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Part of the Series Guide to AccountingAccounting Theories and Concepts
Accounting Methods: Accrual vs. Cash
Accounting Oversight and Regulations
Public Accounting: Financial Audit and Taxation
Accounting Systems and Record Keeping
Accounting for Inventory
Financial accounting is a specific branch of accounting involving a process of recording, summarizing, and reporting the myriad of transactions resulting from business operations over a period of time.
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 a specified period.
Work opportunities for a financial accountant can be found in both the public and private sectors. A financial accountant’s duties may differ from those of an accountant who works for many clients preparing their accounts, tax returns, and possibly auditing other companies.
Financial accounting utilizes a series of established principles. The accounting principles used depend on the business's regulatory and reporting requirements. Companies and organizations often have an accounting manual that details the pertinent accounting rules.
U.S. public companies are required to perform financial accounting in accordance with generally accepted accounting principles (GAAP). Their purpose is to provide consistent information to investors, creditors, regulators, and tax authorities.
The statements used in financial accounting cover the five main classifications of financial data or financial accounts, which are:
Revenues and expenses are accounted for and reported on the income statement, resulting in the determination of net income at the bottom of the statement. Assets, liabilities, and equity accounts are reported on the balance sheet, which utilizes financial accounting to report ownership of the company’s future economic benefits.
International public companies also frequently report financial statements in accordance with International Financial Reporting Standards (IFRS).
A balance sheet reports a company’s financial position as of a specific date. It lists the company’s assets, liabilities, and equity, and the financial statement rolls over from one period to the next. Financial accounting guidance dictates how a company records cash, values assets, and reports debt.
A balance sheet is used by management, lenders, and investors to assess the liquidity and solvency of a company. Through financial ratio analysis, financial accounting allows these parties to compare one balance sheet account with another.
For example, the current ratio compares the amount of current assets with current liabilities to determine how likely a company is going to be able to meet short-term debt obligations.
An income statement, also known as a “profit and loss statement,” reports a company’s operating activity during a specific period of time.
Usually issued on a monthly, quarterly, or annual basis, the income statement lists the revenue, expenses, and net income of a company for a given period. Financial accounting guidance dictates how a company recognizes revenue, records expenses, and classifies types of expenses.
An income statement can be useful to management, but managerial accounting gives a company better insight into production and pricing strategies compared with financial accounting.
Financial accounting rules regarding an income statement are more useful for investors seeking to gauge a company’s profitability and external parties looking to assess the risk or consistency of operations.
A cash flow statement reports how a company used cash during a specific period. It is broken into three sections:
Financial accounting guidance dictates when transactions are to be recorded, though there is often little to no flexibility in the amount of cash to be reported per transaction.
A cash flow statement is used by management to better understand how cash is being spent and received. It extracts only items that impact cash, allowing for the clearest possible picture of how money is being used, which can be somewhat cloudy if the business is using accrual accounting.
A shareholders' equity statement reports how a company’s equity changes from one period to another, as opposed to a balance sheet, which is a snapshot of equity at a single point in time.
It shows how the residual value of a company increases or decreases and why it changes. It gives details about the following components of equity:
Nonprofit entities and government agencies use similar financial statements; however, their financial statements are more specific to their entity types and will vary from the statements listed above.
There are two primary types of financial accounting: the accrual method and the cash method. The main difference between them is the timing in which transactions are recorded.
The accrual method of financial accounting records transactions independently of cash usage. Revenue is recorded when it is earned (when a bill is sent), not when it actually arrives (when the bill is paid). Expenses are recorded upon receiving an invoice, not when paying it. Accrual accounting recognizes the impact of a transaction over a period of time.
For example, imagine a company receiving a $1,000 payment for a consulting job to be completed next month. Under accrual accounting, the company is not allowed to recognize the $1,000 as revenue, as it has technically not yet performed the work and earned the income.
The transaction is recorded as a debit to cash and a credit to unearned revenue, a liability account. When the company earns the revenue next month, it clears the unearned revenue credit and records actual revenue, erasing the debt to cash.
Another example of the accrual method of accounting is expenses that have not yet been paid. Imagine a company received an invoice for $5,000 for July utility usage.
Even though the company won’t pay the bill until August, accrual accounting calls for the company to record the transaction in July, debiting utility expenses. The company records a credit to accounts payable. When the invoice is paid, the credit is cleared.
The cash method of financial accounting is an easier, less strict method of preparing financial statements: Transactions are recorded only when cash is involved. Revenue and expenses are only recorded when the transaction has been completed via the facilitation of money.
In the example above, the consulting firm would have recorded $1,000 of consulting revenue when it received the payment.
Even though it won’t actually perform the work until the next month, the cash method calls for revenue to be recognized when cash is received. When the company does the work in the following month, no journal entry is recorded, because the transaction will have been recorded in full the prior month.
In the other example, the utility expense would have been recorded in August (the period when the invoice was paid). Even though the charges relate to services incurred in July, the cash method of financial accounting requires expenses to be recorded when they are paid, not when they occur.
Financial accounting is dictated by five general, overarching principles that guide companies in how to prepare their financial statements. The type of accounting method should be determined at the outset. Changes to this method can happen later but require specific actions.
The principles are the basis of all financial accounting technical guidance. These five principles relate to the accrual method of accounting.
Companies engage in financial accounting for a number of important reasons.
Careers in financial accounting can include preparing financial statements, analyzing financial statements, auditing financial statements, and supporting the technology/systems that produce financial statements.
The entire purpose of financial accounting is to prepare financial statements, which are used by a variety of groups and often required as part of agreements with the preparing company. In addition to management using financial accounting to gain information on operations, the following groups use financial accounting reporting.
The key difference between financial and managerial accounting is that financial accounting provides information to external parties, while managerial accounting helps managers within the organization make decisions.
Managerial accounting assesses financial performance and hopes to drive smarter decision-making through internal reports that analyze operations. It is not an allowable basis for financial statements.
Managerial accounting uses operational information in specific ways to glean information. For example, it may use cost accounting to track the variable costs, fixed costs, and overhead costs along a manufacturing process. Then, using this cost information, a company may decide to switch to a lower quality, less expensive type of raw materials.
Members of financial accounting can carry several different professional designations.
A public company’s income statement is an example of financial accounting. The company must follow specific guidance on what transactions to record. In addition, the format of the report is stipulated by governing bodies. The end result is a financial report that communicates the amount of revenue recognized in a given period.
Financial accounting is intended to provide financial information on a company’s operating performance. Though management can analyze reports generated using financial accounting, they often find it more useful to use managerial accounting, an internally geared method of calculating financial results that is not allowable for external reports. Financial accounting is the widely accepted method of preparing financial results for external use.
Public companies are required to perform financial accounting as part of the preparation of their financial statement reporting. Small or private companies may also use financial accounting, but they often operate with different reporting requirements. Financial statements generated through financial accounting are used by many parties outside of a company, including lenders, government agencies, auditors, insurance agencies, and investors.
Financial accounting is the framework that sets the rules on how financial statements are prepared. The U.S. follows different accounting rules than most other countries. These guidelines dictate how a company translates its operations into a series of widely accepted and standardized financial reports. Financial accounting plays a critical part in keeping companies responsible for their performance and transparent regarding their operations.