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 may seem complicated, but it’s really not — especially if you have excellent accounting software and set up your books and records properly. Once your accounting system is set up, you’ll just need to track your ongoing transactions and periodically prepare relevant reports.

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.

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.

Types of financial statements

Here’s an overview of the most significant financial statement types and what they reveal about your company.

These are just some of the core financial statements your business can produce using standard financial accounting practices. Keep the following information in mind:

• Financial statements have standard formats. Though each statement type has a standard format, you can customize statements to suit your business’s particular needs.
• Financial statements provide nuanced information. You’ll use each financial statement type in different scenarios because 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 specific period.
• Financial statements tell different stories. Because of their differences, these financial statements tell very different stories; you’ll 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. In contrast, 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.

• 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.

The best accounting software

Many startups and small businesses don’t have the budget for a full-time accountant or bookkeeper. However, that doesn’t mean they can’t reap the benefits of financial accounting. The best accounting software can output all the reports you need to make strategic decisions. Here are a few of our top picks:

Intuit QuickBooks Online

QuickBooks is an exceptionally popular accounting software for small businesses. It offers numerous financial accounting features, including reports on inventory levels, cash flow and aged receivables. You can also set up custom reports to run automatically and be automatically emailed to you. QuickBooks integrates with more than 750 business apps, so it can use data from other programs for its reports. Our detailed QuickBooks Online review highlights the platform’s AI chatbot, which can help you make sense of your financial data.

FreshBooks

FreshBooks is a well-known alternative to QuickBooks with similar robust features. While it doesn’t have as many reporting options as QuickBooks, it can generate your company’s bank reconciliation sheets, general ledger reports, balance sheets and profit-and-loss statements. As our FreshBooks review explains, if your company doesn’t need inventory management or batch invoicing, FreshBooks may be a good choice.

Oracle NetSuite

If your company does business internationally or is rapidly growing, consider using Oracle NetSuite for your accounting software. The software’s automation feature makes financial transactions such as accounts receivable, accounts payable, and taxes easier and faster. It also excels in financial accounting — seamlessly using your company’s financial data to inform strategic decisions. Our NetSuite review explains how, using big data, NetSuite can even help with budget planning and revenue forecasting.

Jennifer Dublino contributed to this article.