The Role of Financial Accounting
Financial accounting focuses on the tracking and preparation of financial statements for internal management and external stakeholders, such as suppliers, investors, government agencies, owners, and other interest groups. These financial statements are consistent with accounting guidelines and formatting, particularly for publicly traded organizations. This allows individuals unfamiliar with day to day operations to see the overall performance, health, and relative profitability of a given organization.
Characteristics of Financial Accounting
Generally speaking, it is expected by financial accounting standards that an organization maintain the following qualities when submitting financial accounting information:
- Relevance - Financial statements must be applicable to the decisions being made, and presented in a way that allows for distilling useful insights.
- Materiality - The information present must be of the quality that indicates consequence in strategic or legal decisions. This is to say that nothing of materiality should be omitted as well.
- Reliability - All information must be free of error, and reported with pinpoint accuracy.
- Understandability - Clarity and efficiency in presentation is important, as it must be immediately readable and without the possibility of being misinterpreted.
- Comparability - Finally, all presented financial statements should align with current best practices in accounting to ensure that the material presented is validly compared to that of other organizations.
How to Conduct Financial Accounting
Financial accountants are tasked with producing three primary documents that indicate a health check on various aspects (or at times all aspects) of the organization. These three statements are the balance sheet, the income statement, and the statement of cash flows.
Balance Sheet
A balance sheet demonstrates the overall value of organizational assets by listing current and long-term assets (fixed or otherwise) alongside short term and long term liabilities and stakeholder equity. Through balancing the assets against the combination of liabilities and stakeholder equity, the financial accounting should encounter a zero sum game.
Simply put: Assets = Liabilities + Shareholder Equity. This is the golden rule of balance sheets (hence the name: balance). The items on a balance sheet can range from long term debt to current inventory to dividends to accounts receivable to cash on hand. Anything and everything that can be valued should be included in this calculation.
Balance Sheet Example
This balance sheet demonstrates such common line items an account will be populated and measuring when creating and releasing this financial statement.
Income Statement
As opposed to something that balances, the income statement is more of a one directional document. Picture this as a mathematical illustration of the organizations operations, from the production floor all the way to the hands of the consumer. When organizations go through such a process (producing, shipping, storing, paying taxes, selling, providing service, etc.), the expectation is that the price point established will cover all relevant costs while producing some percentage of net income. An income statement calculates whether or not a business is accomplishing this.
To picture it, let's create a simple example. You own a pizza shop. You sold 1000 pizzas last month. Each pizza sold for $10 on average. That gives you $10,000, but this is your revenue, not your profit. For each pizza, it costs $4 in cheese, dough, sauce and toppings. That brings you down to $6,000. You have to pay your bills and your rent, which is takes you down another $2,000. Now, you're at $4,000, and you end up paying $1,500 to your employees in wages. Of your $2,500 remaining, 40% goes to state and federal taxes. Your overall net income for the month is $1,500. This process is what an income statement does.
Statement of Cash Flows
The final statement is the statement of cash flows, which aims to identify how much capital in the organization is liquid (i.e. easily converted into spend). This is more of a chronological statement, as it takes the previous pay period and the current pay period, and identifies the difference in overall available cash.
The purpose of this document is quite interesting. An organizations available cash could be considered their flexibility in capturing external opportunities (e.g., investing in new opportunities, such as offering a new product or acquiring a competitor).
Combine these three documents, and stakeholders have a fairly clean view of what goes on in the organization. The balance of their assets, the overall profitability of their operations, and the availability of capital for expansion. This is the role of financial accountants.