What Is Financial Accounting? Definition and Examples

By Gillian Davenport

Updated May 9, 2022 | Published February 4, 2020

Updated May 9, 2022

Published February 4, 2020

Gillian Davenport is a business writer with professional experience in finance and accounting.

Companies may use a variety of procedures and recording methods to understand their financial health and assess the performance of their business. Organizations typically rely on financial accounting to track and review transactions, costs, sales and other financial changes. Understanding what this process involves and the statements it involves can help businesses perform adequate financial analysis for internal and external stakeholders.

In this article, we discuss what financial accounting is, the different types of statements it produces and the principles to follow when generating these statements.

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What is financial accounting?

Financial accounting is a field of accounting that focuses on recording, analyzing and reporting on a company’s business transactions in order to generate statements that are used by internal and external shareholders to assess a company’s financial stability.

Financial statements can allow investors and organizational leaders to assess the financial health of a company and examine its overall performance. This means that financial accounting and the statements it creates are essential in setting business goals, reviewing financial progress and allocating resources to internal departments and professionals. Statements follow requirements and guidelines set by the International Financial Reporting Standards (IFRS).

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Financial accounting statements

The financial accounting process allows professionals to use a variety of statements to record transactions and track the business' performance. Professionals typically report these statements in two comparison periods, so they can understand the business's current financial performance as it relates to another financial period.

Five of these statements include:

1. Statement of change in equity

A statement of change in equity is a financial document that allows a company to evaluate the shifts in owner's equity within a particular accounting period. This means it provides an overview of the transactions related to a business shareholder's equity. Professionals can use it when reviewing a variety of elements, including:

  • Equity withdrawals

  • Retained earnings and accumulated reserves

  • Net loss and net profit

  • Dividend payments

  • Results of previous accounting period corrections

  • Effects of changes in accounting policies

2. Statement of cash flow

A statement of cash flow allows professionals to track the movement of funds to and from a business within a specific accounting period. It can help a company stay up to date about its financial well-being and allow stakeholders to make well-informed decisions. Investors may rely on these statements because they offer a transparent view of the amount of money that a company spends and receives.

These statements typically evaluate the cash flow in three primary business areas: investing activities, operating activities and financing activities. Adequate and frequent analysis of cash flow statements is an important aspect of understanding planning for an organization's future.

Related: How To Calculate Cash Flow (With Methods and Example)

3. Income statement

An income statement is a financial document that reports three primary aspects of a business' performance for a particular financial period, which are profit or loss, revenue and expenses. Revenue includes the sales of goods and services that a company creates within an accounting period, whereas expenses include operational costs within the same timeframe.

Profit or loss refers to the net income that a business generates. Companies can use this to calculate their net income by subtracting revenue from their expenses.

Professionals may also call this form a statement of financial performance because it lets them review and analyze the financial performance of a company and compare it to internal financial performance during other periods or external competitors.

4. Noted to financial statements

It's important not to forget the noted to financial statements, which is mandatory according to the IFRS. It requires a business to include all information and details pertaining to financial statements that allow users to understand the information these documents include.

This statement may include a variety of details that make a company's financial information easier to review, including elements like:

  • Accounting policies

  • Standards and compliance

  • Regulations

  • Disclosure

  • Overview of the account

5. Balance sheet

A balance sheet is a financial accounting statement that allows professionals to review a company's liabilities, assets and owner's equity. Liabilities are obligations that a company has to other individuals or entities, including interests payable, taxes payable and credit purchases.

Alternatively, assets are resources that a company owns legally and economically. Lenders and investors may use balance sheets when making important decisions regarding loans and investment opportunities.

These documents allow businesses to create their "debt-to-equity ratios," which can help them analyze the viability of a company using its equity to pay its debts. Professionals may also use this statement to assess whether a company can pay its debts within 12 months by calculating the "current ratio," which divides the number of current assets by the business' current liabilities.

Related: How To Create a Balance Sheet in 5 Simple Steps

Two methods of financial accounting

There are two different ways a company can record its transactions, and a company may use one of the two methods or a combination of both. Here are the two primary methods:

1. Cash accounting

Cash accounting records solely cash transactions made by employees of an organization. For example, if an employee is traveling on a business trip, they can make cash transactions on meals and lodging and incidental expenses. After they make a cash transaction, they hold onto a receipt and report all transactions made to their manager. These are logged in once they're approved.

Cash transactions usually don't appear on financial statements but they can still be logged to show proof that a transaction occurred.

2. Accrual accounting

Accrual accounting is when a bookkeeper records all data from transactions. Thus, it's an expansion of cash accounting because it incorporates credit, debit and other forms of payment for transactions made by employees, with cash included. Accounts payable and accounts receivable also fall under this category, which can represent capital owed to or by a customer.

This type of accounting gives a clearer picture of your organization's cash flow and it helps you determine if you have current assets or liabilities.

The principles of financial accounting

There are basic guidelines that financial accounting must follow when generating statements for stakeholders. These principles are referred to as generally accepted accounting principles (GAAP). Bookkeepers understand the detailed rules issued by the Financial Accounting Standards Board and abide by industry-standard practices.

Here are the 10 accounting principles according to GAAP:

1. Economic entity principle

The economic entity assumption states that the business and business owners exist as separate entities. This means that the financial activities of the owners differ from the financial activities of their company. This principle makes sure accountants keep business transaction records separate from an owner's purchases made outside of the company.

2. Monetary unit assumption principle

This principle specifies that companies can only report financial transactions in U.S currency. If they're made overseas, the conversion to the total cost in U.S. dollars is required. Accountants do not take inflation into account when documenting financial transactions as their purchasing power is considered the same despite when the business made a transaction.

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3. Cost principle

The cost principle requires accountants to document all complex and continuous financial activities over a financial period, and present it at the top of each financial statement they produce. This gives stakeholders an in-depth understanding of how much capital the organization spent over a given period. It also allows stakeholders to evaluate the cash flow of a business based on numbers included in statements.

4. Time period principle

The time period principle states that accountants can track and evaluate transactions and financial occurrences within various time periods, including weeks, months, quarters or a calendar or fiscal year. This principle requires companies to identify the time period by listing it in the heading of financial documents. Financial accounting statements that require this heading may include the statements of cash flow, owner's equity statements and income statements.

5. Full-disclosure principle

The full-disclosure principle requires companies to disclose all accounting information to investors and lenders within a financial statement. Financial statements typically include a footnote section that informs stakeholders about certain data related to financial transactions. This allows all users to make informed decisions and understand the documents they're reviewing.

6. Going concern principle

This principle operates under the assumption that you'll carry out all financial obligations and liquidate them in the near future. If you decide to liquidate, then it must be clearly stated on all financial statements. You may be able to defer prepaid expenses to future accounting statements in the event of a liquidation.

7. Matching principle

This principle requires you to use accrual accounting instead of cash accounting to record transactions, and company expenses must align with revenue. For example, you may report commissions made from purchases during quarter four at the time the customer made the purchase. Also, wage costs are reported during the week an employee worked, rather than during their pay period.

Related: IFRS vs. GAAP: Definitions and Differences

8. Revenue recognition principle

The revenue recognition principle states that the accrual basis of accounting requires companies to report revenue on the corresponding income statement for that financial period. For example, a company may earn $10,000 in revenue but may only receive $1,000 in cash. A cash receipt confirms the form of payment and cash coming into an organization.

9. Materiality principle

The materiality principle includes a misstatement in financial records when a listed amount is immaterial or insignificant. This means that accounting statements typically include financial amounts rounded to the nearest dollar, to avoid insignificant sums. A footnote in a financial statement can explain any mention of the cost being allocated over a differing period of time.

Related: GAAP vs. Non-GAAP: What's the Difference?

10. Conservatism principle

The conservatism principle allows companies to exhibit potential future losses but doesn't permit them to list future gains. This means they can detail accurate financial activity and potential threats that could appear on future financial statements. Accountants may use this principle when they're unsure how to list an item on a statement.

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