Financial accounting refers to collecting, summarizing and presentation of the financial information resulting from business transactions. It reports the operating profit and the value of the business to the stakeholders. In other words, financial accounting is used for reporting financial transactions to the stakeholders in a format that is acceptable and adaptable by all businesses.
Accounting Concepts that form the basis of financial accounting are:
Financial accounting can be done on an accrual basis or cash basis. Accrual basis is highly accepted. An organization may also use a combination of both. Cash basis of accounting requires transactions to be recorded only when the transaction results in a flow of cash. However, under accrual basis, a transaction is recorded when the transaction occurs and revenue is recognized.
Once an organization selects the method, cash or accrual, it should consistently use the same.
This concept assumes that the owners are separate from the business and there are no personal transactions recorded in business.
Under this concept, it is assumed that the organization will remain in business for a long time and hence the revenue can be deferred to a different period.
This concept stresses that the expenses relating to a particular income must be recorded in the same period. This ensures that a transaction is fully accounted for.
Reporting of all material transactions should be the aim of reporting. Material transactions are those transactions if omitted can alter an investors analysis of the business.
A revenue must be recorded only when it is reasonably certain that it will be realized in the near future.
The heart of financial accounting is the Double entry system of bookkeeping. Double entry system refers to recording two aspects of the same transaction. The recording of the aspects will be as per the Golden Rules for Accounting.
How are financial statements prepared?
The financial statements of all businesses in a particular country/region will follow a standard format and standard accounting principles. This enables consistency and helps in effective comparison of the financial statements and financial position of different companies. The accounting principles that an organization follows depends on the regulatory and reporting requirements of the region and audience to which a business caters. Indian companies follow Indian Accounting Standards, while the companies operating in the US follow the Generally Accepted Accounting Principles (GAAP) and companies with international exposure follow International Financial Reporting Standards (IFRS).
The standards issued by the various boards, not only assist an organization in reporting the transactions correctly but also give clarifications for complex transactions faced by businesses. The standards ensure uniform accounting. These standards issued are amended from time to time keeping in mind the nuances of business.
Presentation of financial statements
Financial accounting is the reporting of transactions that have occurred during the financial period. A financial period can be any period. However, year-end financial statements are usually prepared for 12 months. In India, a financial year is from 1st April to 31st March. Some companies follow the calendar year for reporting. At the end of the said period, the organizations will present its financial statements also known as financial reporting.
The financial statements report on five main aspects of a business.
The revenue and expenses are accounted for in the income statement and the asset, liabilities, and equity are reported for in the balance sheet.
The income statement records the revenue and expenses for the financial period. It records all the revenue earned and expenses incurred for that period. It shows the operating wellness of the organization; this statement also provides the necessary information for tax computation.
The balance sheet is a parameter to check the financial health of the business. It records assets, liabilities, and equity of an organization. The balance sheet analysis enables an investor to derive at the worth of the company. It is also used to gauge the credibility of the organization.
In addition to the statements above, an organization also prepares the cash flow statement which shows the movement of cash; this is presented under the following three categories:
- Cash Flow from operating activities
- Cash Flow from investing activities
- Cash Flows from financing activities
Shareholders Equity Statement
This statement shows the changes in shareholders equity for the accounting period. It also depicts the changes in ownership if any.
Accounting is a vast function, it varies depending on the purpose it is used for. Financial accounting is used for business analysis, by parties external to the organization. While managerial accounting is used for reporting to the management and assist in decision making. On the other hand cost accounting is used by management to effectively manage costs.