What Is Financial Accounting? It’s Critical Information

Accounting is the most crucial element of a business. Financial accounting is the recording or procedure of creating documents containing all the essential details about the company’s operations and decisions. It gathers information and then distributes it to the stakeholders to ensure the company is managed with utmost transparency.

Let us dive deeper into the nitty-gritty of financial accounting.

What is Financial Accounting?

In simple terms, financial accounting is the process that accounts for every money that flows in and out of a company. The process involves recording, categorising and summarising every financial transaction.

There are various categories to define the different types of transactions:

• Revenue: It is usually derived from the selling of services or goods.
• Expenses: These are the business expenses, including office rent, salaries and other services.
• Assets: This is the worth of a business. Assets could be physical (tangible), such as property or equipment. Also, they can be intangible, like databases, software patents, clients, intellectual property, and so on.
• Liabilities: This is the amount a company has to pay. It’s not just about debt and outgoings but also projected expenses. Examples include payroll, mortgages and payments to suppliers.
• Equity: This is the amount left after subtracting assets from liabilities. It’s the money that the business’s owner and shareholders have.

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Different Types of Financial Accounting

A business can track the transactions it makes in two different ways:

• Cash Accounting: This type of financial accounting is based on cash transactions. Therefore, every transaction is a credit and debit entry.
• Accrual Accounting: Most companies prefer this method of recording cash and other transactions. Accrual accounting focuses on recording transactions as and when they happen, regardless of the currency exchange.

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Different Types of Financial Accounting Statements

Financial statements organise information to provide a clear overview of the company’s financial situation. But no one statement can tell the entire story. 

The following four kinds of statements create a complete picture of financial accounting:

Balance Sheet

A balance sheet can be described as a statement that outlines an organisation’s liabilities, assets and equity. Assets can include inventory, cash and equipment, investments, property, accounts receivable, and other accounts. The liabilities could consist of accounts payable, loans, tax due, paying mortgages, and non-earned income. Equity can include shareholder-owned stocks, retained earnings or total income.

Assets = Equity + Liabilities

Analysts, investors and shareholders use balance sheets to assess the financial condition of a business.

Income Statement

An income statement, or profit and loss report, accounts for an organisation’s net earnings over a time period. It is calculated by subtracting total costs from the total revenue. It will show profits, expenses and losses.

Cash Flow Statement

Cash flow statements are a thorough overview of the organisation’s revenue and liabilities. However, it is confined exclusively to cash transactions. Statements of cash flow are split into three parts which include investing activities and financing. When an income statement details the results, losses, gains as well as expenses, the statement does not address cash directly.

The cash flow is the amount of money an organisation can access at any time, indicating the sustainability of its operations and the profit it earns.

The report consists of three distinct types of cash flows:

• Operational activities- This is the case for selling items or services (money coming in) and salaries or supplier invoices (money being sent out).
• Investment activities-  It tracks changes in a company’s assets, liabilities and cash equivalents. For example, the acquisition of new software could be reported within this area as cash-in since it’s an expense. Selling assets, such as equipment or property, is one example of cash-in.
• Financing activities-  The cash flow statement details the money flowing in and out of bonds, loans, and investments.

Shareholders’ Equity Statement

A shareholder’s equity statement shows how equity fluctuates with time. It’s an addition to the balance sheet, which shows the equity at a particular time.

A statement of equity for shareholders includes additional information about the equity components:

• Share capital is the amount the company has raised through selling shares.
• Net profit is the company’s earnings after deductions and expenses.
• Dividends represent the proportion of profits that the company pays to shareholders.
• Retained earnings are the company’s earnings after it has paid dividends.

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Who Uses Financial Accounting?

There are multiple users who use financial accounting, as it helps them make informed decisions in their respective spheres. Here are some of the users who use financial accounting quite frequently.

• Customers 
• Government agencies
• Creditors and lenders
• Employee and labour unions
• Top company management and internal stakeholders

Financial Accounting

Why Are Financial Statements Important?

Why are financial statements part of the financial accounting definition? They are a vital source of information for four key groups:

• Shareholders: Shareholders would like to know how their business is doing. If the financial results are poor, they could sell their shares in the company. In certain instances, particularly for smaller businesses, shareholders can request clarification or suggestions from management. Or, they could request a change in management.
• Potential investors: Investors looking for investment opportunities assess financial statements to determine which stocks to buy and at what price. They calculate metrics like the price-earning ratio (the stock price divided by profits per share). Since all publicly traded companies utilise GAAP accounting methods, shareholders can compare the ratios of different companies and decide on the most promising investment.
• Management: Financial statements show the management teams how the business is doing and what’s working and what’s not. If the company has adjusted its operations or introduced innovative products or services, the financial reports can help determine the success of the efforts.

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Wrapping Up

Companies use financial accounting to keep track of their financial transactions. Businesses worldwide employ professionals trained and skilled in financial accounting principles and practices to achieve this. Globally-recognised certifications like ACCA program and CMA can open the doors for a lucrative career as an accounting professional. Check out ACCA and CMA courses from Zell Education today and build a thriving career in accounting.

FAQs

1. What is financial accounting, and what is its example?

Financial accounting is the process of recording, summarising and reporting the revenue-expense generation and transactions of a company. The income statement of a company is an example of financial accounting.

2. What is the main purpose of financial accounting?

Financial accounting aims to record a company’s financial transactions over time. Different types of financial accounting statements help in the process and dues. Accounting professionals follow their own Generally Accepted Accounting Principles (GAAP) to create income statements, cash flow statements, balance sheets, and shareholder’s equity reports.

3. What are the 4 types of financial accounting?

Income Statement (Profit and Loss Statement), Balance Sheet (Statement of Financial Position), Cash Flow Statement and Statement of Changes in Equity (Statement of Shareholders’ Equity).

4. What is the role of financial accounting?

Financial accounting involves systematically recording all financial transactions of a business, including sales, purchases, expenses, revenues, and investments. These transactions are recorded in accounting journals and ledgers using double-entry accounting principles to ensure accuracy and completeness of financial records.

Anant Bengani, brings expertise as a Chartered Accountant and a leading figure in finance and accounting education. He’s dedicated to empowering learners with the finest financial knowledge and skills.