Investopedia / Laura Porter
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 the 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 a general accountant, who works for himself or herself rather than directly for a company or organization.
Financial accounting utilizes a series of established accounting principles. The selection of accounting principles to use during the course of financial accounting depends on the regulatory and reporting requirements the business faces.
For U.S. public companies, businesses are required to perform financial accounting in accordance with generally accepted accounting principles (GAAP). The establishment of these accounting principles is to provide consistent information to investors, creditors, regulators, and tax authorities.
The financial statements used in financial accounting present the five main classifications of financial data: revenues, expenses, assets, liabilities and equity. Revenues and expenses are accounted for and reported on the income statement. They can include everything from R&D to payroll.
Financial accounting results in the determination of net income at the bottom of the income statement. Assets, liabilities and equity accounts are reported on the balance sheet. The balance sheet 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.
A balance sheet reports a company’s financial position as of a specific date. The balance sheet reports 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 to another. For example, the current ratio compares the amount of current assets to current liabilities to determine how likely a company is going to be able to meet short-term debt obligations.
An income statement reports a company’s operating activity during a specific period of time. Often reported on a monthly, quarterly, or annual basis, the income statement reports 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 is useful to management, though cost accounting techniques may allow a company to determine better production and pricing strategies compared to financial accounting. Instead, financial accounting rules regarding an income statement are more useful for investors seeking to see how profitable a company is and external parties looking to assess the risk or consistency of operations.
A statement of cash flow reports how a company used cash during a specific period. The report is broken into sections that summarize the operating, financing, and investing sources and uses. 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 statement of cash flow is used by managed to better understand how cash is being spent and received. Financial accounting that requires accrual accounting records transactions that have been paid for as well as transactions where the cashflow may not have happened yet. A statement of cash flow extracts only items that impact cash, allowing for greater analysis of how money is specifically be used.
A statement of shareholder’ equity reports how a company’s equity changes from one period to another. The report shows how the residual value of a company increases or decreases as well as why the residual value changed. The statement of changes in shareholder equity summarizes a company’s net income, dividend distributions, distributions to ownership, and other changes to equity.
Nonprofit entities and government agencies use similar financial statement; however, their financial statements are more specific to their entity types are will vary from the statements listed above.
There are two primary types of financial accounting: the accrual method and the cash method. The primary difference between the two types of financial accounting in the timing in which transactions are (or are not) recorded.
The accrual method of financial accounting is a method of preparing financial statements that records transactions independently of cash usage. Journal entries may be posted prior to an item having to been paid for, and certain financial accounting principles recognize the impact of a transaction over a period of time (as opposed to the entire impact being recorded in the period the cash impact happened).
For example, imagine a company receives a $1,000 payment for a consulting job to be completed next month. Under accrual method of financial accounting rules, the company is not allowed to recognize the $1,000 as revenue as the company has technically not performed work and earned the income. Under the accrual method of financial accounting, this transaction is recorded as a debit to cash and a credit to unearned revenue, a liability account. When the companies earns the revenue next month, it clears the unearned revenue accounting and records actual revenue.
Another example of the accrual method of accounting are 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, the accrual method of accounting calls for the company to record the transaction in July. In addition to debiting Utility Expense, 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. Under the cash method, transactions are recorded only when cash 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 in the month prior.
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 be recorded when they are paid, not when they occur.
Records transactions when benefit is received or liability is incurred
Often a more accurate method of accounting that depicts more realistic business operations
Required for larger, public companies as part of external reporting
Records transactions when cash is received or distributed
Often an easier method of accounting that simplifies a company down to what has already actually occurred
Primarily used by smaller, private companies with low to no reporting requirements
Financial accounting is dictated by five general and overarching principles. These principles guide how companies are to prepare their financial statements and 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 but are limited to preparing the financial statements, analyzing the financial statements, auditing the financial statements, or supporting the the technology/systems that produce financial statements.
The entire purpose of financial accounting is to prepare financial statements. These financial statements are used by a variety of groups and are often required as part of agreements with the company preparing the financial statements. 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 aims at providing information to parties outside the organization, whereas managerial accounting information is aimed at helping managers within the organization make decisions.
Financial accounting is the set of rules used to compile a company’s financial statements. Alternatively, cost accounting is a range of accounting techniques used to analyze financial performance and drive smarter decision-making. Financial accounting is the basis for externally-shared financial statements; cost accounting is not an allowable basis for financial statements.
Cost accounting is rooted in using operational information in specific ways to glean information. For example, cost accounting may track the variable costs, fixed costs, and overhead costs along a manufacturing process. Then, using this information, a company may decide whether to convert to a lower quality, less expensive type of raw materials. While companies rely on financial accounting for preparing financial statements, companies rely on cost accounting to internally analyze operations and generate internal-only reports.
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 its financial statement reporting. Small or private companies may also use financial accounting, but they often operate with different reporting requirements. Financial statements prepared using financial accounting are used by many parties outside of a company such as lenders, government agencies, auditors, insurance agencies, or investors.
Financial accounting is the framework that sets the rules on how financial statements are prepared. 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 accountable for their performance and transparent regarding their operations.
Financial Accounting Standards Board. "About the FASB."
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