Financial accounting is a critical aspect of business management, focused on recording, summarizing and reporting a company’s financial transactions. Its primary function is to generate financial statements such as the balance sheet, income statement and cash flow statement that provide transparency and insights into a company’s financial health. These reports are essential not only for compliance but also for informed decision-making by investors, creditors and internal stakeholders. Ultimately, financial accounting ensures accountability and supports a company’s long-term financial strategy.
What is financial accounting?
Financial accounting is like a GPS system for navigating the financial landscape of a business. It’s a structured process of recording, categorizing, and reporting a company’s financial transactions and performance to external users, including creditors, investors, and regulators. This system serves as a critical tool for stakeholders to assess the company’s current financial position (where it is) and make well-informed decisions about its future direction (where it wants to go).
In contrast, managerial accounting focuses on providing internal users, such as management, with the financial insights needed to make operational decisions.
Key Highlights
- Financial accounting is more than just numbers; it tells the story of a company’s financial journey. As a navigation tool, it helps users model financial trajectories, assess risks, and allocate resources effectively.
- The Balance Sheet, Income Statement and Cash Flow Statements are the cornerstones of financial reporting, revealing a company’s assets, liabilities, profitability, and liquidity. These reports enable users to make informed and strategic decisions.
- Accounting principles like GAAP and IFRS provide a framework for creating reliable and consistent financial reports. Stakeholders, ranging from investors to regulators, rely on these reports to ensure transparency and accountability.
What distinguishes accounting from financial accounting?
Accounting covers the full range of financial transactions within a company. A well-run accounting department ensures that there are clear policies and procedures in place for managing expenses, maintaining accurate data, and generating comprehensive financial reports.
Financial accounting is specifically dedicated to the creation of these reports. It ensures that they are based on precise data and adhere to Generally Accepted Accounting Principles (GAAP), guaranteeing both accuracy and consistency in how financial information is presented.
==> Read more: Accounting services
What do generally accepted accounting principles (GAAP) refer to?
GAAP (Generally Accepted Accounting Principles) refers to a set of standardized rules for financial statement preparation, established by the Financial Accounting Standards Board (FASB). It covers a wide range of areas, including accounting practices and the appropriate format for presenting financial statements.
Publicly traded companies must follow GAAP to ensure consistency, transparency, and comparability in their financial reporting. Private companies, however, have more flexibility—they may either follow GAAP or prepare their financial statements according to another comprehensive accounting framework, such as tax-basis or cash-basis accounting.
The 4 core financial statements in financial accounting
The four main financial statements used in accounting are the Income Statement, Balance Sheet, Cash Flow Statement, and Statement of Owner’s Equity. These statements work together to provide a full picture of a company’s financial health.
1. Income Statement
The Income Statement shows a company’s net income over a specific period. It’s calculated by subtracting total expenses from total revenue. Essentially, it tells you whether the company made a profit or incurred a loss during that time.
It’s also known as the Profit and Loss Statement (P&L).
2. Balance Sheet
The Balance Sheet provides a snapshot of a company’s financial position at a single point in time. It lists the company’s assets (what it owns), liabilities (what it owes), and owner’s equity (the value of the company after liabilities are subtracted from assets).
Assets include:
- Cash
- Prepaid expenses
- Accounts receivable
- Notes receivable (money owed to the company within 1 year)
- Inventory
- Investments (e.g., real estate)
- Property, machinery, and vehicles
- Intangible assets (such as patents)
Liabilities include:
- Accounts payable
- Loans and notes payable (money owed within 1 year)
- Unearned revenue (payments received for services or products not yet delivered)
- Taxes payable
- Payroll (owed but not yet paid)
- Warranty obligations
- Mortgages
Owner’s Equity includes:
- Common and preferred stocks
- Retained earnings (profits reinvested into the business)
- Comprehensive income (profits or losses from investments over a period)
The balance sheet equation must always balance:
Assets = Liabilities + Owner’s Equity
3. Cash Flow Statement
The Cash Flow Statement tracks a company’s cash inflows and outflows over a period of time. Unlike the income statement, it only focuses on actual cash transactions and excludes non-cash expenses like depreciation.
This statement is vital for assessing whether a company has enough cash to cover its day-to-day expenses, such as paying employees and suppliers.
4. Statement of Owner’s Equity
The Statement of Owner’s Equity outlines the changes in the ownership value of the company over a reporting period. It includes income earned, contributions made by owners, and withdrawals or distributions to owners.
For corporations, this is referred to as the Statement of Shareholders’ Equity, and it includes information about stock issued and retained earnings (profits kept in the business after dividends).
Why are financial statements important?
1. Legal Requirement
For registered companies, financial statements such as the balance sheet, income statement, and cash flow statement are not optional; they are required by law. These documents are typically included in a company’s annual report, ensuring compliance with regulatory standards.
2. Essential for Effective Financial Planning
Management relies on financial statements to assess the company’s current financial situation, identify potential issues, and make informed decisions for the future. These insights help guide budgeting, investments, and other strategic financial choices.
3. Requested by External Parties
While private companies are not obligated to share their financial reports, publicly traded companies that issue shares must provide them. Various stakeholders often request access to these reports:
- Investors – To evaluate a company’s financial health and make decisions about potential investments.
- Banks – If seeking a loan, a company may be asked to provide financial statements to demonstrate their ability to repay the loan on time.
- Auditors – During an IRS audit or other government examination, auditors will use these statements as the foundation for their analysis.
- Lawyers – In legal matters involving financial disputes, lawyers will examine the company’s financial statements to understand the issue.
- Suppliers – Before offering goods or services, suppliers may review a company’s financial health to ensure they can fulfill payment obligations.
For any questions or challenges related to completing your accounting records, please don’t hesitate to contact Informly. We’re here to provide the most tailored and detailed advice for your specific needs.
