What is Financial Accounting?

Financial accounting is the recording and reporting of a company’s transactions. These transactions are presented in financial reports that provide an insight into a company’s activities and financial position.

Businesses report their performance on a regular basis, and it is vital to have a thorough understanding of the financial statements in order to undertake effective analysis.

For the majority of countries, it is a requirement that companies report their financial statements on a regular basis. How they must report their financial data will vary from country to country, but most will follow one of two frameworks:

  • US Generally Accepted Accounting Principles (US GAAP) or
  • International Financial Reporting Standards (IFRS)

The frameworks provide a list of rules and guidelines to help companies prepare their financial statement. The frameworks are based on four main principles:

  • Consistency (calculations are completed consistently period on period)
  • Going concern (the business will continue for the foreseeable future)
  • Accruals (revenues and expenses are recognized as incurred)
  • Offsetting (items are not netted off unless required by rules)

Most businesses produce audited financial statements once a year with periodic announcements throughout. Within the US, the yearly reports are called 10Ks and the quarterlies are 10Qs. Outside the US, the yearly reports are normally annual reports with the periodic ones being referred to as interim reports.

The primary beneficiaries of these reports include investors, creditors and lenders. It is essential the reports are prepared according to one of the two frameworks to fairly reflect the financial results and condition of the company.

Key Learning Points

  • Financial accounting is the process of recording and reporting a company’s business transactions
  • For most countries, it is a legal requirement for companies to report their activities in annual reports which consist of the three key financial statements: income statement, balance sheet and cash flow statement (the majority report under IFRS or US GAAP guidelines)
  • There are many beneficiaries and users of financial statements including but not exclusive to investors, creditors, employees, government authorities and third-party institutions
  • Annual reports (or 10-K for US companies) include a large amount of information covering the strategy, business model, goals, financial reports and supporting information of a business

Components of Financial Statements

Most businesses comprise of many individual legal entities which are part of the “family” of business or group. The financial reports cover all members of the family and are normally referred to as consolidated. Financial statements are generally made up of the following key sections:

Management, Discussion and Analysis (MD&A)

Management discussion and analysis (MD&A) is produced by the management of the company, who address the performance of the business. The report outlines the reasons for the company’s performance, whether this is positive or negative. Often the report is tainted with a biased view but is still very useful for providing further information to analysts. Management will include both qualitative and quantitative assessments of the company, as well as future plans or projects.

Financial Statements

The financial statements provide a record of an organization’s activities and financial position. The income statement, balance sheet and cash flow statement are known as the three “key” statements. These outline the company’s total income and expenses across a period, its resources and financial obligations at a specified point in time, and the company’s net cash flow. A strong understanding of their content is second nature to an effective analyst. Companies also provide a statement of shareholder’s equity which reports the changes in the value of shareholders’ equity or ownership interest in a company from the beginning of an accounting period to the end of it. Finally, a statement of comprehensive income which represents a company’s change in equity during a specific period from transactions and events that are typically non-cash gains and losses.

Financial Statement Footnotes

The footnotes are the final section of the report and provide supporting calculations and additional detail to the statements. Footnotes can be formed of many pages and are a goldmine of data and include the company’s accounting policies.

The Importance of Financial Accounting

Understanding the fundamentals of these reports is essential when reviewing a company. Professionals from an array of industries will need to understand what these reports show and how to read them. The ability to read and analyze the reports is vital to building a successful career in the finance industry.