1.4 Financial Accounting
The second flavor of accounting is financial accounting. Financial accounting involves reporting the summary results of a business or an organization to people outside that organization
Let's say that you have a friend, Lily. Lily has a dream: She wants to start and operate her own ice cream business. Lily has figured out what she's going to need to make this happen and she wants to build her ice cream factory right where you're sitting right now. Look around where you are right now; that's going to become Lily's ice cream factory. She's going to buy the land, she's going to buy the building, and she's going to fill it full of big, gleaming stainless steel ice cream making machines. Then Lily is going to buy some cream, some sugar, some strawberries -- all natural of course -- and she's going to start making some ice cream. Lily has figured out that in order to turn her dream into reality she needs a hundred million dollars. That minor little barrier is all that stands between Lily and her dream of her own ice cream business. The question is, where can Lily get a hundred million dollars?
Where could YOU get a hundred million dollars if you wanted to start your own business? I don't know about you, but if I'm going to get a hundred million dollars to start a business it's going to have to come from strangers, because I don't have a hundred million dollars myself. Even if I go to all my friends, all my family, all my cousins, all my aunts and uncles and as many people as I can think of, I will still be short of a hundred million.
How could Lily convince strangers to give her a hundred million dollars for her ice cream company? She can't, without reliable financial statements. She must provide those strangers with a financial report that summarizes the profitability of the ice cream business and that lists the resources and obligations of the business. Without reliably communicating the financial situation of her business, Lily cannot convince strangers to give her the hundred million dollars.
In our modern economy financial accounting is fundamental because many businesses raise money by getting it from strangers. If you're going to start an ice cream factory in Germany it's very likely that you're going to borrow money or get investment funds from France and from South Africa and from Russia and from Hong Kong. You're going to get money from people you've never seen before, and people whom you may never see, so they don't have any personal basis on which to decide to invest in your company or loan money to your company.
How do you communicate with them, how do you make it so that they're comfortable with you and your business plan? With reliable financial statements. Accounting is right there at the crucial point in business. Accounting allows people to raise money from strangers so that they can turn their dreams into reality. It's accounting that makes that happen.
What are these fabulous financial statements? They are called the balance sheet and the income statement. A balance sheet is a very fundamental report. It is a list of an organization's resources, accountants call those assets, and an organization's obligations, accountants call those liabilities. Examples of assets are cash, land, trucks, and equipment. Examples of liabilities are bank loans, taxes you owe to the government, and wages you owe to your employees. A balance sheet is a fundamental report for any business; it reports what you have and what you owe.
The next fundamental financial report is called the income statement which reports how much money the company is making. If I'm thinking of loaning money to your company or investing in your company I need a report of how much money you're making.
The balance sheet and the income statement are summary reports that are provided by businesses to people outside the company so those people outside can decide: "Should we loan that company money?” "Should we invest in that company?"