Every company, whether a huge operation or a “mom and pop” outfit, requires tracking of its financial transactions. That’s where a financial accountant comes in. This type of accounting is done for the public, as in customers, investors, suppliers, government agencies, lenders or creditors. It uses Generally Accepted Accounting Principles (GAAP) as the standard. Financial accounting differs from managerial accounting, in which the accountant prepares reports solely for company management. Financial accounting is also known as financial reporting.
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Financial Accounting Objectives
Financial accounting is far more than systemically recording all of a business’ transactions. It provides information for the company’s owners or managers as to the firm’s current financial status, whether healthy or unhealthy, and is crucial for decision-making going forward. The financial statement provides this information to all interested parties, public or private. The information lets owners and stakeholders know the company’s liquidity, or ability to meet short-term obligations, as well as its solvency over the long-term.
Profit and Loss Statements
Profit and loss statements, also known as income statements, cover specific time periods, generally monthly, quarterly or annually. Such statements offer a description of what is happening financially at a company during the period in question and are regulatory requirements by the Internal Revenue Service. A profit and loss statement’s basic formula is, “Sales, minus expenditures, equals profits.”
The elements of a profit and loss statement include:
Operating revenue concerns business activities, including sales, credits or refunds. The business’ investment income is listed here.
Operating expenses are those needed for conducting business, including salaries and benefits, administration, rent, utilities, advertising, research and development and anything else involved in running the business. For capital investments, there is depreciation and amortization, also considered expenses. Instead of writing off the whole investment purchase in the year the company bought it, some such investments, such as equipment or technology, are depreciated over their useful life. That useful life is determined by the IRS. For example, commercial buildings are generally depreciated over 39 years. Amortization is depreciation of the company’s intangible assets, such as patents, trademarks and intellectual property, and is also based on the useful life of the intangible asset.
When a company’s expenses exceed its revenues, it will experience a net loss for the period. While companies may undergo a net loss for a month or quarter, ongoing losses require investigation into why the losses occurred and mitigation options.
These are funds either coming from a non-primary source, or money from one-time events.
The upper part of the income statement is the trading account, which shows the gross profit, or the entire business income for the period. The financial accountant then subtracts overhead expenses to obtain the net profit, known colloquially as the bottom line. That’s where the information is located on the income statement.
Double Entry and the Accrual Basis
Financial accounting uses the double entry method of bookkeeping and the accrual basis of accounting. The former means each transaction is entered in one account as a credit and another as a debit. For example, if the company borrows $100,000 from a lender, a credit is entered to a cash account and a debit is entered to debit account, with the credit and debit equaling the same amount. Under the accrual basis, revenues are not reported when they are received, but when they are earned. Expenses are not reported when they are paid, but when they are incurred. As an example, real estate taxes are not reported when paid quarterly, but divided by 12 to reflect a monthly real estate tax bill.