Learn how financial accounting can set up your SMB for success.
It’s important for small business owners and solopreneurs to explore the different types of accounting so they can understand how each can benefit their bottom line. Given the variety of accounting approaches, this is easier said than done. With tight schedules and limited resources, many small to midsize businesses (SMBs) don’t have the time to study the different types.
This article breaks down one of the more useful approaches, financial accounting, defining it and providing examples so you can decide if and how to use it.
What is financial accounting?
Financial accounting is the process of recording and analyzing your financial transactions so you can gain an accurate picture of your company’s financial performance. It’s also a useful tool for communicating your financial progress to other stakeholders, such as creditors, investors, and compliance authorities.
For SMBs, financial accounting makes it easier to track cash flow so you can ensure the long-term solvency of your business. It also makes it easier to stay on top of financial obligations, such as loan payments, overhead expenses, and salaries.
This is important if you have to demonstrate your business’s performance to others including lenders or those interested in merging with your company. Financial accounting gives you the reports you need to quantify your success.
Fundamentals of financial accounting
The fundamentals of financial accounting include:
Recording each financial transaction
Posting entries in ledgers
Preparing financial statements for analysis or to present to stakeholders
For SMBs, it’s important to make sure you perform these tasks in a way that ensures accuracy and compliance with any applicable regulations.
Principles of financial accounting
Financial accounting principles refer to standards that help you maintain consistent, actionable records. Some of these include:
Generally Accepted Accounting Principles (GAAP), which is accepted in the United States as a core set of standards that comprise acceptable approaches to accounting.
International Financial Reporting Standards (IFRS), similar to GAAP, establishes accepted accounting standards in an international setting.
By adhering to these principles, you can produce reports and records that are regulated and accurate. You also make it easier to onboard an accountant who has already learned and adopted these principles.
Types of financial accounting
There are two primary types:
The accrual method. This involves recording transactions without taking into account when cash comes in or leaves your accounts. You record revenue when you send a bill—not when someone pays you—and you record expenses after you’ve received an invoice—not when you’ve sent out a payment.
The cash method. The cash method involves recording transactions when you pay or receive cash—after you’ve completed a transaction.
For example, suppose a fictional company, ABC Software, hires a team of external developers, DevReady, to code a game for a client. DevReady sends ABC Software an invoice in February, but ABC Software isn’t going to pay the bill until March. Using the accrual method, ABC Software would record the transaction in February as a debit in its “Outsourcing Expenses” category. At the same time, ABC Software would record a credit to its accounts payable.
After the company pays the invoice in March, it removes the credit from accounts payable.
Using the cash method, ABC Software would handle the transaction differently. The outsourcing expense would be recorded after the invoice was paid to DevReady—in March, not February, when DevReady sent the bill.
/ Learn more
Since you’re here, check out our Accounting Software Buyers Guide to help you understand the ins and outs of accounting software, from key features to price ranges.
Why is financial accounting important?
Financial accounting is key for SMBs because it paves the way for:
Improving the credibility of your business, especially when you have to talk to investors or lenders.
Making sure you are in compliance with requirements that apply to your industry reporting.
With a comprehensive financial accounting system, you can quickly generate reports in a matter of moments that demonstrate your business’s performance.
Financial accounting vs. managerial accounting
Financial accounting deals with producing reports that you can use when interacting with stakeholders, while managerial accounting is more focused on providing data to make decisions. With managerial accounting, the records you keep are designed for internal purposes, empowering you to guide your company in the right direction.
The method you choose may depend on what you need to use accounting for. For instance, if you know you’ll be applying for a business loan down the road, you should make sure you have a robust financial accounting system in place. In this way, you can have the documents on hand to prove you have the financial history to repay the loan.
A managerial accounting system is key to keeping decision-makers informed regarding how money is flowing in and out of the business. They can then use this data to identify trends and make decisions about how to adjust operations or decision-making to ensure maximum profitability.
Financial statements using financial accounting principles
Your financial accounting system consists of several statements you prepare based on revenue and expense data.
Balance sheet
Your balance sheet gives you a snapshot of your financial position at a specific point in time. In your balance sheet, you include:
Assets
Liabilities
Shareholder equity
You continue to add to your balance sheet as time goes on, making it a valuable resource when you have to look back and compare a previous period with your current financial position.
Income statement
Your income statement provides a report of your revenue and expenses, as well as your company’s net income. It’s sometimes referred to as a profit and loss statement. Typically, a company produces an income statement for a specific period, such as a quarter, a year, or a month.
For instance, suppose you’re applying for a loan with a local bank. The loan officer examines your income statement for the previous five years. They may be looking for evidence of well-managed expenses or increasing profits. Or they may have a formula they use to decide whether you qualify for a certain amount based on the ratio of your revenue to expenses.
Cash flow statement
A cash flow statement outlines how you spend cash over a specific period. It includes money you spend and receive from operations, financing, and investments. Using a cash flow statement, an internal or external stakeholder can gain a better understanding of how these elements impact the amount of cash you have on hand to make purchases or pay your obligations.
For instance, a company may have a positive cash flow, but that may be because they’ve been liquidating their assets. The company’s cash flow statement would make this clear, and a potential investor may then investigate why the organization has been selling off its assets.
Statement of shareholders’ equity
As the equity each shareholder holds in the company changes over time, the shareholders’ equity statement reflects the variations, as well as the different factors that may impact shareholder value.
The statement would include money you raise by selling stock, dividends paid out to shareholders, what you have left after paying dividends, and net income.
It’s common for companies to produce shareholder equity statements at the close of a fiscal year, such as December 31, if the organization uses the calendar to determine its fiscal timeframe. When shareholders see the equity statement, they can see, at a glance, how the value of their shares has risen or dropped over that period.
Examples of financial accounting
Here are some hypothetical examples of financial accounting to make it easier to see how to use the different reports:
Example 1: Jim Jones Law, LLC. Shareholders’ Equity
Shareholders’ Equity:
Shareholders’ equity on January 1: $800,000
Shares issued for cash: $500,000
Net income: $2,000,000
Dividends paid out: ($400,000)
Total Shareholders’ Equity on December 31: $2,900,000
Example 2: ABC Manufacturing Income Statement for 2024
Revenues:
Net sales: $500,000
Other revenue: $15,000
Returned products: ($10,000)
Total revenues: $505,000
Cost of goods sold: $150,000
Gross profit: $355,000
Expenses:
Accounting: $2,500
Marketing: $25,000
Employee payroll tax: $15,000
Wages: $100,000
Insurance premiums: $2,000
Website expansion: $1,000
Vehicle maintenance: $5,000
Total expenses: $150,500
Net income before taxes: $204,500
Start using financial accounting to showcase your company’s performance
Using the information above, you can design your financial accounting system as well as strategize how to leverage it when communicating with other stakeholders. Your accounting system can be an effective tool in showcasing how well your company is doing when you need to secure a loan or demonstrate performance.
Your next step is to explore accounting tips, dive deeper into how accounting works, and start choosing the best accounting software for your business. Here are some resources to help you get started: