What is financial accounting?

Financial accounting is a type of accounting for keeping track of a business’s financial transactions. This branch of accounting must adhere to accounting rules set by standard-setting organizations.

Financial accounting vs. managerial accounting

While the nature of financial accounting is primarily for external stakeholders, managerial accounting helps internal stakeholders, such as managers, make decisions. 

There are three key differences between financial and managerial accounting: 

• Financial accounting looks at the past, reporting previous transactions. Managerial accounting’s primary focus is on the future and strategizing. 
• Financial accounting statements must follow strict rules, while managerial accounting statements do not. 
• Reports for financial accounting must be objective and unbiased. Managerial accounting is customizable to fit management needs.

What is the primary purpose of financial accounting?

Companies primarily use financial accounting to report their financial position to stakeholders. A stakeholder is anyone who has an interest in the company and can affect the company or be affected by it. 

They can be individuals or other companies. Note that shareholders are investors in a company and are a type of stakeholder. 

Typical stakeholders include: 

• Employees
• Shareholders and investors
• Customers or clients
• Suppliers and vendors
• Creditors 

Prioritize financial recordkeeping 

The financial accounting definition requires that it provide a comprehensive record of financial transactions. Recordkeeping is the process of using an accounting system to track business activities. 

Recordkeeping can help improve a business’s ability to:

• Track key accounts—income, expenses, assets, and liabilities
• Analyze financial performance
• Set and maintain budgets
• Pay taxes, invoices, and employees
• Compile financial statements

Meet legal requirements

Financial accounting helps small businesses meet requirements for tax filings. Some companies must also disclose financial information to the government. Companies can avoid fines and penalties by following accounting standards and principles. 

Share information

The other key purpose of financial accounting is to share information. Most companies will have four primary stakeholders that use the financial statements. 

Management

Management takes advantage of financial accounting by assessing the company’s performance. Business owners can also assess their company from the viewpoint of an external stakeholder.

They can find things that could get in the way of getting a loan, like too much debt. And then work to pay down those obligations before applying.

Creditors

Creditors, such as banks and lenders, will use financial statements to assess a business’s creditworthiness. But they may also require reports on an ongoing basis to assess company performance. 

Shareholders

Investors are another group that benefits from financial accounting and financial statements. Public companies must publish these reports, but many investors in private businesses will also want periodic financial reports. Prospective investors will ask for access to your company’s financials before investing. 

Suppliers

Suppliers that offer lines of credit will likely ask for your financials as part of the credit application process. Similar to credit card companies, suppliers will want to see your creditworthiness before allowing you to purchase goods on credit.

Standards and principles of financial accounting

Accounting standards and principles guide how businesses record financial accounting transactions. Public companies in the US must adhere to these financial recordkeeping rules. Many private companies also follow the same standards.

Accounting principles ensure that financial statements are consistent across previous periods and comparable to other companies. A principle of financial accounting is that it follows the principles below. 

US GAAP

The rules governing US financial statements are Generally Accepted Accounting Principles (GAAP).

The Financial Accounting Standards Board (FASB) maintains US GAAP. Publicly-traded companies must use GAAP for financial accounting. The GAAP framework outlines how to record specific transactions, such as the value of inventory on your balance sheet or revenue on the income statement.

Note that GAAP is a rules-based system with strict standards. Here are the 10 key principles of GAAP:

1. Regularity: Reports use GAAP regularly
2. Consistency: Accounting standards are the same each period
3. Sincerity: No bias in financial statements 
4. Permanence: Consistent reporting over a long period
5. Non-compensation: Full transparency about finances
6. Prudence: Fact-based, speculation-free reporting
7. Continuity: Assumption the business won’t change its practices
8. Periodicity: Transactions are in the relevant accounting period
9. Materiality: Full disclosure of all material financial information
10. Good faith: Honest completion of reports and transactions 

IFRS

Companies outside the US use International Financial Reporting Standards (IFRS)—a set of standards created by the International Accounting Standards Board (IASB) and used in over 120 countries.

There are key differences between GAAP and IFRS. GAAP is rule-based, but IFRS is principle-based. GAAP requires more detail and complex disclosures, while IFRS provides flexible guidelines. Though following US GAAP is more work, it has its benefits for small businesses. 

Methods of financial accounting

Despite having to follow ‌standards and principles, small businesses do have some flexibility. You can choose to either use the cash method or the accrual method for financial accounting.

Cash method 

The cash method calls for an accounting transaction at the time of payment. For example:

1. A company makes a sale on Nov. 1
2. It collects payment on Nov. 15
3. It books the sale as revenue on Nov. 15

The cash method doesn’t work for most companies. It can obscure the company’s true financial position in the financial statements. 

The IRS also has limits on which companies can use the cash method for tax reporting. The cash method is available for corporations or partnerships that have average annual gross receipts of less than $27 million for the past three tax years. 

Accrual method 

The accrual method requires you to recognize transactions when they happen—regardless of when you pay or collect payment. Here’s an accrual method example: 

1. A company makes a sale on Nov. 1
2. It collects payment on Nov. 15
3. It books the sale as revenue on Nov. 1

The accrual method can also help accurately track inventory. As a result, most companies that carry inventory must use the accrual method. 

Types of financial accounting systems

In addition to the cash method vs. accrual method, there are two types of financial accounting systems: single- and double-entry.

Single-entry accounting

The single-entry system uses just one account for every transaction, such as income or expense, while the double-entry system uses at least two.

Single-entry accounting is similar to balancing a checkbook. There’s a starting balance, and each transaction is a deposit or withdrawal. It’s a simple, cheap system that only works for a limited number of businesses. It doesn’t provide a checks-and-balances framework to prevent errors—although double-entry accounting is also subject to mistakes. 

For example, a business buys supplies and inventory for $200 and later makes sales totaling $400. With the single-entry method, their ledger looks something like the following:

1. Beginning bank balance $500
2. Supplies and inventory -$200
3. Sales $400
4. Ending bank balance $700

It works for a simple business, but you miss out on a lot of useful info. It doesn’t provide the capacity to track assets or liabilities, nor provide insights into profitability.

Double-entry accounting

Double-entry has at least two accounts for each transaction. It’s required for financial accounting and expands the capabilities of tracking and managing your business, but it also makes it possible to create financial statements.

An example of a double-entry for a $200 purchase of supplies and inventory on credit would look something like this:

1. Debit supplies expense for $100
2. Debit inventory account for $100
3. Credit accounts payable for $200

A transaction for double-entry accounting must have equal debits and credits. 

Note that if you adopt the accrual method, you must ‌use double-entry accounting. For the cash method, you can use either single- or double-entry.

Financial statements overview

The financial accounting definition requires that transactions follow certain rules. That means all company financial transactions, like buying a computer or getting a bank loan, will appear in the financial statements. The nature of financial accounting makes creating financial statements possible.

Balance sheet

Balance sheets reveal a company’s financial health. It’s a snapshot of the company’s assets, liabilities, and equity at a given point in time. Liabilities are what a company owes, and assets are what it owns. Equity is what’s left when you subtract total liabilities from total assets.

Assets – liabilities = shareholders’ equity

The balance sheet provides insight into how much money a company has available to spend, as well as how much debt it has.

Income statement

The income statement lays out all the revenue, expenses, and income. It provides a detailed look at a company’s profitability over a given period, such as one quarter or a year. 

Cash flow statement

The cash flow statement outlines a company’s cash inflows and outflows over a set period. It’s a great tool for seeing how much cash a company generates and where it goes. 

Just because a company shows income on its income statement, it could still have negative cash flow—and vice versa. This is true if the company has high debt payments, which don’t reduce net income but do reduce cash balances. 

If your business is cash-strapped, the statement of cash flows will help reveal where the major outflows are. 

Statement of owner’s equity 

The statement of owner’s equity outlines changes in owner’s equity over a period of time. It details all the changes to the owner’s equity, including distributions and capital contributions. 

This report will also include other things, such as net income that carries over from the income statement.

Financial accounting examples

Companies of all sizes and industries use financial accounting. Here are three financial accounting examples that show the system in action.

Professional services companies 

Professional service companies, such as dentists, lawyers, landscapers, and marketing agencies, all benefit from financial accounting. For example, a dentist is selling their business. The first things potential buyers will ask for are financial statements.

If they use financial accounting software, it’ll be easy to create and generate financials for various periods. Let’s say the interested buyer asks for the income statement for the last 12 months to calculate the business’s net profit margin. 

On the income statement, the business generated $900,000 in sales and had $630,000 in expenses. Its net income shows $270,000. The financial statement makes the net profit margin a quick calculation—$270,000 divided by $900,000, or 30%.

Manufacturers 

Companies that make products, such as manufacturers, also use financial accounting. The big benefit for these companies is that they can track their cost of goods sold (COGS), which is the direct cost of producing their products. It includes raw materials, labor, and overhead

The company can run financial statements to assess the profitability of its products quickly. 

For example, over the last three months, they’ve generated $1 million in monthly sales. COGS has increased from $250,000 to $300,000.

With a detailed view of the income statement, the company finds that raw material costs are rising due to inflation. Further analysis can reveal ways to protect their business from inflation, such as buying more supplies in bulk and embracing automation. 

Consumer goods businesses 

An e-commerce store is using financial accounting to track inventory. They’re also using past financial statements to estimate how much inventory they need on hand.

By doing so, they avoid missing sales due to out-of-stock items. But it also keeps them from tying up too much of their money in inventory that could become obsolete. 

The concept of financial accounting is necessary for any company that needs to track inventory. Holding too much inventory could mean having to mark it down later. It also limits the available cash for investing in other parts of the business.

What type of accounting do you need?

Small businesses may benefit from using other types of accounting, such as managerial accounting, cost accounting, and project-based accounting, in tandem with financial accounting. Together, they help internal stakeholders, such as managers, better control costs.

This article originally appeared on the Quickbooks Resource Center and was syndicated by MediaFeed.org.

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