Financial accounting is the documentation of your firm's finances using various reports and statements. These statements detail your company's income, expenses, assets and liabilities. Managers and shareholders often use this information to make decisions about your business and its operations.
Though some conceptual aspects of financial accounting can be somewhat technical, it's much easier in practice thanks to modern accounting software. Some of the best accounting software solutions help your managers track their transactions and build custom reports. Financial accounting is essential because it helps you and your managers make informed decisions about your business.
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What is financial accounting?
In business, accounting is the process of creating financial systems and procedures, and tracking your company's revenue and expenses. Financial accounting goes deeper; it involves compiling individual transaction records into comprehensive reports that management, shareholders and others can review.
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 special reports.)
Financial accounting can sound complicated, but it's really not, especially if you have excellent accounting software and get a little help setting up your books and records. Once you're set up, you'll just need to track your ongoing transactions and periodically prepare relevant reports.
What is the difference between accounting and financial accounting?
Basic accounting for small businesses is the process of establishing policies and procedures regarding how revenue, expenses, assets, and liabilities are treated. Financial accounting involves taking all that data and compiling it into a usable format – concise financial statements that summarize your company's financial situation.
Small business accounting involves the following:
- Setting up books and records
- Recording all of your company's transactions – both cash and noncash
- Implementing policies and procedures for the treatment of revenue, expenses, assets and liabilities
- Managing all your company's data pertaining to its finances, such as accounting records
Lastly, small business accounting requires establishing a process for generating reports that reflect your company's financial situation, which is where financial accounting comes into play.
Financial accounting involves compiling all the transactions recorded in the course of normal accounting activities. With accounting software, these records are consolidated into statements. Here are some of the main statements financial accounting will generate:
- Income statement: This shows all revenue, expenses, gains and losses for your company, team, department or project for a set time period.
- Balance sheet: This 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 time period. This includes cash in and out in the form of revenue (collected) and expenses (paid).
- Statement of retained earnings: This shows the value shareholders hold in a business based on initial capital contributions and net earnings that haven't been distributed in the form of dividends.
How does financial accounting work?
Financial accounting involves recording all of your company's transactions in accounting software. That software – or an accountant – reconciles those individual transactions into appropriate accounts or categories, and then generates reports based on those consolidated transactions. These reports summarize your company's financial circumstances.
Despite the many nuances for certain industries, accounting and financial accounting aren't difficult; both just require dedication and persistence. Regardless, you should address small business accounting challenges head-on.
It's relatively easy to generate the reports you and your staff will use to assess your organization's financial health. Among standard accounting software features is the ability to generate reports with just a few clicks. It's knowing what to do with the information, and what decisions to make based on those records, that's hard.
Types of financial statements
Here's an at-a-glance view of the most significant financial statement types and what they reveal about your company.
|Statement||What it shows|
|Income statement||Your company's income and expenses over a period of time|
|Balance sheet||A snapshot of your organization's assets, liabilities and net value|
|Cash flow statement||The flow of cash into and out of your business's coffers over a period of time|
|Retained earnings||The amount of earnings your company has that have been retained - not distributed to shareholders or creditors|
|Shareholder equity||The total liquidation value of your company to its individual owners|
These are just some of the core financial statements your business can produce using standard financial accounting practices. Though each statement type has a standard format, you can customize statements to suit your business's particular needs.
You'll use each financial statement type in different scenarios, as they provide unique details about your firm's financial circumstances. Some – such as the balance sheet or statement of shareholder equity – provide snapshots of specific accounts at one point in time. Others – like an income statement or statement of cash flow – report changes over a period of time.
Because of their differences, these financial statements tell very different stories, and you will use them to make very different decisions. For example, the right combination of statements can depict if your business makes a lot of money but has little actual value; while another statement combination can show if your business (based on assets) makes very little money each year relative to its size.
Accounting types: Accrual method vs. cash method
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.
Under accrual accounting, your business would 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.
If your company uses cash accounting, on the other hand, you would record transactions not when they agree to a transaction, but 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 rather than 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. Consequently, most 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 it determines when to book revenue and expenses. This can have a significant impact on the condition of your company as it appears on paper – and, therefore, has serious implications if you're looking to buy or sell the business, or raise or borrow money.