Financial accounting involves analyzing business transactions and creating financial statements representing a company’s financial health. Discover what financial accounting is, the different types of statements it produces, principles to follow, and other key information below.
What is Financial Accounting?
Financial accounting involves analyzing business transactions and creating financial statements that represent a company’s financial health. Discover what financial accounting is, the different types of statements it produces, principles to follow, and other key information below.
How Financial Accounting Works
Financial accounting uses a series of established accounting principles. The selection available for use during financial accounting depends on the regulatory and reporting requirements businesses face. U.S. public companies have to perform financial accounting per generally accepted accounting principles (GAAP). These accounting principles are crucial to providing consistent information to investors, creditors, regulators, and tax authorities.
In financial accounting, the Financial statements used present five main classifications of financial data: revenues, expenses, assets, liabilities, and equity. Revenues and expenses are accounted for and reported on the income statement. Anything from R&D to payroll is included on it.
Financial accounting determines net income and is found at the bottom of the income statement. Assets, liabilities, and equity accounts are reported on the balance sheet. Balance sheets employ financial accounting to report ownership of a company’s future economic benefits.
What is the Difference between Accrual Method and Cash Method in Financial Accounting?
Accrual accounting consists of recording transactions when they have occurred, and the revenue is still recognizable. Cash accounting entails recording transactions only upon the exchange of cash. Revenue is only recorded upon the receipt of payment, and expenses are only documented upon the payment of the obligation. Financial accounting can be performed by either of these methods or a combination of the two.
What are the Objectives of Financial Accounting?
Financial accounting is essential since it is required by law. Balance sheets, income statements, and cash flow statements are legally necessary for registered companies. These statements are usually included in a company’s annual report. Also, financial statements are often referenced by people both inside and outside of a company. They include management, investors, auditors, lawyers, suppliers, and banks. Financial accounting aims to provide and track data about various companies’ transactions.
What are the Financial Accounting Advantages?
The advantages of financial accounting include systematically maintaining records, allowing accountants to prepare financial statements and gauge a company’s current position, and comparing profits of one year to years before obtaining facts about the change. Other benefits of financial accounting are that books of accounts can serve as legal evidence in case of disputes, tax liability situations are handled better, and there is more control over assets with information such as cash balance and stock debtors.
What are the Financial Accounting Limitations?
With anything, there are disadvantages or limitations along with the advantages. The limitations of financial accounting are that financial accounting only records transactions measured in monetary terms. There is no consideration of price level changes, and data may not be as realistic since it is prepared following basic concepts. Other things to note are that accounting statements are influenced by personal judgment of the account and “window dressing” for balance sheets. “Window dressing” refers to when balance sheets cannot demonstrate the true and fair view of the state of affairs in the business.
What are the Financial Statements in Financial Accounting?
Financial accounting uses the following four types of statements to share with stakeholders:
1. The Income Statement
The income statement calculates net income by subtracting revenue from expenses. Revenue is added once the sale of a product is completed, or the service is confirmed as finalized. Income statements offer valuable insight into a company’s operations, show how efficient the management is, and identify underperforming sectors and their performance related to industry peers.
2. The Balance Sheet
A balance sheet is drafted at the end of a period in which you are monitoring financial activity (the end of the year). This sheet should include the value of your assets, which is determined by the addition of liabilities and the number of equity stockholders have.
3. The Cash Flow Statement
The cash flow statement is the sum of capital based on how much is coming in and out of your business. It also accounts for operational, investment, and financial costs.
4. The Statement of Retained Earnings
A retained earnings statement shows the dividends paid to shareholders and your saved earnings to put back into your business.
What are the Principles of Financial Accounting?
The principles of financial accounting are called generally accepted accounting principles (GAAP). They are basic guidelines that financial accounting has to follow in drafting statements for stakeholders. All bookkeepers must understand the detailed rules issued by the Financial Accounting Standards Board and follow industry-standard practices.
There are nine primary principles financial accountants have to follow:
- Economic Entity Assumption
- Monetary Unit Assumption
- Cost Principle
- Full-Disclosure Principle
- Going Concern Principle
- Matching Principle
- Revenue Recognition Principle
- Materiality
- Conservatism
What are the Financial Accounting Examples?
Financial statements are held to strict rules to be useful and of high quality. This reason is why GAAP governs the principles and standards of financial accounting. It ensures external users will have quality information for making financial decisions.
All external users require different things concerning financial information. Suppose a lender is primarily concerned with a company’s cash flow and ability to repay loans with interest. On the other end, an investor is more concerned with company profit performance and longevity.
What Is the Difference Between Cost Accounting and Financial Accounting?
There are countless differences between cost accounting and financial accounting. The key difference is that cost accounting focuses inwardly on management decisions. In contrast, financial accounting focuses on issuing financial statements to outside parties.
Financial accounting involves preparing reports for an outside audience and checking that formats are highly specific in documents. It also ensures that financial results and the position of an entire business entity are reported. It incorporates the cost of materials into its financial reports (balance sheets). In contrast, cost accounting accounts for the cost of raw materials, work-in-process, and finished goods inventory. Reports are delivered in much greater detail within the company, and information can be formatted in any way specified by management. Moreover, a broad range of reports is prepared that management needs to run a business.
While financial and cost accounting are different, they share basic accounting terminology, produce reports, and analyze data to improve a company’s performance. Both of them are essential to keeping things running smoothly.
What Is the Difference Between Managerial Accounting and Financial Accounting?
The main difference between managerial and financial accounting is that financial accounting gears toward providing information to parties outside of an organization. Meanwhile, managerial accounting information aims to assist managers in making decisions.
The preparation of financial statements is most relevant to regulatory organizations and financial institutions. Since numerous accounting rules do not translate well into business operation management, different accounting rules and procedures are used by internal management for internal business analysis.
