Last updated on July 25th, 2024 at 03:03 pm
Do you innately feel like your business finances could be better? Are statements and spreadsheets swirling around your head? Financial accounting is your way out of this financial clutter. It is more than just number crunching.
Want to learn about what is financial accounting? Read this article to find out everything that you need to know about this essential practice and how it helps businesses with better decisions and smoother operations.
What is Financial Accounting?
Financial accounting is the practice of recording, summarising and reporting a business’s economic activities. It’s a translator that turns complex transactions into financial statements like balance sheets and income statements.
These statements are a snapshot of the company’s financial health, showing its profitability, liquidity and overall financial position. Consider taking a financial management course to learn more about this.
Core Principles of Financial Accounting
Financial accounting may seem like a maze of numbers and jargon but don’t worry! After all, what is financial accounting but a set of core principles that are the foundation of understanding your business’s financial health? Here are the principles:
- The accounting equation: This states that assets (everything a business owns) must always equal liabilities (what the business owes) plus the owner’s equity (the owner’s investment in the business). This equation ensures the books are balanced and shows the true financial picture.
- Accrual accounting: What is financial accounting-accrual? To answer this, it is the principle about recording transactions when they happen, not when the cash is exchanged. For example, if you provide a service today but get paid next month, the revenue is recorded in the current month under accrual accounting.
- Cost principle: Assets are recorded at their historical cost, what you paid for them. This principle ensures consistency in reporting and avoids speculation on current market value.
- Matching principle: This principle means expenses are matched to the revenue they helped generate. For example, the cost of goods sold for a product sale is recorded in the same period as the revenue from that sale. This gives a clearer picture of the company’s profitability.
- Going concern principle: This principle assumes the business will continue to operate shortly. This allows for assets to be reported at long-term value rather than liquidation value.
Types of Financial Accounting
What is financial accounting in practice, when it comes to the actual recording of transactions? Well, within this practice there are many types, each for different businesses and complexities.
Accrual Accounting
This is the way most businesses operate, especially larger companies with complex financial transactions. Accrual accounting records revenue when earned, regardless of when the cash is received and expenses when incurred, regardless of when the payment is made. This gives a more accurate picture of a company’s financials for a given period.
Now imagine you provide a service today with a 30-day net payment term. What is financial accounting doing here? Accrual accounting recognises the revenue in this month, even though the cash won’t show up for another month.
Similarly, if you buy office supplies on credit, the expense is recorded in the current month, even though the payment might be due later. This way you get a clearer picture of your company’s profitability by matching expenses to the revenue they helped generate.
Cash Accounting
Cash accounting takes a more simple approach. It only records transactions when cash is physically received or paid out. This is often used by smaller businesses with limited financial activity.
So, what is financial accounting doing here? Let us say that you sell a product for cash. Cash accounting records the revenue at the exact moment the customer hands you the money. Likewise, if you pay a vendor for supplies in cash, the expense is recorded at that specific moment.
While cash accounting is simple, it doesn’t give a complete picture of a company’s financial health. It doesn’t account for outstanding receivables (money owed to you by customers) or payables (money you owe to vendors). This can lead to misinterpretation of profitability and liquidity.
Which Type of Financial Accounting is for You?
The type of financial accounting you choose depends on the size and complexity of your business and regulatory requirements.
Generally, accrual accounting is the way to go for most businesses as it gives a more accurate picture of financials. But cash accounting can be an option for very small businesses with limited financial transactions where simplicity is key.
So, what is financial accounting, anyway? It’s the basis for understanding your business’s financial health and the different types of financial accounting are the tools you need to build that foundation.
This five-step regime will help you choose the right financial accounting for your business.
Step 1: Map Your Business
If you have a high volume of daily sales or purchases, accrual accounting’s ability to track outstanding receivables and payables gives a more accurate financial picture. Finally, research your industry.
Certain industries like healthcare or finance might have specific accounting requirements you need to follow.
Step 2: What is Financial Planning Without Expertise?
Financial accounting shouldn’t be a foreign language for your business. Test your current knowledge.
Do you have a basic understanding of accounting principles or starting from scratch?
Cash accounting with its simple approach of recording transactions only when cash changes hands is easier to manage initially. But consider your internal resources.
Do you have dedicated accounting staff or will you be using software solutions? Accrual accounting requires more advanced software and potentially more staff to manage the complexities of recording revenue and expenses.
Step 3: What Are Your Needs and Goals?
What is financial accounting according to you? Having a clear understanding of your needs and goals will guide your accounting plan choice. How important is a detailed picture of your business’s financial health for decision-making?
Accrual accounting gives you a more detailed view so you can analyse profitability and cash flow more accurately. Time commitment is another big factor. How much time are you willing to commit to managing your financial records?
Cash accounting requires less time investment than accrual accounting’s intricate record keeping. Finally, consider your budget. Accrual accounting may require additional investment in software and staff so cost factor when making your decision.
Step 4: Accrual vs. Cash Accounting
What is financial accounting in terms of the types? Now that you’ve mapped your business, tested your expertise and defined your goals, it’s time to weigh the two options: accrual and cash accounting.
Choosing the right accounting method depends on your business.
Accrual accounting gives you a more accurate view of your finances (pros: better insights, compliant) but requires a complex system and more time (cons: complex, time-consuming).
Cash accounting is simpler and faster (pros: simpler, less time) but gives you a less complete picture and may not be compliant for all industries (cons: less complete, hinders planning, compliance issues).
Step 5: Get Professional Advice
What is financial accounting from the perspective of an expert? While not necessary, consulting a financial advisor or accountant can give you tailored advice for your business. They can help you weigh your options, go deeper into your needs and choose the right financial accounting plan for you.
Common Financial Traps and How Accounting Saves the Day
Financial potholes are everywhere, but you have to navigate your way out of it and often avoid it in the first place. Here are some of the common mistakes people make.
Trap 1: Living Beyond Your Means (Business Edition)
It’s easy to spend freely, especially during growth periods. But without budgeting and financial tracking, you can get in over your head. Ask yourself —what is financial accounting to me if I cannot account for every single spend?
Trap 2: The Grey Area Between Personal and Business Finances
Mixing your personal and business finances is a financial disaster. You can’t track business expenses and income and you are personally liable for business debts.
Having separate business and personal accounts is key. Good accounting practices mean clear and separate records of business income and expenses. This makes tax time easier, protects your assets and gives you a clear picture of your business’s financial health.
Trap 3: Unpaid Invoices
Late payments and outstanding debts can stop your cash flow and prevent you from meeting your financial obligations.
Use your accounting system. Send invoices on time, follow up on late payments and offer early payment discounts and you’ll improve your collection rate and keep your cash flow healthy.
Trap 4: Tax Time Blues
What is financial accounting for my salary bracket? Tax time is a nightmare for business owners if you haven’t kept accurate records all year.
Good accounting practices signify that you have all your records in order come tax time. This includes receipts, invoices and expense logs.
Trap 5: Flying Blind Without Financial Data
Making decisions based on gut feeling only is a recipe for disaster. You need cold hard data to make informed decisions. Financial statements like the balance sheet show you your assets, liabilities and overall financial position.
Why Depreciation Matters
Suppose you are buying a brand-new delivery truck for your business. It seems like a great investment today but what is financial accounting doing here? Financial accounting recognises that this truck won’t retain its original value forever.
Over time due to wear and tear, obsolescence (becoming outdated), or other factors the truck’s value will decrease. Depreciation allows us to spread this cost of value decline over the life of the asset.
How Depreciation Works
Financial statements generated from good accounting practices like the income statement and cash flow statement will give you a clear picture of your income, expenses and cash flow.
Calculating Depreciation
There are several ways to calculate depreciation but a common one is the straight-line method. This method takes the asset’s cost, subtracts its estimated salvage value (the value you expect to get when you sell it at the end of its useful life) and divides the difference by the asset’s useful life (the number of years you expect to use it).
For example, if your truck costs $50,000, has an estimated salvage value of $5,000 and a useful life of 5 years, the annual depreciation expense would be ($50,000 - $5,000) / 5 years = $9,000 per year.
Depreciation: The calculated depreciation expense is recorded on your income statement every year for the life of the asset.
Are There Benefits of Depreciation Too?
Depreciation has its benefits too. Make better financial decisions during depreciation and you will reap the benefits later. Depreciation gives a more realistic picture of your company’s financial health by showing the true cost of owning an asset.
What is financial accounting during depreciation, you ask? It is accounting for every spend in the same manner. Depreciation expense is a tax-deductible expense, so it reduces your taxable income and potentially your tax liability.
Bottom Line
We hope we have addressed the question “What is financial accounting?” by now. Financial accounting has given you the tools to read your business’s financials.
To become a financial expert, register for Imarticus’s financial management course. The program benefits you in more ways than one with industry experts guiding you in every path, and guiding you towards a steady financial career.
This program will sharpen your accounting skills, boost your financial intelligence and take you to financial literacy for your business. So, what are you waiting for?
Frequently Asked Questions
What is financial accounting?
The most simple financial accounting definition would be that it is a practice that translates complex business transactions into financial statements that reveal a company's financial health.
What are the primary principles of financial accounting?
Key principles include the accounting equation (Assets = Liabilities + Equity), accrual accounting (recording transactions when they happen, not when cash is exchanged), and matching principle (matching expenses to the revenue they generate).
What are the different types of financial accounting?
Accrual accounting offers a more precise financial picture by recording revenue when earned and expenses when incurred. Cash accounting is simpler, recording transactions only when cash is received or paid out.
Which type of financial accounting is right for me?
Business size, complexity, and regulations determine the best type. Accrual accounting usually provides a more accurate view, but cash accounting can be an option for smaller businesses prioritising simplicity.
