Financial accounting and financial statements

Financial accounting is the process of preparing financial statements that companies use to show their financial performance and position to people outside the company, including investors, creditors, suppliers, and customers.

This is one of the most important distinctions from management accounting, which by contrast, involves preparing detailed reports and forecasts for managers inside the company.

Most companies put together quarterly and annual financial statements, which they make available to shareholders and the investing public. There are four basic financial statements used in the corporate world to show a company’s financial performance.

Statement of Financial Position, also known as the Balance Sheet, presents the financial position of an entity at a given date. It is comprised of the following three elements:

• Assets: Something a business owns or controls (e.g. cash, inventory, plant and machinery, etc)
• Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc)
• Equity: What the business owes to its owners. This represents the amount of capital that remains in the business after its assets are used to pay off its outstanding liabilities. Equity, therefore, represents the difference between the assets and liabilities.

Income Statement, also known as the Profit and Loss Statement, reports the company's financial performance in terms of net profit or loss over a specified period. Income Statement is composed of the following two elements:

• Income: What the business has earned over a period (e.g. sales revenue, dividend income, etc)
• Expense: The cost incurred by the business over a period (e.g. salaries and wages, depreciation, rental charges, etc)

Net profit or loss is arrived by deducting expenses from income.

Cash Flow Statement presents the movement in cash and bank balances over a period. The movement in cash flows is classified into the following segments:

• Operating Activities: Represents the cash flow from primary activities of a business.
• Investing Activities: Represents cash flow from the purchase and sale of assets other than inventories. (e.g. purchase of a factory plant)
• Financing Activities: Represents cash flow generated or spent on raising and repaying share capital and debt together with the payments of interest and dividends.

Statement of Changes in Equity, also known as the Statement of Retained Earnings, details the movement in owners' equity over a period. The movement in owners' equity is derived from the following components:

• Net Profit or loss during the period as reported in the income statement.
• Share capital issued or repaid during the period.
• Dividend payments.
• Gains or losses recognized directly in equity. (e.g. revaluation surpluses)
• Effects of a change in accounting policy or correction of an accounting error.

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