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Financial accounting (or financial accountancy) is the field of accounting concerned with the preparation of financial statements for decision makers, such as stockholders, suppliers, banks, employees, government agencies, owners, and other stakeholders using either the Historical Cost or Constant Purchasing Power Accounting model. Financial capital maintenance can be measured in either nominal monetary units (HCA) or units of constant purchasing power (CPPA). Most entities use the historical cost basis (financial capital maintenance in nominal monetary units) to prepare their financial reports during low and high inflation and deflation. International Financial Reporting Standards (IFRS) require entities to implement Constant Purchasing Power Accounting (financial capital maintenance in units of constant purchasing power) in terms of IAS 29 Financial Reporting in Hyperinflationary Economies during hyperinflation. The fundamental need for financial accounting is to reduce principal–agent problem by measuring and monitoring agents' performance and reporting the results to interested users.
Financial accounting is used to prepare accounting information for people outside the organization or not involved in the day-to-day running of the company. Management accounting provides accounting information to help managers make decisions to manage the business.
In short, financial accounting is the process of summarizing financial data taken from an organization's accounting records and publishing in the form of annual (or more frequent) reports using Historical Cost Accounting during low and high inflation and deflation and Constant Purchasing Power Accounting during hyperinflation for the benefit of people outside the organization.
Financial accountancy is governed by both local and international accounting standards.
- 1 Objectives of financial accounting
- 2 Qualities of financial accounting
- 3 Five components of financial statements
- 4 Basic accounting concepts
- 5 Graphic definition
- 6 Financial accounting vs cost accounting
- 7 Related qualification
- 8 See also
- 9 Further reading
- 10 References
Objectives of financial accounting
Financial accounting and financial reporting are often used as synonyms.
1. According to International Financial Reporting Standards the objective of financial reporting is:
To provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.
2. According to the European Accounting Association:
Capital maintenance is a competing objective of financial reporting.
Qualities of financial accounting
Financial accounting is the preparation of financial statements that can be consumed by the public and the relevant stakeholders using either HCA or CPPA. When producing financial statements, they must comply to the following:
- Relevance: accounting which is decision-specific. It must be possible for accounting information to influence decisions. Unless this characteristic is present, there is no point in cluttering statements.
- Materiality: information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.
- Reliability: accounting must be free from significant error or bias. It should be capable to be relied upon by managers. Often information that is highly relevant isn’t very reliable, and vice-versa.
- Understandability: accounting reports should be expressed as clearly as possible and should be understood by those at whom the information is aimed.
- Comparability: financial reports from different periods should be comparable with one another in order to derive meaningful conclusions about the trends in an entity’s financial performance and position over time. Comparability can be ensured by applying the same accounting policies over time.
Five components of financial statements
The Statement of Cash Flows considers the inputs and outputs in concrete cash within a stated period. The general template of a cash flow statement is as follows: Cash Inflow - Cash Outflow + Opening Balance = Closing Balance Example 1: in the beginning of September, Ellen started out with $5 in her bank account. During that same month, Ellen borrowed $20 from Tom. At the end of the month, Ellen bought a pair of shoes for $7. Ellen's cash flow statement for the month of September looks like this:
- Cash inflow: $20
- Cash outflow: $7
- Opening balance: $5
- Closing balance: $20 – $7 + $5 = $18
Example 2: in the beginning of June, WikiTables, a company that buys and resells tables, sold 2 tables. They'd originally bought the tables for $25 each, and sold them at a price of $50 per table. The first table was paid out in cash however the second one was bought in credit terms. WikiTables' cash flow statement for the month of June looks like this:
- Cash inflow: $50 - How much WikiTables received in cash for the first table. They didn't receive cash for the second table (sold in credit terms).
- Cash outflow: $50 - How much they'd originally bought the 2 tables for.
- Opening balance: $0
- Closing balance: $50 – $50 + $0 = $0 - Indeed, the cash flow for the month of June for WikiTables amounts to $0 and not $50.
Important: the cash flow statement only considers the exchange of actual cash, and ignores what the person in question owes or is owed.
Profit and Loss Statement (also called Statement of Comprehensive Income)
Statement of Financial Position (also called Balance Sheet)
Basic accounting concepts
THE STABLE MEASURING UNIT ASSUMPTION One of the basic principles in accounting is “The Measuring Unit principle:
The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.”
Historical Cost Accounting, i.e., financial capital maintenance in nominal monetary units, is based on the stable measuring unit assumption under which accountants simply assume that money, the monetary unit of measure, is perfectly stable in real value for the purpose of measuring (1) monetary items not inflation-indexed daily in terms of the Daily CPI and (2) constant real value non-monetary items not updated daily in terms of the Daily CPI during low and high inflation and deflation.
UNITS OF CONSTANT PURCHASING POWER The stable measuring unit assumption is not applied during hyperinflation. IFRS requires entities to implement capital maintenance in units of constant purchasing power in terms of IAS 29 Financial Reporting in Hyperinflationary Economies.
Financial accountants produce financial statements based on the accounting standards in a given jurisdiction. These standards may be the Generally Accepted Accounting Principles (GAAP) of a respective country, which are typically issued by a national standard setter, or International Financial Reporting Standards (IFRS), which are issued by the International Accounting Standards Board (IASB).
Financial accounting serves the following purposes:
- producing general purpose financial statements
- producing information used by the management of a business entity for decision making, planning and performance evaluation
- producing financial statements for meeting regulatory requirements.
Objectives of Financial Accounting
- Systematic recording of transactions: basic objective of accounting is to systematically record the financial aspects of business transactions (i.e. book-keeping). These recorded transactions are later on classified and summarized logically for the preparation of financial statements and for their analysis and interpretation.
- Ascertainment of result of above recorded transactions: accountant prepares profit and loss account to know the result of business operations for a particular period of time. If expenses exceed revenue then it is said that business running under loss. The profit and loss account helps the management and different stakeholders in taking rational decisions. For example, if business is not proved to be remunerative or profitable, the cause of such a state of affair can be investigated by the management for taking remedial steps.
- Ascertainment of the financial position of business: businessman is not only interested in knowing the result of the business in terms of profits or loss for a particular period but is also anxious to know that what he owes (liability) to the outsiders and what he owns (assets) on a certain date. To know this, accountant prepares a financial position statement of assets and liabilities of the business at a particular point of time and helps in ascertaining the financial health of the business.
- Providing information to the users for rational decision-making: accounting as a ‘language of business’ communicates the financial result of an enterprise to various stakeholders by means of financial statements. Accounting aims to meet the financial information needs of the decision-makers and helps them in rational decision-making.
- To know the solvency position: by preparing the balance sheet, management not only reveals what is owned and owed by the enterprise, but also it gives the information regarding concern’s ability to meet its liabilities in the short run (liquidity position) and also in the long-run (solvency position) as and when they fall due.
The trial balance, which is usually prepared using the double-entry accounting system, forms the basis for preparing the financial statements. All the figures in the trial balance are rearranged to prepare a profit & loss statement and balance sheet. Accounting standards determine the format for these accounts (SSAP, FRS, IFRS). Financial statements display the income and expenditure for the company and a summary of the assets, liabilities, and shareholders' or owners' equity of the company on the date to which the accounts were prepared.
Assets and expenses have normal debit balances, i.e., debiting these types of accounts increases them.
Liabilities, revenues, and capital have normal credit balances, i.e., crediting these increases them.
0 = Dr Assets Cr Owners' Equity Cr Liabilities . _____________________________/\____________________________ . . / Cr Retained Earnings (profit) Cr Common Stock \ . . _________________/\_______________________________ . . . / Dr Expenses Cr Beginning Retained Earnings \ . . . Dr Dividends Cr Revenue . . \________________________/ \______________________________________________________/ increased by debits increased by credits Crediting a credit Thus -------------------------> account increases its absolute value (balance) Debiting a debit Debiting a credit Thus -------------------------> account decreases its absolute value (balance) Crediting a debit
When the same thing is done to an account as its normal balance it increases; when the opposite is done, it will decrease. Much like signs in math: two positive numbers are added and two negative numbers are also added. It is only when there is one positive and one negative (opposites) that you will subtract.
Financial accounting vs cost accounting
- Financial accounting aims at finding out results of accounting year in the form of Profit and Loss Account and Balance Sheet. Cost Accounting aims at computing cost of production/service in a scientific manner and facilitate cost control and cost reduction.
- Financial accounting reports the results and position of business to government, creditors, investors, and external parties.
- Cost Accounting is an internal reporting system for an organization’s own management for decision making.
- In financial accounting, cost classification based on type of transactions, e.g. salaries, repairs, insurance, stores etc. In cost accounting, classification is basically on the basis of functions, activities, products, process and on internal planning and control and information needs of the organization.
- Financial accounting aims at presenting ‘true and fair’ view of transactions, profit and loss for a period and Statement of financial position (Balance Sheet) on a given date. It aims at computing ‘true and fair’ view of the cost of production/services offered by the firm.
Many professional accountancy qualifications cover the field of financial accountancy, including Certified Public Accountant (CPA), Chartered Accountant (CA or other national designations) and Chartered Certified Accountant (ACCA).
- Constant item purchasing power accounting
- Historical cost accounting
- Philosophy of accounting
- Accounting analyst, whose job involves evaluating public company financial statements
- Management accounting, the other main division of accounting
Alexander, D., Britton, A., Jorissen, A., "International Financial Reporting and Analysis", Second Edition, 2005, ISBN 978-1-84480-201-2
- Framework, Par 104 (a)
- IFRS Conceptual Framework(2010) Par. OB2
- European Accounting Association, Response to Question 26, Comment Letter to the Discussion Paper regarding the Review of the Conceptual Framework, on Page 2 of comment letters, dated 2014-01-24
- Chew, Lynsie; Parkinson, Alan (2013). Making Sense of Accounting for Business. Harlow: Pearson. ISBN 9781782369295.
- Paul H. Walgenbach, Norman E. Dittrich and Ernest I. Hanson, (1973), Financial Accounting, New York: Harcourt Brace Javonovich, Inc. Page 429.
- "Basic accounting principles you should know", Entrepreneurial Insights
- Cost and Management Accounting. Intermediate. The Institute of Cost Accountants of India. p. 17.