What is accounting?

Stan Synder Stan Snyder, CPA and expert bean counter

Accounting is the art of recording, summarizing, reporting, and analyzing financial transactions. An accounting system can be a simple, utilitarian check register, or, as with Microsoft Office Accounting, it can be a complete record of all the activities of a business, providing details of every aspect of the business, allowing the analysis of business trends, and providing insight into future prospects.

Bookkeeping is the practice of recording transactions. Bookkeepers tend to focus on the details, recording transactions in an efficient and organized manner, and they may or may not see the overall picture.

Accountants use the work done by bookkeepers to produce and analyze financial reports. Although accounting follows the same principles and rules as bookkeeping, an accountant can design a system that will capture all of the details necessary to satisfy the needs of the business — managerial, financial reporting, projection, analysis, and tax reporting. A good accountant will create a system of financial reporting that gives a complete picture of a business.

By using Office Accounting, you can work with your accountant to set up your accounting system to meet the needs of your business. You can then enter transactions and generate reports — all the bookkeeping tasks and some accounting tasks, such as generating reports, that you might previously have relegated to your accountant.

Recording, summarizing, reporting, and analyzing

Recording transactions includes documenting revenues (by invoices or sales receipts), and entering purchases (in the account payable account) and expenditures (in the check register). Using Office Accounting, the small business owner can move beyond daily recording to higher level accounting tasks, such as recording sales orders, tracking prospective customers, and projecting sales opportunities and cash flow.

Calculating and summarizing transactions in a traditional accounting system is a tedious process. Microsoft Office Accounting frees you from these repetitive tasks by calculating and summarizing hundreds or thousands of individual transactions and generating reports to satisfy managerial, governmental, investing, or banking needs. Based on a generally accepted standard, these reports are powerful tools to help the business owner, accountant, banker, or investor analyze the results of their operations.

Double-entry accounting

Since the fifteenth century, when Luca Pacioli first wrote about the practice, the term "accounting" has referred to double-entry accounting. Double-entry accounting uses a system of accounts to categorize transactions. Each transaction that is entered consists of one or more debits and credits, and the total debits must equal the total credits. For example, if you purchase a car with a down payment of $1,000 and a loan from your bank for another $14,000, the entries to record this transaction would be the following:

  • A debit of $15,000 to your fixed asset account named, for example, "Vehicles."
  • A credit of $1,000 to your bank account for the down payment.
  • A credit to an Auto Loans account for $14,000.

The entries balance because the $15,000 debit is equal to the sum of the two credits.

It's all in how you look at it

If you're not a bookkeeper or an accountant, the whole system of debiting certain accounts and crediting others can seem reversed. This is because banking transactions have traditionally been described from the bank's perspective. A credit from the bank will increase your checking account balance on the bank's books. Bank accounts are assets on your books, so you will record a debit (see the following table) to your checking account while the bank records a credit to its liability account.

Account Type Normal Balance Debit Credit
Asset Debit Debits increase asset balances Credits decrease asset balances
Liability Credit Debits decrease liability balances Credits increase liability balances
Equity Credit Debits decrease equity balances Credits increase equity balances
Income Credit Debits decrease income balances Credits increase income balances
Expense Debit Debits increase expense balances Credits decrease expense balances

The following table illustrates which accounts are debited and which are credited for three types of transactions.

Action Account Type Debit or Credit
Sell an inventory item Accounts Receivable Debit
  Income Credit
  Inventory Credit
  Cost of Goods Sold Debit
Create a credit memo for a customer for an inventory item Inventory Debit
  Cost of Goods Sold Credit
  Income Debit
  Accounts Receivable Credit
Purchase an inventory item Inventory Debit
  Accounts Payable Credit

If debits and credits seem overwhelming, don't be discouraged. Office Accounting uses double-entry accounting; however, the debiting and crediting to various accounts is done for you. You enter transactions and Office Accounting will calculate and enter the debits and credits. Because you are freed from thinking about debits and credits, you can focus on the accounts used to summarize and categorize transactions.

Office Accounting focuses on individual transactions. The user enters transactions on forms that represent paper documents, using accounts to categorize transactions. Selecting an account on the transaction form dictates how Office Accounting applies debits and credits, summarizes transactions, and which information is included in reports. Each transaction that is entered must be in balance; by accepting only transactions that are in balance, Office Accounting keeps the balance sheet and the accounting system in balance.

The five account types

Double-entry accounting uses five — and only five — account types to record all the transactions that can possibly be recorded in an accounting system. There are sub-types of the following list, but all financial transactions can be recorded using these five types of accounts. The five account types are the following:

  • Balance sheet accounts:
    1. Assets     Things of value that are owned and used by the business.
    2. Liabilities     Debts that are owed by the business.
    3. Equity     The owner's claim to business assets.
  • Profit and loss accounts:
    4. Revenue     The amounts earned from the sale of goods and services.
    5. Expenses     Costs incurred in the course of business.

You must select the proper account types when entering a transaction. Using an incorrect account type can result in a report that is incomplete or that makes no sense. The balance sheet accounts are permanent accounts that carry a balance from year to year, like checking accounts, accounts receivable, and inventory accounts. The profit and loss accounts are temporary accounts which track revenues and expenses for a yearlong fiscal period and are then closed, with balances transferred to an equity account. Using an asset, liability, or equity account type for a revenue or expense transaction will result in a report that is incorrect and improper.

The accounting equation

The accounting equation defines the relationship between the five account types. The basic equation is assets equal liabilities plus equity. This is the format seen on a balance sheet. The profit and loss accounts — revenues and expenses — also affect equity. Revenues from the sale of goods and services increase equity, while expenses incurred in the course of business decrease equity. Therefore, the accounting equation can be expanded to assets equal liabilities plus equity plus revenues minus expenses. Office Accounting will record the appropriate debits and credits, and track the changes to assets, liabilities, equity, revenue, and expense accounts.

Double-entry accounting provides a system of checks and balances, where the accuracy of the system can be verified by reconciling asset, liability, and equity accounts to external sources. For example, the bank account is reconciled to a statement of account from the bank to verify that all transactions that have cleared the bank have been recorded in the accounting system. Similarly, accounts payable can be reconciled to statements received from vendors, and accounts receivable can be verified by mailing statements to customers. The inventory account is commonly reconciled by taking a physical count of inventory and comparing the physical account to the accounting records.

You can uncover simple errors, such as transposing numbers or misplacing a decimal point, when you reconcile accounts. Because each entry in a double-entry system affects two or more accounts, and virtually all entries affect at least one balance sheet account, reconciling the balance sheet accounts provides a high degree of probability that the profit and loss accounts are correct.

An efficient system of organization

Double-entry accounting is a system of organization that records financial transactions in an efficient process that has been used by private enterprise for over 500 years. It has been said by some that the industrial revolution could not have occurred without the system of organization created by double-entry accounting. The famous author Johann Wolfgang Von Goethe wrote about double-entry accounting in 1796:

"Double-entry bookkeeping is one of the most beautiful discoveries of the human spirit… It came from the same spirit which produced the systems of Galileo and Newton and the subject matter of modern physics and chemistry. By the same means, it organizes perceptions into a system, and one can characterize it as the first Cosmos constructed purely on the basis of mechanistic thought… Without too much difficulty, we can recognize in double-entry bookkeeping the idea of gravitation, or the circulation of the blood and of the conservation of matter."

Microsoft Office Accounting combines double-entry accounting with the personal computer to create a complete, easy-to-use computerized accounting system.


About the author

Stan Snyder is a certified public accountant with over 25 years experience dealing with the accounting and computer problems that small business owners face. He teaches at Colorado Mountain College, and regularly consults with small business owners using accounting software of all types. If you have questions about this topic or another accounting topic, send Stan some feedback by responding to the question below "Was this article helpful?" Stan may use your questions or topic ideas in an upcoming column.

 
 
Applies to:
Accounting 2008