Financial accounting is the process of preparing, presenting, and communicating financial information that relates to the operations of a business entity for a certain time period. It is similar to the history of the business but recorded in terms of dollars and cents. The main purpose is to provide the users with financial statements and other financial reports such as balance sheets, income statements, cash flow statements, statement of changes in equity to the outsiders like investors, creditors and government regulatory bodies etc. In other words, financial accounting may be described as the process of putting into precise and understandable terms the financial information about the business.
Content Outline
How Financial Accounting Works
Financial accounting follows a structured process:
- Recording: Every financial transaction is recorded.
- Classifying: Transactions are grouped into categories that facilitate their identification and management.
- Summarizing: Financial data is compiled into financial statements.
- Reporting: Financial statements are shared with stakeholders.
This process ensures that all financial activities are accounted for and reported in the right manner.
Financial Statements
Financial statements are the culmination of financial accounting and include:
Balance Sheet
A balance sheet is a statement that provides the financial position of a business at a given date and time. It addresses the question of “What do own and owe right now?”
Income Statement (Profit & Loss Statement)
An income statement reveals the income, expenditures and earnings made over a specific period. It reveals how effectively the business operated.
Cash Flow Statement
A cash flow statement tracks the flow of cash in and out of the business. It shows how the cash is acquired and then utilized.
Statement Of Changes In Equity
Statement of changes in equity reveals how the owners’ equity was affected for a given period. They present the flow of retained earnings, dividends and other similar equity items.
Accrual Method Vs. Cash Method
Accrual Method
Using the accrual method, revenue and expenses are recorded when they are earned or incurred, even if the cash is exchanged at a different time. It is preferable because it furnishes a clearer view of the financial condition of a business, but can be complex. It is like looking at it and saying, ‘Okay, I did good here,’ even when the benefit is received later.
Cash Method
The cash method offers any revenue and expense recognition only when actual cash is received or paid out during the period. It is easier to use and understand but can paint an inaccurate picture of how well a company is performing. It is similar to only celebrating a payment that you have received in hand and not when it’s promised.
Principles Of Financial Accounting
Financial accounting follows a set of guiding principles known as Generally Accepted Accounting Principles (GAAP). Some key principles include:
- Consistency: Stick to the same accounting methods over time.
- Relevance: Provide information that is useful for decision-making.
- Reliability: Ensure information is accurate and verifiable.
- Comparability: Allow comparisons between different periods and companies.
- Full Disclosure: Reveal all relevant information in financial statements.
Importance of Financial Accounting
Financial accounting is crucial for several reasons:
- Informed Decision-Making: It ensures that the stakeholders in the organization have all the information they require to make decisions.
- Transparency: Enhances trust and credibility with investors and creditors.
- Regulatory Compliance: Ensures compliance with laws and regulations.
- Performance Evaluation: Helps assess the company’s financial performance and health.
Key Takeaways for Financial Accounting
Financial accounting provides a historical view of financial performance, focusing on past transactions and results.
It offers valuable insights but does not predict future performance.
For forward-looking analysis, rely on management accounting and financial forecasting.
Financial accounting ensures transparency and consistency, building trust with stakeholders.
Understanding financial accounting principles helps in making informed, strategic decisions.
Example
Imagine you run a lemonade stand. Here’s a quick look at how financial accounting works for your stand:
- Recording: You note down every sale of lemonade and every purchase of lemons and sugar.
- Classifying: You organize these transactions into sales and expenses.
- Summarizing: You create a balance sheet showing your lemonade stand’s assets (lemons, sugar, cash) and liabilities (money owed for a new lemonade stand sign).
- Reporting: You prepare an income statement showing your profit from lemonade sales.
Summary
Financial accounting is the structured process of recording, classifying, summarizing and reporting of a company’s financial transactions. It relies on financial statements to communicate financial health and follows principles to ensure consistency and accuracy. Understanding financial accounting is essential for making informed decisions, maintaining transparency, and evaluating performance.