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what-is-financial-accounting

Financial Accounting: Definition, Types, Functions & Examples

what-is-financial-accounting

Financial accounting is a type of accounting undertaken by businesses to report a company’s transactions via financial statements. Businesses have multiple transactions daily that need to be recorded and analyzed for important financial decisions, that is exactly when financial statements prepared for financial accounting play a vital role.

Financial Accounting Definition

The process of recording, classifying, reporting, and analyzing business transactions is called financial accounting. This is a necessary process required to analyze the overall financial health of the organization. All the transactions related to sales, purchases, accounts payable, and accounts receivable are recorded to be analyzed correctly.

These transactions are maintained by accounting teams under different financial statements like balance sheets, cash flow statements, income statements, and shareholder’s equity statements. 

The main aim of financial accounting is to display a company’s profits and losses so that the stakeholders can make the right decisions.

Financial Accounting Guidelines 

Organizations need to undertake financial accounting following the Indian Accounting Standard (Ind AS) for credibility and uniformity across accounting processes. These guidelines are at par with the International Financial Reporting Standards (IFRS). 

Who uses Financial Accounting?

Organizations are supposed to make their financial accounting data public via quarter and annual financial statements. This provides internal and external stakeholders with vital financial data.

Financial accounting is majorly done for external stakeholders like investors and creditors to understand the financial health of the organization and take decisions accordingly.

Financial accounting is used by the following stakeholders:

  • Financial accounting data is used by suppliers and trade creditors to know the short-term liquidity of an organization
  • Investors use data to estimate the possible investment risk and predict future dividends
  • Lenders use data to predict the company’s ability to pay back loans
  • Customers use financial statements to know the long-run prospects of a business
  • Employees use data to know the company’s profitability and stability
  • Company management evaluates progress and identifies areas for improvement
  • Government agencies use data to levy appropriate taxes
  • Investment analysts use financial statement data to know the company’s competitive position

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Importance of Financial Accounting for Businesses

  • Financial accounting is important to track financial transactions and prepare financial statements.
  • As financial accounting is done following the Indian Accounting Standard guidelines, it is easier for companies to create financial statements that are universally accepted.
  • Financial statements are public documents that help improve a company’s credibility in the market.
  • Businesses can invest and allocate their resources better following the analysis of their financial performance.
  • Financial accounting defines rules that organizations must follow while making their financial performance public.

Types of Financial Accounting

Financial accounting is broadly divided into two types – Cash Accounting and Accrual Accounting.

The major difference between them is the timing of transaction recording.

Cash Accounting

This method of accounting records transactions when they occur in cash. A company records income after receiving cash from sales. It requires transaction recording only when money moves in and out of the bank account. 

Businesses with large inventories don’t use cash accounting as it doesn’t consider liabilities incurred but not paid yet. 

Accrual Accounting

This method of accounting records transactions whether they are earned or incurred. Businesses use accrual-based accounting to create journal entries for sales and expenses even before collecting or making payments. 

Accrual-based accounting is standard among businesses handling large volumes of credit transactions. 

Objectives of Financial Accounting

The main aim of financial accounting is to provide accurate financial information to internal and external stakeholders. This analysis allows businesses to protect the interests of their stakeholders, fulfill legal requirements, and optimize resource allocation.

These are the objectives of financial accounting:

  • Recordkeeping
  • Compliance with statutory requirements
  • Know profitability
  • Facilitates management decision-making

Recordkeeping

Financial accounting facilitates a systematic process for recording financial transactions in the accounting books. Organizations use these books to analyze their financial performance. 

Compliance with statutory requirements

Organizations comply with tax regulations and other statutory requirements following the process of financial accounting.

Know profitability

Businesses can know their net income from assets, liabilities, and equity with financial accounting. 

Facilitates management decision-making

The accounting process allows stockholders, creditors, and investors to know the company’s financial position. It also helps the management while making analytical decisions for the company’s growth.

Features of Financial Accounting

Financial accounting keeps a record of only monetary transactions from a business point of view.

Financial accounting tracks transactions that have already taken place in the past.

Organizations are required to keep their financial accounts updated with timely auditing of financial statements to ensure accuracy. 

Financial accounting informs customers, investors, suppliers, and financial institutions about the financial performance of an organization. 

Organizations consider financial accounting statements covering less than a year as interim reports. These reports are used to convey the financial performance before a full-year reporting cycle ends.

Financial accounting is the foundation for other accounting branches such as management accounting, cost accounting, and other advanced accounting methods. This is so as it deals with raw data from journals and ledgers. 

What are the main functions of Financial Accounting?

  • Financial accounting helps create financial statements that allow investors, tax authorities, and lenders to understand the organization’s financial position.
  • Financial accounting maintains a systematic record of financial transactions while following accounting standards and regulatory guidelines. 
  • Accounting teams analyze and summarize financial records in the trial balance. The final statement showcases the profits or losses of an organization during a financial year.
  • Financial accounts enable organizations to share their annual financial performance with internal and external stakeholders. 
  • Financial accounting encourages organizations to fulfill their legal obligations, such as book auditing and tax liabilities.

What are the 4 main financial statements?

The four main financial statements are

  1. Balance sheet
  2. Income statement
  3. Cash flow statement
  4. Statement of retained earnings (also known as the statement of owner’s equity)

Balance Sheet

A statement of net worth that showcases an organization’s assets, liabilities, and shareholders’ equities at a particular time. Also known as a statement of financial position, a balance sheet has an accounting equation that balances out the assets by adding liabilities and shareholder’s equity.

Assets = liabilities + shareholders’ equity

A balance sheet is used by accountants to calculate key financial ratios. It also helps investors know the capital structure of an organization and calculate rates of return. 

Income Statement

A profit and loss or income statement showcases an organization’s gains, revenues, expenses, and losses in a particular period. Also known as a revenue and expense statement, it allows organizations to assess depreciation, figure out less-performing areas, and compare performance against their competitors.

Cash flow Statement

A cash flow statement showcases incoming and outgoing cash and cash equivalents (CCE) to allow businesses to evaluate their operational abilities. Organizations use this financial statement to gauge their ability to generate cash for operating expenses. 

A cash flow statement includes the following activities:

  • Operating activities that showcase the incoming cash flow from selling goods and services
  • Investing activities that help in cash generation from physical and non-physical property buying and selling
  • Financing activities that include cash flow from debt and equity financing

Statement of Retained Earnings

The owner’s equity statement has the sum of earnings that an organization reserves for investing in business operations. Organizations use these earnings to pay debt, buy fixed assets, or as working capital. 

Best Practices for Financial Accounting

Businesses must follow these best practices for efficient financial accounting: 

  • Establish internal accounting policies to minimize risks and fraud
  • Manage accounts payable, receivable, and reconciliation processes efficiently
  • Keep business finances separate from personal to prevent cash flow issues and tax filing complications
  • Establish the appropriate accounting principle, depending on organizational needs
  • Use accounting software to track and record transactions and cash flows
  • Create correct financial statements to be shared with stakeholders

How does Financial Accounting software help?

Financial accounting software solutions capture incoming and outgoing financial transactions automatically. This helps organizations access all financial records from a centralized platform.

These accounting softwares monitor capital expenditure and identify unknown expenses to help organizations optimize cash flow.

Financial accounting allows organizations to perform accurate recordkeeping, which forms the basis for creating financial statements that meet accounting standards and legal guidelines. 

Frequently Asked Questions

What is financial accounting?

The detailed process of recording, analyzing, and summarizing the financial transactions of an organization for an accounting period is financial accounting. It allows businesses to evaluate their financial health and stability.

What are the three major types of accounting?

Three types of accounting are:

1. Financial Accounting
2. Cost Accounting
3. Managerial Accounting 

What is the main aim of financial accounting?

The main aim of financial accounting is to create and share financial statements with external stakeholders so that they can evaluate the overall financial performance of the company.

What is an example of financial accounting?

A financial statement made public is the best example of financial accounting. Prepared using universally accepted accounting guidelines, it keeps a record of both incoming and outgoing financial transactions. 

What is the difference between cost accounting and financial accounting?

Cost accounting is undertaken for internal management to make informed decisions related to product pricing and budget strategy. 

Financial accounting is primarily concerned with external stakeholders and is made public for them to make decisions accordingly.

Financial Accounting: Definition, Types, Functions & Examples

what-is-financial-accounting

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