What is Financial Accounting: Definition, Types, Principles & Importance

Have you ever been concerned with the financial situation of your business? Perhaps you are asking yourself where all those transactions are going to be processed.

It’s financial accounting: recording, analysing, and communicating all business transactions. This provides unambiguous clarity and solidity and lets us know the actual state of affairs of our company’s finances.

It is like running a marathon without knowing how far one has reached in the race. That is what running a business without financial accounting is. We need to know the direction we are heading and the actions being taken regarding it.

In this blog, we will discuss what is financial accounting, its techniques and theories, and why it is crucial in organisational planning.

What is Financial Accounting?

So, the elephant in the room is, what is financial accounting? It can be defined as the process of capturing, analysing, and communicating business events that are reflected in financial statements.

These financial statements are balance sheets, income statements, cash flow statements, statements of changes in equity, and others. Consider them as a way of narrating the financial stories of the business; every transaction is a part of the story being told.

The US Financial Accounting Standards Board, FASB, has set such rules. These are also known as Generally Accepted Accounting Principles, GAAP, and their formulation aims to increase simplicity, believability, and uniformity in accounting practices between and within organisations.

Now, it is the correct time to look at the techniques of financial accounting. As for the techniques, we have two – the accrual method and the cash method.

Accrual Method of Accounting

The accrual method of accounting records transactions when they occur, regardless of cash exchanges. Compared to other methods, this one provides a much clearer picture of our business’s functioning.

For instance, if we deliver services worth £10,000 in December but receive payment in January, then the income is recognised in December.

Thus, we allocate such income where it belongs, i.e., in the period in which it was earned, and paint the right picture of performance.

Cash Method of Accounting

On the other extreme, the cash method records revenue and expenses only when the business has received or paid the cash. This is obviously a far less complex and less detailed method that is usually employed by smaller businesses with less transaction volume.

For example, if we receive payment for the services that were provided in January, then this payment is recorded in January, though it may be for the services that were provided in December.

While this method is easy to use, it does not give as comprehensive a view of the finances as the accrual method.

Also Read : Limitations of financial accounting

Differences Between Accrual and Cash Methods

Here’s a quick comparison to help us understand better:

Also Read: Accrual Accounting

Fundamental Principles of Financial Accounting

Wondering how to make sure your financial reports are accurate? Worrying about missing out on key details?

Financial accounting principles guide us to keep everything in check.

Revenue Recognition Principle

Revenue should be recorded when earned, not when cash is received.

If we complete a project in November but get paid in December, we record the revenue in November. This way, our income statement reflects true performance.

Cost Principle

Expenses must be recorded at their original cost. When we buy a new machine, we log it at the purchase price, not its market value.

This principle helps in tracking the real cost of assets.

Matching Principle

We must match expenses with the revenue they help generate.

If we incur costs in December for a project that generates revenue in January, both should appear in the same period. This gives a clearer picture of profitability.

Full Disclosure Principle

Financial statements should include all necessary information. If there are pending lawsuits or changes in accounting methods, they must be disclosed.

This transparency helps investors make informed decisions.

Objectivity Principle

Financial reports should be based on objective evidence. Estimates and personal opinions have no place here.

Using verifiable data, like receipts and invoices, keeps our reports reliable.

The Different Types of Financial Statements

Financial statements are the backbone of financial accounting. They tell the story of our financial health in different ways.

Income Statement

• Also known as the profit and loss statement, shows revenues, expenses, and profits over a specific period.

• Helps see how well the business performs.

• Example: If sales are £50,000 and expenses are £30,000, the net income is £20,000.

Balance Sheet

• Provides a snapshot of the financial position at a given moment.

• Lists assets, liabilities, and equity.

• Example: If assets are worth £100,000 and liabilities are £40,000, equity is £60,000.

Cash Flow Statement

• Records cash inflows and outflows.

• Has three sections: operating, investing, and financing activities.

• Example: If £10,000 is received from sales and £5,000 is spent on new equipment, cash flow from operations is positive, while investing activities show a cash outflow.

Statement of Changes in Equity

• Details changes in equity over a reporting period.

• Shows how net income, dividends, and other changes affect shareholder equity.

• Example: If £10,000 of net income is retained after dividends, it boosts equity.

Key Differences Between Financial Accounting and Managerial Accounting

Confused about the difference between financial and managerial accounting?

Here’s a simple breakdown:

Importance of Financial Accounting in Business Operations

Do you wonder why financial accounting is so crucial? Ever worry about keeping your business financially sound?

Financial accounting is the backbone of any business, large or small. It provides transparency, helps in decision-making, and builds trust with stakeholders.

Let’s see how it can benefit us.

Transparency and Trust:

• Financial accounting ensures that all transactions are recorded and reported accurately.

• This transparency builds trust with investors, creditors, and regulatory bodies.

• Easier to attract investment and secure loans when everyone knows the financial state of the business.

Informed Decision-Making:

• Accurate financial data enables informed decisions.

• Helps manage costs better by knowing where money is going.

• High expenses in a particular area can be identified and steps taken to reduce them.

Regulatory Compliance:

• Helps stay compliant with laws and regulations.

• Ensures financial statements meet required standards.

• Can save from penalties and legal issues.

Performance Evaluation:

• Analysing financial statements helps evaluate business performance.

• Identifies what’s working and what’s not.

• For example, increasing sales with rising costs indicates a need to control expenses.

Investor Relations:

• Investors rely on financial reports to assess investment viability.

• Clear and accurate reports can attract potential investors.

• A well-documented balance sheet shows a strong financial position, making the business more attractive.

Also Read: difference between financial accounting and management accounting

Examples Illustrating Financial Accounting Concepts

Let’s look at some real-life examples to understand these concepts better.

Example 1: Revenue Recognition

Imagine we run a small business and complete a £5,000 project in July but receive payment in August. Under the revenue recognition principle, we record the £5,000 in July when the work is done.

Example 2: Expense Matching

Suppose we pay £1,000 for advertising in December, which leads to sales in January. The matching principle tells us to record the advertising expense in January to match the revenue it generates.

Example 3: Budgeting and Forecasting

Imagine we run a small retail shop. At the end of the year, we review our income statement. We notice that sales peaked during the holiday season. With this information, we can budget for more stock next holiday season, boosting our profits.

Example 4: Cost Management

Suppose we have a consultancy firm. Our financial statements show that travel expenses are significantly high. By implementing virtual meetings instead of travelling, we can cut these costs. This decision is based on insights from financial accounting.

Example 5: Loan Approval

We apply for a business loan to expand our operations. The bank reviews our balance sheet and income statement. Our clear and accurate financial reports help the bank see our financial health, increasing our chances of loan approval.

Conclusion

We have discussed what is financial accounting and how useful it is in making decisions to ensure compliance with legal requirements.

We have reviewed the key principles guiding us toward our quest to ensure the accuracy and reliability of financial statements: the revenue recognition and matching principle. We have also seen how the two most common methods of accounting, namely, accrual and cash, work and how each can be utilised depending on our business.

Understanding and using these notions can help one regulate oneself, make the correct decision, avoid mistakes that can lead to unwanted consequences, and properly represent our business concerning the financial aspect to relevant stakeholders.