Financial Accounting: What You Need to Know

What is financial accounting?

Financial accounting is a branch of accounting that focuses on reporting, summarizing, and categorizing a business’s transactions and crucial financial data.

Financial accounting is often legally required if your company generates financial statements as part of its annual reports or reports to shareholders. These financial statements also come in handy when making management decisions and deciding on tax strategies. (Note that while financial statements are helpful during tax time, actual tax filings require separately prepared reports.)

“Financial accounting provides you with the tools to truly understand your business,” said Teresa Thomas, founder of Ridge CFO. “By applying solid accounting principles, you can track performance, identify trends and make confident decisions based on facts rather than guesses.”

What’s the difference between accounting and financial accounting?

Business accounting is the process of creating financial systems and procedures and tracking your company’s revenue, expenses, assets and liabilities. Financial accounting goes deeper; it involves compiling individual transaction records into comprehensive reports that management, shareholders and others can review. It compiles all accounting data into a usable format — concise statements summarizing your company’s financial situation.

Small business accounting

Small business accounting involves the following:

• Setting up books and records, including accounts payable and accounts receivable processes
• Recording all of your company’s transactions — both cash and noncash
• Implementing policies and procedures for how you’ll treat revenue, expenses, assets and liabilities
• Managing all your company’s financial data

Notably, small business accounting requires that businesses establish a process for generating reports that reflect your company’s financial situation. This is where financial accounting comes into play.

Financial accounting

Financial accounting involves compiling all the transactions recorded during normal accounting activities. Accounting software features help you consolidate these records into statements.

Here are some of the most significant statements financial accounting will generate:

• Income statement: An income statement shows all revenue, expenses, gains and losses for your company, team, department or project for a set period.
• Balance sheet: A balance sheet provides a snapshot of your company’s current financial condition — including net value — by totaling assets and debts as of a particular day.
• Cash flow statement: Cash flow statements summarize how money flows in and out of your business over a specific period. It includes cash in and out in the form of revenue (collected) and expenses (paid).
• Statement of retained earnings: This statement shows the value shareholders hold in a business; it’s based on initial capital contributions and net earnings that haven’t been distributed as dividends.
• Statement of shareholder equity: A statement of shareholder equity is part of a business’s balance sheet. It lists the difference between total assets and total liabilities.

How does financial accounting work?

Financial accounting involves recording all your company’s transactions in accounting software. That software — or your accountant or CPA — reconciles those transactions into appropriate accounts or categories; then, it generates reports summarizing your company’s financial circumstances.

“When your books are clean and accurate, you can see where your business stands financially, identify problems early, and take advantage of tax deductions and credits you might otherwise miss,” Thomas said. “It also helps you stay compliant and avoid surprises, whether it’s an IRS notice or a cash flow crisis. I always tell my clients that solid accounting isn’t a luxury. It’s a foundation.”

It’s relatively easy to generate the accounting reports you and your staff will use to assess your organization’s financial health. In fact, most accounting software platforms allow you to create insightful reports with just a few clicks. The challenge lies in knowing what to do with the information and what decisions to make based on those records.

Financial accounting methods

Financial accounting involves many different processes and reports, but all depend on which type of accounting your company uses: cash or accrual. These accounting methods determine when your business books new revenue and expenses.

“Cash accounting is straightforward,” Thomas explained. “You record income when you receive payment and expenses when you pay them, making it great for freelancers and very small businesses. Accrual accounting provides a clearer picture of your profitability because it aligns income and expenses with when they’re actually earned or incurred. This is important if you invoice clients, manage inventory or want to understand how your business truly performs over time.” 

• Accrual accounting: Under accrual accounting, your business will book all transactions when they are agreed upon. For example, when your company receives an invoice, you or your accountant books the invoice as an expense.
• Cash accounting: If your company uses cash accounting, you will record transactions when cash actually changes hands. In this case, items such as unpaid invoices may still be recorded in your financial records but could be categorized separately until paid. An unpaid invoice, for example, would appear as a liability instead of an expense.

Unfortunately, you may not be able to use cash accounting because of IRS restrictions. According to the IRS, several business types are prohibited from using cash accounting:

• A C corporation with average annual gross receipts of $25 million or more over the past three years
• A partnership with a C corporation where the partner’s average annual receipts are more than $25 million over the past three years
• A tax shelter under Section 448(d)(3)
• Any business that makes sales on credit

While these businesses are required to use accrual accounting, your business can choose to use it. Many companies that are allowed to use cash accounting do so because it’s easier to implement. Nevertheless, most small businesses use accrual accounting.

The differences between cash and accrual accounting may seem like semantics, but this choice determines when you’ll book revenue and expenses. Your decision can significantly impact how your company appears on paper; also, it may have serious implications if you’re looking to buy or sell the business or raise or borrow money.

Financial accounting examples

You don’t need to be an accountant or bookkeeper to understand financial accounting. While you might not want to prepare your own reports, as your business grows, understanding how to read different statements, especially a balance sheet, income statement and cash flow statement, is a good first step.

Balance sheet

A balance sheet acts as a snapshot of a company’s financial situation at the time the statement was prepared. It includes information about assets and liabilities, as well as shareholder equity. When the balance sheet is prepared, it should show that assets are equal to liabilities plus shareholder equity.

This example displays Apple’s balance sheet as of September 2020 and compares it to the same period in September 2019. As you can see, it includes all of the assets that Apple owns, as well as a section for liabilities. Plus, you can see which shares are outstanding and shareholder equity. The double-underlinded total from the assets section equals the total from the liabilities and shareholder equity section.

Income statement

An income statement can help you understand where your revenue is coming from and quickly identify your expenses. Your net income is your revenue and gains minus your expenses and losses. 

You can see Microsoft’s most recent income statement from a federal filing above. The statement starts with the revenue section, showing where the revenue comes from: products and services. Then it offers a look at the cost to produce that revenue.

Other costs and income are listed, and this income statement includes a provision for taxes. Once you get further down, you can see the net income, or what is left after all the costs.

Cash flow statement

A cash flow statement gives you an idea of how a company’s money flows through its system. You can get an explanation of investment activities as well, and obtain a better feel for how sustainable the company’s operations are.

This example of an Apple cash flow statement provides information about changes in assets and liabilities, proceeds from different activities, how investing activities contribute to the overall cash the company has and which items are generating the most cash. At the bottom, you can see that Apple’s ending balance was higher at the end of September 2023 than it was in September 2022.

Miranda Marquit and Jennifer Dublino contributed to the reporting and writing in this article.