Financial accounting is an essential tool that’s a part of the broader accounting umbrella allowing you to track your company’s revenue, expenses, debts, and profits—all while generating valuable insights that can help you run your business more efficiently and build confidence with shareholders.
Understanding the basics of financial accounting
Although it sounds pretty straightforward, financial accounting is a complex practice—and many businesses struggle with it: In fact, more than half of small business owners make decisions based on incomplete financial information.
Without a firm grasp of financial accounting, it’s difficult for business owners to use these insights to create long-term strategies that drive organizational growth. But with a basic understanding of your vital financial statements and reporting methods, you can rely on the numbers to make great changes within your company—whether that’s adjusting business strategy, avoiding excessive expenses, or developing improved revenue models.
Financial accounting focuses on tracking every transaction that occurs within a business, which is recorded and summarized using generally accepted accounting practices and standards. This essential information appears in financial statements like income statements, balance sheets, and cash flow statements.
Businesses must track their transactions continuously and engage in financial reporting on a scheduled basis. Internal and external stakeholders, such as owners, regulators, and investors, use these financial reports to understand the company’s performance and its overall health.
For example, public companies have to publish their financial reports so that stakeholders can evaluate and forecast future performance. With that information, they can decide to adjust their investments based on forecasted future results and market trends.
The purpose of financial accounting
Financial accountants go through extensive training to learn accounting rules and regulations, like the generally accepted accounting principles (GAAP). By following specific accounting methods, they can accurately report on a company’s financial position, and stakeholders can use that information to understand the success of business operations.
But even if you have your accounting team or software, you as a business owner must understand why and how financial accounting is so critical to your business, both legally and financially.
The government legally requires financial accounting
When it comes to financial accounting and reporting, businesses will need to keep in mind the requirements and roles of a handful of government bodies. For example, the standards for financial reporting and accounting are set by the Financial Accounting Standards Board (FASB), but it’s the SEC that maintains control of enforcing the rules. Furthermore, SEC reporting is only mandatory for public companies.
On the other hand, the IRIS calls for financial reporting every year or quarter, gained from information available on financial statements for the purpose of collecting taxes. And the IRIS and that includes requiring every company to engage in financial reporting.
Governments require accurate financial reporting to ensure you don’t present incorrect numbers that could mislead investors and other stakeholders, causing them to believe your company is doing better than it is.
Financial reports are essential for investors, suppliers, and creditors
Internal and external stakeholders rely on a company’s annual report to gauge its financial well-being and are often used to provide an in-depth look for those considering partnering with, investing in, or even lending to businesses.
And if the reports are GAAP-compliant, there’s a greater chance for trust and transparency between you and potential investors or lenders.
While your company’s management relies on financial and managerial accounting to drive decision-making, investors use the numbers to decide if they want to invest in your business or not. Similarly, suppliers want to know how you’re doing to determine if they will work with you, and banks use financial reports to determine if they can provide you with funding.
Basic financial statements
To manage your financial accounting, you’ll need to compile various statements, which must conform to US GAAP principles outlined for all companies.
There are three specific financial statements you’ll need to create a complete picture of your financial accounting metrics. These include:
- Income statement
- Balance sheet
- Cash flow statement
There are some caveats to the “big three” of financial statements. Occasionally, you may see a supplemental statement known as “Other Comprehensive Income,” but this is only applicable if your company is public. Additionally, you may also come across the “Statement of Stakeholders’ Equity,” and, while insightful, these aren’t traditionally used for decision making.
Let’s dive deeper into these statements and explore why they’re essential for understanding your company’s financial health.
Income statement
The income statement (also called a profit and loss statement) indicates your company’s net income within a specific period. Companies create income statements every month, quarter, or year to get a better idea of their revenue, expenses, and overall profitability.
The main components of an income statement include:
- Revenue: The money you generate as a business, such as sales, interest revenue, and service revenue
- Expenses: The costs that your business pays to continue operation, such as the costs of goods sold (COGS), salaries, utilities, rent, advertising, and interest payments
- Net income: Your company’s take-home number after you’ve deducted expenses, interest, depreciation, and taxes
The income statement is crucial for every company because it indicates profitability and shows the main items that make up your revenue and expenses. However, it can also serve as the basis for further analysis. Business leaders and accountants can opt to perform financial modeling and variance analysis to learn more about their company’s growth and health.
Among other uses, an accountant using variance analysis as an approach can compare actual performance numbers to planned or projected numbers during a reporting period. Engaging in variance analysis can provide insight into whether a company is over-delivering or under-performing as well as use it to draw conclusions about their own costs versus standard costs in their industry.
The bottom line is that the numbers tracked and reported on income statements offer a concrete look into potential challenges, opportunities, and changes in a business’s income statement from year to year.
A quick note on “Other Comprehensive Income Statements”
Public companies will also include a document known as “Other Comprehensive Income, which is a supplemental financial reporting statement that builds off the income statement, adding another layer of vital information.
Comprehensive income statements take the net income item from the income statement and add or subtract adjustments for foreign currency, hedging, or other items that involve realizing gains or losses because of a fluctuation in asset value.
Balance sheet
The balance sheet provides an in-depth view of the company’s financial value by listing all the assets and liabilities that a company currently has:
- Assets of a company are cash, accounts receivable, any inventory, and properties.
- Liabilities include obligations such as accounts payable, wages payable, loans, and interest payable
- Equity is the shareholders’ stake in a company and is a company’s total assets minus its total liabilities.
Together, these three sections of a balance sheet are a critical tool for measuring the health of a company. It also helps calculate several financial ratios, such as ROE, to indicate and evaluate the health of a company.
There are key pieces of information that you can derive from the numbers on a balance sheet. For example, comparing total liability to total assets gives us insight into how leveraged a company is (through the calculation of the debt-to-asset ratio).
The numbers that appear on a balance sheet do require further analysis and if you’re using them to understand a company’s health, it’s best to take an investigator’s mindset. For example, if a company takes on debt, both cash and debt would increase. You may then want to ask yourself what this indicates about a company’s behavior or preferred method of capitalization.
A greater amount of cash available doesn’t necessarily mean that the business has enough money to pay its debts as there could be interest and uncapitalized leases that live off the balance sheet.
Similarly, if you examine the stockholder’s equity section in the sample balance sheet above, you’ll see that there’s a positive stockholder’s equity. If there was a negative stockholder’s equity, it doesn’t always translate into a company with a pessimistic future.
The situation could be that the company may be able to recognize a lot of non-cash expenses on the income statement, which then translates into negative retained earnings. However, non-cash expenses don’t have an impact on the company’s future or its debt situation.
The bottom line is that despite their transparency and structure, balance sheets still require support and additional information from related financial statements (and further analysis) to give you a full picture of business operations. And, of course, investors, lenders, and creditors will rely on summaries of balance sheet numbers to back up their decision-making process.
Stockholders’ equity statement
The stockholders’ equity statement, which appears under the liabilities section, is a supplemental statement that is not used for decision-making. Instead, it appears as a summary in the equity section and the detail provided in this statement isn’t necessary for calculating financial ratios and appears under the liabilities section.
Information tracked and included on this supplemental statement includes common stock, owners’ equity, preferred stock, additional paid in capital, net income, treasury stock, retained earnings, and dividends.
Cash flow statement
The cash flow statement allows you to see your company’s cash flow for a specific period of time and provides insight into how cash is coming into or out of the business:
- Operating activities show how much cash you earned and spent from your main business activities, such as manufacturing, sales, and marketing
- Investing activities show cash you have spent or received from purchasing or selling fixed assets (“property, plant, and equipment”) such as trucks, computers, etc. It could also include acquisitions and or divestitures, and marketable securities.
- Financing activities show cash you have from long-term debt, stock issuance, or cash you have spent on long-term liabilities
Analyzing a cash flow statement over multiple years or months provides a better sense of how much cash you have to continue operations.
Typical accounting methods within financial accounting
As you might guess, there are several accounting methods and ways to record information, including the accrual, cash, and tax accounting methods. Let’s take a look at two primary accounting methods first: Accrual and cash basis accounting.
Accrual basis accounting
With accrual accounting, a company recognizes revenue when it’s actually earned, rather than when the sale first occurs.
An example of this principle in action is a service agency only recognizing revenue when the service has been fulfilled and completed. Or, in the case of an e-commerce company, this would mean only recognizing revenue when a product has been shipped or actually arrives at its destination. Expenses follow this same principle: the company only records expenses when they are actually committed to and fulfilled, not when they’re charged.
The accrual basis method recognizes revenue as “earned” and expenses as “incurred” during an accounting period, not when the cash or payment is received or has left the account.
Some of this does depend on the nature of the contract or the terms of the transaction. For example, a $20,000 client may recognize the sum as “earned income,” not revenue, until the contract has been fulfilled. On the other hand, if the contract articulates milestones, and these are substantially complete, then the amounts due at each milestone are technically revenue.
The accrual basis method also helps to realize key tax advantages because you accrue expenses and defer revenue under the accrual method.
Cash basis accounting
Cash basis accounting is different from the accrual method because it recognizes revenues and expenses when cash payments are made or when money is received or has left the business account.
Per the above example, your business would recognize the $20,000 client contract when the client pays the money, instead of when revenue was earned.
The cash method is widely used in small businesses that make less than $25 million in revenue and are not publicly-traded companies. It’s also very simple and offers potential tax advantages: You can control the timing of a transaction, speed up expenses, and slow down revenue to decrease your tax liability. Cash and accrual come together in double-entry accounting
Once you choose between cash or accrual accounting, double-entry accounting is relatively easy to understand: Double-entry accounting refers to the fact that all business transactions affect at least two accounts and therefore need to be recorded for both accounts.
Let’s take an example: Suppose your company borrows $30,000 from a lender. Since there is a debit and a credit to two accounts, they should be equal, so you would record that money as an increase in Cash in your assets and an increase in Loans Payable in your liabilities.
Keeping your financial statements accurate
Accurate financial accounting is crucial to the growth of any business. Properly tracking your financial transactions and creating financial statements can help you land new deals, gain investments and funding, and create a sustainable cash flow.
Here are three tips on keeping your financial reports accurate:
Tip #1: Follow the concept of double-entry bookkeeping
Double-entry is key to adhering to general accounting standards, and following them makes your finances look professional, so make sure all your financial transactions that affect two accounts are also recorded in those accounts. Luckily, most accounting and reporting software options use double-entry bookkeeping, so you can make sure you remain compliant.
Tip #2: Choose the proper accounting method for your business
If you’re a small business that intends to remain small, you can easily use the cash basis method. This is a clear and straightforward way to keep track of your income and expenses.
But if you intend to grow, you should follow the accrual method to be compliant with US GAAP. And don’t worry if you want to switch to a different method down the line: As long as you qualify, all you have to do is fill out an Application for Change in Accounting Method (Form 3115).
Tip #3: Track all of your business’s revenue and expenses
You can make your financial accounting and reporting process even easier by tracking revenue and expenses via an expense management system.
Automated software can pull and input numbers from any financial statement from any period, making generating income statements, balance sheets, or cash flow statements practically effortless so that you’re prepared to analyze or present at any time.
Using revenue and expense management software to simplify financial accounting
To make sound financial decisions for your business, you need accurate insights into your company’s performance.
And that’s where financial accounting comes in: The essential statements and methods within this umbrella allow you to understand your expenses, income, and budgets to generate better results.
The best part is that BILL Spend and Expense provides an easy-to-use spend and expense management software that helps businesses of all sizes accurately assess their spending and make healthier financial decisions.
