A Beginner’s Guide to Financial Accounting

The primary objective of financial accounting is to gather and record financial transactions, culminating with the running of financial statements at the end of the accounting period.

These statements are then shared internally with business partners, owners, and managers and outside stakeholders such as shareholders, investors, and financial institutions.

Overview: What is financial accounting?

As a small business owner, you must take on the role of bookkeeper or accountant. That’s why understanding the basic principles of accounting is so important. Financial accounting is the analyzing and recording all financial transactions and reporting those transactions using financial statements.

Financial statements should always be based on accurate data and should follow Generally Accepted Accounting Principles (GAAP). Unlike management accounting, financial accounting focuses on past performance and is important to external stakeholders such as banks, financial institutions, and investors.

How financial accounting works for small businesses

A financial accounting system can be intimidating to new business owners, particularly for those without prior bookkeeping or basic accounting knowledge. If you’re a new business owner and you’re not sure where to start, here are steps to guide you:

Step 1: Choose an accounting method. One of the most important first steps, as a business owner, is deciding whether to use cash basis or accrual basis accounting for your business.

  • Cash method: The cash method is the easier method and is better suited for sole proprietors and freelancers that have few transactions to record. The cash method recognizes revenue and expenses only when money changes hands.
  • Accrual method: The accrual method is recommended by CPAs with good reason. The accrual method recognizes revenue when it’s earned (through a sale of goods and services), and expenses when they occur, not when they’re paid. The accrual method is also required if you wish to follow GAAP principles which include the matching principle and the revenue recognition principle.
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Step 2: Create a chart of accounts. This is vital. The chart of accounts serves as a repository for all of your accounting transactions going forward, using five types of accounts:

  1. Assets: Assets are anything of value that your business owns.
  2. Liabilities: Liabilities are anything that you owe.
  3. Revenue: Revenue is the money you receive from the sale of goods and services.
  4. Expenses: Expenses are the cost of doing business.
  5. Equity: After expenses have been subtracted from revenue, what’s left is equity.

Step 3: Learn the accounting equation. The accounting equation is:

Assets = Liabilities + Owners’ Equity

If you’re using the accrual method of accounting, you will use the accounting equation every day.

In order to use the accounting equation and the accrual method of accounting properly, all of your transactions will need to use double entry accounting, which means having a debit and credit entry for each transaction recorded.

  • Debit: A debit entry increases an asset or expense account. Debit transactions are always recorded on the left side of any entry.
  • Credit: A credit entry increases the balance of a liability, revenue, or equity account. Credit transactions are always recorded on the right side of the entry.

Step 4: Learn to manage your financial transactions. To get started in bookkeeping or accounting, you’ll need to properly manage all of your income and expenses.

This includes invoicing customers, recording payments, paying vendors and employees, and recording any other expenses incurred. If these transactions are not entered regularly, your financial statements will be inaccurate.

Step 5: Run financial statements. After all of your transactions have been properly recorded, whether manually or using accounting software, you’ll need to run your financial statements. The heart of financial accounting, financial statements report on financial data for a specific period, called an accounting period or accounting cycle.

Types of financial statements in financial accounting

You can run a variety of reports, but these four basic financial statements should be run every accounting period:

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Type 1: Balance sheet

A balance sheet displays the value of your business assets, liabilities and equity. Assets typically include bank accounts and accounts receivable balances, while liabilities include accounts payable and notes payable. Finally, equity includes the owner’s share of the business including stocks and retained earnings.

Sample balance sheet

Sample balance sheet from Wave Accounting. Source: Wave Accounting software.

The balance sheet uses the accounting formula to ensure that your assets equal your liabilities and equity. If they don’t equal, you research why and record an adjusting entry to correct the imbalance.

A balance sheet is always run using an ‘as-of’ date, rather than an accounting period. For instance, if you’re running financial statements for May, you would run your balance sheet as of May 31. Totals from a balance sheet are also frequently used when calculating financial ratios.

Type 2: Income statement (profit & loss statement)

An income statement is also known as a profit & loss statement. An income statement displays all profits and losses incurred during a specific period.

Example of income statement

The income statement displays total income, gross income (profit) and net income or loss. Source: Patriot Software.

While most businesses run an income statement monthly, smaller businesses may run an income statement quarterly, or even yearly if desired.

The income statement provides you with a ton of useful information, with the profitability of your business at the top of the list.

An income statement is also used when determining operational profitability, which is gross profit. Other non-operational expenses such as depreciation and taxes are also included on an income statement.

You can choose from a variety of income statement formats, with smaller businesses typically using the single-step income statement, while retailers and manufacturers will get more use out of the multi-step income statement.

Type 3: Cash flow statement

The cash flow statement details all money that flows into and out of your business. Like the income statement, the cash flow statement can be run for any period you choose.

For businesses with limited cash on hand, the cash flow statement provides cash flow details for three different business activities:

  1. Operating activities: These are the day-to-day activities that affect your business such as net income for the period and accounts payable and receivable balances.
  2. Investing activities: If you purchase or sell any long term assets, they will be included in this section.
  3. Financing activities: Financing activities covers areas such as loans, dividends, either received or paid, and any debts.

Because the cash flow statement deals only with actual cash on hand, it’s a useful reference tool for business owners and investors.

Type 4: Statement of retained earnings

The retained earnings statement provides you with a view of all retained earnings activity for a specified period.

ABC Services Quarterly Retained Earnings Statement as of March 31, 2020

The retained earnings statement calculates changes over a specific period of time.

You can add your retained earnings directly to your balance sheet, or you can run a separate statement at the end of an accounting period. Though not always considered one of the necessary financial statements, a statement of retained earnings can be useful for investors, creditors, or for obtaining a loan.

The format for creating a retained earnings statement is simple. Just start with the beginning retained earnings balance, add any net income or losses for the period, and subtract any dividends that you’ve paid your investors. This leaves you with your new retained earnings balance.

Financial statements are the core of financial accounting

Financial statements are the most important component of financial accounting, providing an excellent overview of your company’s financial health. But for these documents to be useful for business owners, accountants, and investors alike, they need to be accurate.

The best way to create accurate financial statements is by using accounting software. If you’re ready to make the move to a software application, be sure to check out The Blueprint’s accounting software reviews.

View more information: https://www.fool.com/the-blueprint/financial-accounting/

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