Principles of Financial Accounting
What Is Financial Accounting?
Financial accounting is a specific branch of accounting involving a process of recording, classifying, 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 statement of financial position, 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 a general accountant, who works for themself AND NOT a company.
How Financial Accounting Works
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.
The statements used in financial accounting cover the five main classifications of financial data, which are:
- Revenues – Included here is income from sales of products and services, plus other sources, including dividends and interest.
- Expenses – These are the costs of producing goods and services, from research and development to marketing to payroll.
- Assets – These consist of owned property, both tangible (buildings, computers) and intangible (patents, trademarks).
- Liabilities – These are all outstanding debts, such as loans or rent.
- Equity – If you paid off the company’s debts and liquidated its assets, you would get its equity, which is what a company is worth.
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 statement of financial position, which utilizes financial accounting to report ownership of the company’s future economic benefits.
Financial Statements
Statement of Financial Position
A statement of financial position 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 statement of financial position is used by management, 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.
Income Statement
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, a quarterly, or an annual basis, the income statement lists 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.
Cash Flow Statement
A cash flow statement reports how a company used cash during a specific period. It is broken into three sections:
- Operations – These are the costs of a company’s core business activities.
- Financing – This is money the company receives from taking loans or issuing shares, as well as money paid in interest on loans
- Investments – This is money that comes from buying and selling the company’s investments, such as securities or fixed assets.
A cash flow statement is used by managers 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.
Shareholders’ Equity Statement
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 changed. It gives details about the following components of equity:
- Share Capital – Money raised by selling stock in the company
- Net Income – Any profit after expenses and deductions
- Dividends – The part of profit that is paid to shareholders
- Retained Earnings – Whatever is left after paying dividends
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.
Accrual Method vs. Cash Method
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.
Accrual Method
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.
Cash Method
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.
Accrual Method
- Records transactions when benefit is received or liability is incurred
- A more accurate method of accounting that depicts more-realistic business operations
- Required for larger, public companies as part of external reporting
Cash Method
- Records transactions when cash is received or distributed
- 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
Principles of Financial Accounting
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.
- Revenue Recognition Principle – This states that revenue should be recognized when it has been earned. It dictates how much revenue should be recorded, the timing of when that revenue is reported, and circumstances in which revenue should not be reflected within a set of financial statements.
- Cost Principle – This states the basis for which costs are recorded. It dictates how much expenses should be recorded for (i.e. at transaction cost) in addition to properly recognizing expenses over time for appropriate situations (i.e. a depreciable asset is expensed over its useful life).
- Matching Principle – This states that revenue and expenses should be recorded in the same period in which both are incurred. It strives to prevent a company from recording revenue in one year with the associated cost. The principle dictates the timing in which transactions are recorded.
- Full Disclosure Principle – This states that the financial statements should be prepared using financial accounting guidance that includes footnotes, schedules, or commentary that transparently report the financial position of a company. It dictates the amount of information provided within financial statements.
- Objectivity Principle – This states that while financial accounting has aspects of estimations and professional judgment. A set of financial statements should be prepared objectively. It dictates when technical accounting should be used as opposed to personal opinion.
Importance of Financial Accounting
Companies engage in financial accounting for a number of important reasons.
- Creating a standard set of rules – By delineating a standard set of rules for preparing financial statements, financial accounting creates consistency across reporting periods and different companies.
- Decreasing risk – Financial accounting does this by increasing accountability. Lenders, regulatory bodies, tax authorities, and other external parties rely on financial information; financial accounting ensures that reports are prepared using acceptable methods that hold companies accountable for their performance.
- Providing insight to management – Though other methods such as managerial accounting may provide better insights, financial accounting can drive strategic concepts if a company analyzes its financial results and makes reactionary investment decisions.
- Promoting trust in financial reporting – Independent governing bodies oversee the rules of financial accounting, making the basis of reporting independent of management and a highly reliable source of accurate information
Encouraging transparency – By setting rules and requirements, financial accounting forces companies to disclose certain information on how operations are going, and what risks the company is facing, painting an accurate picture of financial performance regardless of how well or poorly the company is doing.
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