Financial Accounting

FINANCIAL ACCOUNTING REFERS TO THE BRANCH OF ACCOUNTING THAT DEALS WITH THE RECORDING,
SUMMARIZING, AND REPORTING OF FINANCIAL TRANSACTIONS OF A BUSINESS OR ORGANIZATION. ITS
PRIMARY PURPOSE IS TO PROVIDE FINANCIAL INFORMATION THAT IS USEFUL FOR EXTERNAL
STAKEHOLDERS, SUCH AS INVESTORS, CREDITORS, REGULATORS, AND OTHER INTERESTED PARTIES.

THE AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS DEFINES ACCOUNTING AS:

THE ART OF RECORDING, CLASSIFYING, SUMMARISING IN A SIGNIFICANT MANNER AND IN TERMS OF

MONEY, TRANSACTIONS AND EVENTS WHICH ARE, IN PART AT LEAST OF FINANCIAL CHARACTER, AND
INTERPRETING THE RESULTS THEREOF.
Nature of financial accounting

• Identifying monetary transactions – First, the transaction has to take place and be
identified so that it can be accounted for. To identify financial transactions, store
and check the receipts and bills of every transaction is a must. Sometimes, the
exchange of money is not directly involved, but it still needs to be identified. This
involves depreciation in the value of goods over time, which forms an important
aspect of financial accounting.
• Measuring and recording transactions – The value of transactions has to be
measured in terms of money and those concerned with revenues and
expenditures need to be recorded. The recording is done in journals.
• Classifying payments – The huge data needs to be classified in a record known as
a ledger. For example, all salary-related expenses can be classified under one
column. Leasing related data can be classified in another column and so on.
• Summarisation – The larger the corporation, the more complicated the record.
Hence, the record needs to be summarised in a form where it can be easily
comprehended.
• Analysing, interpretation, and communication: The summarised data needs to be
analysed well and interpreted so that it can be communicated to the concerned
stakeholders so that they have the full knowledge of the company’s financial
position.
Scope of Financial Accounting

The scope of financial accounting is broad and encompasses various

activities related to the recording, reporting, and analysis of financial
transactions. Here’s a detailed breakdown of its scope:
1. Recording Financial Transactions
• Journal Entries: Capturing all financial transactions in chronological
order through journal entries.
• Ledger Accounts: Posting journal entries to ledger accounts to
categorize and summarize transactions.
• Trial Balance: Preparing a trial balance to ensure that debits and
credits are balanced.
2. Preparation of Financial Statements
• Balance Sheet (Statement of Financial Position): Shows the financial
position of an organization at a specific point in time, detailing assets,
liabilities, and equity.
• Income Statement (Profit and Loss Statement): Summarizes revenues,
expenses, and profits or losses over a specific period.
• Cash Flow Statement: Provides information on cash inflows and outflows
from operating, investing, and financing activities.
• Statement of Changes in Equity: Details changes in equity accounts over a
period, including retained earnings, contributed capital, and other
comprehensive income.
3.Financial Reporting
• External Reporting: Preparing reports for external stakeholders, including investors, creditors, and
regulatory authorities.
• Annual Reports: Compilation of comprehensive financial reports that include financial statements,
management discussion and analysis, and auditor’s reports.
• Regulatory Filings: Ensuring compliance with reporting requirements set by regulatory bodies such
as the Securities and Exchange Commission (SEC) or similar entities.

4.Compliance with Accounting Standards

• Generally Accepted Accounting Principles (GAAP): Following standards and principles established in
the United States.
• International Financial Reporting Standards (IFRS): Adhering to global standards for entities
operating internationally.
• Local Accounting Standards: Complying with accounting standards specific to a country or industry.
5.Internal Controls
• Safeguarding Assets: Implementing controls to prevent theft, fraud, and mismanagement of
assets
• Accuracy and Reliability: Ensuring the accuracy and reliability of financial reporting through
control systems and audits.
• Segregation of Duties: Designing processes to separate responsibilities to reduce the risk of
errors and fraud.
6. Financial Analysis
• Ratio Analysis: Calculating and interpreting financial ratios to assess liquidity, profitability, and
solvency.
• Trend Analysis: Analyzing financial performance trends over time to make forecasts and
strategic decisions.
• Benchmarking: Comparing financial performance against industry standards or competitors.
7. Budgeting and Forecasting
• Budget Preparation: Developing budgets based on historical data and
future projections to guide financial planning.
• Forecasting: Estimating future financial performance based on various
scenarios and assumptions.

8. Audit and Assurance

• Internal Audits: Conducting internal reviews to ensure adherence to
policies and accuracy in financial reporting.
• External Audits: Engaging external auditors to review and verify the
financial statements and provide an independent opinion.
9.Tax Reporting and Compliance
Tax Returns: Preparing and filing tax returns in compliance with tax laws
and regulations.
Tax Planning: Strategizing to minimize tax liabilities through effective
planning and compliance.
10. Historical Record Keeping
Documentation: Maintaining accurate records of all financial
transactions and reports for historical reference and future audits.
Retention Policies: Following legal and organizational policies on the
retention of financial records.
11. Regulatory Compliance

Adherence to Standards: Financial accounting ensures compliance with generally accepted

accounting principles (GAAP), International Financial Reporting Standards (IFRS), or other
local accounting standards. This adherence helps prevent legal issues and maintains
transparency.

Tax Reporting: Accurate financial records are essential for preparing and filing tax returns,
ensuring compliance with tax laws and avoiding penalties.

12. Transparency and Accountability

Stakeholder Trust: By providing a clear and standardized view of a company’s financial

health, financial accounting fosters transparency. This transparency helps build trust among
investors, creditors, customers, and other stakeholders.

Preventing Fraud: Accurate and systematic financial accounting practices reduce the risk of
financial mismanagement and fraud, as internal controls and audits help detect and prevent
irregularities.
Functions Of Accounting

• Keeping financial records: Accounting helps businesses maintain an accurate and up-to-
date record of the day-to-day financial transactions of the company, such as supply
purchases, product sales, receipts and payments.
• Monitoring financial transactions: Accountants may track multiple financial transactions
related to payments due to the company to ensure it receives the revenue and remains
profitable.
• Making bill payments: Accounting involves checking invoices to ensure the legitimacy of
the charges, setting payment dates and paying the bills that the company owes to various
vendors and suppliers.
• Paying employee salaries: Companies can use accounting to make payroll payments from
company funds, manage employee benefits and issue employee work-related bonuses.
• Keeping digital records: Accounting may involve creating, maintaining and updating
digital accounting systems to store and calculate the company's financial data.
• Writing financial reports: Accounting involves repairing detailed quarterly and annual
financial reports about the company's assets, profits and losses for internal and external
stakeholders.
• Maintaining fiscal history: Accountants assist with creating, documenting and storing the
fiscal history of the company's transactions and making it available for audits and
assessments.
• Achieving business goals: An accountant can analyse financial data to formulate and
implement comprehensive financial policies and strategies to advance the company's
business goals.
• Preparing budgets: The accounts department may reference the company's financial data
to prepare the overall company budget, the department budgets and the project budgets.
• Making financial projections: Accounting involves analysing the company's available
financial resources, expected revenues and business goals and using this information to
predict future business expansion and growth.
• Auditing finances: Accountants may conduct financial audits of the company, identify
accounting discrepancies and implement corrective solutions.
• Assessing financial resources: Companies can use accounting to identify the financial
weaknesses and strengths of the organisation, determine how to counter weaknesses and
boost strengths and implement appropriate strategies.
• Reviewing performances: Accounting involves performing regular
financial reviews of the company's departments to assess their
performance and make changes to reduce waste, increase productivity
and streamline expenses.
• Complying with legal requirements: Accountants make sure the
company complies with industry and government rules, regulations and
policies related to taxation, financial reporting and employee wages.
• Preventing mismanagement: The accounting department can keep
accurate track of the company's financial transactions to ensure no
mismanagement or wastage of money occurs in the company.
• Ensuring vigilance against fraud: Accounting includes implementing
strong security measures to protect the company assets against data
breaches and internal and external fraud.
Limitations of Financial Accounting
1. Historical in Nature -The nature of financial accounting is mostly historical. It keeps track of
previously completed transactions and events. As a result, as part of the stewardship
function of management, financial statements are created and presented at the closing of
the accounting period. Although the data is historically significant, it does not offer
management with current data for analysing operational efficiency.
2. Overall Performance: Financial accounting reveals and reflects the profit or loss of a
company as a whole. It fails to offer information on expenses and profit of various sub-
divisions of the organization since it does not classify accounts on the basis of departments
or segments, products, processes, and sales territories.
3. No Objective Classification: Personal and impersonal accounts are the two primary types of
accounts in financial accounting. Such a subjective basic classification is of limited help to
management in determining costs by products, jobs, and processes.
4. Distinction between Direct and Indirect Expenses: Expenses are not divided into direct and
indirect, fixed and variable, controllable and uncontrollable, and assigned to departments,
jobs, or products in financial accounting. As a result, for the objectives of cost control and
cost reduction, controllable and uncontrollable expenditures cannot be differentiated.
5. Material Losses: There is no protection against material losses due to wastage, pilferage,
depreciation, and obsolescence of materials since there is no material management system
functioning under financial accounting.
6. Labour Cost Control: Because workers are paid on the basis of hours worked, there is no
way to compare the time taken with the time allowed in financial accounting. As a result,
losses due to idle time, work evasion, and loitering are uncontrollable. Furthermore, no job-
specific labour time is documented. As a result, there is no way to assess the effective use
of labour time, and no incentive schemes based on results can be implemented.
7.Idle Facilities: – Losses owing to idle plant and equipment are not recorded in financial
accounting.
8.No Cost Comparison: – Financial accounting does not provide data that may be used to
compare costs between periods, businesses, jobs, divisions, or procedures. As a result,
conclusions about the profitability of various items, positions, departments, procedures, or
sales areas are impossible to reach.
9. Distortion of Trading Results: The value of closing inventory is calculated in financial
accounting for the income statement and balance sheet. Costs and revenues cannot be
effectively matched if the values are not expressed precisely. As a result, trading outcomes
are skewed due to the wide range of values.
10. Lack of Data for Decision-Making: -One of the most essential roles of management in
every organization is decision-making. Financial accounting, on the other hand, fails to
provide the necessary data for decisions such as the introduction of a product line, the
discontinuation of production of a product or a department, whether to produce or purchase,
equipment replacement, and appropriate product mix, and so on.
Types of Accounting
1. Financial accounting

Financial accounting involves capturing and summarizing a business’s financial

transactions and creating and reading reports to provide a clear overview of those
business transactions. ‍

Financial accountants also generate financial records that provide valuable information
about a company’s fiscal health, such as balance sheets, cash flow statements, and
income statements. Financial accounting is focused on past performance, not the future.

The statements created by financial accountants are useful for internal purposes,
providing businesses with a snapshot of a company’s performance.
2. Managerial accounting

The management accounting method is used by businesses to gain greater insights into
a company’s operations. Since managerial accounting is strictly focused on providing
accounting information for internal use, it doesn’t have to stick to the same strict GAAP
guidelines as financial accounting. Instead, it focuses on things like financial analysis,
budgeting, and cost analysis.

By analyzing past financials and forecasting future outcomes—for example, how much a
company could cut expenditures by switching software providers—
managerial accountants provide business owners with the data they need to make savvy
business decisions. Generally, the emphasis is on strategic management, risk
management, or performance management.

Techniques commonly used by management accountants include margin analysis, capital

budgeting, and constraint analysis. Trend analysis—which identifies patterns in business
expenditures over time—is also useful.
3. Cost accounting

Cost accounting is considered a subcategory of management accounting, focusing

specifically on a company’s cost of doing business. This is used explicitly for
internal purposes, helping determine how to reduce costs and increase profit
margins. Companies may hire cost accountants to determine how to streamline
overall operations.

Cost accounting is particularly useful in manufacturing environments. It takes into

account various expenditures, including fixed costs and variable costs, including
from sources like commercial rent, materials costs, and labor expenses. The aim is
to ensure the cost needed to produce a good (the cost per unit) is reasonable. If
not, business owners can strategize on how to lower costs.

There are different types of cost accounting methods, each with its own focal
point. For example, activity-based cost accounting considers all activity needed to
produce a company’s goods or services, while lean accounting focuses on
eliminating waste.
4. Tax accounting

Tax accounting ensures a business, nonprofit, or individual abides by

applicable tax laws and regulations. In the U.S., tax accountants operate
according to guidelines set forth by the Internal Revenue Code (IRC), which
helps ensure a level playing field across all taxpayers in the country.

When working with a business, a tax accountant’s primary goal is to ensure

the entity accurately calculates and reports its tax liabilities. Proper tax
preparation can help a company avoid errors on their tax paperwork that can
result in getting an audit from the IRS—a time-consuming and potentially
costly process that small businesses want to avoid.

A tax accountant has in-depth knowledge of applicable tax laws, which vary
at the state and federal levels and can help business owners navigate these
complex guidelines. A tax accountant can also support future tax planning,
finding ways to avoid unnecessary tax burdens.
5. Auditing

Auditing is a type of accounting that provides an independent analysis of a

business’s financial activity. By objectively tracking and reporting all
activities, auditing ensures the company abides by relevant regulations
and best practices.

‍ uditors are never directly involved in the organization that they audit.
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After reviewing financial records, they create an in-depth audit report
detailing their findings.

An audit can be external or internal. Internal auditors aim to determine how

effective a business’s current accounting processes are. This can help a
company improve financial planning by identifying potential wasted
resources, mitigating the risk of fraud, and avoiding mismanagement.
External auditing involves reviewing a company’s formal financial
statements, ensuring they’re prepared in line with GAAP.
Types of Accounting Systems
1.Manual Accounting System
Manual accounting system means recording financial data by hand, using pen & paper in a
general ledger. There is no need for a computer, accounting software or any complex systems.
A physical ledger records the financial transactions in the order of events. Transactions are
recorded & verified from the physical invoices and receipts.

Manual accounting system is cost-effective and easy to understand. This system is suitable for
small businesses with limited transactions. The downside of this system is that it is very time
consuming and error-prone than the other accounting systems.

2.Computerized Accounting System

A computerized accounting system uses accounting software to automate the transaction
recording process and produce financial reports. This system provides faster data entry, real-time
updates, and accurate reporting.

There are various types of accounting software available with different kinds of features. The
accounting software is customizable according to business needs. This
accounting software is easy to use with intuitive interfaces and helpful tutorials or customer
support to help users manage their finances effectively.

The computerized accounting system has various accounting features like invoicing, payroll
processing, managing accounts payable and inventory management. This system is suitable for
3.Cloud-Based Accounting System
Cloud-based accounting system is also a computerized system
where financial data is stored on remote servers accessed via
the internet. This system allows users to access their financial
information from anywhere, at any time.
Cloud-based accounting software can be integrated
directly into bank accounts. So, whenever a payment is made
or received, the particular entries will be created and assigned
to the appropriate accounts automatically.
Cloud-based accounting systems can do invoicing, generating
financial reports, calculating sales tax, reminding & processing
payments, and many other things. This system is particularly
beneficial for businesses of all sizes, especially, businesses
with multiple locations.
4.Enterprise Resource Planning (ERP) System
An ERP system is an integration of various business processes
including accounting. An ERP system is used to manage
inventory, processes in finance, procurement, project
management, risk management, and various other tasks.
This system helps to run an entire business. But it is really
expensive. ERP systems are typically used by large industries &
organizations with multiple departments and complex financial
needs.
ACCOUNTING PRINCIPLES

• Accounting principles based on certain concepts, convention, and tradition

have been evolved by accounting authorities and regulators and are
followed internationally.
• These principles, which serve as the rules for accounting for financial
transactions and preparing financial statements, are known as the
“Generally Accepted Accounting Principles,” or GAAP.
• The application of the principles by accountants ensures that financial
statements are both informative and reliable.
• It ensures that common practices and conventions are followed, and that
the common rules and procedures are complied with
• Accounting principles involve both accounting concepts and accounting
conventions.
ACCOUNTING CONCEPTS

• The accounting concept is a process that helps prepare and

record the financial transactions in an organisation, along with
organising the bookkeeping processes.
• Accounting concepts are the basic assumptions on which
accounting operates.
• It is always important for business accountants and owners to
clearly understand the basic accounting concepts. Such
understanding helps in integrating uniformity and consistency
within the business accounting processes.
TYPES OF ACCOUNTING
CONCEPTS
• Business entity concept: A business and its owner should be treated
separately as far as their financial transactions are concerned.
• Money measurement concept: Only business transactions that can be
expressed in terms of money are recorded in accounting, though records
of other types of transactions may be kept separately.
• Dual aspect concept: For every credit, a corresponding debit is made.
The recording of a transaction is complete only with this dual aspect.
• Going concern concept: In accounting, a business is expected to
continue for a fairly long time and carry out its commitments and
obligations. This assumes that the business will not be forced to stop
functioning and liquidate its assets at “fire-sale” prices.
• Cost concept: The fixed assets of a business are recorded on the basis of their
original cost in the first year of accounting. Subsequently, these assets are recorded
minus depreciation. No rise or fall in market price is taken into account. The concept
applies only to fixed assets.
• Accounting year concept: Each business chooses a specific time period to complete
a cycle of the accounting process—for example, monthly, quarterly, or annually—as
per a fiscal or a calendar year.
• Matching concept: This principle dictates that for every entry of revenue recorded in
a given accounting period, an equal expense entry has to be recorded for correctly
calculating profit or loss in a given period.
• Realisation concept: According to this concept, profit is recognised only when it is
earned. An advance or fee paid is not considered a profit until the goods or services
have been delivered to the buyer.
ACCOUNTING CONVENTIONS

• Accounting conventions, also known as doctrine, are

known to be principles that act as restrictions
regarding organisational transactions that are
unclear or complicated.
• The guidelines that are followed to prepare financial
statements are called accounting conventions.
• The accountants in a company adopt the use of
these conventions so that they act as a guide while
preparing accounting statements and reports
• Conservatism is the convention by which, when two values of a transaction are available, the
lower-value transaction is recorded. By this convention, profit should never be overestimated,
and there should always be a provision for losses.

• Consistency prescribes the use of the same accounting principles from one period of an
accounting cycle to the next, so that the same standards are applied to calculate profit and
loss.

• Materiality means that all material facts should be recorded in accounting. Accountants
should record important data and leave out insignificant information.

• Full disclosure entails the revelation of all information, both favourable and detrimental to a
business enterprise, and which are of material value to creditors and debtors.
 Accounting Equation

The accounting equation is the basic element of the balance sheet and
the primary principle of accounting. It helps the company to prepare a
balance sheet and see if the entire enterprise’s asset is equal to its
liabilities and stockholder equity. It is the base of the double-entry
accounting system.

Double-entry accounting is a system that ensures that accounting and

transaction equation should be equal as it affects both sides. Any
change in the asset account, there should be a change in related liability
and stockholder’s equity account. While performing journal entries
accounting equation should be kept in mind.
Accounting equations are the foundation of double-entry bookkeeping. The basic
accounting equation is:
Assets = Liabilities + Owner's Equity
This equation shows that everything a company owns (its assets) is financed
either through debt (liabilities) or through the owner's investment (equity).
Here's a breakdown of the components:
1. Assets: These are resources that the company owns or controls, like cash,
inventory, accounts receivable, property, etc.
2. Liabilities: These are obligations the company owes to others, such as loans,
accounts payable, or other debts.
3. Owner's Equity: This is the residual interest in the assets of the entity after
deducting liabilities. It's what the owners "own" once all debts are paid, often
including capital invested and retained earnings.
This equation must always be balanced, meaning any transaction that
affects one side will always affect the other. For example:
• If a company takes out a loan (increasing liabilities), it also increases
its cash (assets).
• If a company earns revenue (increasing assets), it also increases
owner’s equity through retained earnings.