No business can be successful in the long-term without establishing solid accounting systems. While it is true that a successful business has a number of crucial components to it including clever marketing, understanding the needs of the customers and quality products or services delivered on time, the best of all these endeavours will still fall short if the financial systems are inadequate. Not only does poor control of financials mean day-to-day decisions essential to operational effectiveness are being made without a sound statistical and financial base, but the business can also be vulnerable to theft and misappropriation of funds.
Financial accounting is the term for preparing a set of accounting records by an accountant to establish a true and fair view of profit and loss. The method for arriving at the end result has been developed over many years and is accepted practice through much of the world, as is the way in which the financial statements are presented.
While every business has its own way of capturing the required information, the sources documents are fairly standard and include quotations, purchase orders, invoices, receipts, cheque butts and payment vouchers. The process followed to bring all this information to account is called the accounting cycle.
The source documents find their way into the accounts via journal entries, and these entries then flow into individual accounts in the general ledger. Bank accounts are reconciled and a trial balance prepared at the end of each accounting period to check that all the accounts are in balance. The preparation of the profit and loss statement can then proceed, followed by the balance sheet.
The profit and loss statement will show how well the business is trading month to month, while the balance sheet shows the liquidity of the business at a given point in time. A cash flow statement is then prepared to show the inflow and outflow of liquid funds, and is invaluable for forward planning to make sure the cash in the bank is sufficient to support the ebbs and flows of the business cycle.
Financial accounting should not be confused with cost accounting which is a different approach altogether. Cost accounting is often used to support decisions made to reduce the operating costs of a business and improve its profitability. It’s primary use is as an internal management tool, while financial accounting produces information required by external parties such as shareholders, lending institutions, government agencies and other stakeholders.
With modern computerised accounting software, the actual process of entering the information into the accounting system has become quite automated. The system will produce a profit and loss statement and balance sheet, but the interpretation of these results should be left to an accountant trained to understand what the figures actually mean to give a true picture of the health of the business. If you need help understanding the story behind your figures, get in touch – we’d love to help.