July 1, 2022

What is financial accounting? | Learn more

Successful businesses have money flowing in and out in an almost constant flow. To keep track of all of this requires diligent financial accounting. This branch of accounting focuses on keeping records of all financial transactions of an organization, in order to measure the economic performance and financial condition of the organization. Financial accounting is responsible for summarizing and preparing all financial reports.

While the mission of financial accounting is the same for any business, the practice and scale vary wildly by business. A small family store can outsource its accounting to a single CPA. Meanwhile, a mega-business may have a whole team of internal accountants and external accounting partners to manage its prolific flow of transactions.

Whatever the scale, good financial accounting is essential to business success. Whether it’s for the IRS, investors, or third-party auditors, a business should stay on top of its financial accounting at all times.

The financial accounting process

Although this is an ongoing and constantly evolving practice, most companies break down accounting into eight distinct phases.

  • Transaction. Financial transactions are the things a business tracks as part of the accounting. Without them there is no need to account for anything.
  • Logging. It is the action of recording financial transactions in the company journal. It requires a balance of both debits and credits (accrual basis).
  • Assignment. Journal entries are recorded in the general ledger, which officially records them as a company ledger transaction.
  • Verification scale. At the end of an accounting period, the company would compile the total balance of all active and open accounts.
  • Worksheet. If there are discrepancies between debits and credits, accountants should identify them and make the appropriate adjustments, recorded on the spreadsheet.
  • Adjustment. The business records the adjusted postings in the general ledger and posts accrued liabilities and deferrals.
  • Reports. This step sees the preparation of the main financial documents, including the cash flow statement, balance sheet and income statement.
  • Closing. The income and expense accounts return to zero as the business begins its new accounting cycle.

The goal is, ultimately, to provide a clear and accurate statement of the company’s financial performance. Is the business profitable? Of how many? Where does this profit come from? Is this sufficient to support operations? These questions and many, many more lead to the need for thorough financial accounting.

Cash accounting vs accrual accounting

There are two main accounting methods What Businesses Are Watching: Cash vs. Accrual Accounting. Although every public company adheres to accrual accounting, many small businesses favor cash-based accounting. The difference is when a business records transactions in its general ledger:

  • Cash basis accounting only records transactions after the money has changed hands.
  • Exercise base accounting records transactions at the point of origin.

The difference between cash and accrual accounting makes a big difference in keeping financial records. For example, if a business spends $ 100 today on inventory that it won’t receive for six months, the difference between cash and accrual accounting can skew cash flow. Cash would see $ 100 in cash out today and $ 100 received in assets six months from now. Conversely, accrual accounting would see $ 100 in cash outflows and $ 100 credited to accounts receivable today, balanced.

What is a financial report?

A financial report is the end result of the accounting process. It contains all the main financial statements of the company: the balance sheet, the income statement and the cash flow statement. It also offers notes and explanations on each. For public companies, the Securities and Exchange Commission (SEC) imposes certain levels of financial reporting. Companies file a 10-K, representing annual finances, and a 10-Q, representing quarterly finances.

Ratings are also an important part of financial reporting. It provides context for the figures presented in the report. The annotation applies to inventory methods used, changes in equity, contingent liabilities, bad debt impairment methods and more. It provides additional context to the figures represented in the report.

What are generally accepted accounting principles (GAAP)?

Generally accepted accounting principles (GAAP) are a standardized set of rules that all businesses must follow when accounting and reporting financial data. They are used to keep metrics and reporting methods consistent across businesses, making it easier to compare financial performance. The SEC requires all public companies to report in accordance with GAAP rules.

International companies follow International Financial Reporting Standards (IFRS), which shares many similarities with GAAP. The two are not directly interchangeable, but serve to standardize financial reporting globally.

Who manages the financial accounting of companies?

Financial accounting and reporting are complex and arduous processes that require significant training. Companies traditionally employ chartered accountants (CPAs) to oversee financial accounting in its entirety. Small businesses tend to outsource the task; large companies employ in-house staff and maintain mandated CPA firms to meet ongoing accounting and auditing requirements. All public company financial reports are audited, and the task is also performed by CPAs.

In the UK and Canada, Chartered Accountants (CA) fulfill the same role as CPAs. CAs follow much the same path to certification and observe many of the same standards as CPAs.

Why is financial accounting important?

Accounting is arguably the most important duty of a business. For internal stakeholders, this helps clarify the efficiency of operations, whether the business is profitable and healthy. For external stakeholders (like investors), this highlights the viability of an investment in this business. And for regulators like the SEC or the IRS, accounting is the way to identify and prevent fraud or other embezzlement.

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Every business, public or not, needs a firm grasp of its financial accounting practices. It is imperative to adhere to GAAP standards, keep abreast of finances, and have qualified CPAs oversee reports and audits. Companies that stay on top of accounting and use it to inform better business operations are companies that are ready to attract investors and succeed.