Financial accounting plays a crucial role in recording financial activities of a business entity. Financial accounting creates a standard way of financial reporting of companies. The process of financial reporting assists stakeholders such as investors and regulatory bodies for making judgments about companies’ performance.
In this blog, we will discuss what financial accounting is, its relevance, how financial accounting is performed, and finally, what is so indispensable about financial accounting in a business.
What is Financial Accounting?
Financial Accounting includes recording and reporting an organization’s financial activity that takes place in a fixed period of time, often on a quarterly or annual basis. Financial Accounting is guided by accounting principles or IFRS, depending on organizational or country-based criteria. Accounting principles help to ensure an element of consistency and comparability between various businesses.
The Process of Financial Accounting
Key Steps Explained
Financial accounting revolves around the history of the financial information of a business and seeks to offer a correct, detailed, and standardized representation of the financial position of the business. The procedure generally entails the following:
- Recording transactions: It entails documenting economic transactions such as sales, expenses, and investments.
- Classifying and summarizing the data: This transaction is categorized into groups for ease of interpretation and reporting.
- Financial statement preparation: The information is then formatted into important financial statements that indicate the company’s operation results.
Overview of Important Financial Statements in Financial Accounting
In financial accounting, the three main financial statements are:
1. Income Statement (Profit and Loss Statement)
From this statement, an organization’s income, expenditure, and profits or losses for a given time have been clearly indicated. Generally, this statement indicates whether an organization has generated profits or incurred losses within a given time, typically six months or one year.
2. Balance Sheet
The balance sheet provides an insight into the assets and liabilities as well as the equities of a company at a particular point in time. The balance sheet helps in understanding the assets and liabilities owned by the company.
3. Cash Flow Statement
This provides an outline of the cash received and paid for the different activities undertaken by the business. This statement is essential in determining the liquidity of the business, referred to as the ability of the business to meet its short-term financial obligations.
Why Is Financial Accounting Important?
1. Provides Transparency and Accountability
Financial accounting plays a pivotal role as far as transparency of financial activities of the organization is concerned. Financial accounting that involves accurate and appropriate recording and reporting of financial transactions enables any stakeholder, such as an investor or any other individual, to understand an organization’s financial position.
2. Allows for Informed Decision-Making
Financial accounting offers necessary information that promotes effective decision making. For instance:
- Shareholders rely on financial statements to make an assessment of a company’s profitability and growth prospects to identify whether to sell, hold, or buy their stocks.
- Creditors study financial statements to assess a company’s ability to repay borrowings, thus determining whether they will lend funds to the company.
- The data helps management in making strategic decisions on charging prices, expansion, cuts in cost, and other fundamental operations.
3. Legal and Regulatory Compliance
Financial accounting can therefore be used to help in monitoring compliance with financial regulations. Organizations have to follow all financial regulations, especially if they operate in the public sector or if they are listed. Organizations have to make their financial statements, especially if they issue stocks. Financial statements have to be in accordance with GAAP/IFRS. SEC, for instance, in the United States, has to be followed.
4. Performance tracking and financial health
Financial accounting enables the business entity to evaluate its financial health and performance over time. It allows companies to determine the strong and weak points of their operations through financial statements, manage costs and optimize spending in order to have better profitability. It also provides data on which the entity decides for expansion, investment, and allocation of capital.
5. Aids in Tax Reporting
Accurate financial accounting is crucial in terms of tax reporting and compliance. When filing taxes, the IRS and other tax authorities require businesses to provide minute details about their finances. Financial accounting ensures that organizations correctly present their income liable to taxes and follow the requirements of the tax laws.
Final Thoughts
In summary, financial accounting plays a crucial role in ensuring transparency, accuracy, and integrity of financial information. It provides business entities with the tools to measure their performance, make informed decisions based on evidence, and comply with relevant legal and regulatory requirements. It serves as a useful source for third-party users-for example, investors, creditors, and regulators-giving them a broader view of the financial stability and profitability of an organization.