Startups have multiple financial responsibilities, from tracking income and expenses to complying with taxation regulations. Without a system to record and track data correctly, startups can find themselves in hot water with lenders, investors, and the IRS.
Accountability and transparency are crucial to running a successful startup, which is why financial accounting is vital. By implementing financial accounting in your startup, you'll be able to develop more accurate record-keeping systems, identify areas for growth, and determine cash flow needs. Plus, having a standardized set of rules for preparing financial statements will help ensure that all stakeholders have the same understanding of the company's financial state.
What Is Financial Accounting?
Financial accounting branches from the general accounting umbrella and encompasses the reporting, collecting, and summarizing of financial data. Data collected through this accounting method helps founders determine the current financial position of a company and analyze trends in operations.
How Does Financial Accounting Work?
Financial accounting follows pre-determined accounting principles to help businesses compile data into financial statements like balance sheets, income statements, and cash flow statements. Founders use these records to develop insights about the company's finances, answer questions from investors and lenders, and prepare reports for external parties.
Financial accounting principles like generally accepted accounting principles (GAAP) compliance and International Financial Reporting Standards (IFRS) provide guidelines and structure for financial reporting to ensure accuracy. Adhering to these standards helps to build trust with stakeholders and maintain transparency in the organization.
What Is Financial Reporting In Accounting?
Financial reporting is the simple act of passing financial data and reports to internal and external stakeholders. Founders can share this information in investor updates or board meetings.
Providing investors with accurate finances in real-time strengthens investor relationships and gives investors the floor to advise founders on current cash management.
What Is The Primary Purpose Of Financial Accounting?
The primary purpose of financial accounting is to provide stakeholders with information about the business's financial status. This includes providing meaningful and reliable financial statements that accurately reflect the company's current financial position. It also involves tracking income and expenses, maintaining accurate records, and preparing reports to help inform investment decisions.
Financial accounting also provides insights into a company's future performance and risk profile. Stakeholders can use this information to evaluate the growth potential and identify areas of improvement.
Financial reports are also essential for founders to make informed business decisions. From allocating resources and setting budgets to developing forecasts and analyzing performance, financial statements provide the information needed to improve operations and achieve success.
Types Of Financial Accounting Methods
Before we dive into the main principles of financial accounting, it’s important to understand the two primary types of financial accounting. Each type mainly differs in how and when businesses record transactions and prepare reports:
Accrual Accounting
Accrual accounting is the most commonly used method of financial accounting. This method involves recording revenues when they're earned rather than after receiving payment. It also includes expenses when they're incurred, not when they're paid.
Accrual accounting uses the accrual principle and allows for the timely recognition of revenues and expenses, providing a more accurate picture of a company's financial health.
Cash Basis Accounting
Cash basis accounting is another type of financial accounting that records transactions only when cash changes hands. Smaller businesses and startups that don't have the resources to use accrual accounting may use cash basis accounting instead.
This method does not require a detailed analysis of revenues and expenses. It can also lead to inaccurate financial statements and make it more difficult for investors and lenders to assess the company's performance.
Financial Accounting Principles
Financial accounting principles are a set of rules and guidelines that startups must follow when preparing financial reports. These principles help maintain accuracy and consistency in reporting across businesses, help to protect investors from financial misrepresentations, and aid founders in making better investment decisions.
While there are several accounting principles that a business can choose to use, the following principles all align with the accrual method of accounting that we discussed above:
- Revenue Recognition Principle – Businesses should only recognize revenue when it is realized or earned.
- Accrual Principle – Similar to the Revenue Recognition Principle but also encompasses expenses. Businesses should record revenues and expenses when earned or incurred, not when parties exchange payment.
- Matching Principle – Statements should compare costs with the related revenue.
- Going Concern Principle – Assumes that a business will continue to operate in the foreseeable future.
- Conservatism Principle – Organizations should record assets and income at a lower cost or market value.
- Materiality Principle – You should only report significant amounts in financial statements while omitting immaterial details.
- Cost Principle – Companies should record assets and liabilities at their historical costs.
- Objectivity Principle – Accountants must exercise professional judgment and independence when preparing financial reports.
- Full Disclosure Principle – Organizations must provide all relevant information that could affect decision-makers.
Financial Statements Needed For Financial Accounting
Startups must develop and maintain financial statements to track their finances. Financial statements for business communicate the company's financial performance and position. Without financial statements, it isn't easy to assess the company's performance accurately.
The most common financial statements for financial accounting in the accounting cycle include the following:
Balance Sheet
A balance sheet provides an overview of the company's assets, liabilities, and equity at a particular point in time.
Income Statement
An income statement shows the company's revenues, expenses, gains, and losses over a period of time. This is where you view your net income.
Cash Flow Statement
A cash flow statement shows how money flows into and out of the company over a period of time. This report shows if your startup has a negative or positive cash flow.
Who Uses Financial Accounting Statements
Financial accounting statements allow investors, lenders, and other external parties like financial bodies and government agencies to assess the financial performance and stability of the business.
Investors seek consistency in performance, financial strength, and potential future profits or growth opportunities. Lenders need to see that a company is capable and willing to repay any loans it takes on.
Financial bodies like the Securities and Exchange Commission (SEC) use these statements to evaluate a company's compliance with regulations. In addition, government bodies such as the Internal Revenue Service (IRS) can use this financial information for tax purposes.
Financial Accounting Vs Managerial Accounting
Financial accounting is the systematic process of recording financial transactions and preparing reports for external parties, such as investors and lenders. On the other hand, managerial accounting is an accounting process that provides information to internal stakeholders such as managers and employees.
Unlike financial accounting, managerial accounting does not focus on generally accepted principles or regulations but on providing timely and accurate information about the company's financial health. Internal stakeholders can use this information to make better decisions and increase the company's profitability.
Does Standardized Financial Accounting Improve Business Outcomes
Startups have a unique set of needs and challenges when understanding their finances. But why is financial accounting important?
Standardized financial accounting provides startups with a framework for recording transactions, tracking performance, and making informed decisions. By consistently using accurate financial statements, companies can offer investors and lenders a better understanding of their operations and stay compliant with regulations.
The bottom line is that financial accounting helps startups manage their finances effectively and positions them for success in the long term. Without it, startups may struggle to make sound business decisions and have difficulty obtaining the funding they need to grow.
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