If you’re starting a business, you’re probably asking, ” What is financial accounting?” Long story short is, this is about recording transactions. All your small business debits and credits.
What Exactly is Financial Accounting?
This covers all business operations over a specific time. There are categories detailing the financial transactions involved. Like revenue, expenses, liabilities and equity. This type of financial accounting aims to corral the numbers. To give a good picture of small businesses’ financial position over a specific period.
There are three statements included in a final report. Financial accounting brings all the necessary information into one place. That makes it more user-friendly and easier to understand. Without this type of financial reporting, SMBs would have a hard time operating.
Types of Financial Accounting
- Accrual Accounting
- Cash Accounting
There are several different types of accounting methods involved. Learn more about the accrual method and cash accounting below.
Accrual Accounting
The accrual method of accounting is a systematic approach that emphasizes the economic events of a transaction over the actual cash flow.
With this method, expenses and revenues are recorded at the time they are earned or incurred, regardless of when the money changes hands.
For instance, if a business provides services in December but doesn’t receive payment until January, the revenue would be recorded in December under the accrual method.
This offers a more comprehensive picture of a company’s financial health as it recognizes all business activities, both cash and credit. Given its holistic approach, accrual accounting is the preferred method for many businesses, especially larger entities, as it provides a clearer, long-term view of financial performance and position.
While it may require more diligent bookkeeping, it ensures a smoother financial picture by evening out the ebbs and flows of cash transactions.
Cash Accounting
The cash method is different. The financial information recorded is more immediate. Revenue and expenses are recorded as they happen. There’s a drawback with this. The cash basis of accounting doesn’t always provide accurate financial results for bigger companies and ones with larger inventories.
The cash basis method is good for sole proprietors.
Main Financial Statements in Financial Accounting
Financial accounting statements have reporting requirements. This type of accounting is the process of seeing how the following financial statements interact.
Income Statement
This shows profitability for a specified period. It’s also called a profit and loss statement. Included are revenue from sales and expenses to arrive at a net income. A big indicator of financial health.
Balance Sheet
A balance sheet is one of the most important financial statements. It’s a summary of the current assets, liabilities, and shareholder’s equity. Public companies include accounts payable and accounts receivable.
A retained earnings statement is added, along with stockholder’s equity.
Statement of Retained Earnings
This financial statement is in between the income statement and the balance sheet. It’s another one of the accounting practices focusing on transactions. It reports on any deductions like dividends paid and the net amount left.
Cash Flow Statement
Financial statements dealing with cash flows are big indicators of how well a small business is doing. A statement of cash flow on any balance sheet should be positive. A good cash flow has more money coming in than going out. A negative cash flow on basic financial statements can lead to bankruptcy.
A cash flow statement also looks at how well you generate money. These financial statements use an indirect or direct method to gauge business operations. A cash flow statement complements the income statement and balance sheet.
Read More: what is cost accounting
Summary
| Financial Statement | Description |
|---|---|
| Income Statement | Shows profitability over a period, also known as a profit and loss statement. Includes revenues and expenses to derive net income. |
| Balance Sheet | A summary of assets, liabilities, and shareholder's equity, including accounts payable, accounts receivable, and retained earnings. |
| Statement of Retained Earnings | Positioned between the income statement and the balance sheet; reports on transactions like dividends paid. |
| Cash Flow Statement | Measures cash inflows and outflows, indicating business financial health. Utilizes direct or indirect methods for analysis. |
Why Financial Accounting is so Important
Recording a company’s financial transactions over a period of time is critical. Financial accounting rules cover several important aspects in the same period. Like stockholders equity.
Here are five reasons why these financial statements matter.
- They Detect Fraud: These accounting rules weed out fraud. And suspicious activity. Like an income statement full of fake revenues.
- They Highlight Performance: A company’s annual report accesses its performance in relation to previous years and industry averages. The net income measures sales revenue.
- They Determine Taxes: The accounting principles involved determine the taxes a small business needs to pay.
- They Help With Decisions: Any company’s management uses these financial accounting reports to move forward with decisions about loans, expansions, etc.
- Double-entry accounting: It provides a comprehensive income picture. Management can trust numbers like these since there are at least two accounts. One debit and one credit.
A trial balance detects any errors. Using the accrual basis also helps to see which months are profitable.
They Are Legal
The GAAP ( see below) are accounting standards adopted by the securities and exchange commission. These records can be presented in court.
Financial Accounting Vs. Cost Accounting
There are some differences between these two types.
- Cost accounting handles cost records. Financial accounting cuts a bigger swath. It handles all of a small businesses’ financial data.
- The period of time these get reported is different too. Costs get reported at frequent intervals while a financial report comes at the end of a fiscal year.
Similarities include the fact they both use the double-entry method to record a company’s business transactions.
Financial Accounting Vs. Managerial Accounting
There are similarities and differences between these two methods too. The differences come down to the purpose for each.
- Financial accounting collects data that gets turned into financial statements.
- Managerial accounting is internal. It’s used to look at business transactions.
Both of these look at the numbers for a small business. They are similar in that they show how any transaction affects a bottom line.
The Role of Financial Accounting in Strategic Planning
Strategic planning is essential for any business aiming for long-term success and sustainability. Financial accounting plays a crucial role in this process by providing a factual basis for making informed decisions and setting realistic goals.
At its core, financial accounting involves recording, summarizing, and reporting the myriad of transactions a business undertakes, offering a clear picture of its financial health and performance.
Informing Strategic Decisions
Financial statements are invaluable tools for business owners and managers. They offer insights into the company’s profitability, liquidity, and solvency, which are critical for strategic planning.
For example, an income statement reveals trends in revenue and expenses, highlighting areas of strength and those requiring improvement. This information can guide decisions on whether to expand into new markets, invest in research and development, or cut costs.
Budgeting and Forecasting
Accurate financial records are the foundation of effective budgeting and forecasting, which are pivotal in strategic planning. By analyzing past financial performance, companies can set realistic budgets and forecasts for the future. This not only helps in allocating resources efficiently but also in setting financial targets and measuring progress towards them.
Risk Management
Financial accounting helps in identifying and managing potential financial risks. Through the analysis of financial statements, businesses can detect warning signs early, such as declining cash flows or increasing debt levels. This enables them to take corrective actions promptly, such as adjusting their strategic plan to mitigate risks.
Facilitating Communication
Financial statements are a universal language for communicating a company’s financial status to various stakeholders, including investors, creditors, and regulatory bodies.
A well-crafted strategic plan, supported by solid financial data, can build confidence among stakeholders, securing their support for the company’s strategic initiatives.
Compliance and Control
Compliance with financial regulations is crucial for any business. Financial accounting ensures that all financial transactions are recorded in accordance with relevant laws and standards, thereby avoiding legal issues that could derail strategic plans.
Moreover, it provides a framework for internal controls, helping prevent fraud and ensuring that resources are used efficiently and aligned with strategic objectives.
Understanding GAAP: The Foundation of Financial Accounting
The Generally Accepted Accounting Principles (GAAP) are a set of rules and standards designed to ensure consistency, transparency, and integrity in the financial reporting of companies. In the United States, GAAP is the cornerstone of financial accounting, guiding the preparation and presentation of financial statements.
What is GAAP?
GAAP encompasses a wide range of accounting practices, from the recognition of revenue and the valuation of assets to the presentation of financial statements. It is developed by the Financial Accounting Standards Board (FASB), an independent organization responsible for establishing and improving financial accounting and reporting standards.
Importance of GAAP
GAAP ensures that financial statements are prepared on a consistent basis across all companies, making it easier for investors, creditors, and other stakeholders to compare financial information accurately. This comparability is crucial for making investment decisions, lending, and other financial assessments.
Key Principles of GAAP
- Revenue Recognition: GAAP specifies when and how revenue should be recognized in financial statements, ensuring that it reflects the true earnings of a company.
- Matching Principle: Expenses should be matched with the revenues they helped to generate, providing a more accurate picture of a company’s profitability.
- Full Disclosure: Companies must disclose all relevant financial information that could affect the understanding of their financial statements.
- Conservatism: Accountants should err on the side of caution when faced with uncertainty, ensuring that assets and income are not overstated and liabilities and expenses are not understated.
Compliance with GAAP
Compliance with GAAP is not optional for publicly traded companies in the United States. The Securities and Exchange Commission (SEC) requires that financial reports adhere to GAAP to protect investors and maintain fair and orderly markets. Non-compliance can result in legal consequences, including fines and sanctions.
The Evolving Nature of GAAP
GAAP is not static; it evolves in response to changing financial landscapes, new types of transactions, and emerging technologies. The FASB regularly updates GAAP to address these changes, ensuring that the standards remain relevant and effective in promoting transparency and accountability in financial reporting.
Understanding GAAP is fundamental for anyone involved in financial accounting or interested in analyzing financial statements. It provides the framework within which financial decisions are made and strategic plans are developed, ensuring that businesses operate on a level playing field and that stakeholders have a clear, accurate view of their financial health.
How Much Does it Cost to Hire a Financial Accountant?
As you might imagine, the cost to hire one of these professionals varies. Location, experience, and the type of work that needs to be done all factor in. According to ZipRecruiter, the national average is $55,045 a year which translates into about $26 per hour.
Deciding on the features you need will affect the cost. Maintaining financial records and tax planning advice are just a few to think about. Managing equity accounts that highlight performance is another.
Is Financial Accounting Right for Your Business?
Every business needs a comprehensive income statement along with having other types of financial statement boxes checked. An accountant can decide what works best. Whether to use the accrual basis or cash accounting for your enterprise. But there’s a DIY option that can handle any accounting, such as FreshBooks or Quickbooks.
Do financial accountants follow generally accepted accounting principles?
The short answer is yes. The Financial Accounting Standards Board works to improve the quality of financial reporting. They develop standards and monitor their implementation. They follow the Generally Accepted Accounting Principles ( GAAP). They monitor both private and public companies.
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