The 3 Types of Accounting in Small Business
A Guide to Financial, Managerial, and Cost Accounting
Accounting is the language of business. It is the system of recording and summarizing business and financial transactions and analyzing, verifying, and reporting the results.
The small business accounting function is important since it allows the business owner or the accountant to analyze both historical and current financial data in a manner that helps the different stakeholders. In larger small businesses, there is typically a financial manager who is the recipient of the accounting information and performs different types of financial analyses.
There are three types of small business accounting necessary to provide financial information to a number of different stakeholders. Financial accounting is the process of recording the financial transactions for the company and developing reports using the information for the owner, accountant, or financial manager. Those statements and reports are used to perform financial analysis. Managerial accounting is the generation of financial information for use internally by the business firm. Cost accounting is the process of analyzing the costs of production of the company's products or services.
What Is Financial Accounting?
The purpose of financial accounting is to record, organize, report, and analyze the financial data generated by the company's daily financial transactions. The financial transactions made by the firm during an accounting period are used to develop the firm's financial statements. From the financial statements, the owner, manager, accountant, or financial manager can perform various forms of financial analysis.
The results of the financial analysis are then reported to the firm's stakeholders. The Stakeholders include parties with a vested interest in the performance of the company. The firm's stakeholders include the business owner, the Board of Directors, the stockholders and creditors of the firm, prospective investors, and the Securities and Exchange Commission (SEC) if the firm is publicly traded.
Publicly traded companies are required to follow the Generally Accepted Accounting Principles (GAAP) when preparing their financial reports for reporting or for investors.
GAAP is established by the Financial Accounting Standards Board (FASB). Their goal is to guide businesses through accounting procedures and practices by using these standardized principles.
The Accounting Cycle
Financial accounting for a business is based on the accounting cycle. Here are the steps:
- Record financial transactions: All daily financial transactions are recorded in chronological order in the accounting journal.
- Transfer financial transactions: The journal entries are transferred to the firm's general ledger at the end of the accounting cycle.
- Classify financial transactions: At the end of the accounting period, the journal entries are classified by account, according to the firm's Chart of Accounts. The major classifications on the Chart of Accounts are Revenue, Expenses, Assets, Liabilities, and Shareholder's Equity.
- Trial balance and adjusting entries: The trial balance for the accounting cycle is the sum of the debits and credits in the general ledger. Adjusting entries are then made and the firm's accounts balance as specified by the accounting equation.
- Preparation of financial statements: Using the financial information from the general ledger, the income statement, balance sheet, and statement of cash flows can now be prepared. These are the primary financial statements generated by the accounting data of a business.
The Financial Statements
The three financial statements generated by the accounting cycle provide the information used in the financial analysis of the business firm. These statements are:
- Balance Sheet: The balance sheet provides a snapshot of the firm's financial condition at a point in time. It tells you what the firm owns (assets) and what it owes (liabilities and shareholder's equity) on a particular date.
- Income Statement: The income statement depicts the firm's financial position over a period of time; for example, it might be "Year Ending December 2020." It shows the net results of the firm's operations through stating revenue and expenses. Profitability or loss is the result.
- Statement of Cash Flows: Cash is king in a business, especially a small business. The Statement of Cash Flows shows the inflows and outflows of cash over a period of time and the firm's net cash position at the end of the time period.
The company's financial statements are used as a basis for comparison, either through time or by industry groups. There are many types of financial analysis that are possible ranging from very simple for small businesses and very complex for large corporations. Here are two types of financial analysis that are relatively simple and appropriate for small businesses:
- Common size financial statement analysis: The analyst states every item on the company's income statement as a percent of sales. Every item on the balance sheet is stated as a percent of assets. The analyst can then compare data across different accounting periods.
- Financial ratio analysis: There are several areas of the business that an analyst needs to address. The calculation of the key financial ratios used in an analysis can tell the business manager a lot about the financial performance of a small business. There are six major categories of financial ratios used in financial analysis.
The financial statements provide the accounting data that financial managers, the owner or manager of the business, and outside stakeholders need to do a simple analysis of the firm's financial performance. The ratios are then compared to those of the firm from previous accounting periods or from other firms in the industry. Here are the six categories of financial ratios:
- Liquidity ratios: Liqudity ratios are a measurement of how quickly a firm can convert its assets to cash, in the short term, in case the need arises.
- Asset management ratios: Asset management, or efficiency, ratios are a measurement of how efficient the company is at using its assets to generate sales and to make a profit and maximize shareholder wealth.
- Solvency ratios: Also called debt management ratios, the solvency ratios help a company manager understand the financial leverage position of the company. The solvency ratios are used to determine how a business uses debt to finance its operations.
- Coverage ratios: The coverage ratios indicate to the firm manager how well the business can meet its fixed obligations, such as interest payments and lease payments. It is used along with the solvency ratios to keep an eye on the firm's debt and equity positions.
- Profitability ratios: The profitability ratios sum up the effects of liquidity management, asset management, and debt management on the firm. They show the net profit of the firm along with how well the firm maximizes the wealth of its shareholders if the firm is publicly traded.
- Market value ratios: The market value ratios are not widely used for small business since most small businesses are not publicly traded.
What Is Managerial Accounting?
Managerial accounting, also called management accounting, is the process of gathering, organizing, and reporting the company's financial data for the purpose of managerial decision making. Both financial accounting and cost accounting provide their financial data to management to assist them with decision-making. Using the data provided by financial and cost accounting together, management can look at a broader picture of the firm's financial performance.
Managerial accounting looks at the historical financial data offered by the financial and cost accounting functions. The reporting functions of financial and cost accounting are important to managerial accounting since raw financial data is summarized for the managers in report form.
Using historical information allows management to see where the firm has been, financially, and better plan for where they want it to go. The information that managerial accountants have allows management to forecast future firm performance.
Managers benefit from reports on the results of both common size financial analysis and financial ratio analysis. Managers use that financial information to go a step further. They perform, with the help of finance staff, more sophisticated analyses like variance analysis, cost-volume-profit analysis, risk assessment, sales forecasting, and budget development. Management will compare the company to others in the industry to get a good picture of where the company stands. All this information is used for making future decisions involving operations, product offers, pricing, or marketing plans.
Managerial accounting measurements are usually kept in-house due to the sensitive nature of the information.
What Is Cost Accounting?
Cost accounting is the practice of determining the costs of producing a product and reporting those costs to management to facilitate more informed decision making primarily about product pricing. Cost accounting usually is associated with businesses that actually manufacture a product. It is possible to assign costs to the output of service businesses as well. After costs are determined, management can then assign product prices. Assigning costs lays the groundwork for determining product prices.
Fixed and Variable Costs
The costs of producing a product for a business to sell are either fixed or variable in nature. There are a limited number of costs considered semi-variable:
- Fixed costs: The fixed costs of producing a product are those costs that do not change with the amount of the product that is manufactured. Examples of costs that do not change with quantity are leasing your plant and paying the insurance on the facility.
- Variable costs: The variable costs of producing a product are those that change with the quantity of the product manufactured. Examples of variable costs are the raw materials that go into the production process and the labor you pay to produce the product.
- Semi-variable costs: Only a few costs in production have characteristics of both fixed and variable costs. One is sales commissions which usually have both a fixed and a variable component.
Direct and Indirect Costs
Costs of producing a product are classified as either direct or indirect costs:
- Direct costs: These are costs that are directly associated with the product that you sell. For example, if you manufacture automobiles, a direct cost would be steel, one of the raw materials.
- Indirect costs: The indirect costs are on a company level rather than a product level. They are costs that affect the entire company as a whole. Utilities would be an example of an indirect cost.
Direct and indirect costs have to be tracked carefully by cost accounting. These costs help determine the profitability and efficiency of the firm and manipulating them is the basis for cost improvement programs.
Cost accounting is another functional area of accounting that is primarily for managers and not for the outside world.
How Do The Accounting Methods Differ?
Financial Accounting and Managerial Accounting
Financial accountants record, organize, and report the financial data generated by the business. Managerial accountants then take the reports developed from that information and analyze it. They then give it to the firm's owner or manager for internal use. The managers, in turn, put programs in place to improve the firm's bottom line.
Financial Accounting and Cost Accounting
These are two separate functional areas of accounting. Financial accountants deal with the raw financial data generated by the day-to-day operations of the business, while cost accountants focus on the costs of production and developing a pricing strategy for products.
Managerial Accounting and Cost Accounting
In the past, cost accounting was considered to be a part of the managerial accounting functional area. More often now, cost accounting is considered a separate area since managerial accountants deal with cost containment for the entire firm and cost accountants deal with individual products, their costs, and their pricing. The data from both functional areas is used by management to make decisions. Cost accounting reports are used to analyze costs incurred by processes.
Merriam-Webster.com."Accounting: Definition of Accounting." Accessed Nov. 30, 2020.
Investor.gov. "Generally Accepted Accounting Principles (GAAP)." Accessed Nov. 30, 2020.
Corporatefinanceinstitute.com. "The Accounting Cycle." Accessed Nov. 30, 2020.
Principles of Accounting, Vol. 2: Managerial Accounting. " Distinguish Between Financial and Managerial Accounting." Accessed Nov. 30, 2020.