Financial accounting. Two words to strike fear into any student, young professional, or business person looking to learn the ropes of how companies operate.
What strikes this fear? A reputation of dryness? A convoluted system of credits and debits? The need to keep track of every transaction?
What is financial accounting?
Financial accounting involves preparing statements of a company’s transactions and overall financial health for employees inside the company, investors, creditors, and customers.
Essentially, financial accounting involves preparing reports of a company's financial information on a regular basis, be it quarterly, monthly, or yearly. However, it’s important to note that these reports are not meant to convey a particular argument or conclusion about the company. They should be meant solely to present data that external recipients of the reports can use to draw their own conclusions about a company’s financial health.
As you can see, financial accounting includes a number of moving parts that potentially overcomplicate the subject more than it’s worth. In this guide, we’ll break down the imposing narratives of what exactly financial accounting is in simple terms.
Financial accounting: key elements and examples
We’ll go over some of the essentials of financial accounting and why they are important for reporting a company’s financial information.
Financial accounting is centered on the practice of double-entry bookkeeping, introduced within the history of accounting by Italian monk Luca Pacioili in 1494. A foundational principle, double-entry bookkeeping states that each transaction influences at least two accounts. For example, a company borrowing from a bank results in an increase in the cash account and an increase in the notes payable account.
Another aspect of double-entry bookkeeping is debits and credits. For each transaction, there must be a debit as well as a credit, and they must be equal, maintaining a balance between the cash the company has and the amount they owe banks and shareholders.
Accrual basis accounting
Financial accounting is required to follow the standards of accrual basis accounting, where assets are taken into account upon the agreement of a transaction, not upon the physical exchange of assets. As opposed to cash basis accounting, the accrual basis allows shareholders and other viewers of financial statements to gain insight into a larger picture of a company’s financial health, showing all aspects of what assets are scheduled to flow in and out.
Financial accounting revolves around financial statements that reflect a company’s financial health. These statements are read by employees, shareholders, and current and potential customers to geta look into what the state of finances within a company is at a given time.
The income statement takes into account the revenues and expenses of a business over a given period of time (such as a quarter of a year) in calculating net income. It calculates net income by subtracting total expenses from this period of time from the total revenue.
The balance sheet reflects assets, liabilities, and shareholders’ equity at a given date. This date is typically the last in the accounting cycle. The key equation in the balance sheet is that the total amount of assets must equal the total amount of liabilities plus shareholders’ equity. This equation is what makes the balance sheet, well, balanced.
Statement of retained earnings
The statement of retained earnings shows a company’s earnings over a period of time, breaking down the earnings by what amount of them was paid to shareholders and what amount was kept by the company.
Cash flow statement
The cash flow statement shows the flow of cash into and out of a company over a given period of time. This cash flow is separated by operating activities, investing activities, and financing activities. The net flow of cash shown on this statement is a physical cash number, as opposed to the income statement, which is inclusive of all forms of assets, including those not yet received in cash.
The bottom line
Financial accounting contains a world of key elements and terms that can bog you down. But at its core are the pillars of double-entry bookkeeping, accrual basis accounting, and financial statements. Remembering that these are the foundations of financial accounting that will help you sort through complexities you encounter in the accounting world, and feel free to enlist the help of some of the best accounting software to help you do so.