FINANCIAL ACCOUNTING

Introduction to Financial Accounting

Financial accounting is a specialized branch of accounting that keeps track of a company's financial transactions. Using standardized guidelines, the transactions are recorded, summarized, and presented in a financial report or financial statement such as an income statement or a balance sheet.

Companies issue financial statements on a routine schedule. The statements are considered external because they are given to people outside of the company, with the primary recipients being owners/stockholders, as well as certain lenders. If a corporation's stock is publicly traded, however, its financial statements (and other financial reporting) tend to be widely circulated, and information will likely reach secondary recipients such as competitors, customers, employees, labor organizations, and investment analysts.

It's important to point out that the purpose of financial accounting is not to report the value of a company. Rather, its purpose is to provide enough information for others to assess the value of a company for themselves.

Because external financial statements are used by a variety of people in a variety of ways, financial accounting has common rules known as accounting standards and as generally accepted accounting principles (GAAP). In the U.S., the Financial Accounting Standards Board (FASB) is the organization that develops the accounting standards and principles. Corporations whose stock is publicly traded must also comply with the reporting requirements of the Securities and Exchange Commission (SEC), an agency of the U.S. government.

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Double Entry and the Accrual Basis of Accounting

Double Entry and the Accrual Basis of Accounting

At the heart of financial accounting is the system known as double entry bookkeeping (or "double entry accounting"). Each financial transaction that a company makes is recorded by using this system.

The term "double entry" means that every transaction affects at least two accounts. For example, if a company borrows $50,000 from its bank, the company's Cash account increases, and the company's Notes Payable account increases. Double entry also means that one of the accounts must have an amount entered as a debit, and one of the accounts must have an amount entered as a credit. For any given transaction, the debit amount must equal the credit amount. (To learn more about debits and credits, see Explanation of Debits & Credits.)

The advantage of double entry accounting is this: at any given time, the balance of a company's asset accounts will equal the balance of its liability and stockholders' (or owner's) equity accounts. (To learn more on how this equality is maintained, see the Explanation of Accounting Equation.)

Financial accounting is required to follow the accrual basis of accounting (as opposed to the "cash basis" of accounting). Under the accrual basis, revenues are reported when they are earned, not when the money is received. Similarly, expenses are reported when they are incurred, not when they are paid. For example, although a magazine publisher receives a $24 check from a customer for an annual subscription, the publisher reports as revenue a monthly amount of $2 (one-twelfth of the annual subscription amount). In the same way, it reports its property tax expense each month as one-twelfth of the annual property tax bill. By following the accrual basis of accounting, a company's profitability, assets, liabilities and other financial information is more in line with economic reality. (To learn more on achieving the accrual basis of accounting, see the Explanation of Adjusting Entries.)

Accounting PrinciplesAccounting Principles If financial accounting is going to be useful, a company's reports need to be credible, easy to understand, and comparable to those of other companies. To this end, financial accounting follows a set of common rules known as accounting standards or generally accepted accounting principles (GAAP, pronounced "gap").

GAAP is based on some basic underlying principles and concepts such as the cost principle, matching principle, full disclosure, going concern, economic entity, conservatism, relevance, and reliability. (You can learn more about the basic principles in Explanation of Accounting Principles.)

GAAP, however, is not static. It includes some very complex standards that were issued in response to some very complicated business transactions. GAAP also addresses accounting practices that may be unique to particular industries, such as utility, banking, and insurance. Often these practices are a response to changes in government regulations of the industry. GAAP includes many specific pronouncements as issued by the Financial Accounting Standards Board (FASB, pronounced "fas-bee"). The FASB is a non-government group that researches current needs and develops accounting rules to meet those needs. (You can learn more about FASB and its accounting pronouncements at www.FASB.org.)

In addition to following the provisions of GAAP, any corporation whose stock is publicly traded is also subject to the reporting requirements of the Securities and Exchange Commission (SEC), an agency of the U.S. government. These requirements mandate an annual report to stockholders as well as an annual report to the SEC. The annual report to the SEC requires that independent certified public accountants audit a company's financial statements, thus giving assurance that the company has followed GAAP.

Financial StatementsFinancial Statements Financial accounting generates the following general-purpose, external, financial statements: 1. Income statement (sometimes referred to as "results of operations" or "earnings statement" or "profit and loss [P&L] statement")

2. Balance sheet (sometimes referred to as "statement of financial position") 3. Statement of cash flows (sometimes referred to as "cash flow statement") 4. Statement of stockholders' equity Income Statement The income statement reports a company's profitability during a specified period of time. The period of time could be one year, one month, three months, 13 weeks, or any other time interval chosen by the company.

The main components of the income statement are revenues, expenses, gains, and losses. Revenues include such things as sales, service revenues, and interest revenue. Expenses include the cost of goods sold, operating expenses (such as salaries, rent, utilities, advertising), and nonoperating expenses (such as interest expense). If a corporation's stock is publicly traded, the earnings per share of its common stock are reported on the income statement. (You can learn more about the income statement at Explanation of Income Statement.)

Balance Sheet The balance sheet is organized into three parts: (1) assets, (2) liabilities, and (3) stockholders' equity at a specified date (typically, this date is the last day of an accounting period).

The first section of the balance sheet reports the company's assets and includes such things as cash, accounts receivable, inventory, prepaid insurance, buildings, and equipment. The next section reports the company's liabilities; these are obligations that are due at the date of the balance sheet and often include the word "payable" in their title (Notes Payable, Accounts Payable, Wages Payable, and Interest Payable). The final section is stockholders' equity, defined as the difference between the amount of assets and the amount of liabilities. (You can learn more about the balance sheet at Explanation of Balance Sheet.)

Statement of Cash Flows The statement of cash flows explains the change in a company's cash (and cash equivalents) during the time interval indicated in the heading of the statement. The change is divided into three parts: (1) operating activities, (2) investing activities, and (3) financing activities.

The operating activities section explains how a company's cash (and cash equivalents) have changed due to operations. Investing activities refer to amounts spent or received in transactions involving long-term assets. The financing activities section reports such things as cash received through the issuance of long-term debt, the issuance of stock, or money spent to retire long-term liabilities. (You can learn more about the statement of cash flows at Explanation of Cash Flow Statement.)

Statement of Stockholders' Equity The statement of stockholders' (or shareholders') equity lists the changes in stockholders' equity for the same period as the income statement and the cash flow statement. The changes will include items such as net income, other comprehensive income, dividends, the repurchase of common stock, and the exercise of stock options.

Financial ReportingFinancial Reporting Financial reporting is a broader concept than financial statements. In addition to the financial statements, financial reporting includes the company's annual report to stockholders, its annual report to the Securities and Exchange Commission (Form 10-K), its proxy statement, and other financial information reported by the company. Financial Accounting vs. "Other" Accountingccounting Financial accounting represents just one sector in the field of business accounting. Another sector, managerial accounting, is so named because it provides financial information to a company's management. This information is generally internal (not distributed outside of the company) and is primarily used by management to make decisions. Other sectors of the accounting field include cost accounting, tax accounting, and auditing.

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Most Recent Questions for this Topic

What is financial reporting?
Financial reporting includes the following: the external financial statements (balance sheet, income statement, statement of cash flows, and statement of stockholders equity) the notes to the financial statements press releases and conference calls regarding quarterly earnings and related information quarterly and annual reports to stockholders financial information posted on a corporations website Financial reports to governmental agencies including quarterly and annual reports to the Securities and Exchange Commission (SEC). prospectuses pertaining to the issuance of common stock and other securities

Which financial statement shows a corporation's worth?

Not one of the financial statements will show a corporations worth. The balance sheet, income statement, statement of cash flows, and stockholders equity statement merely provide information to assist financial experts in forming an opinion of a corporations worth. In the past, some people mistakenly thought that a corporations stockholders equity was the corporations worth. However, stockholders equity (or the owners equity of a proprietorship) is merely the result of subtracting the reported amount of liabilities from the reported amount of assets. Since the reported amounts reflect the cost principle and other accounting principles, the net result cannot be assumed to be the companys worth.

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 What is accounting?
Accounting is the recording of financial transactions plus storing, sorting, retrieving, summarizing, and presenting the information in various reports and analyses. Accounting is also a profession consisting of individuals having the formal education to carry out these tasks. One part of accounting focuses on presenting the information in the form of general-purpose financial statements (balance sheet, income statement, etc.) to people outside of the company. These external reports must be prepared in accordance with generally accepted accounting principles often referred to as GAAP or US GAAP. This part of accounting is referred to as financial accounting. Accounting also entails providing a companys management with the information it needs to keep the business financially healthy. These analyses and reports are not distributed outside of the company. Some of the information will originate from the recorded transactions but some of the information will be estimates and projections based on various assumptions. Three examples of internal analyses and reports are budgets, standards for controlling operations, and estimating selling prices for quoting new jobs. This area of accounting is known as management accounting. Another part of accounting involves compliance with government regulations pertaining to income tax reporting. Today much of the recording, storing, and sorting aspects of accounting have been automated as a result of the advances in computer technology.

What are consolidated statements of operations?

A consolidated statement of operations is the heading appearing on the financial statement also referred to as the income statement. In a small survey of 14 U.S. corporations with stock that is publicly-traded, I found that eight used the title consolidated statements of operations. The other six corporations used one of the following titles: consolidated statements of income, consolidated statements of earnings, or consolidated results of operations. In the case of smaller corporations and sole proprietorships, you will more likely see the heading income statements. Seasoned business owners often refer to this financial statement as the P&L, which is short for profit and loss statement. The word statements (instead of statement) are used in the heading because publicly-traded U.S. corporations are required to present the income statements for each of their most recent three accounting years.

The term consolidated is used in the heading of the financial statements when the corporation controls several separate legal entities but is reporting the results as one economic entity. Learn
more about consolidated financial statements.

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What are consolidated financial statements? Why is interest expense a non-operating expense? Where does the purchase of equipment show up on a profit and loss statement? What is ERP? Is standard costing GAAP?

Where does the purchase of equipment show up on a profit and loss statement?
The purchase of equipment that will be used in a business is not reported on the profit and loss statement. However, the depreciation of the equipment will be reported as depreciation expense on the profit and loss statements during the years that the equipment is used. For example, if a company buys equipment for $100,000 and it is expected to be used for 10 years, the companys profit and loss statements will report depreciation expense of $10,000 in each of the 10 years (assuming the straight-line method of depreciation is used). The purchase of equipment is shown on the statement of cash flows for the period in which the purchase took place. The equipment will also be reported on the companys balance sheets at its cost minus its accumulated depreciation. The profit and loss statements are also known as income statements, statements of operations, and statements of earnings.

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Where can I find the amount of income taxes paid by a corporation?

You can find the amount of income taxes paid by a corporation by reading its statement of cash flows and its notes to the financial statements.

US GAAP requires corporations to report the amount of income taxes paid. The AICPAs Accounting Trend and Techniques indicates that approximately half of the 500 large corporations that it surveyed had reported the amount of income taxes paid at the bottom of the statement of cash flows. Almost the same number had reported the amount of income taxes paid in its notes to the financial statements. Only 5 or 6 corporations had reported the amount within its statement of cash flows. For U.S. corporations whose stock is publicly-traded, you will find the statement of cash flows included in its Form 10-K, which is the annual report to the Securities and Exchange Commission (SEC). It is important to understand that the income tax provision reported on the income statement is not the amount of income taxes paid in that period.

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Does the income statement explain the change in the equity section of a balance sheet?
The income statement could explain the change in the equity section of a balance sheet. However, there are likely to be some other explanations as well. Here is a list of the items that would cause an increase in the total amount of a corporations stockholders equity: 1. Positive net earnings or net income reported on the corporations income statement. 2. Some positive Other Comprehensive income items occurred but they are not to be reported on the income statement. 3. Additional shares of stock were issued in exchange for cash or other assets. 4. Donated capital was received. Here is a list of items that could cause a decrease in the total amount of a corporations stockholders equity: 1. Negative net earnings or a net loss reported on the corporations income statement. 2. Some negative Other Comprehensive Income items occurred but they are not to be reported the income statement. 3. The corporation declared cash dividends.

To see all of the explanations for the change in the equity section of a balance sheet, you should review the statement of stockholders equity. This financial statement should be issued along with a corporations balance sheet, income statement, and statement of cash flows.

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