Understanding the necessity of financial accounting is essential before comprehending its nature and use. Let’s say your monthly income is Rs 1 lakh. To spend this money, you would create a thorough budget. You’ll deposit funds into your bank account, as well as other savings accounts and investments. Using the remaining funds, you would create a list of both non-discretionary and discretionary purchases. To keep track of your expenses, savings, and income, it’s crucial to make a list or record this. Now consider a big business that may have several revenue streams, investments, and savings. It is quite difficult to keep track of all the money coming in and going out of the system without adequate accounting.
What is financial accounting?
A particular area of accounting known as financial accounting deals with the process of documenting, compiling, and reporting the numerous transactions that arise from corporate operations throughout time. The creation of financial statements, such as the cash flow, income, and balance sheets, which document a business’s operational performance over a given period, summarizes these activities. Financial accountants can find employment in both the public and private sectors. The responsibilities of a financial accountant may be different from those of an accountant who prepares tax returns, accounts for numerous clients, and possibly audits other businesses.
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Working of financial accounting
A number of well-established principles are used in financial accounting. The business’s reporting and regulatory obligations determine which accounting standards are applied. The relevant accounting principles are described in an accounting manual that is frequently available to businesses and organizations. Generally accepted accounting principles (GAAP) must be followed while performing financial accounting for publicly traded corporations in the United States. Their goal is to give creditors, investors, tax authorities, and regulators consistent information. After accounting for and reporting revenues and expenses, net income is calculated and shown at the bottom of the income statement. The balance sheet, which uses financial accounting to reflect ownership of the company’s future economic benefits, includes accounts for assets, liabilities, and equity.
The five primary categories of financial data or financial accounts are covered by the statements used in financial accounting and are as follows:
- This category includes earnings from product and service sales as well as income from other sources, such as interest and dividends.
- The costs of creating goods and services, including payroll, marketing, and research and development, are referred to as expenses.
- Assets are owned property, including intangibles like patents and trademarks as well as tangibles like computers and buildings.
- All outstanding debts, including rent and loans, are referred to as liabilities.
- Equity is what a business is worth, and it would be obtained if its debts were settled and its assets were sold.
Objectives of financial accounting
The following goals must be met by financial accounting:
- Giving all parties involved information on accounting: When discussing a huge company or organization, the owner is not the only person who is worried about its financial standing. The company’s finances also worry several other stakeholders, including management, tax officers, auditors, shareholders, and investors.
- To determine profitability: A company’s operations might result in either a profit or a loss. Financial accounting is necessary to gauge the company’s direction.
- Maintaining systematic records: Keeping stakeholders informed of the financial status at all times and keeping a systematic financial record are critical to the efficient operation of any business.
Top 2 methods of financial accounting
The accrual method and the cash method are the two main forms of financial accounting. The timing of transaction recording is the primary distinction between them.
1. Accrual method
Transactions are recorded using the accrual method of financial accounting, regardless of the amount of cash used. Revenue is not recorded when it is received (when the bill is paid), but rather when it is earned (when a bill is sent). Expenses are noted when an invoice is received, not when it is paid. Accrual accounting acknowledges a transaction’s influence over time. Consider a business that gets paid $1,000 for a consulting assignment that needs to be finished next month. Since the business hasn’t actually completed the work and received the money yet, accrual accounting prevents it from recognizing the $1,000 as revenue. Accrual accounting requires the business to record the transaction in July, debiting utility expenses, even if the bill won’t be paid until August. A credit to accounts payable is recorded by the business. The credit is released upon payment of the invoice.
2. Cash method
A simpler and less rigorous approach to creating financial statements is the cash technique of financial accounting: Only when money is exchanged are transactions documented. Only when the transaction has been completed through the facilitation of funds are revenue and expenses reported. When the consulting firm in the aforementioned case received the payment, it would have recorded $1,000 in consultation income. The cash method requires revenue to be recorded as soon as cash is received, even when it won’t be done until the following month. Since the transaction will have been fully documented the previous month, no journal entry is made when the business completes the work the following month. In the alternative scenario, the utility cost would have been documented in August, which is when the invoice was settled. The cash method of financial accounting mandates that expenses be recorded when they are paid, not when they occur, even when the charges are related to services rendered in July.
Accounting scope
The scope of accounting is demonstrated by reporting the account statement to different stakeholders. This information is used in a variety of ways by different parties for both their own and the company’s advantage.
The company’s different stakeholders are kept informed about its financial health through financial accounting. Every stakeholder should find it useful when making judgments about the company’s operations. For instance, it enables shareholders to comprehend the business’s profitable subsidiaries. It helps both direct and indirect investors decide whether or not to invest in the company. To determine whether the firm they work for is financially sound, employees must also stay informed about it.
- Reporting to shareholders: Companies that put money into a business in the hopes of making a profit are known as shareholders. They must be informed of the company’s total financial status, including the amount of outstanding loans, assets, expenses, revenue sources, and so forth, because they have invested their funds in the enterprise.
- Reporting to the Public: The public is able to invest in the companies that are listed on the stock exchange. Account statements must be made public since the general public also becomes an investor in order for them to understand their investment options fully.
- Government Reporting: For tax purposes, this is required. The financial standing of the companies that fall within their purview must be known to governments.
Conclusion
The field of financial accounting has expanded over time. Previously restricted to shareholders and a few other chosen entities, it now includes reporting to the public, employees, and communities. Additionally, it aids in preventing financial scams and frauds that threaten the economy’s foundation. Accounting is the art of finding, documenting, categorizing, evaluating, and analyzing a company’s financial data so that it can be utilized to achieve specific goals.