What is Financial Accounting?

Financial accounting is the process of preparing financial statements that companies’ use to show their financial performance and position to people outside the company, Including investors, creditors, suppliers, and customers.

This is one of the most important distinctions from managerial accounting, which by contrast, involves preparing detailed reports and forecasts for managers inside the company.

Financial Statements

Most companies put together quarterly and annual financial statements, which they make available to shareholders and the investing public. There are four basic financial statements used in the corporate world to show a company’s financial performance:

1. The income statement (also called the profit and loss statement) covers a specific period of time (such as a quarter or a year).

   On an income statement, Revenues – Expenses = Net Income.

   In accordance with the Generally Accepted Accounting Principals (GAAP), revenue is always recorded in the period of the sale of the goods and services, which may not be the same period when cash is actually received.

2. The balance sheet is a statement of assets and liabilities at the end of an accounting period. In other words, the balance sheet is a financial snapshot at a specific point in time.

   On a balance sheet, Assets = Liabilities + Stockholders’ Equity.

   Stockholders’ equity is the amount of financing provided by operations (retained earnings not distributed to stockholders) and by stockholders who reinvest through contributed capital.

3. The cash flow statement shows the actual flow of cash into and out of a company over a specific period of time, in contrast to the net income on the income statement, which is a non-cash number.

   A cash flow statement shows cash flows from operating activities, investing activities, and financing activities.

4. The statement of retained earnings covers a specific period of time and shows the dividends paid from earnings to shareholders and the earnings kept by the company.

Notes to financial statements provide additional information about the financial condition of a company. The three types of notes describe accounting rules used to produce the statements, give more detail about an item on the financial statements, and supply more information about an item not on the statements.

Financial Accounting Standards

Financial statements must conform to accounting standards and legal requirements. In the U.S., the Financial Accounting Standards Board (FASB) establishes financial accounting and reporting standards (generally accepted accounting principles, or GAAP). Publicly traded companies must also comply with the requirements of the Securities and Exchange Commission.

The International Accounting Standards Board (IASB) works to develop internationally accepted financial reporting standards. FASB and IASB standards differ in some areas, and a movement is underway to align the standards to make accounting across borders easier in a world of increasingly global commerce.