Financial Accounting is concerned with the preparation of financial statements for people outside the company, such as stockholders, suppliers, banks, employees, government agencies, owners, and other stakeholders. (Source: Wikipedia).
Given the diverse needs of the stakeholders, the presentation of financial accounts is very structured and subject to many more rules than management accounting. The body of rules that governs financial accounting in a given jurisdiction is called Generally Accepted Accounting Principles, or GAAP. Other rules include International Financial Reporting Standards, or IFRS or US GAAP.
There are typically three basic financial statements, accompanied by a management discussion and analysis:
The balance sheet is a snapshot of a firm’s financial resources and obligations at a single point in time, while the income statement summarizes a firm’s financial transactions over an interval of time.
These two financial statements reflect the “accrual basis” accounting used by firms to match revenues with the expenses associated with generating those revenues.
The cash flow statement includes only inflows and outflows of cash and cash equivalents; it excludes transactions that do not directly affect cash.
Let us look at each in more details:
A balance sheet is often described as a “snapshot of a company’s financial condition” and is governed by the accounting equation: Assets = Liabilities + Owners’ Equity.
This financial statement indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the “top line”) is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as Net Profit or the “bottom line”).
It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes. The purpose of the income statement is to show managers and investors whether the company made or lost money during the period being reported.
Income statements should help investors and creditors determine the past financial performance of the enterprise, predict future performance, and assess the capability of generating future cash flows through report of the income and expenses.
The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time.
The cash flow statement is a cash basis report on three types of financial activities: operating activities, investing activities, and financing activities. It captures both the current operating results and the accompanying changes in the balance sheet.
The cash flow statement excludes transactions that do not directly affect cash receipts and payments. These non-cash transactions include depreciation or write-offs on bad debts or credit losses to name a few. Non-cash activities are usually reported in footnotes.
As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. It also improves the comparability of different firms’ operating performance by eliminating the effects of different accounting methods.
The indirect method uses net-income as a starting point, makes adjustments for all transactions for non-cash items, then adjusts from all cash-based transactions. An increase in an asset account is subtracted from net income, and an increase in a liability account is added back to net income. This method converts accrual-basis net income (or loss) into cash flow by using a series of additions and deductions.