When starting a business, whether online or traditional, it is essential to learn about the fundamentals of financial accounting. You can’t expect your business to grow if you don’t know how to read and interpret the numbers and metrics that underpin it.
You might argue: There are many automated tools to help me keep track of my company’s performance and sales, so why should I learn about financial accounting?
Without a basic grasp of financial accounting, your business is unlikely to last for the next five to ten years.
The essential point is: You must understand financial accounting.
You don’t have to learn any of the advanced or sophisticated features of financial accounting. Instead, you only need to learn the key points and apply them to your business.
Fortunately, in this article, we will show you how to achieve finance. We also discuss all the basic details you need to know about financial accounting. Read on.
Financial Accounting in Layman’s Term
Experts define financial accounting as the process of preparing financial statements for a business or enterprise. There are three critical financial statements involved, namely, the income statement, balance sheet, and cash flow statements.
These financial statements are used to report the current financial standing of the company and to show how it’s been performing over time.
Financial accounting also provides stock market investors, business collaborators, creditors, and other interested parties with baselines when making crucial decisions. This is because it indicates whether a business is making money or going bankrupt.
These different types of users also rely on financial accountants to make sure that the financial statements are as accurate and comprehensible as possible.
Simplifying Financial Statements
As mentioned earlier, the three fundamental financial statements are the balance sheet, income statement, and cash flow statements.
All three accounts cover the same daily transactions in a business, but each presents the results or factors quite differently.
The income statement shows a company’s operational results. Using this statement, you can determine if a company is either generating income or losses during the accounting period.
Income statements also show the revenue, expenses, gains, and losses of a company. Stock market investors typically assess this statement before deciding to buy, hold, or sell their stocks.
The balance sheet is like a diagnosis platform for any business. That’s because it presents the business’s health since it started operating up to the specific date of the balance sheet. In other words, it indicates a company’s financial standing.
The balance sheet also lists a business’s assets (cash, inventory, and other resources), liabilities (factors or funds draining the assets), and equity (the difference between assets and liabilities).
In the case of equity, this shows the owner’s overall investment in the company.
Statement of Cash Flows
The cash flow statement shows how a business is generating and spending its cash. Investors and prospect lenders assess this information to determine whether the company has enough cash flow to meet dividends or repay loans.
Warren Buffet, the world’s most significant investor, always speaks about studying a company’s cash flows when deciding on a large stock purchase.
Basic Financial Accounting Terms and Definitions
Financial accounting is full of jargon. If you’re studying it for the first time, you may feel overwhelmed or lost with all the technicalities.
But don’t worry—you don’t have to learn or memorize everything.
Here are just some of the key terms and definitions you should know so you can properly execute financial accounting.
Financial Accounting Information Users
These are the people or companies that see accounting transactions organized and relayed into financial statements before making educated decisions. Such decisions include whether to buy blue-chip stocks or loan money to a company.
Features of Financial Information
Financial accounting information should be:
- Relevant: The information directly portrays the facts you’re trying to assess or understand
- Reliable: You can trust the information to point you in the right direction
- Comparable: Users can determine differences and similarities between the companies they are assessing
- Consistent: A company applies the same accounting approach for the same types of related transactions
Standard Accounting Principles (GAAP)
These are generally accepted rules that financial accountants must consider when doing accounting transactions and preparing financial statements.
Financial accountants cannot just guess numbers on the balance sheet, income statement, or cash flow statements. In other words, a company should have a level playing field so that people reading the reports can come up with comparisons.
Certified Public Accountant (CPA)
A CPA is a professional license given to certified accountants. Once an undergraduate passes the board exam, they automatically earn the CPA title and gain eligibility to work as an accountant in this regulated profession.
Of course, an undergraduate must take a number of accounting and business-related courses and then complete the Uniform Certified Public Accountant exam. The American Institute of Certified Public Accountants (AICPA) writes and scores the test.
Chart of Accounts
It refers to the list of all accounts put in place to manage a company’s accounting transactions. It usually starts with 1000 (assets) and proceeds to 9000 (miscellaneous gains and losses). The accounts are numbered in sequence.
The general ledger records all financial transactions that occur within a company during an accounting cycle. A chart of account number gives this order.
Companies use this method to systematically transition an asset’s cost from the balance sheet to the income statement during the asset’s useful service life. There are three methods used for depreciation:
- Declining balance
- Sum-of-the-years’ digits
Another technique, known as the unit of production method of depreciation, considers the actual physical usage of a fixed asset.
Equity of Stockholders
In every company, especially blue-chip companies, there are claims of specific individuals or separate companies. Financial jargon refers to these as stockholders’ equity.
It has three primary components:
- Paid-in capital: Amount of investment of a shareholder in a company
- Treasury stock: Stock of a company that it buys back from other shareholders or investors
- Retained earnings: Total net income or loss of a company from its opening date to the date printed on the balance sheet
If a business or individual files a lawsuit on a company, that company incurs a liability called a contingency. Other factors, such as internal issues and natural calamities, can lead to such losses.
Also called mergers and acquisitions, a business merger is concerned with the putting together of two or more businesses.
For example, if McDonald’s purchases 50% of Starbucks, this is an instance of a business merger. It is worth emphasizing that mergers come in two forms:
- Asset acquisition
- Stock acquisition
Learning is Paramount
Understanding financial accounting is fundamental for any business. Equip yourself properly by contacting a financial advisor in Jackson, MI. If you’re outside this area, please see our financial advisor page for further details.