Disclaimer: Please note this article is not financial advice. The purpose of our blog is purely educational, so please consult a professional accountant or financial advisor before making any financial decision.
Dipping your feet into accounting can be confusing. Feeling intimidated by terms such as “accounting cycle” or “financial reporting” is a familiar predicament for business owners just trying to get a general understanding of accounting.
Still, entrepreneurs need to have basic accounting knowledge to understand what’s going on when they actually set up an accounting system for their business. So here's a quick lesson about financial accounting before you hire an external accountant.
What Is Financial Accounting?
It is the main discipline that teaches the fundamentals. This branch involves a bookkeeper classifying and recording business transactions that span twelve months, called the accounting reporting period.
Once bookkeepers have recorded everything, they generate reports in the form of financial statements. These statements break down the totals of all the activities involving the operation of your business.
The recording and the generation of financial statements are all under a process called the accounting cycle.
Accounting Cycle: An Overview
Businesses are made of operation cycles. For example, a manufacturing plant has a production cycle just as a service business has a service cycle. So inevitably, accounting would also have its own.
The accounting cycle is the fundamental recording process that bookkeepers recognize and use. It starts with creating a chart of accounts and ends with closing the books and opening new ones for the next reporting period.
Here's an overview of the accounting cycle.
Creating a Chart of Accounts
A bookkeeper can list down generally accepted labels for common transactions such as sales or rent expenses and put a code in each.
Logging Journal Entries
Once a business enters into a transaction with anyone, it must be recorded using an accounting journal. It can be an actual paper journal, a spreadsheet, or financial accounting online software. Each transaction will be recorded using at least two different accounts from the chart.
Posting Accounts on the Ledger
A general ledger is where all the official accounts are recorded. Each account will have two sides—the debit and the credit. This way, bookkeepers record what comes in and goes out of a specific account.
For example, a “Cash” account will have a debit and a credit side. If you receive cash from a customer, it is posted as a debit; if you pay for your rent, it will be recorded on the credit side.
A trial balance is done after calculating the totals of each account on the general ledger. That means subtracting the debit from the credit. If the net result is positive, it will be totaled on the debit side. Otherwise, it will be totaled on the credit side.
The trial balance's bottom line must have the same amount to know that everything is accurately recorded.
Generating Financial Statements
Once everything is balanced, financial statements can now be generated. It starts with classifying income statement accounts and balance sheet accounts, as well as cash transactions. When it's done, you will have a breakdown of your business's current standing, and you can now outsource a professional that can serve as your financial accounting analyst.
Closing Books and Opening New Ones
In preparation for the next accounting period, accounts must be closed. For any accounts that have balances, it will be carried over as the first transaction of the new book, and the process of recording on the journal and ledger begins again.
The Essential Statements
All the activities involved in accounting come down to just one purpose—the generation of financial statements.
Financial statements give you and other business stakeholders a general view of the business's financials. It will tell you what expenses you need to cut back on, what assets are giving you the most profit, and, most importantly, if your business is making money.
Financial statement reports have three kinds.
From the name itself, this statement gives you a picture of your business's income or lack of it. That's why it is also called the statement of profit and loss.
The income statement is a summary of your business's total revenue and expense transactions by the end of the accounting period. These totals are broken down starting with the revenue and then deducting every expense down the line until it reaches the net profit—your business's bottom line.
Income statements are often a good measurement of your operating performance and profitability.
If the income statement tells you how your business performed, the balance sheet is like your business's physical exam result. It gives you a general idea of its health in monetary terms.
The accounts in a balance sheet tell the status of your business. For example, they will tell you the value of the assets your business holds, the amount your business borrowed, and how much of your money is put on the business. The total value of your business assets must equal the liabilities and the equity, hence the name.
Cash Flow Statement
If you've ever heard of the adage “Cash is king,” the cash flow statement proves it right. This financial statement records cash transactions and sorts them into three types: operations, financing, and investment. Therefore, the total cash balance of this report should equal the amount reflected on the cash account on your balance sheet.
The cash flow statement gives you a picture of where the money is flowing in (or out of) your business activities. As a result, you understand the types of activities that bring in a lot of cash or suck it.
Branching Out: Other Relevant Accounting Subdisciplines
Accounting branches out to different subdisciplines. Here are other types of accounting that you may need as your business grows.
- Management Accounting — This subdiscipline focuses on the efficient use of the most liquid asset in your business: cash. The aim is to make financial reports for management and decision-making. Management accounting follows the accepted practices of Global Management Accounting Principles.
- Cost Accounting — Cost accounting doesn't branch out directly from general accounting but from management accounting. This discipline involves the analysis and evaluation of costs to make sound spending decisions.
- Auditing — Auditing is accounting’s policing branch. It involves making sure that reports are accurate, compliant with different tax regulations, and in line with Generally Accepted Accounting Principles. You can hire auditors, or the state internal revenue department can send them your way.
- Tax Accounting — This subdiscipline focuses on preparing all requirements for filing tax returns and making sure the business is compliant with all state tax rules.
Get Sound Accounting for Your Business
Getting started on the right foot in terms of your financial accounting is a sound decision. And what better way to do that than by hiring an expert with an excellent understanding of it?
Talk to Unloop today to get help in setting up accounting systems or dive deep into the concepts we've laid out here. You may reach us at 877-421-7270. We look forward to hearing from you!