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 u s public companies are required to perform financial accounting in accordance with generally accepted accounting principles gaap their purpose is to provide consistent information to investors creditors regulators and tax authorities 1the statements used in financial accounting cover the five main classifications of financial data which are 2revenues 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 balance sheet which utilizes financial accounting to report ownership of the company s future economic benefits 2international public companies also frequently report financial statements in accordance with international financial reporting standards ifrs financial statementsa balance sheet 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 2a 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 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 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 2an income statement can be useful to management but managerial accounting gives a company better insight into production and pricing strategies compared with financial accounting financial accounting rules regarding an income statement are more useful for investors seeking to gauge a company s profitability and external parties looking to assess the risk or consistency of operations 2a cash flow statement reports how a company used cash during a specific period it is broken into three sections 2financial 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 cash flow statement is used by managed 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 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 2nonprofit 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 methodthere 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 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 2for example imagine a company receives a 1 000 payment for a consulting job to be completed next month under accrual accounting the company is not allowed to recognize the 1 000 as revenue as it has technically not yet performed the work and earned the income the transaction is recorded as a debit to cash and a credit to unearned revenue a liability account when the company earns the revenue next month it clears the unearned revenue credit and records actual revenue erasing the debt to cash 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 accrual accounting calls for the company to record the transaction in july 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 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 2in 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 the prior month 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 to be recorded when they are paid not when they occur records transactions when benefit is received or liability is incurreda more accurate method of accounting that depicts more realistic business operationsrequired for larger public companies as part of external reportingrecords transactions when cash is received or distributedan easier method of accounting that simplifies a company down to what has already actually occurredprimarily used by smaller private companies with low to no reporting requirementsprinciples of financial accountingfinancial 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 importance of financial accountingcompanies engage in financial accounting for a number of important reasons careers in financial accounting can include preparing financial statements analyzing financial statements auditing financial statements and supporting the technology systems that produce financial statements users of financial accounting financial statementsthe entire purpose of financial accounting is to prepare financial statements which are used by a variety of groups and often required as part of agreements with the preparing company in addition to management using financial accounting to gain information on operations the following groups use financial accounting reporting financial accounting vs managerial accountingthe key difference between financial and managerial accounting is that financial accounting provides information to external parties while managerial accounting helps managers within the organization make decisions managerial accounting assesses financial performance and hopes to drive smarter decision making through internal reports that analyze operations it is not an allowable basis for financial statements 2managerial accounting uses operational information in specific ways to glean information for example it may use cost accounting to track the variable costs fixed costs and overhead costs along a manufacturing process then using this cost information a company may decide to switch to a lower quality less expensive type of raw materials professional designations for financial accountingmembers of financial accounting can carry several different professional designations 