Financial Accounting is a system for recording information about business transactions to provide summary statements of a company’s financial position and performance to external stakeholders.
For U.S. companies, the financial reports are prepared in accordance to Generally Accepted Accounting Principles (GAAP). Although it is slightly different from our local standards, it is still relevant to learn about if you intend to dabble with the U.S. stock markets. The Securities and Exchange Commission (SEC) requires the filing of 10-K annual reports, 10-Q quarterly reports, as well as 8-K current reports for major events that share holders ought to know.
The management of the company is responsible for preparing the financial statements, which allows for creative manipulation to make the company appear in a better state than the actual performance. Therefore, the Audit Committee of the Board of Directors is supposed to oversee this process, and external auditors will also be engaged to verify that the preparation of the statements is in accordance with accounting standards.
The accounting cycle describes all the accounting activities performed by a company throughout one accounting period.
- Start of the period and during the period – Any transactions made by the company is being analysed by the accountant to decide how it should be journalised and posted in the accounting books.
- End of period – An unadjusted trial balance will be performed to ensure that the records did not have any math errors or mistakes.
- Adjusting entries – entries in the books are adjusted to account for changes that did not relate to any transactions in the current period, such as depreciation. Another adjusted trial balance will be performed to eliminate errors.
- Generate financial statements – after adjusting entries, the financial report will be prepared.
- Closing entries – finally the accounts will be closed and a new period can begin.
Financial Report Overview
A financial report is required to contain these 4 statements:
- Balance Sheet – this is the financial position on a specific date, listing all the resources and obligations of the company.
- Income Statement – the results of company operations over a period of time using accrual accounting, to recognise the true business activity as far as possible. (accrual means accounting for activities when they occur, with or without cash transactions).
- Cash Flow Statement – Sources and uses of cash over a period of time.
- Statement of Stockholders’ Equity – Changes in stockholders’ equity over a period of time.
The following is a short introduction of balance sheet to kick start the learning of financial reports.
To understand the balance sheet, we must first learn the balance sheet equation.
- Assets = Liabilities + Stockholders’ Equity
Another way to look at this is what ever resources that the company holds, the resources either belongs to creditors that the company is liable to, or to the owners of the company. Essentially this is what a company is: a bundle of resources that aims to generate more value. One other note, the equation must always balance.
As balance sheet reflects the financial position of a specific date, changes between two balance sheets over a period of time are summarised in the respective Income Statement, Cash Flow Statement, and Statement of Stockholders’ Equity. Here is a great diagram to visualise this concept:
And here is a breakdown of the balance sheet equation into slightly finer details for better understanding.
An asset is a resource that is expected to provide future economic benefits (i.e. generate future cash inflows or reduce future cash outflows). An asset is recognised when:
- It is acquired in a past transaction or exchange.
- The value of its future benefits can be measured with a reasonable degree of precision.
A liability is a claim on assets by creditors that represents an obligation to make future payment of cash, goods, or services. A liability is realised when:
- The obligation is based on benefits or services received currently or in the past.
- The amount and timing of payment is reasonably certain.
Stockholders’ Equity is the residual claim on assets after settling claims of creditors. It is also called net worth, net assets or net book value. There are 2 sources of Stockholders’ Equity:
- Contributed Capital – which includes the value of common stock (par value), additional paid-in-capital (excess over par value), and treasury stock (stock repurchased by the company).
- Retained Earnings – which is the accumulation of net income, less dividend, since the start of business.Note, dividends are distributions of retained earnings to shareholders and are not considered expenses, but liabilities instead.
(Reference: Coursera Wharton Online Introduction to Financial Accounting)