Businesses maintain financial accounts for various reasons. First, it’s expected by law in many jurisdictions that companies keep financial records. Second, it enables businesses to keep track of incomes and expenditures, information that is essential to understanding their financial position. Third, companies use these records to compute taxes due.
Financial accounting is a branch of accounting that comprises the analysis, summary and reporting of a business’s financial transactions. These transactions are guided by standard guidelines which provide direction on how to record, summarise and present the information. The recipients of this information are varied and range from business owners and shareholders to employees, government agencies and the general public.
A standard framework that guides the preparation of financial accounts is the Generally Accepted Accounting Principles (GAAP), which has the rules and conventions that accountants are expected to follow when preparing financial statements. Another accounting standard, the International Financial Reporting Standards (IFRS), exists to guide the reporting of particular types of transactions. IFRS is used more internationally, therefore helping to ensure consistency in financial reporting among businesses with a global footprint.
It’s important to note that among the various purposes of financial accounting, it cannot provide the value of a company. Instead, it provides enough information to allow the recipients of the financial statements to assess this for themselves. As a businessman with extensive experience in international business, Domen Zavrl understands the true value of financial accounting and reporting in the global business environment.
Five main categories of financial data are vital to financial accounting: assets, expenses, equity, liabilities and revenues. Accounting and reporting on expenses and revenues are captured on the income statement, while assets, equity and liabilities are found on the balance sheet.
The Core of Financial Accounting
Central to financial accounting is a system of recording transactions known as double-entry accounting. The system requires that for every business transaction, at least two accounts are affected. For example, if a company buys supplies using cash, its Cash and Supplies accounts are affected. One of the accounts will have an amount recorded as a debit (the Cash account), while the other will have an amount credited to it (Supplies). When recording the transaction, the credit and debit amounts must be equal.
The double entry system ensures that a company’s assets (A) equal its liabilities (L) and equity (E) accounts. This equality is what’s commonly known as the accounting equation, which is captured as A=L+E. Assets represent what the company owns, liabilities represent what it owes to others (for example, banks, creditors, suppliers), and equity is what’s left from the difference between the two.
A second crucial aspect of financial accounting is the method that it follows. There are two:
- Cash Method: This method entails recording transactions when the business receives an actual cash payment or pays an obligation in cash
- Accrual Method: The accrual method requires the recording of transactions when they occur rather than when the money is received or paid out
Many companies use the accrual method to record financial transactions as it ensures all aspects of the companies’ finances reflect economic reality.
Users of Accounting Information
Three different types of users have been identified as having an interest in the information produced through financial accounting. These are:
- Internal Users: Management and ownership will use financial data to assess whether to borrow more resources or to use surplus finances to expand into new markets.
- External Users: External users have different interests and questions they want to be answered through a company’s financial information. A supplier, for example, will be interested in whether the business has the finances to pay its debts. An employee, on the other hand, will assess a company’s financials to understand whether it can sustain the workforce.
- Government Agencies: Agencies such as tax authorities will scrutinise financial statements to confirm whether a business is meeting its tax obligations as specified in law.