What is Financial Accounting?

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Financial accounting is the process of recording, analyzing, and reporting on a company's business transactions in order to produce financial statements that are used by internal and external shareholders to evaluate the financial stability of a company or a business. As a result, financial accounting reports are critical in defining a company's goals, how it will function, and the number of employees and other resources that can and should be distributed to various departments.

The bookkeeping of financial transactions such as purchases, sales, receivables, and payables are included in financial accounting. Accountants create income statements, cash flow statements, balance sheets, and shareholder equity statements in accordance with Generally Accepted Accounting Principles (GAAP).

Fundamentals of Financial Accounting

Simply put, financial accounting is the process of recording and interpreting transactions. It is used to assess a company's performance and profitability. To standardize the procedure, regulatory authorities have established several basic rules. Companies in the United States adhere to FASB’s (Financial Accounting Standards Board) GAAP principles.

Going concern principle, full disclosure concept, accrual concept, matching, cost, consistency, economic entity, materiality, period, revenue recognition, and monetary unit are all covered by GAAP. GAAP guarantees that reports are accurate and dependable. However, GAAP does not always remain the same. Instead, it is regularly updated to reflect the complications that arise in the accounting world.

Assets, liabilities, income, costs, and equity are the five essential components of all financial transactions. In addition, every financial transaction has two sides. For example, under the double-entry approach, if cash is removed from a bank in the company's books, both the cash and the bank are affected. These two parts are referred to as debit and credit in the double-entry system. The growth in assets and costs, or the decrease in liabilities and revenue, is referred to as a debit. The growth in liabilities and earnings, or the reduction in assets and costs, is referred to as credit.

Types of Financial Accounting

A business can keep track of its transactions in two ways. A business can employ one of the two ways below, or a mix of the two:

  • Cash Accounting

Cash accounting documents only cash transactions performed by an organization's employees. For example, if an employee is on a work trip, they can spend cash on meals, housing, and other costs. They keep a receipt after making cash transaction and then all those transactions are reported to their management. Once verified and accepted, they'll be logged in. Cash transactions aren't normally recorded on financial statements, although they might be logged to prove that they happened.

  • Accrual Accounting

When a bookkeeper records all data from transactions, it is known as accrual accounting. As a result, it's an extension of cash accounting because it includes credit, debit, and other kinds of payment including cash.  This category also includes accounts payable and receivable, which might represent capital owing to or received by a client. This method of accounting allows you to see your company's cash flow more clearly and identify whether you have current assets or liabilities.

Financial Vs Managerial Accounting

The main difference between financial and managerial accounting is that financial accounting is concerned with communicating information to individuals outside the business, whereas managerial accounting information is concerned with assisting managers in making choices within the firm.

Accounting standards are most important to regulatory bodies and financial institutions while preparing financial accounts. Because many accounting standards do not transition well into corporate operation management, internal management use a variety of accounting principles and procedures for internal business analysis.

A company's performance, financial status, and cash flows are depicted in financial statements. The investors, lenders, creditors, and management all make us of these papers to assess a business. The four most common forms of financial statements are listed below.

Balance Sheet

As of the report date, the balance sheet reveals an entity's assets, liabilities, and shareholders' equity. The amount of all assets in this report must equal the sum of all liabilities and equity. The balance sheet's asset information is split into current and long-term assets. In the same way, liability data is divided into current and long-term liabilities. This segmentation is helpful in determining a company's liquidity. The sum of all current liabilities should exceed the total of all current liabilities, indicating that a company has enough assets to meet its current commitments. The balance sheet may also be used to compare the amount of debt owed to the amount of equity invested in the company to determine whether its leverage is suitable.

Income Statement

The income statement summarizes an organization's financial performance over a certain time period. To get at a net profit or loss, it starts with revenues and then subtracts all costs spent throughout the time. If the financial statements are being produced by a publicly-held corporation, earnings per share statistic may also be included. Many businesses generate an internal version of the income statement that compares actual results to the budget and highlights any differences. This is generally viewed as the most important financial statement since it describes performance.

Cash Flow Statement

A cash flow statement depicts the variations in an entity's cash flows over the course of a reporting period. These cash flows are broken down into three categories: operational cash flows, investment cash flows, and financing cash flows. The majority of all cash flows are shown in the operational activities section, which shows the cash inflows and outflows associated with the business's fundamental operations, such as variations in receivables, inventories, and payables balances. The cash flows from the acquisition or sale of investment instruments, assets, or other entities are recorded in the investing activities section. Cash flows connected to debt or purchase, dividend issuances, stock sales, and other financing operations are included in the financial activities section.

The Statement of Changes in Equity

All changes in equity throughout the reporting period are documented in the statement of changes in equity. The issuing or acquisition of shares, dividends paid, and profits or losses are all examples of these developments. Because the information in this document is not wildly valuable to the management team, it is not frequently included when financial statements are released internally.

Supplementary Notes

Supplementary notes are included with financial statements sent to other parties. These comments are required by the appropriate accounting system, such as GAAP or IFRS, and they offer explanations of certain actions, further detail on some accounts, and other topics. The amount and kind of information given will vary depending on the nature of the issuing entity's operation and the sorts of transactions it conducts.

Financial Statement Disclosures

The financial statements described above may have a variety of footnote disclosures when they are distributed to users. These explanatory comments, which may be rather lengthy, clarify some summary-level information contained in the financial statements. The appropriate accounting standard determines what they should contain.

Financial Accounting Limitations

Financial data isn't always accurate. Non-financial factors such as staff satisfaction and client retention are not recorded. Those elements have a significant influence on performance as well. The majority of historical data isn't useful for future planning. Accounting may not reveal the true state of the firm even after all of the steps have been taken. This occurs when a company uses the accrual basis of accounting or the cost concept when real asset costs fluctuate.