Keeping track of the money flowing into and out of your business is fundamentally important. Yet for some small businesses, financial accounting does not receive the proper attention to detail.
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 assures that your numbers are accurate, plus it is vital for your small business to move forward.
The definition of financial accounting
"Financial accounting describes the systems that process business transactions. These systems provide useful information about the financial position, income and expenses, and cash flows of your business," said Marilyn Pendergast, CPA, Managing Director of UHY Advisors.
The data displayed in financial statements is used to report business activities in an understandable, 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 regarding things like investments, loans, or other financial support," said Pendergast.
There are key differences between financial accounting and general accounting. Robert Duron, PhD, CPA, CFE, an 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, the 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.
Accounting concentrates on the past and keeping accurate records, while finance and financial accounting look ahead and serve a strategic function.
Tried-and-true methods of financial accounting
Smart businesses don't make up their own money-monitoring rules. They abide by long-established, widely practiced principles of financial accounting.
Generally accepted accounting principles
"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 or by the Governmental Accounting Standards Board.
GAAP offers guidance in many areas, such as how to recognize revenue and accounting for employee benefit plans, leases, commitments, and the valuation of investments.
"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 2024 but isn't paid until January 2025. Should your business record this income in 2024, when it earned the revenue, or in 2025, when it was reimbursed for the work? Following GAAP's revenue recognition principle, your company should record the revenue in December 2024.
The latter example follows one of the most basic GAAP principles — that financial accounting must be on an accrual basis — which is another vital concept for small businesses to grasp.
Accrual basis vs. cash basis accounting
"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 accounting method produces a more correct financial picture of a business’s 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, as it requires additional journal entries to account for the timing difference between certain transactions recorded and when cash is received," said Sole.
An alternative is the cash basis method of accounting. According to Investopedia, with this approach, revenue is reported on the income statement only when cash is received, and expenses are reported only 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. The accrual basis does require more recordkeeping and a good accountant, bookkeeper, or outside service, but it's worth the cost," said Pendergast.
Double-entry bookkeeping
Another widely adopted accounting method is double-entry bookkeeping. This approach helps keep your books balanced 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. When done correctly, doubly-entry bookkeeping prevents much human error," said Allec.
Why financial accounting is important to your business
A poll performed by BlackLine Inc., a financial controls and automation software company, revealed that 69% of finance chiefs said they or their CEO made important business decisions based on inaccurate data. Additionally, 55% of those surveyed aren't fully confident they can recognize financial errors before reporting results.
Matt Sole, the 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. 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," said Sole.
Do you need accounting software?
If all of this information feels overwhelming, don't worry — many small business owners outsource their accounting or use accounting software. Nearly 65% of small business owners rely on accounting software, according to data compiled by the Chamber of Commerce.
Accounting software can streamline back-office workflows by automating administrative tasks and reducing manual data entry. Many of these tools can also handle invoicing, report generation, and bank account syncing. Read our buyer's guide to accounting software to learn more about accounting software and see if it's the right fit for your business.
This story was originally written by Erik J. Martin.
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