Key Takeaways
- Financial accounting is the branch of accounting that is involved with the preparation of financial statements for use by various stakeholders.
- The four general-purpose financial statements are the Statement of Financial Position, the Income Statement, the Statement of Cash Flows, and the Statement of Changes in Equity.
- The elements of a statement of financial position are assets, liabilities and equity. The income statement elements are revenues, gains, expenses, and losses.
- The four financial statements are interrelated since they are based on the same underlying financial transaction information.
Introduction to Financial Accounting
Financial Accounting is the branch of accounting that deals with the systematic process of preparing general-purpose financial statements that report the financial performance, financial position and cash flows of a business over a certain period of time. This process involves recording, classifying and summarizing the financial transactions of the business.
Financial reporting is closely related to financial accounting. Financial Reporting refers to the disclosure of financial information about a company through financial reports issued primarily to stakeholders outside the business organization.
The main distinction between financial reporting and financial accounting is that the former encompasses a broader scope of reports that includes financial statements, quarterly and annual reports issued for shareholders and government agencies, accompanying footnote disclosures, investor prospectuses, and website disclosures of financial information. Financial accounting, on the other hand, is more focused on keeping track of a company’s financial transactions and the preparation of general-purpose financial statements based on applicable accounting standards such as generally accepted accounting principles (GAAP) and the International Financial Reporting Standards (IFRS).
If you’re an investor or one of the external stakeholders of a company, you’ll be using these financial reports to make important economic decisions involving the company. External stakeholders include investors, creditors, government agencies, suppliers, and even consumers.
On the other hand, if you’re part of the accounting department and management of the company, you’ll have the primary responsibility for the preparation of financial statements to be issued to external stakeholders. This involves the entire accounting process of collecting data, processing data into useful information, preparing financial statements, and finally communicating them to various stakeholders and decision makers.
General-purpose Financial Statements
The key product and main output of the financial accounting process is a set of general-purpose financial statements. This includes the statement of financial position (balance sheet), income statement, statement of cash flows, and statement of changes in equity.
General-purpose means that the financial statements are prepared based on applicable accounting standards for financial reporting and are intended to be communicated to a wide range of users who are not in a position to require financial reports tailored to their specific needs.
The general-purpose financial statements are usually prepared on a quarterly or annual basis, and are included in the annual reports of companies, particularly those whose shares are publicly-traded. Though these reports are primarily distributed to users outside the company, even those within the company such as managers also use them to evaluate and guide them in making strategic decisions towards the long-term objectives of the company.
In contrast to general-purpose financial statements, managerial reports are financial reports that are prepared specifically to meet the request and information needs of management for internal decision making. Management reports are only distributed within the company and are not required to comply with any accounting standards or principles.
The key difference between these reports is that general-purpose financial statements are prepared for external users and the general public, while managerial reports are prepared for internal users such as managers. Other reports that are tailored to the particular needs of certain users are those prepared for use by bankers and suppliers who assess the creditworthiness of the company.
Objectives of Financial Statements
Financial statements are prepared by accountants for the following purposes:
- To communicate important financial information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions. They tell the financial condition of a company and how well it is performing over a specific period of time in terms of profit.
- To provide information about different financial statement elements such as the company’s assets, liabilities, equity, revenues, expenses, gains, losses, owner investments, owner withdrawals, dividends, and cash flows.
- To assist users in predicting the entity’s future cash flows and, in particular, their timing and certainty.
- To show the results of management stewardship and accountability over the resources of the entity. This helps owners and investors assess how effective management is in fulfilling the role entrusted to them.
- Fulfill the financial reporting requirements of government agencies.
However, one limitation of financial statements is that the information they provide are largely financial in nature and does not contain information that are non-financial. If you want to have more context about what those numbers on the financial statements mean, you may refer to the supporting footnotes and disclosures that come with a company’s financial reports.
Components of Financial Statements
There are four (4) important financial statements that are generated by the financial accounting process. A complete set of financial statements includes:
- Statement of Financial Position (also called Balance Sheet)
- Income Statement (also called Statement of Profit and Loss)
- Statement of Cash Flows (also called Cash Flow Statement)
- Statement of Changes in Equity
Notes, comprising a summary of significant accounting policies and other explanatory notes, are also included with the above financial statements to provide disclosures and give more details about the information provided in the financial statements.
The International Accounting Standard (IAS 1) mentions the Statement of Comprehensive Income which provides more information about the financial performance of a company than the income statement alone. According to the standard, you have two options on how you could present income and expense items during a period. These two options are as follows:
- Prepare a single Statement of Comprehensive Income, or
- Prepare two statements as follows:
- An Income Statement displaying components of profit or loss, and
- A Statement of Comprehensive Income displaying components of other comprehensive income below profit or loss.
Comprehensive income includes:
- Income and expense items included in the income statement
- Other comprehensive income which are income and expense items that are not included in the income statement. An example is revaluation surplus recognized after measuring a fixed asset item at its revalued amount.
Preparing only the income statement is enough for a company that doesn’t have any item considered as other comprehensive income. This is particularly applicable for smaller companies that have simple operations.
Statement of Financial Position
The Statement of Financial Position will give you information about the financial position of the business at a specific point in time, usually at the end of the accounting or reporting period. It is also known as the Balance Sheet.
Financial Position describes the status of an entity’s assets or financial resources, liabilities or obligations, and equity or net worth at a certain point in time. It is very helpful when you need to analyze the liquidity, financial stability, and financing needs of the entity.
People usually compare the statement of financial position to a snapshot or photograph of the business taken at one point in time. It answers the question: What does the company own and owe?
Income Statement
The Income Statement will provide you with important information about the financial performance of a company over a given period of time. It is also known as the Statement of Profit and Loss.
Financial Performance refers to the results of the company’s operations and financial activities for a certain period, usually one year or one quarter. A favorable financial performance results to a Net Income which is the excess of total income over expenses. On the other hand, a Net Loss happens when expenses are larger than total income.
The income statement is usually compared to a video clip of the business that shows its activities over a period of time. It answers the question: Is the company making money or not?
Statement of Cash Flows
The Statement of Cash Flows lists the cash inflows and cash outflows related to the operating, investing and financing activities of the company. It is also called the Cash Flow Statement.
This financial statement presents the amount of cash receipts or inflows, cash payments or outflows, and the resulting net change in cash over a specific period. If you want to evaluate how a company manages its cash and if they can generate positive cash flow in the future, the statement of cash flows is a very useful tool.
Statement of Changes in Equity
The Statement of Changes in Equity describes in detail the activities that affect the net worth of the owners or shareholders over the years that the company operated. The name of this financial statement may differ depending on the legal structure of the business as follows:
- Statement of Changes in Owner’s Equity for sole proprietorships
- Statement of Changes in Partners’ Equity for partnerships
- Statement of Changes in Shareholders’ Equity for corporations
This statement will give you a more detailed look into the net assets of a company by showing the opening and ending balance of various equity accounts and all transactions that affected each equity account during the reporting period such as profits and losses, capital contributions and distributions, and other comprehensive income.
Notes to Financial Statements
The Notes to Financial Statements provide additional information that is not included in the four financial statements that we have discussed above. This additional information is often long and detailed which is the reason why it is excluded from the face of the financial statements. This is done for clarity and to avoid confusion in the information presented in the financial statements.
The information in the notes is important because it could provide you with more context and clarity over the items that are reported in the financial statements. The objectives of the notes are as follows:
- Present information about the basis of preparation of the financial statements and the specific accounting policies used.
- Disclose any information required by the IFRSs that is not presented elsewhere in the financial statements.
- To provide additional information that is not presented elsewhere in the financial statements but is relevant to an understanding of any of them.
Elements of Financial Statements
The Elements of Financial Statements are broad classes of business transactions that are grouped as line items in the financial statements according to their economic characteristics. These are the “building blocks” from which the financial statements are constructed.
Statement of Financial Position Elements
The elements that are directly related to the measurement of financial position in the statement of financial position or balance sheet are assets, liabilities and equity.
Assets
Assets are present economic resources controlled by the entity as a result of past events. An economic resource in this context means a right that has the potential to produce economic benefits for the company.
Examples of assets are cash and cash equivalents, inventories, buildings, land, machinery, delivery vehicles, intangible assets, and investment properties.
Liabilities
Liabilities are present obligations of the entity to transfer economic resources as a result of past events. These obligations are owed by the business to others and are expected to be paid or settled in the future.
Examples of liabilities are accounts payable, loans, accrued expenses, bonds, and unearned revenues.
Equity
Equity is the residual interest or claims of the owners over the assets of the entity after deducting all its liabilities. In case of a business liquidation, equity is the portion of the company’s assets that are claimable by its owners after paying off all liabilities.
Examples of equity accounts are share capital, retained earnings, treasury shares, and share premium.
Income Statement Elements
The elements that are directly related to the measurement of financial performance in the Income Statement are income and expenses.
Income
Income are increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity. Income includes:
- Revenues from the course of ordinary operating activities of the company such as sale of goods by a merchandiser or a manufacturer.
- Gains from incidental transactions that are not associated with primary revenue-producing activities and capital investments. They may or may not arise in the course of the ordinary activities of the company. An example of a gain is the amount earned by a business after selling an equipment above its book value.
Expenses
Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity. Expenses include:
- Operating expenses from the course of ordinary activities of the company such as the cost of sales, utilities, wages, rent, advertising, and depreciation.
- Losses from incidental transactions not associated with the company’s major line of business and capital distributions to owners. They may or may not arise in the course of the ordinary activities of the company. An example is a loss incurred after selling a company vehicle below its book value.
Relationship Between Financial Statements
The Statement of Financial Position, the Income Statement and the Statement of Cash Flows are separate financial statements that provide different financial information about the company. However, the information presented on each financial statements are all based on the same underlying financial transactions of the company that occurred during a given period. This is the reason why the financial statements are interrelated in many ways.
From Income Statement to Statement of Changes in Equity to Statement of Financial Position
- The Net Income or Net Loss that is shown as the bottom line figure on the income statement is closed to the capital account (for a sole proprietorship and a partnership) or retained earnings account (for a corporation) in the statement of changes in equity.
- The ending balance on the statement of changes in equity should equal the equity balance on the statement of financial position.
- The three financial statements serve as bridges that connect the income and expense accounts to the assets, liabilities and equity accounts.
- Transactions that involve the purchase, sale and disposal of certain assets such as fixed assets affect the related asset account in the statement of financial position and recognizes any gain or loss in the income statement.
From Income Statement to Statement of Cash Flows to Statement of Financial Position
- If you’re using the indirect method of reporting cash flows in the statement of cash flows, the net income reported in the income statement is shown as the first line item in the computation of cash flows under the operating activities of the statement of cash flows.
- The effects of the company’s operating, financing and investing activities to the asset, liabilities and equity amounts in the statement of financial position are shown in detail in the statement of cash flows.
- The ending cash balance in the statement of cash flows is equal to the cash balance in the statement of financial position.
Even though each financial statement can be analyzed independently from each other, examining all financial statements together could give more context and a complete picture about the company.
Review Questions
- What is financial accounting?
- What are the 4 general-purpose financial statements?
- What is the difference between financial accounting and financial reporting?
- How are the financial statements related to each other?
- What is the difference between revenue and gains?
