If you’ve recently started or are thinking about starting a new business, there are some financial accounting concepts you need to know. This will help you plan ahead, choose the right accounting software, and pick the CPA that’s best for your business.
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This post is provided for general information only. Please confirm the details and circumstances of your unique situation with your tax accountant or other appropriate advisor before taking action.
What is meant by financial accounting?
Financial accounting is the process of tracking your business’s numbers and creating financial reports. Financial accounting covers things like your sales and your cost of inventory.
For big businesses, financial accounting is separate from tax accounting. Financial accounting is the set of rules for creating financial statements that stock market investors use.
Tax accounting doesn’t use the same set of rules. The differences are usually small things like whether to report income in this year or next year. Another example is how quickly you should depreciate a large purchase.
As a small business owner, you usually don’t need to worry about following the formal financial accounting rules, but you should be familiar with the basic concepts.
What is the main purpose of financial accounting?
There are three main purposes for financial accounting for small businesses.
First, you need to know your income and expenses for tax purposes. Tracking this information throughout the year will both make your tax accountant happy and reduce what you have to pay to file your taxes.
Second, you need to be able to plan ahead. If you want to buy a new piece of equipment, can you afford it? Will it really help you make more money? You also need to know basic things like whether you’ll have enough cash to meet your payroll.
Third, you can find ways to be more profitable. If you notice your expenses are high, you can look into why and see if there are ways to reduce them.
What are the 5 types of financial statements?
There are 5 total types of financial statements, but only 3 or 4 that you actually need to be worried about.
The main three are the income statement, cash flow statement, and balance sheet. The half is the statement of shareholder equity. The one you’ll almost never need to worry about is the note to financial statements.
The income statement is also called the profit and loss statement. It has a summary of your net income, gross profit, operating expenses, and non-operating expenses.
The income statement looks a lot like your tax return. In fact, if you follow the tax accounting rules, doing your taxes is often as simple as copying and pasting from your income statement.
Cash Flow Statement
The cash flow statement tells you how much money you have on hand. Cash flow is important because a profitable business can still run out of cash.
For example, you might have made a $50,000 sale to a big customer with the invoice due on the 30th. You know you’re in the black, but what about the bills you need to pay on the 15th?
Measuring your cash flows separately from your income helps you make sure you always have enough cash to meet your obligations.
The balance sheet is a summary of what the business owns, what the business owes, and what the business owners get.
The balance sheet formula is Assets = Liabilities + Equity
Here’s a sample balance sheet:
- Assets: $150,000
- Liabilities: $50,000
- Shareholder’s equity: $100,000
In this example, the business has $150,000 worth of inventory, equipment, vehicles, or other assets. It has taken out $50,000 in loans. If you sold off the business assets, the shareholders could take out $100,000 in cash.
Balance sheets are an important measure of a business’s financial health. Businesses with higher debt are often at higher risk of going under due to short-term disruptions in business. Businesses with low debt and solid assets have a greater chance of weathering a storm.
Statement of Shareholder’s Equity
The statement of shareholder’s equity shows how shareholder’s equity changed during the year. Shareholder’s equity includes investments by shareholders plus retained earnings.
Retained earnings is the business’s net income for the year minus dividends it paid to shareholders. Retained earnings can be negative if the business was holding cash from previous years and decided to give a larger dividend to reduce cash.
This statement isn’t used as much in small business accounting software. Especially when a business only has one owner, the income statement and balance sheet usually give you the information you need.
Note to Financial Statements
The Note to Financial Statements is a special disclosure that big businesses that have to follow International Financial Reporting Standards have to include with their financial statements. It includes things like what assumptions their accountants made and important information that the numbers might not show.
Small business owners almost never have to worry about the Note to Financial Statements.
What are the 5 components of financial statements?
You might also hear about the 5 components of financial statements. These are the key pieces of information that go into the financial statements.
- Assets (cash, accounts receivable, inventory, buildings, equipment, etc.)
- Liabilities (accounts payable, long-term debt, unearned revenue, etc.)
- Equity (what the shareholders own after subtracting liabilities from assets)
- Revenue (money the business received)
- Expenses (money the business paid)
How do you prepare monthly financial reports?
A monthly financial report is creating your three to five financial statements at the end of each month. You might also run other reports like your sales broken down by item.
Monthly financial reports might include data for that month alone, show a year-to-date summary, show the last 12 months, or any other breakdown you might want.
The best way to prepare your monthly financial report is automatically.
You can set up QuickBooks, FreshBooks, and other accounting software to run the reports each month. If you also have your accounting software set up to automatically monitor your transactions, you only need to spend a few minutes to verify the transactions and categorize anything the software didn’t recognize.
Why is the monthly financial report important?
A monthly financial report is important because you want to always have a current picture of your business’s financial performance.
Creating a monthly report gets you in the routine of doing a checkup at least that often.
If you say, “but I look at QuickBooks every day,” there are two problems with that approach.
First, if you get busy with other things, you might end up going a long time without checking your finances. Second, if you don’t have a defined process of what reports to run each month, you might neglect a report that could give you important information you need to know now.
What is month-end financial reporting?
Some businesses with more complex accounting have a more involved month-end process. They might need to get data from multiple systems or run a series of checks like reconciling account statements.
When someone talks about month-end reporting, they’re talking about the process of generating monthly financial reports.
Are financial statements monthly or yearly?
With all this talk about monthly reports, you might be wondering what happened to the annual reports. Many businesses use a combination of monthly, quarterly, and annual financial reports.
The monthly and quarterly reports provide fresher data. They let businesses adapt more quickly, spot problems sooner, and identify ways to grow now. The annual reports show a more long-term view and are also important for tax purposes.
What is included in a monthly financial package?
Many small businesses use a combination of QuickBooks and their tax CPA. Others might get a monthly financial package from an accounting firm or an outsourced accounting department.
A monthly financial package can include many things depending on what the business needs.
- Bookkeeping — either full-service or assistance with bookkeeping software
- Accounting reports — completing any additional accounting tasks and then generating the monthly financial statement
- Advisory services — giving the business advice on everything from following accounting rules to finding ways to become more profitable
- Tax services — planning ahead for tax season plus handling things like sales tax deposits, estimated tax payments, and payroll taxes
Monthly financial packages do two things for your business. First, they save you time so you can focus on other areas of your business. Second, they help you with things you might not know. For example, you might need to make moves before December 31st to claim a tax credit, so if you waited until April to talk to a tax accountant, you might miss out on the credit.
Remember, financial accounting isn’t just about what happened in a prior time period. It’s about taking steps today to make more money in the future.