Financial Accounting

Financial Accounting Definition

Financial accounting is the systematic procedure of recording, classifying, summarizing, analyzing, and reporting business transactions. The primary objective is to reveal the profits and losses of a business. Financial accounting provides a true and fair evaluation of a business. It, therefore, safeguards the interests of stakeholders.

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Financial accounting includes the bookkeeping of financial transactions like purchases, sales, receivables, and payables. Accountants follow the Generally Accepted Accounting Principles (GAAP) for creating income statements, cash flow statements, balance sheets, and shareholder’s equity statements.

Fundamentals of Financial Accounting

Financial accounting is simply the bookkeepingBookkeepingBookkeeping is the day-to-day documentation of a company’s financial transactions. These transactions include purchases, sales, receipts, and payments.read more and interpretation of transactions. It is carried out to gauge corporate performance and profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more. The regulatory bodies have stated some basic principles to standardize the process. In the US, companies follow the guidelines of GAAPGAAPGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting.read more.

All financial transactions revolve around five basic components, i.e., assets, liabilities, income, expenses, and equity. Also, every financial transaction has two equal aspects. For example, if cash is withdrawn from a bank in the company’s book under the double-entry systemDouble-entry SystemDouble Entry Accounting System is an accounting approach which states that each & every business transaction is recorded in at least 2 accounts, i.e., a Debit & a Credit. Furthermore, the number of transactions entered as the debits must be equivalent to that of the credits. read more, both cash and bank would be affected. Under the double-entry system, we call these two aspects; debit and credit. DebitDebitDebit represents either an increase in a company’s expenses or a decline in its revenue. read more is either the increase in assets and expenses or the decrease in liabilities and income. Credit is either the increase in liabilities and income or the decrease in assets and expenses.

Financial Accounting Video Explanation

Financial Accounting Principles

As financial accounting is solely prepared for disclosing a company’s financial informationFinancial InformationFinancial Information refers to the summarized data of monetary transactions that is helpful to investors in understanding company’s profitability, their assets, and growth prospects. Financial Data about individuals like past Months Bank Statement, Tax return receipts helps banks to understand customer’s credit quality, repayment capacity etc.read more, the statements and reports the company produces should be valid and credible. Companies follow specific rules charted under the “Generally Accepted Accounting Principles,” abbreviated as GAAP.

GAAP covers basic accounting principlesAccounting PrinciplesAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts.read more, including going concern principleGoing Concern PrincipleAny analyst analyzing a company will be left to a basic assumption that the company does not go bankrupt or file a chapter 11 bankruptcy. This basic assumption allows the analyst to think that there is no immediate danger to the company. The company can operate until infinity is called the principle of going concern.read more, full disclosure conceptFull Disclosure ConceptFull Disclosure Principle is an accounting policy backed by GAAP and IFRS, asking the management of an organization to disclose every relevant and material financial information to creditors, investors and any other stakeholder who depend on the financial reports and decision-making process.read more, accrual conceptAccrual ConceptAccrual Accounting is an accounting method that instantly records revenues & expenditures after a transaction occurs, irrespective of when the payment is received or made. read more, matchingMatchingThe Matching Principle of Accounting provides accounting guidance, stating that all expenses should be recognized in the income statement of the period in which the revenue related to that expense is earned. This means that, regardless of when the actual transaction is made, the expenses that are entered into the debit side of the accounts should have a corresponding credit entry in the same period.read more, cost, consistency, economic entity, materialityMaterialityIn any financial accounting statements, there are some transactions that are too small to be recognized and such transactions might not have any impact on the analysis of the financial statement by an external observer; removal of such irrelevant information to keep the financial statement crisp and consolidated is called as the concept of materiality.read more, period, revenue recognition, and monetary unit. GAAP ensures accurate and reliable reports. However, GAAP doesn’t always remain the same. Instead, it is constantly updated based on the complexities arising in accounting.

Types of Financial Accounting

A company can record its transactions in two ways.

1. Cash Accounting: The GAAP recommends this method. This kind of financial accounting considers cash transactions. Thus, each transaction has a debit and credit entry.
2. Accrual Accounting: Most corporations prefer this method to record cash and non-cash business transactionsBusiness TransactionsA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements.read more. This method emphasizes the documentation of trades as and when they occur, irrespective of monetary exchange.

Financial Statements

Every investor should go through the following four financial statements of a company.

1. Income Statement: The purpose of the income statementPurpose Of The Income StatementAn income statement is prepared to summarize all revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time, based on the needs of the income statement's users.read more is to find the company’s net income for the year. Accountants take all accounting transactionsAccounting TransactionsAccounting Transactions are business activities which have a direct monetary effect on the finances of a Company. For example, Apple representing nearly $200 billion in cash & cash equivalents in its balance sheet is an accounting transaction. read more (including non-cash ones) and do a “revenue – expense” analysis to determine the year’s profit.
2. Balance Sheet: The Balance SheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more is based on the following equation –
3.  Assets = Liabilities + Shareholders’ Equity.
4.  It states that a business entityBusiness EntityA business entity is one that conducts business in accordance with the laws of the country. It can be a private company, a public company, a limited or unlimited partnership, a statutory corporation, a holding company, a subsidiary company, and so on.read more possesses and owes.
5. Shareholders’ Equity Statement: It is a statement that includes shareholders’ equityShareholders' EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period.read more, retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more, reserves, and other stock-related items. It is an indicator of the changes in the ownership interest of the stakeholdersStakeholdersA stakeholder in business refers to anyone, including a person, group, organization, government, or any other entity with a direct or indirect interest in its operations, actions, and outcomes.read more.
6. Cash Flow Statement: The cash flow statementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business.read more combines three statements – cash flow from operating activitiesCash Flow From Operating ActivitiesCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more, cash flow from financing activitiesCash Flow From Financing ActivitiesCash flow from financing activities refers to inflow and the outflow of cash from the financing activities like change in capital from securities like equity or preference shares, issuing debt, debentures or repayment of a debt, payment of dividend or interest on securities.read more, and the cash flow from investing activitiesCash Flow From Investing ActivitiesCash flow from investing activities refer to the money acquired or spent on the purchase or disposal of the fixed assets (both tangible and intangible) for the business purpose. For instance, the purchase of land and joint venture investment is cash outflow, while equipment sale is a cash inflow.read more.

All non-cash expensesNon-cash ExpensesNon-cash expenses are those expenses recorded in the firm's income statement for the period under consideration; such costs are not paid or dealt with in cash by the firm. It involves expenses such as depreciation.read more (or losses) are added back. Simultaneously, all non-cash incomes (or profits) are deducted. As a result, we derive net cash inflow for the year, total cash inflow – and total cash outflow.

Financial Accounting Examples

Consider the example of Nestle Holdings Inc. and its 2020 financial statements. Notice how they prepare financial statements.  

#1 – Income Statement

Given below is an extract of Nestle’s consolidated income statement for the year 2020:

As we can see, the company generated a net profit of $3290 million in 2020, which is more than three times the net profit of 2019.

#2 – Balance Sheet

The company assets, liabilities, and equity for the year 2020 were recorded as follows:

Therefore, based on the data, we can infer the following:

1. There was a rise in the company’s current and non-current assets in 2020, which led to total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equityread more being valued at $54394 million.
2. Similarly, the company’s current and non-current liabilities increased. As a result, total liabilities rose to $32783 million.
3. In 2020. the total shareholder’s equity rose from $18594 million in 2019 to $21611 million.

#3 – Cash Flow Statement

Now let us have a look at Nestle’s CFS for 2020:

This financial statement signifies the following points:

1. The cash flow generated from operations was comparatively less, amounting to only $1783 million in 2020. In comparison, $2287 million was generated in 2019.
2. Whereas Nestle’s cash flow from investing increased to $2127 million. This was due to the disposal of businesses.
3. Financing represented a negative cash flow which amounted to $3883 million in 2020. This was majorly a result of the loans given to the parent and affiliates.
4. However, the company had a positive balance of $350 million in 2020. This includes both cash and cash equivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation.  Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. read more at the end of 2020. The balance amount was higher than the previous year.

It is important to note that Nestle Holdings Inc. uses the calendar year for financial accounting.

Financial Accounting Advantages

Accounting is an indispensable part of any business since it reveals the actual financial position of the firm. Therefore, records are maintained for every year of operation. As a result, a comparison between different accounting periodsAccounting PeriodsAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more can be made. Also, the firm can compare financial statements against the performance of other companies. Further, accounting is crucial for taxation, and these records become crucial legal documents if and when a dispute arises.

Besides, accounting discourages fraudulent practices and theft within the department. The transfer of every penny is visible. In other words, fraudulent transactions also leave a paper trail. Moreover, these are valuable documents for internal and external parties. Decisions ranging from cash flows and the status of resources to efficient utilization rely on this data. It is a crucial input for investors creditorsCreditorsA creditor refers to a party involving an individual, institution, or the government that extends credit or lends goods, property, services, or money to another party known as a debtor. The credit made through a legal contract guarantees repayment within a specified period as mutually agreed upon by both parties. read more, and lenders as it informs them of the business’ performance and potential risks.

Financial Accounting Limitations

Financial data is not perfect. It fails to record non-financial aspects like employee satisfaction and customer retention. Those factors also play a considerable role in impacting performance. Most historical data is less relevant for future planning. Even after taking all the measures, accounting may not unveil the actual business standing. This happens when a firm adopts the accrual basis of accounting or goes with the cost concept while the real assetReal AssetReal Assets are tangible assets that have an inherent value due to their physical attributes. These assets include metals, commodities, land, and factory, building, and infrastructure assets. read more cost varies.

The financial statements are prone to human errors. Personal bias is inevitable; each person has a different thought process. Opinions and judgments impact the analysis of statements. Financial accounting reveals overall business profits rather than disclosing the income and expense of each unit of goods or services. As a result, it is ineffective for cost managementCost ManagementCost management is an integral part of business management that works on the basis of estimates, where various activities such as data collection, data analysis and mechanisms, process evaluation, and event reporting are carried out so that the decision-maker can plan and control the organization's budget requirements, allowing the decision-maker to make informed decisions.read more.

Frequently Asked Questions (FAQs)

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