What Is Financial Accounting?
Let me explain financial accounting directly: it's a specific branch of accounting where you record, summarize, and report all the transactions from your business operations over a set period. These get compiled into financial statements like the balance sheet, income statement, and cash flow statement, which show how your company performed during that time.
You can find jobs in financial accounting in both public and private sectors. Your duties as a financial accountant might differ from a general accountant who handles multiple clients' accounts, taxes, and audits.
How Financial Accounting Works
Financial accounting relies on established principles, and which ones you use depend on your business's regulatory needs. If you're running a U.S. public company, you must follow generally accepted accounting principles (GAAP) to provide consistent info to investors, creditors, regulators, and tax authorities.
The main classifications in financial accounting are revenues, expenses, assets, liabilities, and equity. Revenues include sales income plus things like dividends and interest. Expenses cover costs from production to payroll. Assets are what you own, like buildings or patents. Liabilities are debts like loans, and equity is what's left after paying off debts and liquidating assets.
You report revenues and expenses on the income statement to find net income, while assets, liabilities, and equity go on the balance sheet to show ownership of future benefits.
Financial Statements
The balance sheet gives you a snapshot of your company's financial position on a specific date, listing assets, liabilities, and equity. It rolls over periods, and accounting rules dictate how you record cash, value assets, and report debt. Use it to assess liquidity and solvency through ratios like the current ratio.
The income statement, or profit and loss statement, covers operating activity over a period, listing revenue, expenses, and net income. It's issued monthly, quarterly, or annually, and rules guide how you recognize revenue and record expenses. It's great for gauging profitability but less so for internal strategies compared to managerial accounting.
The cash flow statement breaks down cash usage into operations, financing, and investments. It focuses only on cash impacts, giving a clear picture especially if you're using accrual accounting elsewhere.
The shareholders' equity statement shows equity changes between periods, detailing share capital, net income, dividends, and retained earnings.
Accrual Method vs. Cash Method
You have two main methods: accrual and cash. Accrual records transactions when they're earned or incurred, not when cash moves. For example, if you get paid $1,000 for future work, you don't recognize it as revenue until the work is done. Expenses get recorded when invoiced, not paid.
Cash method is simpler: record only when cash is exchanged. In the same example, you'd record the $1,000 as revenue when received, even if work happens later. It's easier but less accurate for complex operations. Larger companies often must use accrual for external reporting.
Principles of Financial Accounting
- Revenue recognition principle: Recognize revenue when earned, dictating amount, timing, and when not to report it.
- Cost principle: Record costs at transaction value and expense depreciable assets over their useful life.
- Matching principle: Record revenue and related expenses in the same period to avoid mismatching years.
- Full disclosure principle: Provide complete, accurate financial info with footnotes and schedules.
- Objectivity principle: Base accounting on facts and evidence, free from bias.
Why Financial Accounting Matters
Financial accounting creates standard rules for consistency across periods and companies. It decreases risk by boosting accountability for lenders and regulators. It provides management insights for decisions, promotes trust through independent oversight, and encourages transparency by requiring disclosures.
Users of Financial Accounting
Investors use these statements to evaluate performance before investing. Auditors check for compliance and accuracy. Regulatory agencies like the SEC require them for public companies. Suppliers and banks review them for credit decisions.
Financial vs. Managerial Accounting
Financial accounting is for external parties, while managerial is internal for decision-making. Managerial uses cost data to analyze operations but isn't allowed for external reports.
Professional Designations
You might pursue CPA for U.S. financial accounting, CA internationally, CMA for management focus, or CIA for internal controls.
The Bottom Line
Financial accounting sets the rules for preparing statements under GAAP or IFRS, ensuring responsibility and transparency in operations.
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