Given the importance of financial accounting, the Financial Accounting Standards Board (FASB) sets regulations for financial accounting, referred to as GAAP (the generally accepted accounting principles). Private companies are not required to provide this information; only public companies must. Public companies include any organization that issues shares available to the general public.
What Are the Principles of Financial Accounting?
- Principle of Conservatism
- Principle of Accrual
- Principle of Cost
- Principle of Consistency
- Principal of Economic Entity
- Matching Principle
- Principle of Going Concern
- Principle of Full Disclosure
Financial Accounting Statements
There are five basic statements that are always included in financial accounting documents.
- The balance sheet
- The income statement
- The statement of cash flow
- The statement of shareholders’ equity
- The statement of retained earnings
1. Balance Sheet
The balance sheet provides details describing what the company owns (“assets”) and owes (“liabilities”) as well as shareholder equity.
Businesses can own various types of assets, each of which is recorded on the balance sheet. Assets are any form of capital that the business either possesses or is owed by another entity. Examples include:
- Accounts receivable
- Buildings (separate from real estate investments)
- Intellectual property and other intangible assets
- Investments, which can include real estate assets owned specifically for the purpose of financial investment
- Machinery and equipment
- Notes receivable, or money owed to the company that it expects to receive within one year
- Prepaid expenses
Liabilities are any form of financial obligation that a business has to another entity. Examples include:
- Accounts payable
- Current taxes
- Deferred tax
- Loans payable
- Notes payable, or money the company owes to another entity and must pay within one year
- Unearned revenue, otherwise known as a product or service for which a client has already paid but has not yet received
- Warranty obligations
Shareholder equity refers to all forms of capital owned by the business shareholders. Shareholder equity can include:
- Common and preferred stocks
- Money on hand to invest in the business (retained earnings)
- Profit or loss in company investments over the recorded time period (comprehensive income)
Since the balance sheet details the financial status of the company, every dollar is accounted for in either assets, liabilities or shareholder equity. As a result the total value of a company’s assets is equal to their liabilities plus shareholder equity.
2. Income Statement
The income statement details the net income for the business over the specified time period. This includes all forms of revenue (from the sale of goods or services, rental income from real estate assets, licensing revenue from intellectual property and more) and all expenses (loan payments, payroll, property expenses and more). Comparing revenue to expenses in the income statements provides a clear picture of the income produced by the company.
The income statement is also sometimes referred to as a profit and loss statement.
3. Statement of Cash Flow
A statement of cash flow details a company’s income and debt over a period of time (usually a year). This statement is exclusively concerned with cash and does not include amortization or depreciation (both of which are important entries on the Income Statement). By focusing solely on cash into and out of the business, the statement of cash flow demonstrates the company’s ability to pay existing debts and demonstrates the organization’s short-term viability.
4.Statement of Shareholders’ Equity
The statement of shareholder’s equity details the change in shareholder equity, or ownership value, over the specified time period. As with the other statements, the time period for the statement of shareholders’ equity is typically one year.
Shareholder equity is identified by calculating the difference between the company’s total assets and total liabilities. Larger values indicate that the company has more assets relative to liabilities, and that the company is worth more money. Thoroughly reviewing the statement of shareholders’ equity can provide insight into areas of the company that are increasing or decreasing equity each year.
The statement of shareholders’ equity typically includes the following components:
- Common Stock: This is the most publicly available form of stock in many companies. It is typically lower on the list of priorities than other forms of stock, which means owners of common stock are less likely than other stock owners to receive dividends or a share of liquidation revenues if a company goes out of business.
- Preferred Stock: Preferred stock is a special kind of stock that entitles owners to earnings and dividends before common stock owners. This stock is typically listed on the statement at face value.
- Treasury Stock: This is stock that has been repurchased by the company. An organization might repurchase its stock if it’s attempting to avoid a hostile takeover by a different organization. Shareholder equity is reduced by the amount of capital spent to acquire treasury stock.
- Additional Paid-Up Capital: This represents the excess capital investors pay over face value to obtain company stock.
- Retained Earnings: This is the amount of money that the company has brought in that hasn’t been distributed to investors as dividends or paid out to cover expenses.
- Unrealized Gains and Losses: This entry represents the change in price for investments that have not yet been sold. Increases in stock values prior to stock sale are unrealized gains, while decreases in stock values prior to sale are unrealized losses. When selling the stock the gains or losses become realized.
5. Statement of Retained Earnings
The statement of retained earnings shows the amount of earnings the company has accumulated and kept within the company since inception. This is all cash held on hand after paying expenses and shareholder dividends. Each year the retained earnings shown on the statement changes based on the company’s retained cash from the previous year.
Investors considering a company value the statement of retained earnings because it provides insights into the mindset and motivations of the business’s management team. Higher retained earnings values indicate the company has plenty of cash on hand to finance new initiatives and growth, which is attractive to investors. Low retained earnings could either indicate that the business doesn’t turn a profit, or that the management team distributes the cash to shareholders in the form of high dividends, both of which can be concerning to potential investors.
Why Is Financial Accounting Important?
Financial accounting is critical because it provides critical information to people who are making important decisions. They’re used by the business to drive directional decisions or by outside parties considering investing in the business. Since such important decisions are based on this information, financial accounting documents are strictly regulated and required by law in the United States.
These documents are often referenced by individuals both inside and outside of the organization, including:
- The management team uses financial accounting documents to identify and troubleshoot financial issues within the company and to create plans for the future direction of the organization.
- Investors use these documents to understand the financial health and growth potential of the company prior to deciding whether or not they want to invest their money.
- Government auditors use these documents to understand the inner workings of a company when performing an audit on the organization.
- Lawyers analyze financial accounting documents while reviewing a company’s business practices as part of a lawsuit or other legal action.
- Suppliers will sometimes require review of the businesses finances before agreeing to provide goods or services to the company to ensure the company can pay for the goods or services.
- Banks typically require information about a company’s financial health prior to lending money to the organization.
Principles of Financial Accounting
There are eight general principles of financial accounting. These principles should be followed to ensure that the documents are accurate, reasonable and provide useful information to the readers. The eight principles are:
- Principle of Conservatism: Expenditures and liabilities are to be reported as soon as possible. Profits and assets are registered only after an accountant is confident they will be received. This yields a conservative estimate of the health of the business and prevents providing overly optimistic estimates to readers.
- Principle of Accrual: All amounts should be entered in the amounts they occur instead of when the associated cash flow occurs. This creates a detailed record of finances that allows outsiders to observe what occurred over time.
- Principle of Cost: All equity, contributions, profits and liabilities are to be recorded at their initial purchasing prices. Quantities reported cannot be increased for market value increases or inflation.
- Principle of Consistency: Accounting practices should be consistent across different aspects of the business. This allows an organization to use the same accounting practices and standards for internal and external documents.
- Principal of Economic Entity: A company’s operator has separate legal liabilities and must be treated as separate from the business itself. Transactions between the business and operator must be tracked with clear definition of purchaser and seller.
- Matching Principle: This states that costs and receipts must be correctly identified in financial statements. Following this principle ensures that costs are accurately tracked at the time they were sustained.
- Principle of Going Concern: The principle of going concern indicates the company can sustain for a specified period of time, usually one year.
- Principle of Full Disclosure: This principle demands that a company publish accurate information in its financial reports and ensures that those making decisions have access to accurate information.
Financial Accounting vs. Managerial Accounting
Financial accounting and managerial accounting are two similar but distinct forms of tracking business expenses.
Financial accounting focuses on the reporting processes used to convey information to important stakeholders, including many outside reviewers. Accountants responsible for financial accounting focus on long-term financial strategies related to organizational growth. Additionally, since these documents are legally required they must be prepared in ways that comply with industry standards.
Managerial accounting is a more internal process that uses an understanding of the business to drive management decisions. Accountants responsible for managerial accounting are usually focused on short-term growth strategies relating to economic maintenance. For instance, an accountant may consider the cost/benefit of purchasing a part to help make a product. Since managerial accounting is an internal process, each organization can use their own procedures and templates when creating their documents.