Introduction
Accounting is like a large tree with many branches — financial accounting, managerial accounting, tax, audit, and bookkeeping. Among these, financial accounting is the most widely recognised branch. It serves as the language of business, allowing organisations to record, summarise, and communicate their financial performance to others.
So, what exactly is financial accounting?
It is the process of identifying, recording, summarising, and analysing an entity’s financial transactions and reporting them through financial statements. This guide walks through the eight essential steps of the accounting cycle to help you understand how financial accounting works in practice.
Step 1: Identifying Transactions
The first step in financial accounting is to identify the transactions that affect a business’s finances.
For example, imagine you own Ruff Times, a tabloid newspaper that sells annual subscriptions. During March, you collect $40,000 in cash for subscriptions starting in April and running through the next year. This event represents a financial transaction because it changes your business’s cash position and revenue potential.
Step 2: Preparing Journal Entries
Once a transaction is identified, it must be recorded in a journal using a journal entry.
A journal entry includes:
- A unique journal number and date
- A description of the transaction
- The accounts affected
- Debit and credit values
In the case of Ruff Times, you would debit the Cash account and credit the Subscription Revenue account for $40,000. This process is part of double-entry accounting, where every transaction affects at least two accounts, and total debits always equal total credits.
The Accounting Equation and Double Entry
Financial accounting is built upon one core principle known as the Accounting Equation:
Assets = Liabilities + Equity
- Assets are what the business owns (e.g. cash, inventory).
- Liabilities are what the business owes to others (e.g. loans, creditors).
- Equity represents the owner’s claim on the business after liabilities are settled.
This equation must always balance. Every debit has a corresponding credit, ensuring accuracy and consistency. In our example, cash increases (asset), and revenue increases (equity), maintaining balance.
Step 3: Posting to the General Ledger
After recording transactions in the journal, the next step is to post them to the general ledger.
The general ledger is a central record containing all accounts and their balances. In modern systems, this data is managed digitally through accounting software rather than handwritten books.
Each type of financial information is organised under specific accounts. There are six main types of accounts:
- Assets
- Liabilities
- Equity
- Revenue
- Expenses
- Dividends (or Withdrawals)
To visualise these, accountants often use T-accounts, where debits are recorded on the left and credits on the right. For Ruff Times, this means:
- Debit Cash (Asset) → $40,000
- Credit Subscription Revenue (Revenue) → $40,000
Step 4: Preparing the Unadjusted Trial Balance
At the end of a financial period, businesses compile an Unadjusted Trial Balance.
A trial balance lists all account balances to verify that total debits equal total credits. It’s an internal report used to check for recording errors and forms the basis for creating financial statements later.
This stage ensures that the accounting equation still balances — a sign that transactions have been recorded correctly.
Step 5: Posting Adjusting Entries
Before preparing final reports, accountants make adjusting entries to align with the accrual method of accounting.
There are two major accounting standards:
- IFRS (International Financial Reporting Standards)
- GAAP (Generally Accepted Accounting Principles)
Both require businesses to follow the accrual method, meaning:
- Revenue is recognised when earned, not necessarily when cash is received.
- Expenses are recorded when incurred, not just when paid.
Example of an Adjusting Entry
In Ruff Times’ case, you collected $40,000 in March for subscriptions beginning in April. Although you received the cash, you haven’t yet earned it — the service (the newspaper issues) will be delivered over the following year.
By December 31, you’ve only earned nine months of revenue, or $30,000. The remaining $10,000 is unearned revenue, a liability because you still owe subscribers three months of service.
The adjusting entry would:
- Debit Subscription Revenue $10,000 (to reduce revenue)
- Credit Deferred Revenue $10,000 (to record liability)
After posting, you prepare an Adjusted Trial Balance, showing accurate figures that comply with the accrual method.
Step 6: Creating Financial Statements
Financial statements summarise a business’s performance and position for external users such as investors, lenders, and regulators. There are three key financial statements:
1. The Balance Sheet
Provides a snapshot of the company’s assets, liabilities, and equity at a specific point in time. It shows what the business owns and owes, reflecting its financial position.
2. The Income Statement
Summarises revenues and expenses over a period, showing profit or loss. It reveals the company’s operational performance.
3. The Cash Flow Statement
Tracks the inflow and outflow of cash, detailing how the company generates and uses cash from operations, investments, and financing.
Together, these reports give stakeholders a complete understanding of the business’s profitability, liquidity, and stability.
Step 7: Posting Closing Entries
At the end of the year, temporary accounts such as revenues, expenses, and dividends must be cleared to start fresh for the next accounting period. This is done through closing entries.
In Ruff Times’ books:
- Revenue accounts are debited to bring them to zero.
- Expense accounts are credited to reset them.
- The resulting balance (profit or loss) is transferred to Retained Earnings under equity.
For instance, if your net profit is $26,440, that amount is added to retained earnings on the balance sheet, representing profits held for future growth.
Step 8: Post-Closing Trial Balance
Finally, an after-closing trial balance is prepared to confirm that all temporary accounts are reset and that the ledger is ready for the new financial year.
This ensures that only permanent accounts (assets, liabilities, and equity) carry forward, completing the accounting cycle.
Conclusion
Financial accounting is more than just numbers — it’s a structured process that ensures transparency, consistency, and accountability in business reporting.
From identifying transactions to preparing financial statements, each step of the accounting cycle serves to communicate an accurate picture of a company’s financial health.
In short, financial accounting is about telling the story of a business in numbers — a story that investors, lenders, and managers can rely on to make informed decisions.
