Financial Accounting Meaning, Principles, and Why It Matters

Financial Accounting

Investopedia / Laura Porter

What Is Financial Accounting?

Financial accounting is a specific branch of accounting involving a process of recording, summarizing, and reporting the myriad of transactions resulting from business operations over a period of time. These transactions are summarized in the preparation of financial statements, including the balance sheet, income statement and cash flow statement, that record the company's operating performance over a specified period.

Work opportunities for a financial accountant can be found in both the public and private sectors. A financial accountant's duties may differ from those of a general accountant, who works for himself or herself rather than directly for a company or organization.

Key Takeaways

  • Financial accounting is the framework that dictates the rules, processes, and standards for financial recordkeeping.
  • Nonprofits, corporations, and small businesses use financial accountants to prepare their books and records and generate their financial reports.
  • Financial reporting occurs through the use of financial statements such as the balance sheet, income statement, statement of cash flow, and statement of changes in shareholder equity.
  • Financial accounting differs from managerial (or cost) accounting as financial reporting is more for reporting to external parties while cost accounting is more for strategic planning internally.
  • Financial accounting may be performed under the accrual method (recording expenses for items that have not yet been paid) or under the cash method (only cash transactions are recorded).

Financial Accounting

How Financial Accounting Works

Financial accounting utilizes a series of established accounting principles. The selection of accounting principles to use during the course of financial accounting depends on the regulatory and reporting requirements the business faces.

For U.S. public companies, businesses are required to perform financial accounting in accordance with generally accepted accounting principles (GAAP). The establishment of these accounting principles is to provide consistent information to investors, creditors, regulators, and tax authorities.

The financial statements used in financial accounting present the five main classifications of financial data: revenues, expenses, assets, liabilities and equity. Revenues and expenses are accounted for and reported on the income statement. They can include everything from R&D to payroll.

Financial accounting results in the determination of net income at the bottom of the income statement. Assets, liabilities and equity accounts are reported on the balance sheet. The balance sheet utilizes financial accounting to report ownership of the company's future economic benefits.

International public companies also frequently report financial statements in accordance with International Financial Reporting Standards.

Financial Statements

Balance Sheet

A balance sheet reports a company’s financial position as of a specific date. The balance sheet reports 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.

A 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 to another. For example, the current ratio compares the amount of current assets to current liabilities to determine how likely a company is going to be able to meet short-term debt obligations.

Income Statement

An income statement reports a company’s operating activity during a specific period of time. Often reported on a monthly, quarterly, or annual basis, the income statement reports 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.

An income statement is useful to management, though cost accounting techniques may allow a company to determine better production and pricing strategies compared to financial accounting. Instead, financial accounting rules regarding an income statement are more useful for investors seeking to see how profitable a company is and external parties looking to assess the risk or consistency of operations.

Statement of Cash Flow

A statement of cash flow reports how a company used cash during a specific period. The report is broken into sections that summarize the operating, financing, and investing sources and uses. Financial 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 statement of cash flow is used by managed to better understand how cash is being spent and received. Financial accounting that requires accrual accounting records transactions that have been paid for as well as transactions where the cashflow may not have happened yet. A statement of cash flow extracts only items that impact cash, allowing for greater analysis of how money is specifically be used.

Statement of Shareholders' Equity

A statement of shareholder' equity reports how a company’s equity changes from one period to another. The report shows how the residual value of a company increases or decreases as well as why the residual value changed. The statement of changes in shareholder equity summarizes a company’s net income, dividend distributions, distributions to ownership, and other changes to equity.

Nonprofit entities and government agencies use similar financial statement; however, their financial statements are more specific to their entity types are will vary from the statements listed above.

Accrual Method vs. Cash Method

There are two primary types of financial accounting: the accrual method and the cash method. The primary difference between the two types of financial accounting in the timing in which transactions are (or are not) recorded.

Accrual Method

The accrual method of financial accounting is a method of preparing financial statements that records transactions independently of cash usage. Journal entries may be posted prior to an item having to been paid for, and certain financial accounting principles recognize the impact of a transaction over a period of time (as opposed to the entire impact being recorded in the period the cash impact happened). 

For example, imagine a company receives a $1,000 payment for a consulting job to be completed next month. Under accrual method of financial accounting rules, the company is not allowed to recognize the $1,000 as revenue as the company has technically not performed work and earned the income. Under the accrual method of financial accounting, this transaction is recorded as a debit to cash and a credit to unearned revenue, a liability account. When the companies earns the revenue next month, it clears the unearned revenue accounting and records actual revenue.

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, the accrual method of accounting calls for the company to record the transaction in July. In addition to debiting Utility Expense, the company records a credit to accounts payable. When the invoice is paid, the credit is cleared.

Cash Method

The cash method of financial accounting is an easier, less strict method of preparing financial statements. Under the cash method, transactions are recorded only when cash involved. Revenue and expenses are only recorded when the transaction has been completed via the facilitation of money.

In 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 in the month prior.

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 be recorded when they are paid, not when they occur. 

Financial Accounting

Accrual Method
  • Records transactions when benefit is received or liability is incurred

  • Often a more accurate method of accounting that depicts more realistic business operations

  • Required for larger, public companies as part of external reporting

Cash Method
  • Records transactions when cash is received or distributed

  • Often an easier method of accounting that simplifies a company down to what has already actually occurred

  • Primarily used by smaller, private companies with low to no reporting requirements

Principles of Financial Accounting

Financial accounting is dictated by five general and overarching principles. These principles guide how companies are to prepare their financial statements and are the basis of all financial accounting technical guidance. These five principles relate to the accrual method of accounting.

  • The Revenue Recognition Principle states that revenue should be recognized when it has been earned. This principle dictates how much revenue should be recorded, the timing of when that revenue is reported, and circumstances in which revenue should not be reflected within a set of financial statements. 
  • The Cost Principle states the basis for which costs are recorded. This principle dictates how much expenses should be recorded for (i.e. at transaction cost) in addition to properly recognizing expenses over time for appropriate situations (i.e. a depreciable asset is expensed over its useful life). 
  • The Matching Principle states that revenue and expenses should be recorded in the same period in which both are incurred. This principle strives to avoid a company from recording revenue in one year with the associated cost of generating that revenue in a different year. This principle dictates the timing in which transactions are recorded.
  • The Full Disclosure Principle states that the financial statements should be prepared using financial accounting guidance that includes footnotes, schedules, or commentary that transparently report the financial position of a company. This principle dictates the amount of information provided within financial statements.
  • The Objectivity Principle states that while financial accounting has aspects of estimations and professional judgement, a set of financial statements should be prepared objectively and free from personal bias. This principle dictates the aspects where technical accounting should be used as opposed to personal opinion.

Importance of Financial Accounting

Companies engage in financial accounting for a number of important reasons:

  • Financial accounting creates a standard set of rules for preparing financial statements. This standard set of rules creates consistency across reporting periods and across different companies.
  • Financial accounting decreases risk by increasing accountability. Lenders, regulatory bodies, tax authorities, and other external parties rely on financial information; financial accounting ensures that reports are prepared using acceptable methods that hold companies accountable for their performance.
  • Financial accounting provides insight to management. Though other methods such as cost accounting may provide better insights, financial accounting can drive strategic concepts if a company analyzes its financial results and makes reactionary investment decisions. 
  • Financial accounting promotes trust in financial reporting. Independent governing bodies oversee the rules of financial accounting, making the basis of reporting independent of management and a highly reliable source of accurate information
  • Financial accounting encourages transparency. By setting rules and requirements, financial accounting forces companies to disclose certain information on how operations are going, what risks the company faces, and financial performance regardless of how well or poorly the company is doing.

Careers in financial accounting can include but are limited to preparing the financial statements, analyzing the financial statements, auditing the financial statements, or supporting the the technology/systems that produce financial statements.

Users of Financial Accounting/Financial Statements

The entire purpose of financial accounting is to prepare financial statements. These financial statements are used by a variety of groups and are often required as part of agreements with the company preparing the financial statements. In addition to management using financial accounting to gain information on operations, the following groups use financial accounting reporting: 

  • Investors. Before investing in a company, investors often seek financial reports prepared using financial accounting guidance to understand how the company has been doing and to set expectations about the future of the company. 
  • Auditors. Companies may be required to present their financial position to auditors. Auditors analyze the financial statements to ensure that property financial accounting guidance has been used and the reports are free from material misstatements.
  • Regulatory Agencies. Public companies are required to submit financial statements to governing bodies such as the Securities and Exchange Commission. These financial statements must be prepared in accordance with financial accounting rules, and companies face fines or exchange delisting if they do not comply with reporting requirements.
  • Suppliers. Vendors or suppliers may ask for financial statements as part of their credit application process. Suppliers may require credit history or evidence of profitability before issuing credit or increasing credit to a requested amount.
  • Banks. Lenders and other similar financial institutions will almost always require financial statements as part of the business loan process. Lenders will need to see verifiable proof via financial accounting that a company is in good operational health prior to issue a loan (or as part of determining what the cost, covenants, or interest rate of the loan will be).

Financial Accounting vs. Managerial Accounting

The key difference between financial and managerial accounting is that financial accounting aims at providing information to parties outside the organization, whereas managerial accounting information is aimed at helping managers within the organization make decisions.

Financial accounting is the set of rules used to compile a company’s financial statements. Alternatively, cost accounting is a range of accounting techniques used to analyze financial performance and drive smarter decision-making. Financial accounting is the basis for externally-shared financial statements; cost accounting is not an allowable basis for financial statements. 

Cost accounting is rooted in using operational information in specific ways to glean information. For example, cost accounting may track the variable costs, fixed costs, and overhead costs along a manufacturing process. Then, using this information, a company may decide whether to convert to a lower quality, less expensive type of raw materials. While companies rely on financial accounting for preparing financial statements, companies rely on cost accounting to internally analyze operations and generate internal-only reports.

Professional Designations for Financial Accounting

Members of financial accounting can carry several different professional designations.

  • The most common accounting designation demonstrating an ability to perform financial accounting within the United States is the Certified Public Accountant (CPA) license.
  • Outside of the United States, holders of the Chartered Accountant (CA) license demonstrate the ability as well.
  • The Certified Management Accountant (CMA) designation is more demonstrative of an ability to perform internal management functions than financial accounting. However, this license does test on financial analysis.
  • A Certified Internal Auditor (CIA) demonstrates creditability into maintaining the control environment within a company by overseeing processes and procedures related to financial accounting.
  • The Certified Information Systems Auditor (CISA) exam tests proficiency on maintaining the systems of an entity and may directly or indirectly influence the outcome of the financial accounting process.

What Is an Example of Financial Accounting?

A public company’s income statement is an example of financial accounting. The company must follow specific guidance on what transactions to record. In addition, the format of the report is stipulated by governing bodies. The end result is a financial report that communicates the amount of revenue recognized in a given period. 

What Is the Main Purpose of Financial Accounting?

Financial accounting is intended to provide financial information on a company’s operating performance. Though management can analyze reports generated using financial accounting, they often find it more useful to use managerial accounting, an internally-geared method of calculating financial results that is not allowable for external reports. Financial accounting is the widely-accepted method of preparing financial results for external use.

Who Uses Financial Accounting?

Public companies are required to perform financial accounting as part of the preparation of its financial statement reporting. Small or private companies may also use financial accounting, but they often operate with different reporting requirements. Financial statements prepared using financial accounting are used by many parties outside of a company such as lenders, government agencies, auditors, insurance agencies, or investors.

The Bottom Line

Financial accounting is the framework that sets the rules on how financial statements are prepared. These guidelines dictate how a company translates its operations into a series of widely-accepted and standardized financial reports. Financial accounting plays a critical part in keeping companies accountable for their performance and transparent regarding their operations.

Article Sources
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  1. Financial Accounting Standards Board. "About the FASB."