What is Financial Accounting?
Successful businesses have money coming in and going out in an almost constant stream. To keep track of it all requires diligent financial accounting. This branch of accounting focuses on keeping records of all financial transactions of an organization, to measure economic performance and the organization’s financial position. 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 varies wildly depending on the company. A small mom-and-pop shop might outsource its accounting to a single CPA. Meanwhile, a mega corporation might have an entire team of in-house accountants and external accounting partners to manage its prolific stream of transactions.
Regardless of the scale, good financial accounting is critical to the success of the business. Whether for the IRS, investors or third-party auditors, a business needs to stay on top of its financial accounting at all times.
The Process of Financial Accounting
While it’s an ongoing, ever-changing practice, most companies break down accounting into eight distinct phases.
- Transacting. Financial transactions are the things a company tracks as part of accounting. Without them, there’s no need to account for anything.
- Journaling. This is the action of recording financial transactions in the company’s journal. It requires a balance of both debits and credits (accrual basis).
- Posting. Journal entries become posted to the general ledger, which officially records them as a transaction of the company’s books.
- Trial balance. At the end of an accounting period, the company would tabulate the total balance for all active and open accounts.
- Worksheet. If there are discrepancies between debits and credits, accountants must identify them and make appropriate adjustments, recorded on the worksheet.
- Adjusting. The company posts adjusted entries to the general ledger and accounts for accruals and deferrals.
- Reporting. This stage sees the preparation of major financial documents, including the cash flow statement, balance sheet and income statement.
- Closing. Revenue and expense accounts go back to zero balance as the company begins its new accounting cycle.
The goal is, ultimately, to deliver a clear and accurate statement of the business’ financial performance. Is the business profitable? By how much? Where is this profit coming from? Is it enough to sustain operations? These questions and many, many others drive the need for thorough financial accounting.
Cash vs. Accrual Accounting
There are two chief methods of accounting that businesses observe: cash vs. accrual. While every public company adheres to accrual basis accounting, many smaller businesses favor a cash basis. The difference is in when a business records transactions in its ledger:
- Cash basis accounting records transactions only after money changes hands.
- Accrual basis accounting records transactions at the point of origin.
The difference between cash and accrual makes a big difference in financial record keeping. For example, if a business spends $100 today on inventory that it won’t receive for six months, the difference between cash and accrual can skew cash flow. Cash would see $100 in cash outflows today and $100 received in assets in six months. Conversely, accrual 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 major financial statements for the business: the balance sheet, income statement and cash flow statement. It also offers notes and explanations about each. For public companies, the Securities and Exchange Commission (SEC) mandates certain levels of financial reporting. Companies file a 10-K, representing annual finances, and a 10-Q, representing quarterly financials.
Notation is also an important part of financial reporting. It provides context for the figures outlined within the report. Annotation applies to inventorying methods used, changes in owner’s equity, contingent liabilities, bad debt write-down methods and more. It brings 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 companies must follow when accounting for and reporting financial data. They serve to keep reporting metrics and methods consistent across all companies, making it easy to compare financial performance. The SEC requires all public companies to report against GAAP rules.
International companies follow International Financial Reporting Standards (IFRS), which shares many similarities with GAAP. The two aren’t directly interchangeable, but serve to standardize financial reporting on a global scale.
Who Handles Financial Accounting for Companies?
Financial accounting and 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 companies tend to outsource the task; larger companies employ in-house staff and keep CPA firms on retainer, to meet ongoing accounting and auditing demands. All financial reporting of public companies is subject to auditing, and the task is also performed by CPAs.
In the United Kingdom and Canada, Chartered Accountants (CAs) fill the same role as CPAs. CAs follow roughly the same path to accreditation 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, it provides clarity into the efficacy of operations—whether the company is profitable and healthy. For external stakeholders (such as investors), it illuminates the viability of an investment in that company. And for regulatory bodies like the SEC or IRS, accounting is the means to identifying and preventing fraud or other malpractice.
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Every business, public or not, needs a firm grip on its financial accounting practices. Observing GAAP standards, staying current on finances and entrusting qualified CPAs to oversee reporting and auditing are imperative. Companies that stay on top of accounting and use it to inform better business operations are companies poised to attract investors and succeed.