What Does Financial Accounting Focus On?

Financial accounting is the process of recording, summarizing, and reporting a company’s business transactions through standardized financial statements. Its function is to provide a clear and consistent picture of a company’s financial health and performance to individuals and entities outside of the organization. The focus is on historical data, presenting what has already occurred to ensure objectivity and reliability in the information shared.

The Primary Users of Financial Information

The reports generated through financial accounting are for external parties who have a financial interest in the company but are not involved in its daily operations. One prominent group is investors, who use financial statements to assess a business’s profitability and stability. This analysis informs their decisions to buy, hold, or sell stock and helps them gauge how effectively management is using its resources to generate returns.

Another user group is creditors and lenders, such as banks and suppliers. Before extending a loan or offering trade credit, these entities scrutinize a company’s financial statements to evaluate its creditworthiness and ability to repay debts. They are interested in a company’s cash flow and the relationship between its assets and liabilities to determine the level of risk associated with a loan.

Government and regulatory agencies also rely on financial accounting information. The Internal Revenue Service (IRS) uses these records to verify the accuracy of a company’s tax filings and ensure compliance with tax laws. Publicly traded companies are required by the Securities and Exchange Commission (SEC) to file regular financial reports, such as the annual Form 10-K and quarterly Form 10-Q, to ensure transparency and protect investors.

Core Financial Statements

Balance Sheet

The Balance Sheet offers a snapshot of a company’s financial position at a single point in time. It is structured around the fundamental accounting equation: Assets = Liabilities + Owner’s Equity.

Assets are economic resources owned by the company and are listed in order of liquidity. They are broken down into current assets, such as cash, accounts receivable, and inventory, which are expected to be converted to cash within a year. Non-current assets include long-term investments, property, plant, and equipment (PP&E), and intangible assets like patents. Liabilities represent the company’s financial obligations to other parties. Current liabilities are debts due within one year, including accounts payable and short-term loans, while long-term liabilities are due after more than one year.

Owner’s equity is the amount of money that would be returned to shareholders if all assets were liquidated and all debts were repaid. It includes common stock, which represents ownership shares, and retained earnings. Retained earnings are the cumulative net income the company has earned over its lifetime, minus any dividends it has paid out to shareholders.

Income Statement

The Income Statement, also called the Profit and Loss (P&L) statement, reports a company’s financial performance over a specific period, such as a month, quarter, or year. The basic formula is Revenues – Expenses = Net Income. It begins with revenue, which is the total amount of money generated from the sale of goods or services.

From revenue, the company subtracts the Cost of Goods Sold (COGS), which includes the direct costs attributable to the production of the goods sold. The resulting figure is the Gross Profit. Following this, all other operating expenses incurred during the period are deducted, such as salaries, rent, and marketing costs, to find the Operating Income, which reflects profit from core business operations.

After operating income, the statement accounts for non-operating items, such as interest expense and any gains or losses from investments. Finally, income taxes are subtracted to arrive at the bottom line: Net Income. Net income is a measure of a company’s profitability and is a figure closely watched by investors and analysts. A consistent history of strong net income is often a sign of a healthy, well-managed business.

Statement of Cash Flows

The Statement of Cash Flows provides a detailed summary of the cash inflows and outflows a company experiences during a specific period. This statement is important because it shows how a company is generating and using cash, which is not always apparent from the income statement due to accrual accounting. It is broken down into three distinct activities: operating, investing, and financing.

Cash flows from operating activities include the cash generated from the principal revenue-producing activities of the company, reconciling net income to actual cash by adjusting for non-cash expenses. Cash flows from investing activities report the cash used for or generated from the purchase and sale of long-term assets and other investments, such as buying or selling equipment.

Cash flows from financing activities show the cash movements between a company and its owners and creditors, including issuing or repurchasing stock, paying dividends, and repaying debt. The sum of the net cash flows from these three activities equals the net increase or decrease in cash for the period. This figure is then added to the beginning cash balance to arrive at the ending cash balance, which must match the cash amount reported on the balance sheet.

Guiding Principles and Standards

Financial accounting is governed by a set of rules and principles that ensure consistency, comparability, and reliability. In the United States, companies are guided by Generally Accepted Accounting Principles (GAAP), issued by the Financial Accounting Standards Board (FASB). For companies outside the U.S., many follow International Financial Reporting Standards (IFRS).

A central concept within these standards is the accrual basis of accounting. Under this method, revenues are recognized when they are earned, and expenses are recognized when they are incurred, regardless of when the cash is actually exchanged. This approach provides a more accurate picture of a company’s financial performance for a period than the cash basis, which only records transactions when cash changes hands. For example, if a company provides a service in December but is not paid until January, the revenue is recorded in December.

Another foundational guideline is the principle of consistency. This principle dictates that once a company adopts an accounting method, it must continue to use that method consistently in future accounting periods. For instance, if a business chooses a specific method for depreciating its assets, it should stick with that method for all similar assets. This ensures that financial statements are comparable from one period to the next, allowing users to identify meaningful trends.