You’ll be forgiven for thinking financial accounting is a complicated topic, reserved for accountants, analysts, and general number crunchers. Although it can be complex at times, it’s an important subject that all professionals need to understand to ensure compliance and profitability. In this post, we’ll take the mystery out of financial accounting, using easy-to-understand examples to explain what it is and why it’s important.
What is financial accounting?
In simple terms, financial accounting is the practice of accounting for all money going in and out of an organization. It involves recording, classifying, summarizing, and analyzing all financial transactions.
Recording – Transactions are recorded as either a debit or a credit. When funds come into a business, that’s a credit. And when they go out, it’s a debit.
Classifying – There are several categories used to determine types of transactions:
- Revenue. This is generally from the sales of goods or services.
- Expenses. These are business costs, like salaries, office rents, and services
- Assets. This is the value of what a business owns. Assets may be physical (known as tangible), like property and equipment. Or non-physical (known as non-tangible), like a database of clients and software patents – think intellectual property.
- Liabilities. This is what a business owes. It’s not just debt, but also forecasted outgoings. Examples include mortgages, payroll, and payments owed to suppliers.
- Equity. This is what’s leftover after deducting liabilities from assets. It’s what the business owner and shareholders own.
Summarizing – The transactions are summarized into different reports (we’ll look at this later in the post)
Analyzing – Data and information is analyzed to help make business decisions
There are two different types of financial accounting: cash and accrual. Cash accounting is generally only used for employee cash expenses, such as client meals and travel costs. Accrual accounting is all-encompassing and accounts for all business transactions.
What are the principles of financial accounting?
The practice of financial accounting is based on a series of principles, with the five major ones being:
- Revenue principle – All income to a business is recorded when a client or customer accepts the goods or services – not necessarily when they pay for it.
- Expense recognition principle – All expenses are recorded when a business confirms goods or services from a third party – not when they’re billed for it.
- Matching principle – Each bit of revenue should be matched with corresponding expenses. For example, a marketing agency charges a client to set up their website. The agency’s expenses for this project include the hosting, domain, and the developer’s time. These costs must be matched to the project.
- Cost principle – Historical costs of assets and liabilities should be used, and not current or resell costs. For example, real estate value changes over time but in financial accounting, it’s historical, and not current, the value must be used. This is known as cost accounting.
- Objectivity principle – Only factual and verifiable data should be used on financial accounting, not subjective or estimated figures
These principles form what is known as GAAP Generally Accepted Accounting Principles.
Who uses financial accounting?
External stakeholders use financial accounting to see the current state of business. For example, shareholders will want to see financial reports before deciding to invest in a business. While suppliers need to see a firms’ financial health before extending credit for services. Next, brokers use a company’s financial reports to determine the value of its stocks and shares. And auditors, governments, and regulatory bodies rely on financial reporting to ensure legal and tax compliance.
Financial accounting should not be confused with managerial accounting, which is used internally by managers (hence the name) to help guide decision-making within a business. Whereas financial accounting, as we’ve just established, serves external stakeholders.
Financial Reporting
Accountants use a firm’s accounting information to create reports. These reports usually come in the form of a financial statement and are generally published on a monthly, quarterly, or annual basis. They’re circulated to a firm’s external stakeholders and subject to audits to ensure veracity and accuracy. Collectively, they show a business’ financial performance over a period of time, known as an accounting period.
These are the different types of financial statements that exist:
Income Statement
Also known as ‘profit and loss (P+L)’, this report starts with a record of all revenue over a period of time. It then deducts all matching expenses during the same period and what’s left over is the profit or loss. This is what’s known as a firm’s net income or bottom line.
For example, let’s take a law firm. In the month of August, it recorded total gross revenue of $50,000 against expenses of $37,500. So it’s net income was $12,500 ($50,000 – $37,500 = $12,500)
Income statements are used to determine a company’s profit margins, which you can read more about here.
Balance Sheet
Also known as a statement of financial position, this report provides a snapshot of a company’s financial health at a given moment in time. It takes into account assets, liabilities, and equity. This report shows what a business owns (assets) like accounts receivable, what it owes (liabilities) like accounts payable. Then what’s left over is the equity and this determines what a company is currently worth.
It’s called a balance sheet because the sums will always balance. For example, a business decides to renovate its offices and the work costs a total of $50,000. It uses $20,000 in cash to pay for it (equity) and $30,000 of debt to pay for the remainder (liability). The assets will therefore be $50,000.
Assets = Equity + Liabilities
Balance sheets are used by investors, analysts, and shareholders to help assess a firm’s financial standing. As it’s a snapshot, it doesn’t show trends or changes over a period of time. Instead, it’s compared with previous balance sheets to track changes in a business’ finances.
Cash Flow Statement
As the name suggests, the statement of cash flows is a report that tracks cash coming in and out of a business during a period of time. Stakeholders use this report to determine how well a business manages its cash.
The report is made up of 3 different types of cash flows:
- Operational activities. This includes the sale of goods and services (money coming in) and salaries and supplier payments (money going out)
- Investment activities. This tracks any changes to a business’ liabilities and assets in their cash equivalents. For example, the purchase of new software would appear in this section as cash out, as it’s a cost. The sale of assets, like property or equipment, would be an example of cash in.
- Financing activities. This section of the cash flow statement reports on money coming in and out through investments, debt and bonds.
The cash flow report adds up the sum of these three categories to give an overall cash flow. Here is a simple example. Cash-out is usually displayed in brackets.
Operational Cash Flow
Sales – $15,000
Salaries – ($5000)
Other operating costs – ($3000)
Total operational cash flow: $7000
Investment cash flow
New laptops purchased – ($2000)
Sale of old laptops – $1000
Total investment cash flow: $1000
Financing activities
Capital raised from investors – $4000
Interest paid to bondholders – ($2000)
Total financing cash flow: $2000
So the firm’s overall cash flow is $10,000 (Cash flow = operations + investments + financing)
This statement accompanies the balance sheet and income statement and also helps determine the financial health of a business. The more liquidity a business has, the better a firm’s financial position and the more capital they have to invest and grow. Whereas a business with a poor cash flow represents a risk for investors and lenders.
Under GAAP and different local laws and regulations, firms are obliged to publish financial information and maintain bookkeeping records. Regulatory bodies, like the IRS and financial institutions like the financial accounting standards board, ensure compliance. And to help them with laws and understand their financial data, firms hire certified public accountants (CPA).
Why is financial accounting important?
Bookkeeping and publishing financial statements are important for the following reasons:
- Communication with external stakeholders – Lenders, investors, and shareholders are just some of the third parties who use financial data to determine a business’ financial health. These external users then interpret this information to decide how much to invest or lend.
- Transparency – By publishing their accounts and data, businesses are transparent in disclosing their financial performance. We’ll look into more reasons why transparency is important later in this post.
- Compliance – Not only do they need to comply with laws and tax regulations, but also with international financial reporting standards (IFRS). Several accounting bodies ensure compliance, such as Financial Accounting Standards Board (FASB) in the US.
- Data-driven decision making – Management accounting is the practice of internal reporting of financial data. This allows for company bosses to see trends and overall business performance, which will help better inform their decisions.
How to keep profitability in order?
One of the biggest benefits of reporting financial data is that it helps analysts and managers understand their business and therefore improve its profitability. Let’s take a look at how you can keep profitability in order.
- Understand your gross profit margins.
Use income statements to help you understand your gross profit margins on the services you provide. This will help you to identify performance strengths and weaknesses in the delivery of projects and optimize accordingly.
Optimization could include controlling costs of goods and services, changing prices, and managing employee time. We’ll look at these points a little further down, and you can read about gross profit margins here.
- Understand your operating profit margins.
Your financial statements will also help you to get a better idea of your operating profit margins. This metric takes into account all costs in the overall running of the business, such as office rents. By understanding this figure, you’ll see how efficiently your business is run which then allows you to make improvements.
For example, a business may have a high gross profit margin but low operating margins. This could be a sign of inefficient internal processes or high expenses.
You can read more about different types of project margins here.
- Control your costs.
Following on from the last point, use your financial statements to closely monitor your costs and any changes over time. These reports break down and itemize expenses, allowing the reader to see where money is being spent. For example, the Covid-19 pandemic means remote working has become standard and company offices are no longer in use. So a business could decide to switch to a remote-only model, downsize their office or use a co-working space to save on office rents and reduce costs.
- Correctly charge for projects and services.
This may sound like a no-brainer, but many professionals and firms undercharge for their services. There are several reasons for this: underestimating how long a project will take, scope creep, and not charging the client for all billable activities.
For example, an accountant charges $100 per hour and quotes a project at $1500 – expecting it to take 15 hours. But in practice, it takes much longer, as the accountant didn’t accurately know how long the work would take to complete. Nor did they factor in client meeting time and admin. The project ends up taking 20 hours, reducing the hourly rate to $75. This extra 5 hours also delays the accountant and prevents them from taking on more projects sooner, further affecting profitability.
- Track time spent on all activities.
Following on from the previous point, professional service providers should track all time spent on client work. By tracking all hours, firms and individuals can build up an accurate picture of how long different types of projects take. They can then use this data to correctly charge for future projects, as they know how long similar projects took to complete.
- Automate your processes
Along with tracking time, firms should look to automate as many processes as possible. Through automation of time-consuming tasks, businesses will free up their employees’ time so they can spend more hours on billable work. For example, a graphic designer should spend their time on client work, and not administrative tasks like invoicing and tracking hours. By automating these processes, the graphic designers can take on more work in the same amount of hours.
- Invest in project management software
To help track time and automate processes, consider investing in a project management platform like COR. These tools automate time tracking for your employees and contractors which removes the risk of human error. It also makes it easy for your team members, so they’re less likely to object to recording their hours. These tools also centralize communication and data, which allows for transparency.
By automating processes and tracking time, you’ll also be looking after your team’s wellbeing. Time tracking means they’ll quote more accurately and therefore earn a higher fee. While automating processes alleviates them from time-consuming tasks which helps avoid burnout. With fairly paid team members who aren’t overworked, you’ll attract and nurture greater talent which means higher quality deliverables. And of course, with high standards of work, you can charge higher rates.
Data and transparency are also key to negotiating higher fees. Project management platforms automate reports, making them easy to generate and read. Businesses can then show these reports to their clients to help justify project costs. If your client knows your hourly rate, you can use historical data of project completion time frames to make your pricing transparent. If clients understand your prices, they’re more likely to accept your proposal than your competitors’.
Conclusion
Financial accounting is an essential business process that allows professionals to understand their business’ finances. It allows for transparency, data-driven decision making, and improved profitability.
