Financial accounting is one of the many branches of accounting which refers to the process of collecting, summarizing and presenting all the business transactions which are recorded over a period of time.
These transactions are summarized in a set of financial statements that represent the company’s performance over a period of time. These statements include cash flow statement, income statement and balance sheet.
Financial statements are issued quarterly or yearly and are published across various financial websites and newspapers. This information is consumed by investors, creditors, customers and other stakeholders for making financial decisions. The main objectives of financial accounting can be divided into five categories.
- Recording financial transactions on a regular basis and using the data to prepare financial statements.
- Calculating profit and loss which can help the management to take any action if required.
- Determining the financial strength of the company on the basis of assets and liabilities.
- Communicating all this information to various stakeholders which can help them in making appropriate investment decisions.
- Fulfilling legal requirements of tax authorities and business regulators by adopting good accounting standards.
The purpose of financial accounting is not to report the value of the company but to provide enough information to others so that they can access the value of the company for themselves. Broadly speaking there are two types of financial accounting.
- Cash basis accounting
- Accrual basis accounting
Financial accounting is different from managerial accounting which requires preparing of forecasts and detailed report for managers inside the company. Other branches of accounting include tax accounting, cost accounting and auditing. In this article we will look at various aspects of financial accounting.
Double Entry Bookkeeping System
At the core of financial accounting is the accounting method known as double entry bookkeeping system where each and every financial transaction is recorded in at least two accounts.
If it is recorded as debit in one account then it should be recorded as credit in another account. Double entry bookkeeping system requires that for all the transactions, credit amount should be equal to debit amount.
Debit simply means transaction is recorded on the left side of the account whereas credit means that the transaction is recorded on the right side. Each credit entry should be balanced by a debit entry and vice versa.
Information about which account should be debited or credited is easily available online. For example, decrease in income and increase in expenses are always debit entries whereas increase in liabilities and decrease in assets are always credit entries.
Advantage of double entry bookkeeping system is that it helps in keeping the accounting equation always balanced. If the company maintains its accounts accurately, the left should always match with the right side.
Financial Accounting Statements
Financial statements are written records that summarize financial transactions as well as performance of the company. These statements are regularly audited by various government agencies and accountants for their accuracy.
Financial statements present all the relevant information in structured format which is easy to understand and follow. There are four types of financial accounting statements.
- Balance Sheet
- Income Statement
- Cash Flow Statement
- Statement Of Equity
Audited financial statements and annual report are one of the most important resources for investors, financial analysts and creditors. It helps them to make a prediction about the future stock price of a company.
These statements are used by various stakeholders to evaluate the company’s performance, earning potential and financial well-being. Financial statements are also used by different types of actuaries to evaluate the risk faced by the company and suggest suitable mechanism to spread out the risk.
Balance sheet provides detailed information about assets, liabilities and shareholder equity as of the reporting date which gives you an idea about liquidity and capitalization of the company. The reporting date can either be quarter end or year end.
Structured balance sheet can give you all the information about total assets, total liabilities and total shareholder equity. According to the balance sheet formula, total assets should be equal to the sum of total liabilities and total equity.
Types Of Assets
Assets are things that company owns which can be either sold or used to make different products or provide services. Assets include the following.
- Physical things like plants, equipment and inventory.
- Liquid assets like cash and cash equivalent which may include certificate of deposits and treasury bills.
- Account receivable which is the money owed to the company by its customers or stakeholders.
- Intangible assets owned by the company like trademarks or patents.
- Any other investments made by the company.
Balance sheet identifies how assets are funded, either with liabilities or with shareholders equity. On the balance sheet, assets are listed in order of their liquidity.
Types Of Liabilities
Liability is the amount of money that a company owes to other stakeholders. Liabilities include the following.
- Obligations like debt including long term debt.
- Property rent, employee wages and government taxes.
- Money owed to suppliers and other environmental cleanup costs.
- Dividend payable to shareholders.
- Any other obligations to provide goods and services in future.
On balance sheet, liabilities are listed in the order in which they will be paid. Short term liabilities are expected to be paid within one year whereas long term liabilities are expected to be paid over one year.
Shareholders equity, also known as capital or net worth is the difference between total assets and total liabilities. It also includes retained earnings or dividends which are not yet paid to shareholders.
Shareholder’s equity represents the amount of money that can be given back to shareholders at that point of time if all the assets are liquidated and all the liabilities are paid off.
Income statement, also known as profit and loss statement or statement of revenue and expense or statement of earnings, provides detailed information about revenues, expenses, profits and losses generated during the reporting period.
It is considered as one of the most important financial statements as it categorizes the sources of income and expenses and determines the financial performance of the company over a period of time, usually a quarter or a year.
Income statement formula calculates net income as the difference between total revenues and total expenses. The last line of the statement shows net profit or loss over the reporting period. Below are the components usually present in an income statement.
- Revenue or sales
- Cost of goods sold
- Gross profit
- Marketing, advertising, and promotion expenses
- General and administrative expenses
- Research and development expenses
- EBITDA – Earnings before interest, tax, depreciation, and amortization
- Depreciation and amortization expenses
- Operating income or EBIT – Earnings before interest and taxes
- Other expenses
- Pre-tax income or EBT – Earnings before tax
- Income taxes
- Net income
- EPS – Earnings per share
An income statement provides valuable information about various aspects of business including company’s operations, efficiency of its management, underperforming areas and company’s performance in relation to its peer companies.
Income statement is classified into two types, single step and multi step, depending upon their structure. Both types have their own advantages and disadvantages.
- Single Step Income Statement
- Multi Step Income Statement
Multi step income statement is issued by the companies which categorize expenses into direct costs and indirect costs. However it takes a lot of time and manpower to prepare multi step income statement as each and every expense should be properly categorized.
Single step income statement provides simplified and straightforward summary of revenues and expenses making it easier for accountants who prepare the statements. However, few investors feel that single step income statement does not provide enough information to make appropriate financial decisions.
Cash Flow Statement
Cash flow statement, also known as statement of cash flows is a financial statement which shows how the cash flows in and out of the business. It acts as a link between balance sheet and income statement.
Cash flow statement shows how much money the company spends or receives from financing, investing and operating activities. Using this statement you can see whether the company is generating more cash than it is spending.
Cash flow statement helps investors, creditors, lenders and shareholders to determine the short term viability of the company. Generally cash flow financial statement is divided into three sections.
- Operating Activities
- Investing Activities
- Financing Activities
Operating Cash Flows
Operating cash flow is generated from the primary business activities of a company which include sales, purchases, supplies, employee salaries and other expenses. Any other form of cash flow such as investments or dividends is not included.
Investing Cash Flows
This section includes all the cash flows generated due to various investing activities like buying or selling of a property or a plant and any other capital expenditures. Increase in capex indicates that the company is growing and investing in future operations.
Financing Cash Flows
This is the last section in the cash flow statement which gives you an overview about the cash flows generated due to various business finance activities. These activities include borrowing and repaying the bank loans, issuing or buying back the shares and paying dividends to investors.
Statement Of Equity
Statement of shareholders’ equity can give you information about the changes in equity section of balance sheet as well as other equity related activities during the reporting period. This statement is required under Generally Accepted Accounting Principles (GAAP).
This financial statement is particularly important to investors and shareholders as it includes the purchase and sale of company’s stock. This statement is usually presented in a matrix form which contains following columns.
- Common Stock
- Preferred Stock
- Retained Earnings
- Treasury Stock
- Accumulated Income
- Total Stockholders’ Equity
Statement of stockholders’ equity also includes the statement of retained earnings as well as the information about changes in other equity accounts. This statement is useful to investors and shareholders to check on their investments and performance of the company.
Cash Basis Financial Accounting
Cash basis financial accounting or simply cash accounting is a method of recording transactions as revenues or expenses only when the cash is received or the payments are made. This method does not recognize accounts payable or accounts receivable.
Cash basis financial accounting is mostly used by individuals and small business owners for tax purposes. However, it is not accepted under Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
Advantages Of Cash Accounting
Cash accounting is simple to implement and less expensive than accrual accounting. It is the most suitable method of accounting when there is no need for an audit or no inventory is required to tracked or valued.
This method gives you an accurate picture of how much cash is available with the business at any given time. Also since transactions are not recorded until the cash is received or paid, the business income is not taxed until that time.
Disadvantages Of Cash Accounting
Single entry cash accounting lacks the built-in error tracking which is available with double entry accrual accounting. Also this method does not give you an accurate picture of the company’s health in a scenario where the accounts payable are more than the cash available with the business.
Accrual Basis Financial Accounting
Accrual basis accounting is a method of recording revenues when they are earned and expenses when they are incurred, regardless of when the cash is actually received or paid. This method mostly focuses on accounts payable and accounts receivable.
The accrual basis of accounting is accepted under both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). Auditors will certify the financial statements only if they are prepared by using accrual accounting method.
Advantages Of Accrual Accounting
Accrual accounting gives you an accurate picture of the current profitability of the company. The key advantage of accrual accounting is that it matches the revenue with the expense, so that the impact of business transaction is easily visible during the reporting period.
Disadvantages Of Accrual Accounting
Accrual accounting is complicated which makes it more expensive to implement. Also, as it does not track the cash flow, it cannot give you the correct picture of the company which has high receivables but very limited amount of cash.
Principles Of Financial Accounting
There are basic accounting principles and guidelines which govern the field of financial accounting. Generally Accepted Accounting Principles (GAAP) refers to the common principles, standards and guidelines issued by Financial Accounting Standards Board (FASB).
GAAP helps in standardizing and regulating accounting principles and guidelines which helps in maintaining the consistency of financial statements every year. GAAP consists of following sets of rules.
- Basic accounting principles and guidelines
- Detailed rules and standards issued by FASB
- Generally accepted industry practices
A public limited company which is listed on stock exchanges is required to follow GAAP while preparing financial statements. Also, the company is required to get its financial statements audited from independent auditors before issuing them to public.