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What is Financial Accounting?
Financial accounting is best described as a system of recording, classifying and summarising financial transactions of an enterprise in monetary terms and analyzing and interpreting the results. It is a very wide term and covers various aspects. These include identification of financial transactions, recording them, classifying under relevant heads and finally summarising the transactional data. It also involves analysis and interpretation of the presented results so as to draw out relevant information to be used for decision making and policy decisions of the organisation. Examples of transactions included in financial records are:
- Sales of goods (both, cash and credit)
- Payment of taxes
- Payment of expenses such as salary of workforce, etc.
- Purchase of goods for resale, or raw materials for manufacturing (both, on cash and credit)
- Purchase and sale of assets
Financial accounting is very essential as it serves many decision making purposes.
The following points highlight these uses of financial accounting:
- It helps the management to keep a check on the performance and profitability of the business.
- It provides the required information to the external users.
- It serves as a basis for forecasting.
- It helps to analyse the current shortcomings in the organisation, thereby making plans and policies to overcome them in the future.
- It provides an effective tool for measuring the performance from time to time.
- It provides a basis for computation of firm.
The results obtained from financial accounting are of extensive use for various stakeholders of a business organisation. The financial information is generally for users external to the organisation (as against cost accounting information which is extensively used within the organisation) as it helps them to analyze the performance of the business. This is due to the historical nature of financial accounting data. In order to take decisions for improvement in performance of the business, the management relies more on the cost data or forecasts based on the financial data.
The various external users of information generated by financial accounting are:
- Investors (Shareholders): The investors use the financial data in order to assess the functioning of the organisation to ensure the safety of their investment.
- Customers: The customers are interested in financial information to be assured of efficient performance and thus, be assured of the quality of goods and services being provided by the organisation
- Government and taxation authorities: Government is interested in financial results to ensure compliance to the applicable laws. Taxation authorities use the results to determine the tax liability of the company.
- Lenders: They are interested in the profitability and operational efficiency of the organisation to ensure that they get timely interest payments and principle repayments.
- Suppliers: Before supplying goods on credit, the suppliers look into the financial liquidity of the firm to assess their capacity to make payments at the specified time.
- Employees: Employees are interested in financial results for salaries and other perks and bonuses. Sound financial performance also gives a sense of job security to the employees as they know that the business is doing well.
- Competitors: They are interested in the financial performance so that they can frame an appropriate strategy to face the competition in future.
- Investment analysts: They use the financial results to study the investment potential in the organisation on the basis of past and present performance.
However, financial accounting also suffers from some limitations.
- As accounting ignores the non monetary aspects of business (even though they may be very important such as quality of workforce, customer relationships, etc.), thus, financial accounting also excludes any such events. It only focuses on the monetary aspect of the financial business transactions.
- Financial accounting is based on past data and hence, has limited use in forecasting. They are not adjusted to inflation or changes in foreign exchange rate.
- It does not help in setting up a control mechanism for evaluating the performance of various departments or individuals.
- Preparation of financial records requires the accountant to make some assumptions. To that extent, financial statements are affected by personal bias.
- It does not provide details regarding the costs of the organisation. Therefore, cost control mechanism cannot be established on the basis of financial accounting information.
Basics of Financial Accounting
The double entry book system is followed in financial accounting across the world. Under this system, all transactions have 2 aspects- a credit and a debit of equal amounts. Financial accounting is based on the simple rule of debits and credits. This is well illustrated with an accounting equation.
Assets = Liabilities + Equity
Asset refers to a resource owned or controlled by the business which will provide benefit in future. Liability is what the firm owes. The capital invested by the owners constitutes the equity (often constituted as internal liability).
- Receipts from loan- $500
- Cash purchase of furniture- $50
- Capital introduced by owner- $100
|Assets||= Liabilities + Equity|
|Cash + Furniture||= Loan + Equity|
-50 + 50
|550 + 50||= 500 + 100|
Financial Accounting Concepts
The accounting concepts provide a basis for the preparation of financial records. The various principles are described below.
- Business entity: This principle states that the business and the owners are treated as separate entities. This is why the concept of drawings and internal liability (equity) arise.
- Going concern: This concept states that business will continue in the foreseeable future and there is no intention to shut down or scale down its operations significantly. As a result, the difference between revenue expenditure and capital expenditure can be made.
- Monetary unit: This provides that all financial transactions are to be recorded in a monetary unit such as dollars, pounds, etc.
- Historical cost: Under this concept, all resources are recorded in the books of accounts at the cost at which they were acquired and not at the current market price.
- Matching: All the expenses and revenues relating to a particular period should be matched in order to arrive at the actual (correct) profits.
- Accounting period: For the purpose of regular preparation of financial records and periodic reporting, the life of the business is divided into shorter periods (usually 12 months). This time period is known as the accounting period.
- Conservatism: This concept provides that the business should anticipate all possible losses but, the profits should be recorded only when they are actually realised.
- Consistency: The accounting practices once adopted should be used consistently year after year for the preparation of financial records. This allows for fair comparison of the statements of different accounting periods.
- Materiality: this provides that a transaction should be recorded only if it is material. A transaction is considered material if it is believed that the knowledge of it would influence the decision of an informed investor.
- Objectivity: The financial statements should be prepared objectively and not be influenced by personal bias.
- Accrual concept: This concept provides that transactions should be recorded in the books of accounts when they are entered into and not when the settlement is made.
Since the results of financial accounting are of such a great use to the stakeholders, legislations are made to ensure that the financial reports are subjective and a certain degree of uniformity is maintained while preparation of these statements.
The financial statements that are required to be prepared as per law are:
1) Income Statement (Statement of Profit or Loss): This statement lists all the revenues and expenses of the company and states the profit earned (or loss incurred) during the reporting period. This statement assesses the financial performance of an enterprise.
2) Balance Sheet (Statement of financial position): This statement is generally prepared on the last day of the reporting period and lists the various assets and liabilities of the firm as at that date. Since it is prepared at a particular date, it is a position statement and it shows the financial position as on the given date.
3) Statement of changes in owners’ equity: Since the owners’ equity is of prime importance for the users of financial statements, this statement reconciles the various components of owners’ equity in the beginning to those at the end of the period.
4) Statement of Cash Flows: This statement provides information about the various sources and uses of cash within the organisation. It provides the net cash generation (or usage) from various operating, investing and financing activities.
In Australia, the Australian equivalents of IFRS (International Financial Reporting Standards) are followed by the business entities. This adoption of IFRS ensures uniformity in accounting practices in Australia and the world.
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