Financial accounting is a vital health check and wealth review process for any business. A registered company needs to assess and keep records of the business’s progress and economic condition, and financial accounting is the only way to get a precise picture of how the business is performing. This knowledge is necessary to improve financial productivity and set a course for future survival and health.
Financial accounting can also demonstrate a business's fiscal health to attract investors, build business partnerships, and comply with regulatory bodies and auditors. Let’s look at what financial accounting consists of and why it matters for your business.
What Is Financial Accounting?
Financial accounting records, summarizes, and presents a company's financial activity over a period of time through financial statements. Key reports include:
- The Income Statement
- The Balance Sheet
- The Cash Flow Statement
- The Statement Of Retained Earnings
Financial accounting consists of analyzing and documenting a business's transactions. It’s a process that can reveal a business's financial health by presenting the analysis in the form of financial statements. These statements include an income statement, a balance sheet, a cash flow statement, and a statement of changes in equity. These documents record and display the specifics of a business’s operating performance over a set period of time.
These statements are built from data derived from your business operations. Various methods are available for retrieving the data to feed into your financial accounting, including AI-based receipt data extraction, sales records from online transactions, and business bank statements.
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Accounting And Financial Accounting, What’s The Difference?
Accounting is a more general term for all of a business’s financial activity. This includes expenses, payroll, sales, profits, and expenditures in every part of the business.
Financial accounting, on the other hand, is specifically concerned with generating financial statements according to GAAP (Generally Accepted Accounting Principles), which are a set of rules that all U.S. companies are expected to follow.
Why Financial Accounting Matters
Financial accounting matters because it can help a business in various crucial ways:
- It helps create a standard set of rules that companies can use to maintain consistency in preparing financial statements across the business.
- It enables businesses to gain valuable insights into their operations, providing management with valuable information for forward planning and strategies.
- It increases performance accountability and, therefore, reduces financial risk. It is key to have a clear picture of a business's health and to be able to show this to potential lenders and investors.
- It promotes transparency and trust. Companies can be clear and open regarding their financial operations and provide evidence of this through financial statements.
- It provides a strong basis for planning and expenditure. For example, if your business is considering investing in AI for logistics to streamline and optimize deliveries, accurate financial accounting can provide evidence-based figures to justify and support this expenditure.
Types Of Financial Accounting
There are two types of financial accounting; cash accounting and accrual accounting.
Cash accounting means transactions are recorded when cash is received. The drawback with this form of accounting is that it doesn’t reveal whether revenue or expenses were generated before the cash was received.
Cash accounting is suitable for small businesses with limited capital and a smaller workforce. It’s not a method that’s sophisticated and granular enough for larger businesses with more complex structures and financial transactions.
Accrual accounting, on the other hand, works on the principles of revenue recognition and matching revenue. It’s the most accurate form of accounting as it digitally records each transaction, with revenue earned but the amount not received being logged in the asset account, expense occurred, and cash not paid being logged in the liabilities account. It’s a far more detailed and accurate form of financial accounting for large-scale enterprises.
Principles of Financial Accounting
Financial accounting follows a rulebook of five core principles that act like a recipe for preparing a company’s financial statements. These principles establish the foundation for all the technical rules accountants follow. Let’s break them down with real-world examples:
Revenue Recognition Principle
Imagine you run a consulting firm. This principle dictates you record revenue when the service is delivered, not when you receive payment. So, if you complete a consulting project in December but your client pays in January, the revenue gets recognized in December’s financial statements.
Cost Principle
This principle focuses on recording costs at their original purchase price. For instance, if you buy a new office printer for $500, that’s the cost you record, not what you think it might be worth in a few years. However, for assets like buildings or equipment that wear down over time (depreciate), the cost is spread out over their useful life.
Matching Principle
This principle ensures expenses are recorded in the same period as the revenue they helped generate. Let’s say you buy inventory in November for your retail store. You shouldn’t wait until you sell that inventory in December to record the cost as an expense. The matching principle requires recording the inventory expense in November alongside any sales revenue generated from that inventory.
Full Disclosure Principle
Imagine the financial statements as a story about a company’s financial health. This principle ensures the story is told completely and transparently. Financial statements often include footnotes or extra schedules that explain accounting choices or provide more context. Think of them as additional chapters that give a more complete picture.
Objectivity Principle
Financial accounting involves estimates and judgements, but this principle emphasizes avoiding bias. Imagine valuing a company’s brand name. There’s no set price tag. Objectivity requires accountants to use documented methods and avoid personal opinions when making these estimates.
Types Of Financial Statements
Financial accounting consists of different types of financial statements. We’ll look at them one by one.
Income Statement
An income statement, also known as a profit and loss statement, records the revenues, expenses, profits, and losses generated by a business. Income statements are issued at regular intervals, such as monthly or quarterly. These statements are used within the business by management to look at revenue, expenses, and net income.
Balance Sheet
A balance sheet consists of assets, liabilities, and equity. It reports a company’s financial status at a specific point in time. As a balance sheet shows what a company owns and owes, as well as its owner’s or shareholders’ equity, it can be used to assess a business's liquidity and solvency.
Assets usually consist of the following:
- Cash
- Buildings
- Investments
- Accounts receivable
- Equipment
- Patents and permissions
Liabilities usually consist of the following:
- Loans
- Taxes
- Accounts payable
- Payroll
- Mortgages
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Cash Flow Statement
The cash flow statement, or the statement of cash flows, logs in detail a business’s incoming and outgoing cash. A cash flow statement only logs the cash movement, such as operation costs, financing, and investments. Operation costs could, for example, be expenditures such as employee expenses, which are a movement of cash necessary for employees to be able to perform their roles. These types of cash transactions can be tricky to log accurately, and some businesses find expense management software can help.
A cash flow statement is very useful for financial management as it demonstrates a company's short-term viability. It does this by showing how cash is used and how much working capital is available to cover business debts and pay the workforce.
However, unlike an income statement, a cash flow statement will not show any depreciation, amortization costs, or debt.
Statement Of Changes In Equity
This statement, also known as the statement of retained earnings, exists primarily to help shareholders and other investors make decisions about the business’s future based on movements in equity.
It shows the dividends paid and earnings retained by the company during a set time frame. It helps owners see the value of the business, and it also shows in detail the causes of rises and falls in equity over a period of time.
Who Uses Financial Accounting Statements?
Financial accounting is vital for a business in terms of managerial decision-making and planning, such as whether there is enough money in the company to invest in sales training methodologies to boost revenue via better-equipped sales staff or whether to reduce, retain, or increase assets, staff, and equipment.
Financial statements are also necessary to show the health of a company, in preparing agreements and contracts with groups and investors external to the company.
Examples of external parties who might need to see financial accounting statements include:
- Financial institutions and banks: When a business needs to borrow money, it needs to show reliable proof that it’s financially viable and demonstrate how money moves through the business and is used. Especially where loans are concerned, businesses need financial accounting statements to make the case for a bank trusting and lending to a company. These statements are also often used to set the interest rate, duration, and terms of the loan.
- Potential investors: To attract investors, companies use financial accounting statements to help potential investors understand the company's financial health, make predictions, and reassure them about its future financial trajectory.
- Suppliers and trading partners: External partners considering entering into a business arrangement with a company will often ask for financial statements, either as part of a credit application process or, in the case of a trading partner, to show board members in order to make a decision on whether to join forces with your business.
- Auditors and regulatory bodies: There is often a regulatory or legal necessity to present financial statements about your business. Auditors may want to analyze financial statements to make sure your business is operating legally and within the correct accounting guidelines. Public companies, in particular, are required to submit accurate financial statements or face fines and penalties.
An Example of Financial Accounting
Let's use a coffee shop company, Coffee Shop Co., as an example to illustrate financial accounting in action. Here's a scenario for the month of April 2024:
Transactions
Financial Accounting Principles at Work
- Revenue Recognition Principle: We recognize revenue of $2100 from coffee sales made in April.
- Cost Principle: We recorded the inventory purchase on April 1 for $1000, which represents the cost of the coffee beans and other supplies.
- Matching Principle: Rent expense of $500 for April is recognized in April, even though it might be paid in May. Similarly,a salary expense of $1200 for April is recognized in April, even though salaries might be paid on the last business day of the month. The loan interest of $50 is also recognized as an expense in April.
Financial Statements
Based on these transactions and principles, we can create financial statements for Coffee Shop Co. for April 2024. Here's a simplified example of an income statement:
Conclusion
Financial accounting is imperative for any large-scale business concern. It’s a mechanism for tracking and analyzing financial transactions of all kinds over time. It can give a clear picture of vulnerabilities, pressures, and general business health, as well as the nuts and bolts of where cash is coming from and where it’s going as it passes through the business. It also reveals where capital is held in terms of equipment, buildings, and other assets.
This information reveals a business's often invisible workings and provides crucial data to managers, potential investors, and financial authorities. It keeps your business straight and narrow and gives valuable insights on how to move forward and grow.
The clarity and depth of financial accounting statements are essential to helping your business survive and thrive.
