In this article, you will learn:
Financial Accounting is one of the branches of accounting that has been practiced since centuries. This aspect of accounting is important for a business as it helps to know:
- what it owns,
- what it owes,
- whether it has earned profit or incurred a loss or
- whether it will be able to meet its short term obligations or not
Thus, we can conclude that the very purpose of accounting is to ascertain profit and loss of business operations during a particular period. And to state the financial position of a business as on a particular date at the end of the accounting period.
Now, every business needs to maintain such accounting records so that the income or loss as well as the financial position data can be communicated to all the stakeholders of the business.
These stakeholders can include persons or entities both inside or outside the organization. Such stakeholders use the basic financial statements as these statements help them in taking appropriate decisions.
Thus, financial accounting is one of the oldest branches of accounting that deals with recording financial transactions in a systematic manner so that financial position of a business can be ascertained.
So let’s understand what is Financial Accounting, it’s Objectives and various other concepts and principles related with Financial Accounting.
Financial Accounting Meaning
Financial accounting is a branch of accounting that deals with the process of recording, summarizing and reporting of the entity’s financial transactions.
The objective is to record, prepare and present financial information systematically to be able to ascertain the financial results of the entity for a given accounting period.
Thus, financial accounting involves the reporting of accurate, reliable and timely information of the entity’s operating profit and financial position to its various stakeholders.
Further, these financial reports or statements are prepared as per the standard format and accounting principles specific to the region or country in which the entity is located.
The accounting principles that an entity adheres to while preparing its financial statements depend upon the regulatory and reporting requirements of the area/country or the target market it deals with.
This is to bring uniformity across the financial statements of entities of the specific region/country and undertake inter company comparisons easily.
For instance, companies in India follow Indian Accounting standards. Whereas companies in the US adhere to Generally Accepted Accounting Principles (GAAP).
Financial Accounting Objectives
The main objectives of Financial Accounting are to:
- Keep a systematic record of financial transactions
- Protect business properties from unjustified and unwarranted use
- Ascertain the net profit earned or net loss incurred on account of carrying out business operations during a particular accounting period
- Determine what the business owns, what it owes and whether it will be able to meet its obligations in the near future
- Provide systematized information to the stakeholders
- Facilitate both the internal as well as the external stakeholders in making rational decisions
The motive behind maintaining books of accounts of your business is to provide information about its financial performance to various stakeholders. But, the accounting information needs to be reliable and comparable so that it helps stakeholders to take such decisions.
This is possible only if the information contained in the financial statements is based on consistent accounting policies and principles.
Therefore, generally accepted rules and principles have been developed to bring about uniformity and consistency to the accounting concepts.
Following are the fundamental principles of accounting:
1. Accounting Period Concept
To know the financial performance and position of the business, a business owner is required to prepare financial statements at the end of a specific period.
Therefore, the period for which such financial statements are maintained is termed as ‘accounting period’.
So, to take important financial decisions, a business owner needs to maintain proper financial statements.
2. Conservatism Concept
The Conservatism Concept of Accounting states that a business owner should preferably understate rather than overstate his business’s net income.
This means that profits should not be recorded until they are realized. However, all losses, including the ones that have less chances of occurring, should be recorded in the books of accounts.
Thus, such a policy helps in dealing with business uncertainties and protects the interests of its creditors.
3. Realization Concept
As per this concept, revenues arising on account of sale of goods or services rendered must be recorded only when they are realized.
Typically, a business would realize revenues at the time of selling goods or rendering of services. This means that a business would realize revenues only when the legal right to receive such revenues arise.
4. Matching Concept
This concept of accounting states that expenses incurred in a particular accounting period should match with the revenues generated during the same period.
This means expenses incurred during a particular period should be deducted from revenue earned during the same period.
5. Consistency Concept
The financial statements help in evaluating the performance of a business only when such results can be compared over a period of time.
Therefore, to make such comparisons possible, businesses need to follow uniform and consistent accounting policies over a period of time.
6. Materiality Concept
Materiality concept states that events that are trivial and have an insignificant impact on the books of accounts can be ignored. Whereas, the material facts that reasonably influence the decisions of the stakeholders of your business must be recorded.
7. Historical Cost Concept
As per this concept, all assets are required to be recorded at their historical cost. This means that assets need to be recorded at their purchase price in books of accounts. Such a price includes the cost of (i) acquisition, (ii) transportation, (iii) installation and (iv) making the asset ready to use.
8. Money Measurement Concept
According to this concept, transactions that can be expressed in terms of money only are recorded in the books of accounts.
Transactions or happenings that cannot be expressed in monetary terms are not recorded in accounting statements.
Furthermore, transactions are recorded in terms of monetary units and not in terms of units of physical quantity.
9. Dual Aspect Concept
This concept states that every transaction has a dual affect and should be recorded in two separate accounts. The dual accounting concept is the foundation for recording transactions in books of accounts. Such a concept is expressed in terms of the following accounting equation: Assets = Liabilities + Capital.
As per this equation, the assets of a business are always equal to the claims of owners and outsiders. The claim of owners is termed as capital (owner’s equity). Whereas, the claims of outsiders are called liabilities (creditors equity). Now, the dual effect of every transaction impacts this equation in such a way that both sides are equal at all times.
The Double Entry System of Accounting is based on this Principle of Duality.
10. Going Concern Concept
This accounting principle assumes that a business will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future.
Double Entry System
In order to maintain proper books of accounts, they need to be prepared using the Double Entry System of Accounting.
According to the Double Entry System, every business transaction involves at least two accounts. In other words, every business transaction has an equal and opposite effect in minimum two different accounts.
Thus, this system of accounting is based on the Dual Aspect Concept. As per this concept, each business transaction has a dual or a two way effect. This is to say every amount debited in a transaction must be equal to every amount credited in that transaction.
Furthermore, the principle of duality is expressed in the form of the fundamental accounting equation which is as follows: Assets = Liabilities + Capital.
This accounting equation shows that assets of a business always equate the claims of owners and outsiders. This means that at any given point of time, the resources of a business are always equal to the claims of the stakeholders who have provided funds for such resources.
Accrual Accounting System
In order to record transactions in Financial Accounting, two main systems are used: cash system and accrual system. However, Accrual System of Accounting is preferred over Cash Based System due to the following reasons:
- It gives a complete picture of the financial transactions of a business
- It avoids misleading income statement results that may occur from the timing of cash receipts and payments.
- Accrual system allows the current cash inflows/outflows to be combined with future expected cash inflows/outflows.
- This system requires a business to maintain a complete record of assets and liabilities.
- Plus, it provides a uniform framework for identifying and recording existing liabilities, and potential or contingent liabilities.
So What is Accrual Accounting?
Accrual accounting is an accounting method that measures the performance and position of a business by recognizing economic events. This is regardless of when cash transactions occur in your business. By recognizing, we mean recording of a transaction.
The underlying concept in accrual accounting emphasizes that the revenues of a business are recognized when they are earned. This brings in the matching concept of accounting.
Accordingly, the economic events of a business are recognized by matching the costs incurred with the revenue earned at the time when a transaction occurs. It is regardless of whether cash has been paid or not.
In this way, revenues are matched with expenses. And the net income or net loss of a business is determined. This is unlike the cash based system where transactions are recognized when the cash is paid out or received.
Financial statements are the basic and formal annual reports. They reflect a combination of recorded facts, accounting principles, basic accounting assumptions and personal judgments.
Through these fundamental accounting statements, the corporate management communicates financial information to all of its stakeholders.
Such users of principal accounting statements take financial decisions based on the entity’s 1) financial position, 2) operating performance and 3) financial health.
Using these principal statements, the stakeholders try to analyze the profitability and financial position of any business concern.
Thus, the information regarding the results achieved by an entity during a specified period of time are in terms of assets and liabilities, which provide the basis for taking decisions.
So, the primary objective of financial statements is to assist the users in their decision-making.
Accordingly, the Generally Accepted Accounting Principles (GAAP) requires that 3 such reports need to be prepared:
- A balance sheet (or statement of financial position) that summarizes the financial position of an entity at the end of an accounting period.
- An income statement (or profit and loss statement) that summarizes the results of business operations for a given period.
- A statement of cash flows that summarizes an entity’s operating, financing and investing activities over a period of time.
The balance sheet or the statement of financial position is a report that showcases the financial position of a business entity at a particular time. It reports about a firm’s economic resources (assets), economic obligations (liabilities), and the residual claims of owners (owners’ equity).
Assets are the economic resources of an entity while equities are claims against these assets. Further, equities are of two types: 1) liabilities, which are claims of creditors and 2) owner’s equity, which are the claims of the owners of the business.
Now, all the assets of a business are claimed by either creditors or owners. Additionally, these claims cannot exceed the amount of assets to be claimed. Therefore, it follows that: Assets = Liabilities + Owner’s Equity
This is the fundamental accounting equation that governs all accounting. This equation expresses the dual-aspect concept. This concept states that every transaction has a dual impact on the accounting records.
The income statement or profit and loss statement is a report that summarizes the results of operations for an accounting period.
It explains few of the changes in the assets, liabilities and equity of an entity between two consecutive balance sheets. Further, it provides information relating to return on investment, risk, financial flexibility, and operating capabilities.
The income statement is prepared keeping into consideration two primary accounting principles. The first is the principle of accrual accounting.
Accordingly, the performance of an entity can be measured only if revenues and related costs are accounted for during the same time period. This mandates recognizing the expenses incurred to generate revenues in the same period.
The second principle is the classification of expenses into operating, financing and capital expenses.
Operating expenses are those that provide benefits only during the current period. Financing expenses refer to expenses relating to non-equity financing used to raise capital for the business. And capital expenses are the ones that generate benefits over long periods of time.
Accordingly, in the current period, operating expenses are subtracted from revenues to arrive at operating earnings of the firm. Then, financing expenses are subtracted from operating earnings to estimate net income or earnings to equity. The capital expenses, however, are written off over their useful life as depreciation or amortization.
Statement of Cash Flows
A cash flow statement showcases an entity’s cash receipts earned through major sources and cash payments made due to major uses during a period. It provides useful information about an entity’s activities in generating:
- Cash from operations, where such cash is used to repay debt, distribute dividends or reinvest
- The Cash from financing activities, including both debt and equity &
- Cash from investing activities, including investment in fixed assets or current assets other than cash
In other words, a cash flow statement represents various items which bring about changes in the cash balance between two balance sheet dates.
This statement is prepared in addition to the balance sheet and income statement. This is because the income generated during a period has no direct relationship with the cash flows associated with the operations of that period.