Introduction
The purpose of financial accounting is to know the financial health of a company. This data is used by creditors, investors, stakeholders and even by the company itself to make uniformed decisions. It is a branch of accounting that specifically prepares legal standardized reports that are then used to determine if the company will remain profitable in the long run or not.
Imagine you are a family-owned business which records efficient sales. To you the company is performing well, which might not always be the case, if you are unaware of the various parameters that goes into determining the financial health of a company. Sales itself cannot be considered as a direct contributor to good financial health.
Financial Accounting serves as a backbone of any business, providing crucial insights into the financial performance for a fiscal year. It also ensures that transparency is maintained in all aspects of recording, summarizing and reporting of data. This blog will delve into what is financial accounting, standards used in financial accounting and its significance in the business world.
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What Is Financial Accounting?
Financial Accounting is the process of recording, summarizing and reporting of financial transactions of a business, within a specific period of time. These transactions can be, of the cost incurred for raw materials, day-to-day operations, salaries etc. These transactions are then prepared into financial statement that allows the investors, creditors, suppliers, and stakeholders to assess the company’s financial positions.
You can correlate it with a personal diary, where you record your daily expenses and transactions. Just as your diary gives you insights into your expenses against your monthly income, financial accounting provides a detailed report of a company’s financial transactions, which includes expenses, profits, revenues, amounts owed to stakeholders and much more. These transactions are then used to prepare financial statements such as – Balance Sheet, Income Statement and Cash Flow Statement.
What Is Financial Accounting Standards?
Imagine you are an investor, looking to invest in an off-shore company. When you try to read the company’s financial reports, you are not able to understand as to whether the company is recoding sales using cash method or accrual method of accounting.
You find that their reports are made using different format than yours. Hence you are unable to assess their financial position and performance. To solve this chaos, financial standards steps in. Financial Accounting Standards are the laid guidelines to record financial transactions and report it.
The most commonly used standards to ensuring consistency and compatibility are:
International Financial Reporting Standards (IFRS)
Developed by the International Accounting Standards Board (IASB), the IFRS is the most rational one, using a principle-based approach that is flexible. It uses FIFO (First In, First Out) and Weighted Average Cost method for inventory evaluation. Due to its transparency and natural flow of inventory, FIFO has been an accepted inventory evaluation method within IFRS. The standard – IFRS has been adopted by over 120 countries for its transparency and comparability.
There are more benefits within the IFRS, followed by some cons. However, the key attribute is inventory appraisal, fair value calculation of assets, and transparency in financial reporting.
Generally Accepted Accounting Principles (GAAP)
Developed by the Financial Accounting Standards Board (FASB), GAAP is primarily used in US, offering less flexibility in accounting treatment, with major focus on rule- based approach. Here the inventory evaluation is done with LIFO i.e. Last In, First Out. It also uses historic cost that is the original cost at which the asset was purchased, for its valuation. Suppose you had bought a land around $20000 in 2010, the asset cost in the year 2024 will also be $20000.
There are some benefits to GAAP, followed by some cons. However, it is rigid and requires strict format adherence and minimum discloser of information.
Let’s understand the difference between IFRS and US GAAP, with respect to inventory evaluation:
Purchases:
- January: 100 units at $50 each.
- February: 100 units at $60 each.
- The total sales is 150 units by March
FIFO (Under IFRS)
Under FIFO, the oldest inventory is sold first:
First 100 units at $50 each = $5,000 (January Units)
Next 50 units at $60 each = $3,000 (First 50 units of February)
- Total Cost of Goods Sold (COGS): $8,000 ($5000 + $3000)
- Remaining Inventory: 50 units from February at $60 each = $3,000
LIFO (under US GAAP)
Under LIFO, the newest inventory is sold first:
First 100 units at $60 each = $6,000 (February Units)
Next 50 units at $50 each = $2,500 ( 50 January Units)
- Total Cost of Goods Sold (COGS): $8,500 ($6,000 + $2,500 )
- Remaining Inventory: 50 units from January at $50 each = $2,500
The LIFO results in more COGS – i.e. the cost incurred in producing the goods. This results in lower profit. As for the FIFO, the COGS is low, ultimately the profit is higher.
Why Are Standards Important
When organizations use the same accounting standards, investors can simply compare their financial statements, allowing for improved decision-making. Without standardized reporting, analyzing and comparing financial data becomes difficult, particularly for investors attempting to analyze companies in the same industry or sector.
Example: If a Company in UK and a Company in Canada follows IFRS, then investors can easily compare their financial health, even through they operate in different countries.
What Is a Financial Account for a Business?
The financial account for a business is the data presented by the finance department. It includes –Balance Sheet, Income statement, and Cash Flow Statement. This helps us assess the company’s financial position, their performance and cash flow activities for determining operational effectiveness.
Balance Sheet:
Includes Assets on one side and Equity + Liabilities on the other side. It determines the financial position of a company as of that period of time. Balance sheet represents the current position of the company on a particular date. Ex: Balance Sheet of “Company K” as of 31st March, 2024
Income Statement:
Also known as Profit and Loss statement, it presents the revenue of the company on top hand side, followed by expense and Profit (Bottom Line) – Before Tax and After Tax. The income statement shows the financial performance of a company for a Fiscal Year or a quarter or a month.
Cash Flow Statement:
It tracks the inflow and outflow of cash over a period of time. The statement breaks down the cash flow into operating, investing, and financing activities. It enables the company to forecast whether it’s short-term liabilities will be satisfied or not. This also helps the management to make better decision that are in-coherent with the company’s goals and mission.
What Is the Primary Purpose of Financial Accounting?
Its core purpose is to inform the stakeholders and investors, on the company’s financial performance. This information is used both inward and outward, to gain an in- dept understanding on how the company is functioning. From employee use of data to anticipate their job stabilization to creditors and suppliers knowing that the company is making profit, Financial Accounting builds trust and enhances transparency. It also helps in
- Better Decision Making: Where to cut expenses and on which segment to invest. If the company is not performing well, let’s say – the digital marketing team is not yielding any result, then the company can decide to let go of that department. Vice Versa – when its performing well, the company can look into ways on how to further assist them, on which tools to invest in, and on hiring new talents.
- Compliance: Whether the company is abiding to tax regulations. Are the employees enrolled in Employee Benefit Plan, are the expenses and revenue shown on the financial reports accurate? Financial Accounting enables the company to be transparent in all aspects of their functioning.
Let’s take an example – You are an investor, reading the financial statements of two different companies, both following IFRS Standard. Company A has well-organized financial reports, while Company B’s data is scattered. Now, which company would you decide to invest in. It will be Company A obviously.
How to Get Started with Financial Accounting
- Begin with understanding the basic. Learn what assets, liabilities and equity are. Research on financial ratios and how to read financial statements. Try to read financial statements of listed companies on simplywallst.. Then analyze on why you think this company is performing good.
- Once the concept is clear, start investing in right tools and accounting software’s, tailored to your business size and industry.
- Hire a Finance Analyst or outsource professional help to kickstart your business on the right track.
Conclusion
Financial Accounting is more than just numbers and complex numerical data. It is the effective management of a company’s financial transactions, and reporting them without any malpractice. Its primary objective is to provide transparent and reliable financial information to stakeholders such as investors, creditors, and regulators. So if you’re a startup owner, a seasoned entrepreneur, or an aspiring accountant, understanding what is financial accounting, will prove to be a valuable skill.
At Corient Business Solutions, we specialize in providing tailored financial accounting services to help your business stay compliant, make informed decisions, and achieve sustainable growth. To see how we’ve helped businesses like yours, read our case studies and discover the impact we make on businesses of all size.
