Financial accounting is the process of recording, classifying, summarizing & analyzing financial data. This data is used to prepare the financial statements.
There are numerous business entities operating in the corporate world ranging from sole trader ship, partnerships, private & public limited companies. Public Limited Companies, as the name implies, go public by issuing shares on the stock exchange. In other words, such companies dilute their ownership by spreading it across different shareholders.
As the general public buys shares, they indirectly buy ownership in the company. It is therefore imperative, that companies disclose internal data to these shareholders so that they can make calculated decisions. Here’s where financial accounting comes in.
Financial Accounting Users & Objectives
Let’s take a step by step look at the processes involved in financial accounting.
Most companies record their business transactions based on a double entry bookkeeping system. The system states that every transaction has two aspects. One is debited, while the other is credited. Normally assets have a debit nature, meaning when they increase, the account is debited; while when they decrease, the account is credited. Similarly, liabilities and capital have a credit nature. These accounts are credited when they increase and debited when they decrease. Two examples can be better used to explain the scenario.
Example 1: A person sets up a business with $50000 in cash. As per this example, cash which is an asset account is increasing and therefore will be debited with $50000. Capital which is also increasing will be credited with $50000.
Example 2: A company buys goods on credit for $100,000. According to this transaction, inventory (an asset account) would be debited with $100,000 while accounts payable (a liability account) would be credited with the amount of $100,000.
Before recording can take place, it is also important to classify accounts into different account types. There are five account types as given below.
- Assets. Assets are items that are owned by the company and have economic value. Assets can either be tangible such as land, buildings, cash etc. or intangible such as goodwill & patents. Assets can further be divided into current & non-current assets. Current assets are the assets that are short term in nature and required in the daily operating affairs of the company. Non- Current assets, on the other hand, are long term in nature, have a lifespan of at least a year and are not very liquid.
- Liabilities. Liabilities are objects or items owed by a company to its creditors. Like assets, these can also be classified into Current & Non-Current liabilities. Current liabilities are liabilities with a lifespan less than a year such as accounts payable & accruals. These liabilities are normally paid with current assets. Non-current liabilities have a lifespan of more than a year and are used to procure fixed assets.
- Equity. Equity is the ownership share of shareholders in the company. The formula to calculate equity is as follows:
$$Equity = Assets - Liabilities$$
- Income/revenue. The prime reason to operate a business is to make income. Manufacturing companies make income by selling goods such as Fast-Moving Consumer Goods, Oil & Gas etc. On the contrary, service-oriented companies make revenue by provision of services such as banks, barbers etc. Income or revenue are normally credit in nature.
- Expenses. The operating expenses incurred by a company are classified under expenses. Expenses are debit in nature.
Once transactions are recorded & classified into the correct accounts, they are then summarized into financial statements. There are 3 financial statements.
- Income Statement. Income statements show the profitability of the company for a specified period of time. Most public companies issue four quarterly statements followed by a summarized annual income statement. This statement can also be used to analyze different revenue sources, expenses, gross & net profit margins of the company.
- Balance Sheet. The balance sheet depicts the equity of the owner in the company. It is a statement which summarizes the assets & liabilities of the company at the end of the financial year. The first section of the balance sheet shows the assets, the next shows liabilities and the third & final shows the difference between these assets & liabilities (owner’s equity).
- Statement of Cash Flows. These statements highlight the net cash flow position (cash Inflows minus cash outflows) of a company. The statement like the balance sheet is also divided into three parts. 1) Cash from operating activities, 2) Cash from investing activities & 3) Cash from financing activities.
Users of Financial Accounting
Financial accounting data of companies are used by different users in different ways. Therefore, to reduce the complexity, regulatory authorities have set common rules and accounting standards known as GAAP (Generally Accepted Accounting Principles) that companies must follow. Now let’s take a look at different users of financial accounting.
- Auditors. Third-party auditors need to audit company books and accounts and require an accurate depiction of financial statements to carry successful audits.
- Shareholders. Before investing, shareholders would ideally want a clear depiction of the company’s value. Financial accounting can be used to assess a company’s financial health and make calculated decisions.
- Suppliers. Balance sheets & income statements are assessed by suppliers before selling product on credit. These statements help suppliers deduce whether a company has enough liquidity to pay off its debt.
- Brokers. Most people buy & sell company stocks based on the advice of brokers and brokerage houses. These brokers constantly develop complex financial models using financial statements to predict and assess the true picture of the company.
- Government and regulators. Regulatory bodies also make use of financial information to assess whether companies are complying with laws set by regulatory bodies. Moreover, governments can also use to financial accounting to anticipate & forecast tax revenue from companies.
Financial accounting information is generally used by external users of the company. These users have limited or no knowledge about companies. The general idea is that these users are better able to comprehend the financial position of companies.
As mentioned before, public companies or companies that raise money by issuing shares need to disclose financial data. The general idea is that shareholders should know where they are putting their money into and be able to view the internal information of a company to be able to make better decisions.