The focus of financial accounting is on summarizing and reporting a business's financial position to entities outside the business with a vested interest, such as stockholders, creditors, government agencies and suppliers. The counterpoint to financial accounting is managerial accounting, which provides information to those inside the business and influences decisions by management.
Unlike managerial accounting, financial accounting is required by law for all registered companies, including corporations, limited liability companies (LLCs) and partnerships. Standards to which companies must adhere when reporting their financial positions include generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS).
GAAP comprises a comprehensive list of financial reporting standards including laws set forth by various policy boards and traditional standards that, while not coded into any specific law, represent procedures currently accepted within the financial accounting community. The existence of GAAP helps to ensure consistency and transparency in the financial reporting of thousands of companies across dozens of industries. The goal is to enable investors, regulators and creditors to compare two or more companies side by side using like data sets that are easily procured.
The goal of IFRS is to promote consistency in financial reporting standards from country to country as barriers to trade breakdown and globalization plays an ever-larger role in nations' economies.
The three primary documents associated with financial accounting are the income statement, balance sheet and statement of cash flows. The income statement reports a company's revenues and expenses during a given period, usually one year. A company's revenues are known as its top line; total revenues appear on top of the income statement, after which expenses are subtracted to arrive at net income. Net income is known as a company's bottom line; it is widely regarded as one of the most important numbers in financial accounting.
While the income statement shows a company's profits or losses over a period of time, the balance sheet provides a snapshot of its financial picture at a single moment in time. The balance sheet is divided into three sections: total assets, total liabilities and ownership equity. Assets are listed on one side, with liabilities and equity on the other. As its name suggests, the balance sheet must balance, with the sum of the company's liabilities and ownership equity equaling its total assets. Put another way, a company's ownership equity is its assets left over after liabilities are subtracted.
The third key document in financial accounting is the statement of cash flows. Similar to the income statement, the cash flow statement tracks a company's financial position over a period of time rather than at a specific time. This statement shows how cash flows in and out of a business through three types of activities: operating activities, investing activities and financing activities. Outsiders use a company's statement of cash flows to gauge its solvency and its ability to pay bills on time.