Financial accounting is a specific branch of accounting that involves recording, summarizing, and reporting the myriad transactions resulting from business operations over a period. These transactions are summarized in the preparation of financial statements, including the balance sheet, income statement, and cash flow statement, that record a company’s operating performance over time.
Key Insights
- Financial accounting offers a structured framework for financial recordkeeping.
- Both nonprofits and corporations rely on financial accountants for their books and records.
- Financial statements include the balance sheet, income statement, statement of cash flow, and statement of changes in shareholder equity.
- Different from managerial accounting, financial reporting focuses on external parties.
- Financial accounting can follow the accrual method (recognizing expenses before payment) or cash method (only recording cash transactions).
How Financial Accounting Works
Financial accounting adheres to established principles, influenced by a business’s regulatory and reporting requirements. Companies often have an accounting manual detailing key rules. For U.S. public companies, this means adhering to generally accepted accounting principles (GAAP).
Financial statements reflect five main classifications of financial data:
- Revenues: Income from sales and other sources like dividends and interest.
- Expenses: Costs of producing goods and services, such as marketing and payroll.
- Assets: Owned property, both tangible and intangible.
- Liabilities: Debts like loans or rent.
- Equity: The net value left after all debts are paid.
Revenue and expenses are detailed in the income statement, while assets, liabilities, and equity appear on the balance sheet.
Financial Statements Explained
Balance Sheet
A balance sheet reports a company’s financial position at a specific date, listing assets, liabilities, and equity. It helps management, lenders, and investors assess a company’s liquidity and solvency.
Income Statement
The income statement, or profit and loss statement, depicts operating activity over a period. It’s issued monthly, quarterly, or annually and includes revenue, expenses, and net income.
Cash Flow Statement
The cash flow statement details how a company uses cash in three sections: operations, financing, and investments. It clarifies how funds are being utilized, offering greater transparency than accrual accounting alone.
Shareholders’ Equity Statement
This statement explains how equity changes over time. It covers elements such as share capital, net income, dividends, and retained earnings.
Methodologies: Accrual vs. Cash
Accrual Method
Under the accrual method, transactions are recorded when they are earned or incurred, not necessarily when money changes hands. For instance:
- If a company earns $1,000 for a job to be done next month, it can’t recognize it as revenue yet. Instead, it records it as unearned revenue in liabilities and moves it to revenue once the job is completed.
- Expenses are logged when an invoice is received, irrespective of payment timing.
Cash Method
Here, transactions are noted when money is exchanged. For instance:
- A $1,000 payment for a future job is recognized as revenue upon receipt.
- An invoice received in July and paid in August is recorded in August.
Principles Guiding Financial Accounting
The framework for financial accounting is built on five principles related to the accrual method:
- Revenue Recognition Principle: Recognize revenue when it’s earned.
- Cost Principle: Record expenses at their transaction cost.
- Matching Principle: Match revenues with related expenses in the same period.
- Full Disclosure Principle: Include all relevant financial information transparently.
- Objectivity Principle: Prepare statements objectively, minimizing bias.
The Importance of Financial Accounting
- Standardization: Ensures consistency across reporting periods and companies.
- Decreases Risk: By creating accountability and transparency.
- Provides Management Insight: Aids strategic decision-making.
- Encourages Trust and Transparency: Reliability in reporting promotes investor confidence.
Users of Financial Accounting Statements
- Investors: Assess the company’s financial health before investing.
- Auditors: Ensure statements comply with accounting standards and are accurate.
- Regulatory Agencies: Oversee company compliance with reporting standards.
- Suppliers: Evaluate creditworthiness and operational stability.
- Banks: Verify operational health before offering loans or setting loan terms.
Differences with Managerial Accounting
Managerial accounting assists internal decision-making through operational data, unlike financial accounting, which is external-facing.
Professional Designations in Financial Accounting
- CPA (Certified Public Accountant)
- CA (Chartered Accountant)
- CMA (Certified Management Accountant)
- CIA (Certified Internal Auditor)
- CISA (Certified Information Systems Auditor)
Example of Financial Accounting
A public company’s income statement, adhering to specific reporting guidelines, reflecting recognized revenue.
Main Purpose of Financial Accounting
To provide financial information outlining a company’s operational performance, primarily for external use.
Common Users of Financial Accounting
Public companies and small businesses employ financial accounting, used by external parties like lenders, regulatory bodies, and investors.
The Bottom Line
Financial accounting establishes how financial statements are prepared, fostering transparency and accountability. Companies follow specific guidelines to ensure their operations are reflected accurately and consistently, benefiting all stakeholders.
Related Terms: managerial accounting, cost accounting, financial reporting.
References
- Financial Accounting Standards Board. “About the FASB”.
- University of Nevada, Reno. “What Is Financial Accounting and Why Is It Important?”
