What is Financial Accounting?

    • Financial accounting is the practice of accounting for all money that enters and exits an organization. It includes recording, classifying, summarizing, and analyzing all financial transactions.
    • All transactions are recorded either as a debit or a credit column. When money enters a business, it is referred to as credit. And when the money goes out, it's a debit.
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  • Classifying  - There are several categories used to determine the types of transactions:
  • Revenue - This is usually from the sale of goods or services.
  • Expenses - These are business expenses such as salaries, office rents, and services.
  • Assets - This is the value of what a company owns. Physical assets (also known as tangible assets) include property and equipment. Or non-physical (also known as intangible), such as a client database and software patents – think intellectual property.
  • Liabilities - This is the debt owed by a company. It is not only debt but also anticipated outgoings. Mortgages, payroll, and supplier payments are a few examples.
  • Equity - After subtracting liabilities and assets, this is what's left. The company's owner and shareholders own it.
  • Summarizing - The transactions are summarized into various reports.
  • Analyzing - The analysis of data and information to aid in business decision-making.

What is the objective of Financial Accounting?

Financial accounting aims to achieve various objectives in all types of businesses. Still, its primary goal is to contribute to providing accounting and financial information to its beneficiaries, whether inside or outside the company, such as business owners, creditors, banks, investors, etc.

Financial accounting is dependent on financial statements because they are the primary and most reliable source of information about a company's business activities and financial performance, and financial statements aim to achieve a number of objectives, including:

  • Preparing a company's financial statements for a specific time period.
  • Establishing financial affairs such as debts-liabilities, property and assets, and so on.
  • Providing data to support the company's ability to evaluate cash flows.
  • In the company, the measurement of private income is used regularly.
  • Monitoring and analyzing business performance as well as the company's financial health.
  • Hoarding money out of the wrong hands through fraud and forgery, as well as keeping business costs under control.
  • Providing details of the company's financial resources.
  • Providing all economic data to the parties involved for them to prepare financial statements, reports, and so on time.
  • Developing higher values in individuals and organizations and ensuring transparency and accountability.
  • Creating and evaluating management policies to assure the quality of the business.

What are Accounting and financial reporting?

The process of communicating financial information to stakeholders is referred to as financial reporting. Financial reporting is a financial accounting activity that involves the preparation of financial statements. As synonyms, financial reporting and financial accounting are used interchangeably. Financial reporting and financial accounting both have the same goal.

Financial reporting entails the preparation of financial statements to disclose financial information such as assets, liabilities, the owner's liquidity, revenue, and expenses, among other things.

What differentiates financial accounting from accounting?

Financial accounting is only concerned with producing statements that follow Generally Accepted Accounting Principles (GAAP). On the other hand, accounting is concerned with all aspects of a business's finances and transactions, including payroll, inventory, revenue, and debt.

There are two methods of financial accounting:-

A company can record its transactions in one of two ways. A company may employ one of the two methods listed below or a combination of both:

1. Cash accounting

Cash accounting only records cash transactions made by an organization's employees. For example, if an employee is on a business trip, they can use cash to pay for meals, lodging, and other incidental expenses. After each cash transaction, they maintain a receipt and report all transactions to their manager. Once approved, these are logged in. Cash transactions are not typically recorded on financial statements, but they can be logged to show that a transaction occurred.

2. Accrual accounting

Accrual accounting is how a bookkeeper records all data derived from transactions. Thus, it is an extension of cash accounting because it includes credit, debit, and other forms of payment for employee transactions, including cash. Accounts payable and receivable are also included in this category and can represent capital owed to or by a customer. This type of accounting provides a clearer picture of your company's cash flow and assists you in determining whether you have current assets or liabilities.

What are the advantages of financial accounting?

Financial accounting serves various kinds of functions in a business, and it is also an important factor for decision-making. Businesses would be unable to operate if they could not keep track of their finances through financial accounting. Here are some of the most important ways financial accounting can help a business:

External Communication

The first function of financial accounting is to communicate information to others. Financial accounting allows businesses to share information of their financial status to third parties, which is required when conducting business transactions.  Businesses require financial accounting to qualify for loans and coordinate with suppliers. Before doing business with a company, these external organizations want to know that it is in good standing. Companies can use financial accounting to show these organizations a record of their finances, which determines their capital and their ability to make payments.

Internal Communication

Businesses also use financial accounting for internal communication. Internal communication refers to the employees and finance team of a company. For various reasons, company members need to understand how well the business performs. For starters, knowing a company's financial status can make employees feel more secure in their jobs. Knowing that the company is doing well means that no layoffs or downsizing should occur.

This level of accessibility also makes employees feel more invested in the company's success. Knowing how well the company is doing can motivate employees to keep up the good work. A company's financial report can show which areas of its business are performing well and which are struggling. Employees who are aware of this information can significantly contribute to the company's improvement.

In some companies, meeting financial targets can result in bonuses, which is another reason why employees should be cognizant of the company's financial situation. Employees can participate in stock-based or profit-sharing compensation when financial accounting is used for internal communication.

Comparison of Financial Statement

Financial accounting assists businesses in evaluating their success in comparison to other businesses. The financial accounting process is standardized, which means that the financial statements produced by different companies can be compared. This enables businesses to compare their success to that of their competitors and identify areas for improvement. This type of comparison also enables businesses to identify investment opportunities based on the success of other businesses.

Using financial accounting to compare your company to others in the same industry can provide more insight than simply analyzing your individual report. Although your business may appear to be successful, a comparison to other businesses may reveal that there is plenty of room for growth and expansion in the market. This can assist you in developing new strategies and setting new business objectives.

Recording transactions

Financial accounting is also essential because it maintains a detailed record of a company's transactions. This component of financial accounting, also known as bookkeeping, assists businesses in keeping track of their expenses and remaining organized. These documents may be required during audits or when reevaluating the company's spending and budgeting. Financial accounting is a proactive solution to these concerns, preventing businesses from losing vital records.

Filing taxes and abiding by by-laws

Financial accounting is beneficial to a business and is also required for regulatory compliance and avoiding legal issues. This is especially true when it comes to a company's taxes. When filing taxes, it is always beneficial to have all of your financial information well-organized, but businesses should be aware of their tax compliance at all times. Some taxes must be paid earlier than others, and certain business expenses are tax-deductible. Financial accounting assists businesses in filing their taxes accurately and on time and avoiding unnecessary audits or other legal issues.

Creating budgets and forecasts

Another reason financial accounting is critical is that it enables businesses to create budgets. To create a budget, the company must first determine how much money they have. This critical information is provided by financial accounting, which also shows businesses where their money is going. This assists businesses in determining which areas require more funding.

Financial accounting also assists businesses in making future projections. It helps forecast the company's future financial performance by understanding its current and past financial performance. This information can help to avoid making the same mistakes made in the past, and it can also show more opportunities for your company which exists to capitalize on it.

What Is the Process of Accounting?

Financial statements provide a clear picture of your company's financial health. Different financial statements provide different insights, allowing a business owner to make educated decisions about future investments. For example, based on your debtors' payment performance, you can define or modify your credit policies, and so on. The balance sheet displays the current working capital ratio, allows an assessment of the liabilities, and takes appropriate action.

What are the limitations of Financial Accounting?

Financial accounting is important for management because it assists them in directing and controlling the firm's activities. It also assists business management in developing appropriate managerial policies in areas such as production, sales, administration, and finance.

Financial accounting has the following limitations, which have led to the emergence of cost and management accounting:

  • Financial accounting does not provide detailed cost information for various departments, processes, products, and jobs in the manufacturing divisions. Management may require information about various products, sales territories, and sales activities that are not available through financial accounting.
  • Financial accounting does not establish an effective system for controlling materials and supplies. Without a doubt, if material and supplies are not under control in a manufacturing company, they will result in losses due to misappropriation, misutilisation, scrap, defects, and so on.
  • Wage and labor records and accounting are not kept for various jobs, processes, products, or departments. This complicates the analysis of the costs associated with various activities.
  • It is difficult to understand the behavior of costs in financial accounting because expenses are not classified as direct or indirect and thus cannot be classified as controllable or uncontrollable. Cost management, the most important goal of all business enterprises, cannot be solely accomplished through financial accounting.
  • Financial accounting retains an adequate system of standards for evaluating the performance of departments and the employees who work in departments. Standards for materials, labor, and overheads must be developed so that a company can compare the work of employees, supervisors, and executives to what should have been done in the time allotted.

What are the types of accounting principles?

A few accounting principles are as follows:

  1. Going Concern Assumption: It is assumed that the business will continue to exist for a reasonable period of time. That assumption is significant because, if the company were to liquidate in the near future, it would have to restate its assets and liabilities to reflect the organization's true financial status, based on the actual amount realized or payable, as the case may be.
  1. Matching Principle: This definition requires that income be compared to its corresponding expenditure for a given period to determine the true benefit for that time period.
  1. Accrual Accounting Basis: This concept requires that revenue and expenditure be recorded at the time they are incurred, rather than when cash or cash equivalents are received/spent. Earning the income and incurring the expenditure is significant regardless of the subsequent cash flow.
  1. Accounting Period: This concept implies that a company's accounting process will be completed within a specific time frame, which is typically a fiscal year or a calendar year. As a result, any transaction relating to a specific accounting period must be included in the financial statements prepared for that period.

India's Accounting Principles

Financial statements in India are prepared in accordance with the accounting principles established by the Institute of Indian Chartered Accountants (ICAI) and the legislation outlined in the relevant applicable acts (For example, all companies must comply with Schedule III of the Companies Act of 2013.).

The ICAI also issues guidance notes on various topics regularly to aid in the accounting process and provide clarification. Although basic accounting principles are not explicitly stated in accounting standards and related rules, they are widely practiced and expected.

Financial Statements

The majority of businesses prepare quarterly and annual financial statements and make them available to investors and shareholders. In the business world, four basic financial statements are used to demonstrate a company's financial performance:

The income statement (also known as the profit and loss statement) covers a specific time period (such as a quarter or a year).

  1. Revenues – Expenses = Net Income on an income statement.

According to Generally Accepted Accounting Principles (GAAP), revenue is always recorded in the sale of goods and services, which may not be the same period when cash is actually received, according to Generally Accepted Accounting Principles (GAAP). Revenues, expenses, gains, and losses are the main components of the income statement. Sales, service revenues, and interest revenue are all examples of revenue. The cost of goods sold, operating expenses (such as salaries, rent, utilities, and advertising), and nonoperating expenses are all examples of expenses (such as interest expense). 

  1. Balance Sheet:- At a given date, the balance sheet is divided into three sections: (1) assets, (2) liabilities, and (3) stockholders' equity (typically, this date is the last day of an accounting period). The first section of the balance sheet details the company's assets, including cash, accounts receivable, inventory, prepaid insurance, buildings, and equipment. The section that follows describes the company's liabilities; these are obligations that are due on the balance sheet date and often have the word "payable" in their title (Notes Payable, Accounts Payable, Wages Payable, and Interest Payable). The final section discusses stockholders' equity, which is defined as the difference between assets and liabilities.
  1. Cash Flow Statement:- The statement of cash flows describes the change in a company's cash (and cash equivalents) over the time period specified in the statement's heading. It is classified into three groups: (1) operating activities, (2) investing activities, and (3) financing activities.

The section on operating activities describes how a company's cash (and cash equivalents) have changed due to operations. Amounts spent or received in transactions involving long-term assets are referred to as investing activities. The financing activities section includes information such as cash received from the issuance of long-term debt, stock issuance, and money spent to retire long-term liabilities.

  1. The statement of retained earnings covers a specific time period and shows the dividends paid to shareholders from earnings and the earnings retained by the company.
  1. Income Statement:- The income statement summarizes a company's profitability over a specific time period. The time span could be one year, one month, three months, 13 weeks, or any other time interval determined by the company.

Notes to financial statements provide additional information about a company's financial condition. The three types of notes describe accounting rules used to generate the statements, provide additional detail about an item on the financial statements, and provide additional information about an item not on the statements.

The main reason for preparing financial statements for a business is to understand its financial position. A careful and periodic check on cash inflow and outflow is critical for any business to have consistent growth. Thus, with financial accounting, a business owner can keep track of how much revenue is there versus how many expenses are there to maintain positive working capital.

Several stakeholders involved in critical decision-making can benefit from financial statements. Financial statements are used by everyone from business owners, managers, and employees to external users such as suppliers, banks, customers, investors, potential investors, and tax authorities to make major business decisions.

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