Accounting helps you process and communicate the information related to the finance of your company to interested parties.
That’s why accounting is popularly known as the language of business.
Accounting has some fields or branches of specialization and among all the most famous accounting branches is financial accounting.
In this blog post, we will have a deep talk about financial accounting. Let’s begin!
This blog post is divided into the following sections
- What is financial accounting?
- What are the financial statements?
- How financial accounting works?
- Types of financial accounting
- Financial accounting vs Management accounting
- Characteristics of Financial accounting
- Who are the beneficiaries of financial accounting?
What is financial accounting?
Basically, financial accounting is one of the branches of accounting that handle the preparation and presentation of several reports popularly known as financial statements.
The financial statements prepared by a financial accountant contain a company’s financial position, cash flows, the result of operations and other information.
Also, note that the purpose of financial accounting is not to report the value of a company but to provide enough information for investors and stakeholders to assess a company’s value.
Hey! Have you heard the term forensic accounting? If not, then visit our detailed blog post explaining what forensic accounting is?
What are the financial statements?
In order to ensure the steady financial operations of a company, you have to assemble financial statements on a quarterly or annual basis.
There are four statements that specify a company’s financial performance:
1. Income statement
The income statement shows the net income by subtracting the company’s expenses from its revenue.
Again, the revenue is added once the services are rendered or the sale of a product is completed.
We can divide expenses into two main categories:
Cost of goods sold- expenses directly related to the production of products like raw materials, direct labour
Administrative expenses- all other expenses not included above, for example, rent, advertising expenses, salaries, software subscriptions, accountant’s fees, auditor’s fees.
Besides income and expenses, it also includes tax and one of income and expense items. For example, profit or loss from the sale of fixed assets, government grants etc.
The income statement presents the revenue and expenses of a company.
2. Balance sheet
The balance sheet displays the financial position of a company at a moment in time. It shows assets, liabilities and owner’s equity.
You can divide assets and liabilities presentation into current and non-current categories. Current means due within 12 months of the balance sheet date, and non-current means due after 12 months from the balance sheet date.
The balance sheet is always prepared as of a specific day, as opposed to a profit and loss account which is prepared for a period. For example, if ABC ltd has a financial year starting from 01 January 2021 and ending on 31 December 2021. Then income statement will be prepared from 01 January 2021 till 31 December 2021, whereas the balance sheet will be prepared as at 31 December 2021.
The balance sheet shows the financial position of a company.
3. Cash flow statement
The cash flow statement shows the summary of cash movement throughout the financial period. Cash activities are divided as:
- Cash flow from operating activities- as the name suggests, this shows cash generated from or used in the day to do operations of a business.
- Cash flow from investing activities- this shows cash generated from or used in the investing activities—for example, purchasing fixed assets and acquiring a new company.
- Cash flow from financial activities- This shows cash generated from or used in the financial activities. Example include dividends, the new issue of shares, shares buybacks
In summary, a cash flow statement displays the increase and decrease in cash.
4. Retained earnings statement
A retained earnings statement shows the summary of transactions between shareholders and the equity of a company. Typical examples are the dividends paid to shareholders and earnings that you held onto to put back into your company.
How financial accounting works?
Financial accounting uses various accounting principles, and the selection of those principles depends on the reporting and regulatory requirements a company faces.
For the small and medium-sized businesses in the UK, there are Generally Accepted Accounting Principles (GAAP) – “UK GAAP” rules apply – with a financial reporting framework updated in 2015.
The financial statements display the 5 main classifications of financial information: revenues, expenses, assets, liabilities and equity.
The income statement showcases revenues and expenses, which can include everything from R&D to payroll.
Financial accounting determines the net income at the bottom of the income statement.
The balance sheet reports assets, liabilities and equity, while the balance sheet report ownership of the company’s future economic benefits.
Also, there is another popular term in the accounting world: creative accounting – an accounting practice that is not illegal but somewhat out of the ordinary. Go check our blog post, Creative accounting – definition and meaning, to know more.
Types of financial accounting
Cash and accrual accounting are the two methods of financial accounting.
Both the financial accounting methods rely on the same framework of double-entry accounting to record, report and analyze the transactional information.
1. Cash accounting
Adopting the cash accounting method lets you focus only on the transactions related to cash. Use of the word cash here includes making a transaction through a bank account or any electronic means.
Economic events with no monetary input do not matter when using the cash accounting method because they don’t make it into the financial statements.
Bookkeeper always debits or credits the cash/bank account in each journal entry under this method.
For example, a bookkeeper debits the cash/bank account and credits the sales revenue account to record customer remittances.
2. Accrual accounting
Using the accrual accounting method, a company records all transactional data, regardless of cash inflows or outflows.
In another way, accrual accounting incorporates the cash accounting method but goes beyond it to take into account all the transactions of a company making up a corporation’s operating activities.
The concept of the accrual method can be perfectly illustrated by Accounts payable and Accounts receivable.
Accounts payable or vendor payables represent money a company owes the client at a given point in time.
The entity records the payables as alibility until it settles the underlying debts.
The same applies to customer receivables or accounts receivable that represents money clients owe a company.
The accrual method of accounting is widely used. Its advantages include streamlining the information and giving an accurate picture of business finances.
Financial accounting vs Management accounting
Here, let’s have a look at the difference between financial accounting and management accounting
|Financial accounting||Management accounting|
|Financial accounting analyses, summaries, and records the financial data of a business.||Management accounting helps management to make effective decisions for the company.|
|Financial accounting is used to presents an accurate depiction of financial affairs.||Management accounting is used by the management to draw strategies and take meaningful steps related to business growth.|
|Financial accounting has a universal scope but less broad as compared to management accounting||The scope is quite broad.|
|Not depend on management accounting.||To make effective decisions, management accounting use information on financial accounting.|
|Financial accounting uses Historical information in decision making.||Management accounting uses both predictive and historical information in decision making.|
|In financial accounting, a specific format is required for recording and presenting data.||In management accounting, there is no standard format for presenting data.|
|Financial accounting is used by all investors and stakeholders.||Management accounting is only used by management.|
|Financial accounting should be prepared on the basis of GAAP or other applicable accounting standards, like IFRS.||No mandatory rules required to be followed.|
|The information presented is verifiable.||The information presented is predictive and not verifiable immediately.|
|They are presented at the end of a financial year only.||They are presented very frequently.|
Also, don’t forget to visit our blog post related to management accounting and its functions.
What are the Functions of Financial Accounting?
Functions of financial accounting are as below
- Identifying, and processing financial transactions, including purchase, sales, payment and service delivery.
- Measuring the financial value of the business operations
- Recording results: Recording of all the documents that have been identified as in accounting records.
- Delivery of results: Summarizing results previously recorded in the form of financial statements with the analysis that decision-makers can use to make sound business decisions.
Characteristics of Financial Accounting
Financial accounting is characterized by several characteristics, and these are summarized in the following:
- Clarity – Clear and analytical data or information that beneficiaries can predict what the financial situation will be in the coming period.
- Timeliness – Any data, information and figures related to business must be up-to-date and ready to be presented to beneficiaries.
- Objectivity – A financial accountant must document all the information and data without any personal intervention for the benefit himself of any beneficiary.
- Comparability – Document all the financial transactions systematically so that the beneficiary can quickly compare between any two different periods in the history of the business’s work.
Who are the Beneficiaries of Financial Accounting?
- Management of the business
The management of the business is interested in the financial reports to see the success of the business and help in decision making.
- The owner of the business
Reports provided by financial accounting help the business owner see the state of business finances and its financial performance.
- The current investor
In order to predict the return that will come back to the investor by investing money in the business.
They can reassure the extent to which the business to repay its debts on time.
- Government Agencies
Such as the tax authority, in order to determine the tax dues accurately before the tax collection.
Also, don’t miss to visit our blog post related UK Corporation Tax system.
In short, the information provided by accounting is similar to a giant and complex portrait painted of a business organization. There are mostly thousands, if not hundreds, of aspects that can be, analyzed, examined and evaluated in assessing the financial health, and these pieces of information are best to use when planning the future of your business.