.
- 1Identify transactions. Recognize the financial events of the period using source documents like invoices, receipts, and bank statements.
- 2Record transactions in a journal. Enter each transaction chronologically as a journal entry with matching debits and credits. Every company maintains a chart of accounts — the master list of every individual account — with each account assigned to one of five major types:
- 3Post to the general ledger. Transfer the journal entries into ledger accounts so activity is organized by account rather than by date.
- 4Prepare an unadjusted trial balance. List every account's ending balance and confirm that total debits equal total credits.
- 5Make adjusting entries. Record items like depreciation, accruals, and prepaid expenses so the books reflect what actually happened during the period.
- 6Prepare an adjusted trial balance. Draw up a new trial balance that includes the adjustments, which becomes the basis for the financial statements.
- 7Prepare the financial statements. Produce the four major statements in order, since each one feeds the next:
- Income statement — revenue minus expenses, giving net income for the period.
- Statement of retained earnings — how net income and dividends changed equity.
- Balance sheet — assets, liabilities, and equity at the end of the period.
- Cash flow statement — cash in and out across operating, investing, and financing activities.
- 8Close the books. Zero out temporary accounts into retained earnings and run a post-closing trial balance to confirm only permanent accounts remain.
Two Branches of Accounting
Accounting splits into two main branches that serve different audiences and answer different questions.
Financial Accounting
Financial accounting produces standardized reports for outside parties like investors, lenders, and regulators. Because so many people rely on it, it follows strict rules such as GAAP or IFRS and looks primarily at what has already happened. It encompasses several specialized areas:
Specialized areas
- Public accounting — services provided by CPA firms to outside clients, including audit, tax, and advisory work.
- Auditing — independent examination of financial statements to verify they fairly represent the company's position.
- Tax accounting — preparing tax returns and tax planning, governed by the tax code rather than GAAP.
- Forensic accounting — investigating fraud, embezzlement, and financial disputes, often in support of litigation.
- Government accounting — for federal, state, and local entities, governed by GASB and using fund accounting.
- Nonprofit accounting — for charities and foundations, with conventions around restricted versus unrestricted funds.
- International accounting — multi-currency transactions, foreign subsidiary consolidation, and reconciling between GAAP and IFRS.
Financial Ratios
Once the statements are prepared, ratios turn the raw numbers into something easier to compare and judge. Investors use them to gauge profitability, managers use them to spot operational problems, and lenders use them to set and monitor loan covenants — contractual thresholds a borrower must stay within to avoid default.
- Current ratio (Current Assets ÷ Current Liabilities) — measures short-term liquidity. Lenders often require it to stay above 1.0.
- Debt-to-equity ratio (Total Liabilities ÷ Total Equity) — shows how leveraged a company is. Loan agreements frequently cap it.
- Debt service coverage ratio (Net Operating Income ÷ Annual Debt Service) — tells a lender whether earnings comfortably cover loan payments. Banks commonly require 1.20 to 1.25 minimum.
- Interest coverage ratio (EBIT ÷ Interest Expense) — measures how many times over a company can pay its interest from operating earnings.
- Profit margins (Gross or Net ÷ Revenue) — track profitability and how much of each sales dollar survives after costs.
- Return on equity (Net Income ÷ Equity) — shows how effectively the company turns owner investment into profit.
Managerial Accounting
Managerial accounting serves an internal audience, helping managers run the business. It is forward-looking, tailored to whatever questions leadership needs answered, and free from the formal reporting standards that govern financial accounting.
Key areas
- Cost accounting — tracking and allocating production costs through methods like job order, process, and activity-based costing.
- Budgeting and forecasting — building operating budgets, capital budgets, and cash flow projections.
- Variance analysis — comparing actual results to budget or standard and explaining the gaps.
- Cost-volume-profit analysis — break-even points, contribution margins, and pricing decisions.
- Capital budgeting — evaluating long-term investments using NPV, IRR, and payback period.
- Performance measurement — KPIs, balanced scorecards, and responsibility accounting.
- Decision analysis — make-or-buy choices, special orders, and other short-term operational decisions.
Governing Bodies
Accounting standards do not write themselves. A network of regulators, standard-setters, and professional organizations defines the rules and oversees how they are applied.
United States
- FASB — sets GAAP for private-sector companies and nonprofits.
- GASB — sets accounting standards for state and local governments.
- FASAB — sets accounting standards for federal government agencies.
- SEC — regulates public companies and enforces financial reporting.
- PCAOB — oversees public-company audits, created by Sarbanes-Oxley in 2002.
- AICPA — national professional body for CPAs.
- IMA — leading association for managerial accountants and home of the CMA.
- IRS — administers the federal tax code.
International
- IASB — sets IFRS, used in over 140 countries.
- IFRS Foundation — oversight body that appoints and funds the IASB.
- IFAC — global federation of national accounting organizations.
- IAASB — sets international auditing standards (ISAs).
- IPSASB — sets standards for governments and public-sector entities globally.
- IESBA — sets the global code of ethics for the profession.