Financial accounting is the area of accounting that focuses on providing external users with useful information. In other words, financial accounting is a way of reporting business activity and financial information to investors, creditors, and other people outside the business organization.
Investors and creditors are often called external users because they are people outside of the organization who use the company financial information to make decisions. The most common form of financial information issued to external users by companies is a general purpose set of financial statements.
These financial statements, along with financial accounting standards in general, must be held to strict rules, so the financial statements will be useful and of high quality. That is why GAAP governs the principles and standards of financial accounting. GAAP requires that accounting information be relevant, reliable, and consistent among other things. This insures that external users will be able to have quality information to base their financial decisions on.
All external users have different needs when it comes to financial information. For instance, a lender is primarily concerned with a company’s cash flow and ability to repay loans with interest. An investor, on the other hand, is more concerned with company profit performance and longevity.
The overall purpose of financial accounting is to create information or financial statements that can be used by all external users to base their financial decisions on whether or not these decisions involve lending money or investing money.
Accounting for internal users is typically considered managerial accounting and is subject to less stringent standards and requirements.
Financial statements are reports prepared by a company’s management to present the financial performance and position at a point in time. A general-purpose set of financial statements usually includes a balance sheet, income statements, statement of owner’s equity, and statement of cash flows. These statements are prepared to give users outside of the company, like investors and creditors, more information about the company’s financial positions. Publicly traded companies are also required to present these statements along with others to regulator agencies in a timely manner.
Financial statements are the main source of financial information for most decision makers. That is why financial accounting and reporting places such a high emphasis on the accuracy, reliability, and relevance of the information on these financial statements.
The balance sheet a summary of the company position on one day at a certain point in time. The balance sheet lists the assets, liabilities, and owners’ equity on one specific date. In a sense, the balance sheet is a picture of the company on that date. Investors and creditors can use the balance sheet to analyze how companies are funding capital assets and operations as well as current investor information.
The income statement shows the revenue and expenses of the company over a period of time. Most companies issue annual income statement, but quarterly and semi-annual income statements are also common. Users can analyze the income statement to see if companies are operating efficiently and producing enough profit to fund their current operations and growth.
The statement of owner’s capital summarizes all owner investments and withdrawals from the company during a period. It also reports the current income or loss recorded in retained earnings.
A balance sheet is one of four basic accounting financial statements. The other three being the income statement, state of owner’s equity, and statement of cash flows. The balance sheet uses the accounting equation (assets = liabilities + owner’s equity) to show a financial picture of the business on a specific day. In other words, a balance sheet lists all of the assets that a company owns as well as the debts owed by the company and the owner’s interest or ownership share in the company. Assets are listed separately first and liabilities and owner’s equity are listed together second. Think about the accounting equation. Assets = Liabilities + Owner’s equity. Assets have to total the sum or liabilities and owner’s equity. This is where the “balance” in balance sheet comes from. Assets have to balance with liabilities and owner’s equity.