Keeping track of the money flowing in and out of your business is fundamentally important. Yet for some small businesses, financial accounting does not receive proper attention to detail.
Using the wrong methods, keeping poor records, and failing to generate the necessary statements can lead to errors. Additionally, you could incur tax penalties; turn off creditors, investors, and business partners; and hinder yourself from making good business decisions.
The definition of financial accounting
"Financial accounting describes the systems that process business transactions. These systems provide useful information about the financial position, income and expenses, and cash flows of your business," said Marilyn Pendergast, Partner Emeritus of UHY Advisors.
The data displayed in financial statements is used to report business activities in an understandable, consistent way.
"This allows people outside of your company — such as stockholders, creditors, or donors to non-for-profit entities — to use the information to make better decisions about your company regarding things like investments, loans, or other financial support," said Pendergast.
Financial accounting vs. managerial accounting: What's the difference?
There are key differences between financial accounting and managerial, or general, accounting. Robert Duron, Professor Emeritus (Retired) at Husson University, explained, "Financial accounting is geared toward external users and stakeholders such as investors, creditors, regulators, and the general public, while accounting focuses more on the preparation and dissemination of financial information to an organization and its constituents, whereas finance focuses more on the acquisition and use of financial resources by the organization."
Accounting concentrates on the past and keeping accurate records, while finance and financial accounting look ahead and serve a strategic function.
"Your accounting department will tell you what happened financially at your company, while your finance department will perform an analysis of what happened financially at your company and will make recommendations and forecasts on where the company will be in the future," said Logan Allec, a certified public accountant and the founder of Money Done Right.
Other types of accounting include tax accounting and forensic accounting and auditing, which also rely on the same accounting information system to produce the required information.
Tried-and-true methods of financial accounting
Smart businesses don’t make up their own money monitoring rules. They abide by long-established and widely practiced principles of financial accounting.
Generally accepted accounting principles (GAAP)
“The need for consistent standards is key, especially to the outside parties who will want to compare your company’s financial statements with other companies. If there is no standard for how various items should be recorded, it would be very difficult for lenders, investors, and others to make informed decisions,” Allec said.
Hence, American companies follow GAAP — generally accepted accounting principles — which are set by the Financial Accounting Standards Board (FASB) or by the Governmental Accounting Standards Board (GASB).
GAAP offers guidance in many areas, such as how to recognize revenue, accounting for employee benefit plans, leases, commitments, valuation of investments, special industry areas, and others.
“One might think that accountants, who simply report the financial transactions that occurred at a company, would need relatively few principles to guide them. After all, how hard can it be to simply record how much money your business made and how much it spent? But it’s much more complex than that,” said Allec.
Case in point: Say your consulting firm bills for $1 million in services in December of 2018 but isn't paid for these services until January 2019. Should your business record this income in 2018, when it earned the revenue, or in 2019, when it was reimbursed for the work? Following GAAP’s revenue recognition principle, your company should record the revenue in December 2018.
The latter example follows one of the most basic GAAP principles — that financial accounting must be on an accrual basis which is another vital concept small businesses must grasp.
Accrual basis vs. cash basis
“The accrual basis of accounting means that revenues are recorded when they are earned, and expenses are recorded when they are incurred,” said Pendergast.
The accrual basis produces a more correct financial picture of a business’s operations and curbs companies from manipulating income and expenses by accelerating or deferring cash movement.
“For many smaller businesses, the accrual basis is much more burdensome and complicated,” said Sole, “as it requires additional journal entries to account for the timing difference between certain transactions recorded and when cash is received.”
An alternative is the cash basis method of accounting. With this approach, according to Investopedia, revenue is reported on the income statement only when cash is received, and expenses are only reported when cash is paid out.
However, many experts frown on the cash basis method.
“If you use the cash basis, you may see a $5,000 checking account balance and think, ‘Things are great; I can buy a new computer,’ and forget that you have a $10,000 rent payment that’s overdue,” Pendergast said. “The accrual basis does require more recordkeeping and a good accountant, bookkeeper, or outside service, but it’s worth the cost.”
Double-entry bookkeeping
Another widely adopted accounting method is double-entry bookkeeping. This approach helps keep your books in balance by recording both credits and debits, and, therefore, the full and often opposite effects of transactions.
“Say your small business purchases $500 of supplies. With double entry, it would record not only a $500 supplies expense on its profit and loss statement but also a decrease to the cash account in the amount of $500 on the assets side of its balance sheet,” said Allec. “When done correctly, double-entry bookkeeping prevents much human error.”
Accounting mistakes can stifle growth, cause payment delays, and discourage investors from working with your business.
Why financial accounting is important to your business
Consider that a poll by BlackLine Inc., a financial controls and automation software company, revealed that approximately 70% of finance chiefs have made important business decisions based on inaccurate data, and 55% of those surveyed aren’t fully confident they can recognize financial errors prior to reporting results.
Matt Sole, the Phoenix-based owner of Anago Cleaning Systems franchises, can vouch for how easy it is for small businesses to fall into poor financial accounting practices and how crucial accurate financial accounting is.
“For smaller companies, financial reporting is a method for generating reports on your business and financial statements that may be required by your bank or state or for tax purposes,” Sole said. “It also aggregates transactions from all different aspects of a business, whereas other types of accounting might be focused on one particular component of a business.”
The three core financial statements every business owner must understand
The income statement, balance sheet, and cash flow statement are the three most important financial statements your company has and are required of all publicly traded companies.
An income statement, also known as the profit and loss statement, identifies a business’s profit (revenue) and losses (expenses). The report starts with revenue, followed by expenses and costs, and then taxes. Subtracting costs from revenue gives you the company’s profit before paying dividends.
The balance sheet summarizes the financial components of a company, including its assets, liabilities, and equity. “While the income statement is a record of the funds flowing in and out of a company over a given time period (for example, over a full year), the consolidated balance sheet is a snapshot of a company's financial position at a point in time,” wrote Charles Schwab. “In other words, the balance sheet shows what a company owns (its assets) and owes (its liabilities) and the difference between the two (stockholders' equity).”
Finally, the cash flow statement lists your incoming and outgoing transactions, giving you a clear picture of your liquidity. This statement is crucial: Even if your income statement shows a profit, you can run into issues if your income hasn’t arrived before the time comes to pay your bills. The cash flow statement can tell you when there are gaps and if you need to make changes to keep cash in reserve.
Common financial accounting mistakes small business owners make
Accounting mistakes can stifle growth, cause payment delays, and discourage investors from working with your business.
Many small business owners, especially when they first launch, don’t separate their business and personal finances. It might seem convenient to run everything from one account, but it can cause problems tracking costs, calculating deductions, and budgeting. Set up a separate business account and run all your expenses and revenues through that one.
Another common issue is poor cash flow management. Ignore your cash flow statement at your own peril. “You can show a profit on your income statement and still run out of money if customers pay late, inventory sits, or debt payments hit before deposits clear,” wrote Ramp, an accounting platform.
Finally, make sure you regularly reconcile your expenses and receipts. Falling behind on bookkeeping can create headaches down the road. This is where a financial accounting tool can be a game changer.
Do you need accounting software?
If all of this information feels overwhelming, don't worry — many small business owners outsource their accounting or use accounting software. Nearly 65% of small business owners rely on accounting software, according to data compiled by the Chamber of Commerce.
Accounting software can streamline back-office workflows by automating administrative tasks and reducing manual data entry. Many of these tools can also handle invoicing, report generation, mileage reimbursement, and bank account syncing. Read our buyer's guide to accounting software to learn more about accounting software and see if it's the right fit for your business.
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