Given a good bookkeeping system, would financial accounting be necessary?

By Matt Lee AAA
A:

Bookkeeping and financial accounting may seem like they are new creations, but variations have been around for millennia. The first record keeping systems, according to some, originated in about 4500 B.C. These early forms of record keeping were simple, single entry entities as it related to the company involved in a transaction. A single entry system only records how the transaction affected the company's cash balance, so only cash-related transactions were recorded. Double entry bookkeeping involves the use of debits and credits to record transactions as they occur, but moves beyond cash-only transactions.

Bookkeeping encompasses both single and double entry reporting, but that is where the similarities between bookkeeping and financial accounting end. Although financial accounting could not exist without bookkeeping, bookkeeping may be used on its own under the right circumstances.

If the company was a very small private firm with very simple transactions, and a relatively small amount of transactions in total, then a good bookkeeping system may be all this company would need. When a company only reports transactions on a cash basis, then this is called cash accounting, and is permissible by generally accepted accounting principles (GAAP) under certain circumstances. Financial accounting, and more specifically accrual accounting, becomes necessary when the company becomes larger, more complex, and is incorporated.

For example, a multi-national firm will have to record transactions on a accrual basis, as this will better reflect the company's true financial standing. Accrual accounting was created to assist business evaluators in valuing a company based on its true economic worth, especially on a moving forward basis. Accrual accounting involves recording transactions such as sales made on credit, loans made to the company on credit, and dividends that have been declared, but not yet paid out. Accrual accounting moves beyond cash-only transactions, and is necessary when the firm is involved in credit transactions. Without accrual accounting, the true economic value of a large company would be harder to determine.

Based on the size of the company and the type of transactions it is involved in, the right user system must be evaluated. If the firm is very small, and is a cash-only business, then simple bookkeeping would be all that is necessary for taxation purposes. On the other hand, if a firm is very large, and has complex transactions, then financial accounting is the standard that must be adhered to.

Read our Fundamental Analysis Tutorial to learn more about understanding a company's financial statements, or see our Advanced Fundamental Analysis Tutorial for a more in depth look at financial statements.

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