Successful businesses have money flowing in and out in an almost constant flow. Keeping 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.
Although the mission of financial accounting is the same for any business, the practice and scale vary greatly by business. A small family store could outsource its accounting to a single CPA. Meanwhile, a mega-corporation may have an entire team of in-house accountants and external accounting partners to manage its prolific flow of transactions.
Regardless of the scale, good financial accounting is essential to business success. Whether it’s for the IRS, investors, or third-party auditors, a business needs to stay on top of its financial accounting at all times.
The financial accounting process
Although this is an ongoing and evolving practice, most companies break down accounting into eight distinct phases.
- Transaction. Financial transactions are the things that a business tracks as part of 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 debits and credits (accrual basis).
- Assignment. Journal entries are recorded in the general ledger, which officially records them as a transaction in the books of the business.
- 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.
- Setting. The company posts adjusted entries to the general ledger and records accruals and deferrals.
- Reports. This stage 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 a zero balance 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 it enough to sustain operations? These and many other questions lead to the need for thorough financial accounting.
Cash accounting or accrual accounting
There are two main accounting methods that companies observe: cash flow vs. accrual accounting. While every public company adheres to accrual accounting, many small businesses prefer cash accounting. The difference is when a business records transactions in its ledger:
- Cash accounting accounting records transactions only after the money has changed hands.
- Accrual accounting 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 company spends $100 today on inventory it won’t receive for six months, the difference between cash and accrued liabilities can distort cash flow. Treasury would see $100 in cash out today and $100 in assets six months from now. Conversely, accrual would result in cash outflow of $100 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 statement of cash flows. It also offers notes and explanations on each. For public companies, the Securities and Exchange Commission (SEC) mandates certain levels of financial reporting. Companies file a 10-K, representing annual financials, and a 10-Q, representing quarterly financials.
Rating is 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 write-down methods, etc. 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 set of standardized rules that all companies must follow when recording and reporting financial data. They serve to maintain consistency of measurement and reporting methods across companies, 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?
Accounting and financial reporting are complex and arduous processes that require significant training. Companies traditionally employ Certified Public Accountants (CPAs) to oversee financial accounting in its entirety. Small businesses tend to outsource the task; larger companies employ in-house staff and keep accounting firms under contract, to meet ongoing accounting and auditing requirements. All financial reports of public companies are subject to audit, and the task is also carried out by CPAs.
In the UK and Canada, Chartered Accountants (CA) perform 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 task in a business. For internal stakeholders, it clarifies the efficiency of operations, i.e. whether the business is profitable and healthy. For external stakeholders (such as investors), this sheds light on the viability of investing in that business. And for regulators like the SEC or the IRS, accounting is the way to identify and prevent fraud or other malpractice.
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Every company, public or not, needs a solid grasp of its financial accounting practices. It is imperative to adhere to GAAP standards, keep abreast of finances, and have qualified CPAs oversee reporting and auditing. Businesses that master accounting and use it to inform better business operations are businesses poised to attract investors and succeed.