It goes without saying that keeping track of the money flowing into and out of your business is fundamentally important. Yet, for small businesses, financial accounting is often not given the proper attention to detail it requires.
Using the wrong methods, keeping poor records, and failing to generate the necessary statements can lead to errors, incur tax penalties, turn off creditors, investors and business partners, and prevent you from making good business decisions.
Understanding the tenets of financial accounting gives you the assurance that you’re nailing the numbers and is necessary for your small business to move forward.
Definition of financial accounting
“Financial accounting describes the systems that process business transactions,” said Marilyn Pendergast, CPA and managing director of UHY Advisors. “These systems provide useful information about the financial position, income and expenses, and cash flows of your business.”
Data is displayed in financial statements that are used to report business activities in an understandable and consistent way. “This allows people outside of your company—such as stockholders, creditors or donors to non-for-profit entities—to use the information to make better decisions about your company when it comes to things like investments, loans or other financial support,” Pendergast said.
It’s also pertinent to point out key differences between financial accounting and general accounting.
Robert Duron, PhD, CPA, CFE, associate professor of accounting at Husson University explained, “Financial accounting is geared toward external users and stakeholders such as investors, creditors, regulators, and the general public, while accounting focuses more on the preparation and dissemination of financial information to an organization and its constituents, whereas finance focuses more on the acquisition and use of financial resources by the organization.”
Accounting concentrates on the past and keeping accurate records; while finance and financial accounting look ahead and serve a strategic function.
“Your accounting department will tell you what happened financially at your company, while your finance department will perform an analysis of what happened financially at your company and will make recommendations and forecasts on where the company will be in the future,” said Logan Allec, CPA and owner of Money Done Right.
Other types of accounting include managerial, tax, and forensic accounting and auditing, which also rely on the same accounting information system to produce the required information.
Tried-and-true methods of financial accounting
Smart businesses don’t make up their own money monitoring rules. They abide by long-established and widely practiced principles of financial accounting.
Generally Accepted Accounting Principles (GAAP)
“The need for consistent standards is key, especially to the outside parties who will want to compare your company’s financial statements with other companies. If there is no standard for how various items should be recorded, it would be very difficult for lenders, investors, and others to make informed decisions,” Allec said.
Hence, American companies follow GAAP—Generally Accepted Accounting Principles, which are set by the Financial Accounting Standards Board (FASB) or by the Governmental Accounting Standards Board (GASB).
GAAP offers guidance in many areas, such as how to recognize revenue, accounting for employee benefit plans, leases, commitments, valuation of investments, special industry areas and others.
“One might think that accountants, who simply report the financial transactions that occurred at a company, would need relatively few principles to guide them. After all, how hard can it be to simply record how much money your business made and how much it spent? But it’s much more complex than that,” said Allec.
Case in point: Say your consulting firm bills for $1 million in services in December of 2018 but isn't paid for these services until January 2019. Should your business record this income in 2018, when it earned the revenue, or in 2019, when it was reimbursed for the work? Following GAAP’s revenue recognition principle, your company should record the revenue in December 2018.
The latter example follows one of most basic GAAP principles—that financial accounting must be on the accrual basis—which is another vital concept for small businesses to grasp.
The accrual basis vs. the cash basis
“The accrual basis of accounting means that revenues are recorded when they are earned and expenses are recorded when they are incurred,” said Pendergast.
The accrual basis produces a more correct financial picture of a business’ operations and curbs companies from manipulating income and expenses by accelerating or deferring cash movement.
“For many smaller businesses, the accrual basis is much more burdensome and complicated,” said Sole, “as it requires additional journal entries to account for the timing difference between certain transactions recorded and when cash is received.”
An alternative is the cash basis method of accounting. With this approach, according to Investopedia, revenue gets reported on the income statement only when cash is received and expenses only get reported when cash is paid out.
However, many experts frown on the cash basis method.
“If you use the cash basis, you may see a $5,000 checking account balance and think, ‘Things are great; I can buy a new computer’ and forget that you have a $10,000 rent payment that’s overdue,” Pendergast said. “The accrual basis does require more recordkeeping and a good accountant, bookkeeper or outside service, but it’s worth the cost.”
Double-entry bookkeeping
Another widely adopted accounting method is double-entry bookkeeping. This approach helps keep your books in balance by recording both credits and debits, and, therefore, the full and often opposite effects of transactions.
“Say your small business purchases $500 of supplies. With double entry, it would record not only a $500 supplies expense on its profit and loss statement but also a decrease to the cash account in the amount of $500 on the assets side of its balance sheet,” said Allec. “When done correctly, doubly-entry bookkeeping prevents much human error.”
Why financial accounting is important to your business
Consider that a recent poll performed by BlackLine, Inc., a financial controls and automation software company, revealed that approximately 70% of finance chiefs have made important business decisions based on inaccurate data, and 55% of those surveyed aren’t fully confident they can recognize financial errors prior to reporting results.
Matt Sole, San Francisco-based owner of Anago of the Bay Area, an Anago Cleaning Systems franchise, can vouch for how easy it is for small businesses to fall into poor financial accounting practices, and how crucial accurate financial accounting is.
“For smaller companies, financial reporting is a method for generating reports on your business and financial statements that may be required by your bank or state or for tax purposes,” Sole said. “It also aggregates transactions from all different aspects of a business, whereas other types of accounting might be focused on one particular component of a business.”
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