The 3 Types of Accounting in Small Business – The language of business is accounting. It is a method for documenting, summarizing, analyzing, verifying, and reporting business and financial activities.
The accounting function in a small business is vital because it allows the firm owner or accountant to assess both historical and current financial data in a way that benefits all stakeholders. A financial manager is often the recipient of accounting information and does various types of financial assessments in larger small firms.
To give financial information to a variety of stakeholders, three forms of small business accounting are required. Financial accounting is the process of recording a company’s financial transactions and creating reports for the owner, accountant, or financial manager based on the data. Financial analysis is carried out using those statements and reports. Managerial accounting is the process of generating financial data for internal use by a company. The practice of assessing the costs of production of a company’s products or services is known as cost accounting.
What Is Financial Accounting?
Financial accounting is the process of recording, organizing, reporting, and analyzing financial data generated by a company’s daily financial activities. The financial transactions that a company does over the course of an accounting period are utilized to create the company’s financial statements. The owner, manager, accountant, or financial manager can undertake many types of financial analysis using financial statements.
The financial analysis’ findings are subsequently shared with the company’s stakeholders. Parties with a vested interest in the company’s performance are considered Stakeholders. The business owner, the Board of Directors, the firm’s stockholders and creditors, potential investors, and the Securities and Exchange Commission (SEC) if the firm is publicly traded are all stakeholders.
The Financial Accounting Standards Board establishes GAAP (FASB). 2 Its purpose is to use these standardized principles to guide organizations through accounting procedures and practices.
The Accounting Cycle
The accounting cycle is the foundation for financial accounting in a business. 3 The steps are as follows:
- Record financial transactions: In the accounting diary, all daily financial transactions are documented in chronological order.
- Transfer financial transactions: At the end of the accounting cycle, the journal entries are transferred to the firm’s general ledger.
- Classify financial transactions: The journal entries are classified by account at the conclusion of the accounting period, according to the firm’s Chart of Accounts. Revenue, Expenses, Assets, Liabilities, and Shareholder’s Equity are the primary classifications on the Chart of Accounts.
- The sum of the debits and credits in the general ledger is the trial balance for the accounting cycle. After that, adjusting entries are made, and the firm’s accounts are balanced according to the accounting equation.
- Financial statement preparation: The income statement, balance sheet, and statement of cash flows can now be prepared using the financial information from the general ledger. These are the primary financial statements produced by a company’s accounting data.
The Financial Statements
The information utilized in the financial analysis of the business firm is provided by the three financial statements created by the accounting cycle. These are the statements:
- The balance sheet is a snapshot of a company’s financial situation at a certain point in time. On a given date, it shows you what the company possesses (assets) and what it owes (liabilities and shareholder’s equity).
- Income Statement: The income statement illustrates the company’s financial situation over time; for example, “Year Ending December 2020.” It states revenue and expenses to demonstrate the net results of the firm’s activities. The outcome is either profit or loss.
- Cash is king in a business, especially a small business, according to the Statement of Cash Flows. The Statement of Cash Flows depicts cash inflows and outflows throughout time, as well as the firm’s net cash position at the conclusion of the quarter.
The financial statements of the company are used to make comparisons over time or by industry groups. There are many different types of financial analysis available, ranging from simple for small enterprises to sophisticated for major corporations. Here are two forms of financial analysis that are suitable for small enterprises and are quite simple:
- Every item on the income statement is expressed as a percentage of sales by the analyst in common-size financial statement analysis. On the balance sheet, each item is expressed as a percentage of assets. After that, the analyst can compare data from various accounting periods.
- Financial ratio analysis: An analyst must consider a number of aspects of the business. The calculation of the major financial ratios employed in an analysis can reveal a lot about a small organization’s financial performance to the business management. In financial analysis, there are six major categories of financial ratios.
Financial managers, the owner or manager of the business, and outside stakeholders can use the financial statements to make a straightforward analysis of the firm’s financial performance. The ratios are then compared to those of the company in prior accounting periods as well as those of other companies in the industry. The six types of financial ratios are as follows:
- Liquidity ratios are a gauge of a company’s ability to turn its assets into cash in the short term if the need arises.
- Ratios of asset management: Asset management ratios, also known as efficiency ratios, are a measure of how well a company uses its assets to generate sales and profit, and maximize shareholder wealth.
- Solvency ratios, often known as debt management ratios, assist a corporate manager in determining the company’s financial leverage condition. Solvency ratios are used to analyze how a company finances its operations with debt.
- Ratios of coverage The coverage ratios show how successfully a company can meet its fixed obligations, such as interest and lease payments, to the firm manager. It’s used in conjunction with solvency ratios to maintain track of a company’s debt and equity situations.
- Profitability ratios: Profitability ratios summarize the effects of liquidity, asset, and debt management on the business. If the company is publicly traded, they disclose the net profit as well as how successfully the company optimizes the wealth of its owners.
- Market value ratios: Because most small businesses are not publicly traded, market value ratios are not generally employed.
What Is Managerial Accounting?
Managerial accounting, often known as management reporting, is the act of acquiring, organizing, and reporting financial data for managerial decision-making. Financial accounting and cost accounting both provide financial data to management in order to help them make decisions. Management can receive a better understanding of the company’s financial performance by combining financial and cost accounting data.
Management can assess where the company has been financially and prepare for where they want it to go by using historical data. Managerial accountants have access to data that helps them to forecast future corporate performance.
Reports on the outcomes of both common size financial analysis and financial ratio analysis are beneficial to managers. Managers use financial data to take things a step further. They execute more complex analyses, such as variance analysis, cost-volume-profit analysis, risk assessment, sales forecasting, and budget preparation, with the support of finance staff. To gain a good sense of where the company stands, management will compare it to others in the industry. All of this data is utilized to make future decisions about operations, product offerings, pricing, and marketing strategies.
Due to the sensitive nature of the data, managerial accounting metrics are frequently retained in-house.
What Is Cost Accounting?
Cost accounting is the activity of determining the costs of creating a product and reporting those costs to management in order to help management make better decisions, particularly concerning product price. Cost accounting is typically linked with companies that manufacture goods. It is also possible to attach costs to service businesses’ production. Following the determination of expenses, management can assign product prices. The foundation for calculating product prices is laid by assigning costs.
Fixed and Variable Costs
The costs of making a product for a company to sell are either fixed or variable. There are just a few costs that are considered semi-variable:
- Fixed costs: The costs of creating a product that does not change with the quantity of the product manufactured are known as fixed costs. Leasing your plant and paying the facility’s insurance are two examples of costs that do not change with quantity.
- Variable costs: Variable costs are those that alter depending on the quantity of the product manufactured. The raw materials used in the manufacturing process, as well as the labor you pay to make the product, are examples of variable costs.
- Costs that are semi-variable: Only a few costs in production contain both fixed and variable features. One example is sales commissions, which often include a fixed and variable component.
Direct and Indirect Costs
The expenses of creating a product are divided into two categories: direct and indirect costs:
- Direct costs are expenses that are directly related to the product you are selling. For example, if you make autos, steel, one of the basic materials, is a direct cost.
- Indirect expenses are costs that are incurred at the company level rather than at the product level. They are costs that have an impact on the entire company. A good example of an indirect cost is utilities.
Another functional area of accounting that is largely for managers and not for the general public is cost accounting.
How Do The Accounting Methods Differ?
Financial Accounting and Managerial Accounting
Financial accountants keep track of, organize, and report on the financial information created by a company. The reports generated from that data are subsequently analyzed by managerial accountants. They then give it to the owner or manager of the company to use internally. Managers, in turn, implement programs to boost the company’s bottom line.
Financial Accounting and Cost Accounting
These are two distinct accounting functional areas. Cost accountants focus on the costs of production and devising a price strategy for items, while financial accountants deal with the actual financial data generated by the business’s day-to-day activities.
Managerial Accounting and Cost Accounting
Cost accounting used to be regarded as a part of the managerial accounting functional area. Because managerial accountants deal with cost control for the entire company while cost accountants deal with particular products, their expenses, and their pricing, cost accounting is increasingly being treated as a separate field. Management makes judgments based on facts from both functional areas. Cost accounting reports are used to examine how much a procedure costs.