What is Financial Accounting? How Does it Help a Business?
Accounting is considered the language of business as it helps communicate information about an organization to its stakeholders. In essence, it is a system that helps identify, record, and communicate essential information about a business. Thus, learning the fundamentals of financial accounting is crucial for companies as it helps keep track of their financial status.
What is Financial Accounting and its Importance?
Financial accounting is referred to as the process of recording, classifying, summarizing, and analyzing the financial transactions of a business. Moreover, the primary purpose of financial accounting is to provide accurate information on the finances of a business to external stakeholders like lenders, investors or shareholders, regulatory authorities, and lawyers or other professionals like cost accountants or certified public accountants.
It involves the preparation of financial statements like balance sheets, cash flow statements, or income statements to represent the profit, loss, assets, and liabilities of a business. In addition, financial statements are used to interpret transactions and determine the actual condition of a business in terms of profitability.
Here’s why financial accounting is essential for businesses:
- Facilitates communication with external stakeholders by helping them understand how the business is performing
- Ensures transparency for external stakeholders like investors or lenders and enhances credibility
- Enables data-driven decision-making for the management by providing an overview of a company’s financial position
- Helps businesses follow regulatory compliance
What are the Types of Financial Accounting?
Revenue and expenses are the two core elements of the fundamentals of financial accounting. Based on how and when businesses reflect revenue and expenses in their books of accounts, there are two different types of financial accounting.
Cash Accounting
In cash accounting, transactions are recorded on an actual basis. This means that we record a transaction only when actual income or expenses are incurred. Simply put, cash accounting involves recording a transaction when cash is received or paid. It is simpler and easier than the accrual accounting method. Cash accounting gives accurate information about the cash on hand, making it easier to track income and expenses. This method does not follow Generally Accepted Accounting Principles (explained later in the blog).
Accrual Accounting
In accrual accounting, income and expenses are recorded on an accrual basis and not on actual basis. This means revenue and expenses are added to bookkeeping as soon as they are incurred or accrued, and not when the actual transaction takes place. For example, in accrual accounting, as soon as you send the invoice to a customer, you record the transaction. However, in cash accounting, the transaction will be recorded when you receive the payment from the customer.
What are the Fundamentals of Financial Accounting?
Fundamental Financial Accounting Principles
Financial accounting refers to bookkeeping or recording financial transactions of a business. It includes information related to the purchase or sale of assets, cash receipts, invoices, and travel expenses using Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
The term GAAP refers to standardized accounting rules, or procedures used by companies in the U.S. to prepare financial reports. These rules list down acceptable accounting practices. It ensures transparency and uniformity in financial accounting processes. The U.S. Securities and Exchange Commission (SEC) has made it mandatory for publicly listed companies in the country to follow GAAP guidelines for financial reporting.
In countries other than the U.S., companies can follow GAAP or the IFRS issued by the International Accounting Standards Board (IASB), depending on their jurisdiction. It’s mandatory to follow the IFRS accounting standards in the UK and European nations. This comprises a set of global accounting rules, procedures or standards that determine how companies can represent types of financial transactions in their financial statements.
Fundamental Accounting Assumptions
In addition to the above-mentioned accounting principles, businesses also followed a few accounting assumptions to standardize and simplify the financial reporting process. In essence, the accounting assumptions have been issued by the FASB (Financial Accounting Standards Board), an independent organization that sets accounting standards for companies.
- Going Concern Assumption: The business will continue to operate and not be shut down.
- Monetary Unit Assumption: All business transactions can be expressed in monetary form.
- Time Period Assumption: An entity’s life can be expressed in months or years. This assumption is used to prepare reports for a particular period.
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Financial Accounting Advantages and Disadvantages
Advantages of Financial Accounting
- Allows businesses to get a clear picture of their financial position so that they can prepare future budgets accordingly
- Facilitates a systematic record of transactions that helps in the prevention and detection of financial fraud
- Helps prepare financial statements of the company and eases the compliance management process
Disadvantages of Financial Accounting
- Includes only tangible elements to calculate the financial position of a company and does not consider other essential factors like prevailing market conditions, economic environment, or government regulations
- Does not provide the stakeholders with clear information about the operational efficiency of a company
- Does not provide data for fixing the price of products or services
Financial Accounting Examples
Here are some examples that will help you understand the fundamentals of financial accounting better:
- The income statement or profit and loss statement of a public company like Apple and Alphabet Inc. published in their annual report
- A consolidated balance sheet of a parent company or the holding company which shows the financial position of the parent company as well as its subsidiaries
- A consolidated cash flow statement that represents the cash flow of a parent company as well as its subsidiaries through operations, investment, and finance activities
Book Recommendations to Understand the Fundamentals of Financial Accounting
If you want to learn the fundamentals of financial accounting in-depth, here are the three sought-after finance books on Goodreads that can be beneficial for you:
Financial Accounting Volume One by Conrado T. Valix, Jose F. Peralta, and Christian Aris M. Valix
Goodreads Rating: 4.17 stars
This book explains the conceptual framework of accounting, financial reporting, inventories, cost flow, cash and cash equivalents, and more advanced financial and accounting concepts. Also, it delves into the various methods used to calculate profits, expenditures, assets, and liabilities. “Financial Accounting Volume One” is a must-read for accounting or finance professionals who want to gain a deeper understanding of theoretical frameworks.
Don’t be Afraid of Accounting: Learn the Basics of Financial Accounting and be on Your Way to Greater Success! by Brad Horton
Goodreads Rating: 4.47 stars
This is one of the more popular books on accounting. In fact, it simplifies the fundamentals of financial accounting not only for accountants but also for others who use accounting concepts in their daily lives. In essence, it’s a great way for beginners to grasp the ins and outs of financial accounting.
Financial Accounting with International Financial Reporting Standards by Jerry J. Weygandt, Paul D. Kimmel, and Donald E. Kieso
Goodreads Rating: 4.33 stars
This book explains the principles, features, and fundamentals of financial accounting in detail in the context of IFRS. In fact, it’s highly recommended if you are interested in learning more about the integration of the U.S. GAAP rules. In addition, the book discusses examples of multiple international companies to explain international accounting standards.
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By Sneha Chugh
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