Accounting is often referred to as the language of business. Since firms carry out different activities, from creating plans and designs to manufacturing and selling, they need a common language to determine the effectiveness of actions. Financial accounting transfers all efforts into numbers. Given the importance of getting the numbers right, according to the US Bureau of Statistics, the number of job openings for finance professionals is expected to increase by 7% between 2020 and 2030, averaging up to 135,000 new jobs each year.
It is essential to comprehend that bookkeeping is a broad industry that includes a dozen different activities; one of the main areas of work is financial accounting, which largely depends on the company’s success.
The definition of a financial accounting
Financial accounting (FA) is how a company records and informs about its profits, losses, and liabilities over time. Firms adhere to strict guidelines to ensure financial statements are correct and comply with fiscal and legal regulations. Information from such documents allows business owners and investors to allocate assets rationally.
Knowing the distinctions between financial accounting vs. managerial accounting is vital. While management accounting provides detailed economic insights for decision-making within an organization, FA is designed for external counterparties, including partners, creditors, shareholders, etc.
The number of people accessing an organization’s financial records depends on whether it is a private or public enterprise. State-owned companies send data on their performance to primary and secondary parties; therefore, even competitors and controlling institutions can access it.
Keeping proper financial records is time-intensive and small mistakes can be costly. BooksTime makes sure your numbers are 100% accurate so you can focus on growing your business.
Fundamental principles of financial accounting
A firm’s reports must be truthful, easy to understand, and easy to compare with those of other firms to make FA useful. To meet these challenges, accountants adhere to several norms known as generally accepted accounting principles (GAAP) created by FASB.
GAAP relies on some fundamental norms and conditions, e.g., the principle of cost, compliance, full disclosure, relevance, reliability, etc. However, this system is not static. It contains several complex rules created in response to non-routine financial transactions. GAAP has unique bookkeeping technologies designed for specific fields, such as insurance or the utility industry. Adopting new directives may occur as a reaction to a change in state regulation of the area.
Basic types of financial statements
The financial report is essential to assess the company’s position. However, no single document can provide all the vital data. To get the complete picture, bookkeepers prepare four primary kinds of records at various periods and with varying data sources; let’s discuss them in more detail.
- The balance sheet shows an organization’s total value at a given time. According to the approved form, the balance sheet consists of three parts: resources, obligations, and equity. If liabilities and equity are added together, they should match assets.
- Income statement: the creation of such a document begins by recording all capital receipts for a certain period, then deducts all spending during that same time, and is left with a net profit or loss, that is, the basis for the tax payment. Such a document allows you to calculate the effectiveness of the firm.
- The equity statement demonstrates the capital change over a certain period. When you study it, you can notice a growth or decrease in the company’s residual value and understand why change occurs. The report collects data on the organization’s earnings, dividend payments, separation of property rights, and other capital components.
- The cash flow statement details all the inflows and outflows of money over a certain period; this is relevant only for cash. The document does not analyze depreciation spending and expenses financed by borrowed capital. Based on the capital flow statement, it is possible to conclude the company’s viability in the short term.
The notes provide additional data about the firm’s economic condition to the financial registers. Three groups of remarks describe the bookkeeping standards that are used when creating financial documents, provide data on the items of statements, and explain insights missing from the report.
Accrual method vs. cash method
A company can register transactions in several ways, employing the accrual or cash technique. The distinction between them lies in the period of registration of procedures.
The cash path is a more straightforward option when discussing small businesses that do not transact on credit. It requires the recording of income after the transfer of money and the recording of expenses after paying bills.
The accrual way is more complex and requires some rules to be followed. Instead of waiting for the payment to arrive, the firm records income when it is earned, e.g., when sending invoices to the client. Spending is also recorded when the invoice is received and not at the moment of payment.
Since the accrual method can smooth out the haphazard moment of getting money, it creates a clearer picture of what is happening. It is essential when a firm frequently uses debt capital.
The role of FA in business
The importance of financial accounting stems from the creation of documents such as a balance sheet or a statement of capital movements required by law for registered organizations. These data are included in the firm’s annual report. But there are some other reasons why firms need to implement FA:
- Formation of a set of directives to prepare reports: such standard reports allow you to achieve a unified form for easy comparison of documents for different periods and data from other companies.
- Reducing risk through increasing obligations: lenders, regulators, and other stakeholders rely on economic data. Financial accounting ensures reports are prepared honestly and transparently.
- Ability to assess the situation by the organization’s management: FA allows you to effectively manage strategic concepts if the company owner analyzes financial achievements and considers them when making investment decisions.
FA provides credibility to reports. Independent organizations monitor compliance with all statement directives, making documentation independent of business owners and a reliable data source. Firms are forced to disclose specific data about transactions, company risks, and financial results, regardless of their profits or losses.
Financial accounting plays a significant role in any business, allowing entrepreneurs to control their economic procedures. In addition, such documents help make informed decisions about allocating resources. FA lets you communicate the company’s affairs to other interested members, including creditors and investors. Financial reports created according to the rules provide all the critical data, which can attract partners or, conversely, repel their interactions with your brand.