Financial Accounting: Definition, Types, Functions & Examples (2024)

Introduction to financial accounting

“Accounting is the language of business.” — Warren Buffett

Accounting is an essential business language, as it clearly communicates key financial information to stakeholders. Business transaction data is integral to communicating an organization’s financial performance.

This data serves as the basis of efficient decision-making. But organizations can’t capture it without a structured process. That’s precisely why enterprises use financial accounting to record financial transactions.

Financial accounting is the process organizations use to record, summarize, and report transactions resulting from their day-to-day operations. In this article, we explore how organizations deep dive into financial accounting.

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What is financial accounting?

Indian accountants follow the Indian Accounting Standard (Ind AS) to maintain credibility and uniformity across accounting processes. These guidelines are at par with the International Financial Reporting Standards (IFRS).

In the US, financial accountants follow the Generally Accepted Accounting Principles (GAAP) principles set by the Financial Accounting Standards Board (FASB).

Financial accounting meaning

Financial accounting definition refers to the process that documents, classifies, reports, and analyzes business transactions to assess the financial health of an organization. In other words, it’s a bookkeeping process that captures all sales, purchases, accounts payables, and receivables transactions.

Accounting teams summarize these financial transactions to create different financial statements, such as cash flow statements, balance sheets, income statements, and shareholder’s equity statements. Financial accounting aims to display profits and losses so that stakeholders can make the right decisions.

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Who are all the users of financial accounting?

Public enterprises publish financial statements quarterly or annually to provide internal and external users with critical financial information.

In this section, we explore the purpose of these financial statements.

• Lenders compare assets and liabilities to predict an organization’s ability to repay loans.
• Investors analyze financial statements to estimate investment risks and predict future dividends.
• Suppliers and trade creditors need financial information to measure the short-term liquidity of an organization.
• Customers use statements to understand the long-run prospects of a business.
• Employees and trade unions look at financial data to interpret an organization’s profitability and stability.
• Company management leverages accounting information to evaluate progress and pinpoint areas of improvement.
• Government agencies including income tax and sales tax departments, need financial information to levy and collect appropriate taxes.
• Investment analysts use financial statements to analyze an organization’s competitive performance.

Importance of financial accounting for your organization

Financial accounting is important for tracking financial transactions and preparing financial statements.

Here are a few reasons why organizations opt for it.

• Consistent standards: Financial accounts make it easy for organizations to create financial statements that follow universally accepted standards.
• Improved accountability: Financial statements improve an organization’s credibility among regulatory bodies, tax authorities, and lenders.
• Efficient decision-making: Financial performance analysis enables enterprises to invest and allocate resources better.
• Transparent financial reporting: Financial accounting also promotes transparency by setting rules that organizations must follow while disclosing financial performance.
• A reliable source of information: The rules set by independent governing bodies ensure accurate reporting practices among organizations.

Types of financial accounting

There are two types:

• Cash accounting
• Accrual accounting.

The key difference between them is the timing of transaction recording.

1. Accrual method

The accrual accounting method records transactions as they occur, regardless of when the money exchange happens. Organizations use accrual basis accounting to create journal entries for sales and expenses even before collecting or making payments.

Accrual-based accounting follows the revenue matching principle, which requires revenue and expense recording in the same period of time. It also uses double-entry accounting to record liabilities for debit incurred (but cash not paid) and assets for income earned (but money not received).

The accrual method is standard among enterprises handling large volumes of credit transactions.

Example of accrual method

An example of accrual accounting is how an organization records revenue using accrual accounting. Imagine XYZ Pvt. Ltd. delivered goods and services worth INR 50,000 to ABC Pvt Ltd. on 15th February. Now, XYZ Pvt. Ltd. records revenue as they make a sale, meaning they add revenue to their books before receiving cash. ABC Pvt. Ltd. receives an invoice they must pay within 20 days.

Cash journal entry

The cash journal entries for this transaction require XYZ Pvt. Ltd. to capture service revenue in February and record payment in March.

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2. Cash method

The cash accounting method records transactions when the money exchange happens. For example, an organization records income after receiving cash from sales and expenses after processing accounts payables.

Cash basis accounting requires transaction recording only when money goes in or out of a bank account. This method suits small businesses. Enterprises with large inventories don’t use cash accounting as it doesn’t capture liabilities incurred but not paid yet.

Example of cash accounting

Here is an example of how enterprises record revenue and spending using the cash-based method. Imagine Kurtis Pvt. Ltd. sells curtains worth ₹ 30,000 to Ariz Pvt. Ltd. on April 10. The cash journal entries below show how Kurtis Pvt. Ltd. records the revenue only after they receive payment from Ariz Pvt. Ltd. on April 11.

Cash journal entry

Objectives of financial accounting

According to principles of financial accounting, the main aim is to provide all internal and external stakeholders with an accurate view of profits and losses. This in-depth financial analysis allows organizations to protect stakeholders’ interests, meet legal requirements, and optimize resource allocation.

Here are a few objectives of financial accounting.

1. Compliance with statutory requirements
2. Recordkeeping
3. Determine profitability
4. Management decision-making

1. Compliance with statutory requirements

Through the process of financial accounting, organizations comply with tax regulations, the Companies Act, and other statutory requirements of the country in which it conducts business.

2. Recordkeeping

It creates a systematic process for recording financial transactions in the books of accounts. Organizations use these transactions to analyze and optimize their financial performance.

3. Determine profitability

Organizations maintaining financial accounts can also easily measure net income for a period from assets, liabilities, and equities. While a simple way to calculate profit and loss is to subtract spending from revenues simply, profitability also considers other factors, such as pricing of goods and services, purchases, rent, salary, general expenses, depreciation, interest paid, and taxes.

4. Management decision-making

a robust accounting process enables stockholders, shareholders, creditors, and other parties to gauge an organization’s financial stability. Moreover, it aids the management team in making analytical decisions for maximizing sales and profits.

Features of financial accounting

Here are some of the characteristic features:

• Monetary recordkeeping: Financial accounts don’t record non-monetary transactions, regardless of their importance from a business point of view.
• Historical transaction recording: Financial accountants only track transactions that have already taken place in the past.
• Legal requirements: As law mandates, organizations must keep their financial accounts up-to-date. They should also get financial statements audited to ensure accuracy.
• Made for external use: Financial accounting reports inform customers, investors, suppliers, and financial institutions about the financial performance of an organization.
• Interim reports: Organizations treat financial account statements covering less than a year as interim reports. These reports are useful for conveying the financial performance before a full-year reporting cycle ends.
• Forms the basis of other accounting branches: Financial accounting deals with raw data from journals and ledgers. Therefore, it is the foundation for other accounting branches, such as management accounting, cost accounting, and other advanced accounting methods.

Financial accounting concepts

Financial accountants use the following concepts or fundamentals while analyzing an organization’s operational performance over some time.

• Economic entity concept mandates that organizations keep their financial transactions separate from business owners’ personal transactions.
• Going concern principle assumes that an enterprise will remain in business in the foreseeable future. Therefore, there’ll be no reason for liquidation or operation discontinuance.
• Matching concept emphasizes that an organization must record and match related revenues and expenditures in the same period.
• Materiality principle states that financial statements should report all material item transactions. Material transactions are those that significantly impact financial decision-making when included or excluded.
• Conservatism requires organizations to record losses when discovered and profits only when fully realized. It also states that accountants must practice caution and verification even while preparing basic accounting statements.
• Revenue recognition principle dictates that enterprises should recognize revenue as they earn it, not when they receive it. Accurate revenue recognition impacts the integrity of an organization’s financial reporting.
• Verifiable objective concept states that accounting data should be verifiable and free from personal bias.

What are the main functions of financial accounting?

The significant advantages of financial accounting are to create financial statementsthat help investors, tax authorities, and lenders understand an organization’s financial position. Accountants create these reports (income statement, cash flow statement, and balance sheet) by tracking incoming and outgoing cash flow transactions.

Here are some of the functions of financial accounting.

• Maintain systematic records: Financial accounting records financial transactions accurately while meeting accounting standards and regulatory guidelines.
• Analyze and summarize financial records: Accounting teams create final accounts after analyzing and summarizing transactions in the trial balance. The final statement shows the profits or losses of an organization during a financial year.
• Communicate results: Financial accounts help organizations share their annual financial performance with investors, shareholders, government bodies, lenders, creditors, and debtors.
• Meet legal requirements: Financial accounting ensures organizations fulfill their legal obligations, such as book auditing and tax liabilities.

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What are the 4 main financial statements?

The four main financial statements are

1. Balance sheet
2. Income statement
3. Cash flow statement
4. Statement of retained earnings (also known as the statement of owner’s equity)

What are the financial accounting examples?

This section explores how different financial statements play a key role in helping organizations deliver a complete picture of their financial performance.

1. Balance sheet

A balance sheet or a statement of net worth reveals an organization’s assets, liabilities, and shareholders’ equities at a particular time. It’s also known as a statement of financial position.

Balance sheets follow a three-part accounting equation to balance out assets by adding liabilities and shareholders’ equity. That’s why it’s known as a balance sheet.

Assets = liabilities + shareholders’ equity

Accountants use balance sheets with other statements to calculate key financial ratios. Balance sheets also help investors assess the capital structure of an enterprise and calculate rates of return.

Example of balance sheet

Here is the balance sheet of State Bank of India as of December 31, 2022. All values are in millions of INR.

This example shows that the total assets always balance out the total liabilities and shareholders’ equity.

2. Income statement

An income or profit and loss statement reveals an organization’s revenue, gains, expenses, and losses for a particular period. It’s also known as a revenue and expense statement. Income statements help organizations analyze depreciation, identify underperforming areas, and measure performance against competitors.

Example of income statement

Here is an example that shows State Bank of India’s income statement for December 2022. All values are in millions of INR, except for per-share items.

This example shows how an income statement arrives at the net income available to all stakeholders and basic earnings per share (EPS).

3. Cash flow statement

A cash flow statement (CFS) summarizes incoming and outgoing cash and cash equivalents (CCE) to help organizations evaluate their operational abilities. Enterprises use this financial statement to assess their ability to generate cash for paying debt and operating expenses.

A statement of cash flows includes three types of activities.

• Operating activities reveal the incoming cash flow from selling goods and services.
• Investing activities refer to cash generated from physical and non-physical property buying and selling.
• Financing activities include cash flow from debt and equity financing.

Cash flow from these activities helps organizations visualize how much cash they generate and make decisions accordingly.

Example of cash flow statement

The below is the cash flow statement of SBI as of December 31, 2022.

This example shows how a cash flow statement considers depreciation, taxes, interests, working capital changes, capital expenditures, and cash dividends paid to summarize all CCE transactions.

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4. Statement of retained earnings

A retained earnings or owner’s equity statement reveals the sum of earnings that an organization has reserved for investing in business operations. Organizations generally use these earnings for paying debt, buying fixed assets, or as working capital.

Retained earnings statements reconcile starting and ending earnings for an accounting period. Analysts use these statements to understand how an organization uses corporate profits.

Example of retained earnings statement

Let’s look at a retained earnings statement for a company that pays cash dividends to stockholders.

This example shows how a retained earnings statement looks at starting and ending earnings of a period to summarize the reserved capital.

Read More: Difference Between Cost Accounting and Financial Accounting

Best practices for financial accounting

Efficient financial accounting enables organizations to unlock growth opportunities, monitor spending, and optimize resource allocation. However, it can be challenging without a well-planned strategy.

Here are a few best practices enterprises follow to mitigate risks and boost profit margins.

• Keep personal and business finances separate to prevent cash flow issues and tax filing complications.
• Establish internal accounting policies to minimize risks.
• Determine the appropriate accounting principle, depending on organizational needs.
• Use accounting software to track and record transactions and cash flows.
• Create accurate financial statements for ease of sharing information with stakeholders.
• Manage accounts payable, receivable, and reconciliation processes efficiently.

What is financial accounting software?

Financial accounting software solutions are cloud-based tools that record and manage the day-to-day financial transactions of an organization. Moreover, these tools also help organizations manage revenue, fixed assets, accounts receivables, and accounts payables.

Best-in-class financial accounting software packs the following features.

• Transaction recording and processing: Financial accounting tools record, process, and reconcile all types of transactions, including AP, AR, cash, and fixed assets.
• Reporting: These software solutions help organizations create custom dashboards for cash books, customer ledgers, final account statements, payables, and receivables.
• Multi-currency support: Most accounting solutions also support multiple currencies, meaning organizations can use a single system to manage finances across locations.
• Real-time reconciliation: Financial accounting software reconciles ledgers and sub-ledgers in real-time. As a result, it becomes easier for organizations to create provisional statements for financial performance analysis.
• Analytics: These tools automatically analyze transactions to discover hidden expenses and monitor capital utilization — both key to optimizing organizational cash flow.
• Centralized system: Financial accounting systems centralize all financial data, so anyone can access data from anywhere.

Modern enterprises and financial consultants use financial accounting software to organize data, create financial reports, and allocate resources efficiently.

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How does financial accounting software help?

Financial accounting software solutions automatically capture incoming and outgoing financial transactions. As a result, organizations can effortlessly access all financial records from a centralized platform.

These tools also enable organizations to manage fixed assets, ledger, budgeting, cash management, and bank-related activities. Moreover, these tools monitor capital expenditure and identify hidden expenses to help organizations optimize cash flow.

Best financial accounting software

• Oracle Fusion Cloud ERP
• Zoho Books
• NetSuite Cloud Accounting Software
• myBillBook
• DataSnipper

Quick Read: Difference Between Financial Accounting and Management Accounting

Conclusion

Financial accounting helps organizations with accurate recordkeeping, which is key to creating financial statements that meet accounting standards and legal guidelines. Organizations following accounting best practices evaluate and optimize their performance more efficiently. As a result, they remain in a better position to weather any financial hardship.

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