Financial accounting is the process of recording, summarizing and reporting a company’s business transactions through financial statements. These statements are: the income statement, the balance sheet, the cash flow statement and the statement of retained earnings.
What Is the Difference Between Accounting and Financial Accounting?
“Accounting” encompasses all of a company’s financial transactions. A well managed accounting department will have set policies and procedures for expenses, data management and the generation of financial reports.
Financial accounting is concerned specifically with the generation of these reports, that they are based on accurate information and follow “Generally Accepted Accounting Principles” (otherwise known as GAAP). GAAP sets accounting standards in the United States for a wide array of topics, including financial statement presentation.
What Are the Four Basic Financial Statements?
The four basic financial statements used in financial accounting are as follows:
THE INCOME STATEMENT
An Income Statement is a company’s net income for a certain period of time. It is a company’s total revenue minus its total expenses.
You will also hear the income statement being referred to as the “Profit and Loss Statement”.
THE BALANCE SHEET
A balance sheet shows what a company owns (its “assets”) and owes (its “liabilities”) as of a particular date, along with its shareholders’ equity.
Assets can include:
- Prepaid Expenses
- Accounts Receivable
- Notes Receivable (money owed to the company within 1 year)
- Investments (including real estate)
- Machinery and equipment
- Intangible Assets (such as patents)
Liabilities can include:
- Accounts Payable
- Loans Payable
- Notes Payable (money the company owes within 1 year)
- Unearned Revenue (a product or service a client has paid for, but the company has not yet provided)
- Deferred Tax
- Current Taxes
- Payroll (owed but not yet paid)
- Warranty Obligations
Shareholders’ Equity can include:
- Stocks (preferred and common stocks)
- Retained Earnings (money to be invested back into the business)
- Comprehensive Income (profit or loss in a company’s investments during a specific time period)
On a balance sheet, Assets = Liabilities + Shareholders’ Equity.
THE CASH FLOW STATEMENT
The cash flow statement documents in detail all of a company’s income and debts over a specific period of time. It is only concerned with cash, as such the statement does not include depreciation and amortization costs (like an income statement would).
A cash flow statement reflects the short-term viability of a company by indicating whether the operation has enough working capital on hand to pay its employees and debts.
For more on cash flow statements, please read “What Is a Cash Flow Statement”.
STATEMENT OF RETAINED EARNINGS
This is the amount of income a company has left over after dividends are paid to stockholders.
Why Is Financial Accounting Important?
Financial accounting is important because:
FINANCIAL ACCOUNTING IS REQUIRED BY LAW
Statements such as the balance sheet, income statement and cash flow statement are legally required for registered companies. These statements are typically included in a company’s annual report.
FINANCIAL ACCOUNTING STATEMENTS ARE CIRCULATED EXTERNALLY
Financial statements are often referenced by individuals both inside and outside a company, they include:
These statements allow a company’s management to troubleshoot money issues, and to plan for the future.
Investors will need to see the numbers in order to decide whether the business is attractive enough to invest in.
If the company is subject to an IRS audit, then government auditors are going to start their analysis with these statements.
If there’s a lawsuit or other legal action related to a company’s income or expenses, lawyers will need to be able to analyze this information.
Suppliers may want to know a company’s financials, before providing goods or services, to ensure that they will be able to pay their invoices.
If a company wants a loan, the bank may request certain financial statements. This will allow the company to show that they have the ability to pay the loan back, and on time.
A private company is not required to share its financial statements outside of the organization, only registered (or “public”) companies are. Registered companies are businesses that issue shares.