Financial accounting is a snapshot of the state of your business for your use and for possible lenders, so get it right
Financial accounting is the single most critical information system your business will require. Financial accounting aims to produce two basic financial reports, the balance sheet and the profit and loss statements. Traditional software systems uses a ledger of accounts to categorize financial activities of your company. Typically, the ledger is divided into two major portions, the assets portion, usually envisioned as being on the left side of the ledger, and the liabilities and equity portion, that being on the right side. Under assets you will have such accounts as the cash account, accounts receivables, and fixed assets, including inventory, buildings owned, and office equipment and other assets for which you paid money. Each account is also split into two parts, the left side being the debits side and the right side being the credits side. Now, the ledger should be balanced such that the assets side debit sum of all assets accounts is equal to the sum of all liabilities and equity on the credit side of the ledger.
Common practice has devised the double entry method for maintaining balances between assets on the one side and liabilities and equity on the other side. For instance, if you start a business with $1000, you would enter $1000 in the equity account on the right side as a credit and a $1000 debit on the assets side in the cash account. The ledger remains balanced.
In financial accounting you create your two pertinent reports from your general ledger. Your profit and loss statement reports ordinary income/expense, the cost of goods sold being subtracted from total income to derive gross profit. Your profit and loss statement will also report expenses. Subtracting total expense from gross profit will render your net ordinary income. You will also account for other income and add it to net ordinary income to derive you net income, the end point of this financial accounting report.
The principal financial accounting report, the one you often submit to lenders, is the balance sheet. This summarizes your entire ledger. It will first show current assets, starting with cash, including undeposited funds, checking and saving, all added together to render total cash. Next, you will show total accounts receivable and then other current assets, such as owner loans receivable and prepaid insurance. The other current assets are added together with total cash and total accounts receivable to get your total current assets. Next, still on you assets side, you will show fixed assets, such as furniture, vehicles, the amount of depreciation to be subtracted from these fixed assets to obtain your total fixed assets. Finally, you add total fixed assets with total current assets to obtain you total assets.
Your financial accounting balance sheet isn’t complete until you’ve shown your liabilities and equity portion of the general ledger. You will show current liabilities, including accounts payable and credit card amounts owed, as well as other current liabilities such as payroll. These added together give you your total current liabilities, but you still have to show your long term liabilities, such as notes payable, tax payable and other payroll liabilities. Adding together you total current liabilities and long term liabilities gives you your total liabilities. Finally, you have to account for equity, the amount of money invested by owners and shareholders. Total liabilities are added to total equity to obtain the end result, total liabilities and equity.
If you’ve done your accounting properly, total assets will equal total liabilities and equity – balanced. Your finance accounting reports are now available for you and your lender to measure the health, value, and profitability of your company.