What is Financial Accounting?
Financial accounting is the process of recording, summarizing, and reporting a business’s financial transactions to external users, such as investors, creditors, and regulatory agencies. The goal of financial accounting is to provide an accurate and complete picture of a business’s financial performance and position, which can be used to make informed decisions by stakeholders.
Table of Content
- 1 What is Financial Accounting?
- 2 Nature and Scope of Financial Accounting
- 3 Objectives of Financial Accounting
- 4 Objectives of Accounting
- 5 Financial Accounting, Management Accounting and Cost Accounting
- 6 Advantages of Financial Accounting
- 7 Disadvantages of Financial Accounting
Nature and Scope of Financial Accounting
In simple words, accounting refers to the process of identifying, classifying, summarising and analysing the financial transactions of an organisation in a systematic manner. In addition, accounting involves interpreting the business results to various interested users such as proprietor, creditor, managers, shareholders and investors.
According to the American Accounting Association (AAA), Accounting is the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of the information.
Financial accounting is the field of accounting involving the preparation of financial statements for decision makers, such as stockholders, suppliers, banks, employees, government agencies, owners and other stakeholders.
Let us discuss these aspects in detail in the following section:
Financial Accounting as a Service Activity
Financial accounting is a service activity because of its intangible nature. It is an important service activity of any organisation because it supports economic decision making and it helps in choosing the best alternative course of action. It also enables management with the all-important financial information required to get desired results.
Financial Accounting as a Profession
As a profession financial accounting provides good opportunity to finance students who want to pursue their careers as finance managers, charted accountants, financial accountants, etc. As per India’s scenario, Institute of Charted Accountants of India, Institute of Cost Accountants of India, National Institute of Financial Management, etc. are the apex bodies in this field.
Financial Accounting as Language of Business
It is a means of reporting and communicating information about a business. The expression, exhibition and presentation of accounting data known as accounting principles or rules (such as numerals and words and debits and credit) are accepted as symbols which are unique to the discipline of accounting.
Irrespective of a business being located in any part of the world, financial information is analysed in a similar manner. For instance financial experts use data in financial statements such as balance sheet, profit and loss accounts to interpret and establish whether a business is performing well or not.
Financial Accounting as Science and Art
Financial accounting follows a principle of double entry system, is based on various rules, concepts, conventions and assumptions. Therefore, financial accounting is regarded as a science. However, financial accounting requires interest and experience apart from the knowledge of accounting and can be learnt only by practice.
An individual having greater experience in accounting would be able to understand a new transaction, new developments and changes in accounting easily compared to a less experienced individual. Thus, financial accounting is also an art.
Financial Accounting as an Information System
Accounting information is used for forecasting, comparing and evaluating the earning capability and the financial position of a business entity. Therefore, distribution of information is a vital function of accounting.
The input data is collected from different business activities and later processed to make it comprehensible. The resultant output (interpretation) provides information to various users such as government, suppliers, researchers, investors, managers, creditors, etc.
Objectives of Financial Accounting
Some of the major objectives of financial accounting as information system are as follows:
- Financial accounting provides information that helps in making financial decisions.
- It fulfils the requirements of the users who rely on financial statements as their standard source of information for decision making.
- It provides information, for judging managerial efficiency to use the resources effectively for attaining the business goals and objectives.
- It provides accurate and interpretive information regarding assumptions taken for evaluation, forecast and assessment.
- It provides historical information to the management to reveal historical events
Objectives of Accounting
Some of the major objectives of accounting are as follows:
Permanent and Systematic Records of Transactions
Every organization needs to maintain a permanent and systematic record for all of its transactions. These records are necessary for both external (taxation, annual reports, etc.) and internal purposes (examining current business position) and these records can be produced as per the requirement.
To Identify Operational Profit or Loss
A business organization is involved in various activities on a daily basis and out of these activities some may result in profit and some other in loss. Accounting shares daily, weekly, monthly, quarterly and annual reports to measure all these activities in terms of good and bad outcomes, i.e. profit and loss. These reports further enable a firm to take corrective actions as and when required.
Proper Utilization of Financial Resources
Accounting data is also useful to conduct internal analysis of various resources and it provides clear picture regarding usage of resources. After conducting this analysis an organisation can minimise wastage by assigning budget to various activities and this budget limits the usage of resources in various resources and hence, efficiency in resource utilisation can be achieved.
To Identify the Financial Position of a Business
By analysing Profit and Loss A/c, Balance Sheet and Final Statements, and a business organisation can project its financial position in comparison with its competitors.
Logical Decision Making
Accounting process can explore, identify and measure accounting and economic information and this information can be used by the managers to ensure the development of rational and logical decision making.
Corporate Governance (CG)
An organisation can practice good CG by ensuring transparency in recording of accounting events and this can also enable top decision makers to ensure sustainable growth of the business.
Financial Accounting, Management Accounting and Cost Accounting
Although management accounting and financial accounting are often used interchangeably, it should be noted that management accounting is simply an off-shoot of financial accounting. In simple terms, management accounting uses the financial data provided by financial accounting by the management of an organisation to improve the efficiency.
According to Institute of Management Accountants (IMA), Management accounting is a profession that involves partnering in management decision making, devising planning and performance management systems, and providing expertise in financial reporting and control to assist management in the formulation and implementation of an organization’s strategy.
However, in spite of the interrelationship between financial and management accounting, there are certain points of difference between the two, which are summarised in Table:
|Primary users of information
|External users (such as creditors, stockholders, and government regulators) are the primary users of the information.
|Internal users (such as managers) are the primary users of the information.
|It focuses on historical information. Only external party transactions are considered.
|It focuses on the future projections and focuses on internal transactions with a detailed view of analysis.
|It follows the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) to create a sense of confidence as the data is used by external users.
|It can use any accounting standard or technique to generate useful information as there is no limitation to follow any of the accounting standards.
|In this, reports are prepared annually, semi-annually & quarterly on a regular basis.
|In this, reports are prepared depending on management’s need. Some are daily while others may be prepared only when needed.
|Independent certified public accountants audit the annual financial statements of publicly traded companies.
They also express an opinion on the fairness of the financial information.
|There are no independent audits verifying the information and organisation’s internal audit.
Team examines the procedures used in preparing reports.
|Unit of measurement
|The financial information is usually expressed in monetary terms. This is to help in making comparisons between different data.
|Besides, monetary units, management accounting uses measures such as machine hours, labour hours, product units, etc. for the purpose of analysis and decision making
|Report is about the company’s performance at a whole, which is consolidated in financial statements. The standards to use for financial reporting are determined IFRS or GAAP
|Management determines the contents and format of a report according to company’s products, customers, geographical regions, departments, divisions. Reports are generally prepared only when management believes the benefit of using the report exceeds the cost of preparing the report.
|Subject matter and scope
|It produces information and reports for external users such as researchers, government, etc.
|It identifies, collects, measures, classifies and reports information that is useful to managers in planning, control and decision making.
The Chartered Institute of Management Accountants (CIMA), London, defines Management Accounting as the process of identification, measurement, accumulation, analysis, preparation, interpretation, and communication of information used by management to plan, evaluate and control within an entity and to assure appropriate use of and accountability for its resources.
Management accounting also comprises the preparation of financial reports for non-management groups such as shareholders, creditors, regulatory agencies and tax authorities.
Cost accounting is a part of financial accounting used to calculate and control the cost of different business operations. Cost accounting involves the analysis of variable cost, fixed cost, overheads and capital cost in business operations.
However, there are certain points of difference between the two, which are summarised in Table:
|Primary users of information
|It involves the preparation of a standard set of reports for an outside audience, which may include investors, creditors, credit rating agencies and regulatory agencies.
|It involves the preparation of a broad range of reports that management needs to run a business.
|It provides information about the financial performance and financial position of an organisation.
|It provides information about the determination of cost in order to control cost and take relevant decisions.
|Reports prepared under financial accounting are highly specific in their format and content, as mandated by either GAAP or IFRS.
|In this, reports are prepared using the format specified by management with the intention of including only that information pertinent to a specific decision or situation.
|Unit of measurement
|Financial accounting classifies records and presents interpreted data in monetary terms.
|Cost accounting classifies records and presents the material, labour and overheads costs.
|Financial accounting primarily focuses on reporting the results and financial position of an entire business entity.
|Cost accounting usually results in reports at a much higher level of detail within the company, such as for individual products, product lines, geographical areas, customers, or subsidiaries.
|The structure of financial accounting reports is tightly governed by either generally accepted accounting principles or international financial reporting standards.
|There is no regulatory framework governing cost accounting reports.
|Content of report
|It contains an aggregation of the financial information recorded through the accounting system.
|It contains both financial and operational information. Operational information is collected from a variety of sources that are not under the direct control of the accounting department.
|Financial accounting personnel issue reports only at the end of a reporting period.
|Cost accounting issues reports at any time and with any degree of frequency, depending upon management’s requirement.
|Analysis of costs and profits
|It presents the profit/loss incurred by an organisation as a whole.
|It provides detail of cost incurred and profit earned from each job, product, process, contracts, etc. separately.
|Recording of data
|It records historical data.
|Cost accounting collects and presents the budgeted data. It includes both historical and estimated cost data.
Advantages of Financial Accounting
We have previously discussed that accounting is the art and science of recording business transactions. It records data and further analyses it to reduce it to accounting reports. These reports help in facilitating the dissemination of important information among the different groups of users to take the appropriate decisions.
Maintaining Business Records
Accounting helps in recording all financial transactions in the books of accounts in a systematic manner. Therefore, we do not need to rely on human memory.
Preparing the Financial Statement
Accounting helps in determining the profit or loss as well as the financial position of the business during a particular period. Accounting records and classification provide the relevant information to the accountant for preparing financial statements.
Accounting involves comparing the profits or loss in a given year with those of previous years. The comparison helps in gathering important information and planning for the future operations.
Helping in Decision Making
It implies that accounting assists the management decision-making by providing significant information for solving numerous problems, such as deciding the selling price of goods produced, or deciding whether a part should be manufactured in the industrial unit or procured from outside.
Providing Information to Interested Groups
It implies that the accounting process provides appropriate information to various interested parties, such as owners, creditors and management who are concerned about the accounting information related to various aspects, such as, sales, production and profit.
Providing Legal Evidence
This refers to the documentary evidence of the accounting information for legal requirements. This helps to prevent any misconduct or threats from rival organisations.
Disadvantages of Financial Accounting
Apart from the advantages of accounting, it has some disadvantages. Some of the limitatmions of accounting are as follows:
- It focuses only on financial transactions or events while ignoring the non-monetary items.
- It leads to wrong conclusions if the assumptions of accounting data are inaccurate.
- It obtains biased information from the accountant if he/she willingly makes inappropriate estimations.
- It shows fixed asset at a particular cost, which would depreciate over time. Hence, there is a significant difference between the original cost at which assets were purchased and the current replacement cost.
- It provides accounting information on a yearly basis only, while the information can also be required for a shorter duration.