The history of accounting is as old as the history of a human being. No chapter of a human’s life is completed without accounting. No matter if you are thinking about personal, business, or professional life, accounting has its role to play.
Imagine financial transactions of your business are not recorded and accounted for properly; you may not be able to obtain accurate financial data. Hence, it can be really challenging to make informed operational and strategic decisions on incomplete financial information. In this article, we’ll focus on the business aspects of using financial accounting and its usefulness for the entire world.
So, what is financial accounting?
It is defined as “the process of maintaining a financial record of business transactions. “The financial accounting process involves recording, summarizing, analyzing, and reporting all the transactions in financial statements to help the user in decision-making.
It is the process of recording business transactions systematically so that nothing remains unrecorded. Likewise, proper recording of financial information is vital for comparing the performance of a business over the years.
Financial accounting as a process can be divided into three phases that include the following,
- Entering a date in the accounting system
- Extracting report from an accounting system
- Interpretation and decision making
Components of financial statement
Components of the financial statement include a statement of financial position, income statement, cash flow statement, changes in equity, and notes to the financial statement. The primary purpose of preparing a financial statement is to provide user disciplined financial information that is accurate, reliable, and can be used to make an informed decision.
How financial accounting works for a company?
Companies hire accountants and advisors to run accounting functions. The number of accountants hired by the company depends on the size and revenue. For instance, small firms can employ a few accountants to run their accounting functions, while a large company may need to maintain a complete finance department to keep the accounting records up to date.
Likewise, companies need a different level of staff to perform different duties. For instance, a junior accountant can be allocated tasks to enter data in the accounting system. Managers can be responsible for managing technical aspects of the accounting like tax computations, applying accounting treatment, ensuring compliance, and coordinating with other departments like purchase, sales, etc.
Similarly, HOD is allocated with overall responsibility to ensure accounting functions remain viable. They are responsible for ensuring financial statements are prepared in compliance with applicable regulations and accounting standards. Further, they need to ensure accounting-related needs of the board and regulator are fulfilled.
Advantages of Financial Accounting
Following are some of the advantages related to financial accounting.
1. Systematic maintenance of Business Records
Companies need to keep a record of all transactions incurred for business purposes. Proper books of accounts are systematically maintained to record all the business’s monetary transactions.
Keeping a record of all the business transactions is crucial for every business because,
- Financial record is required to report financial performance.
- Keeping a financial record is a regulatory requirement.
- Used in the preparation of the financial statement.
- Used by auditors to obtain sufficient and appropriate audit evidence.
2. Fraud Detections
Financial accounting involves recording all business transactions in business records that ultimately help to prevent and detect any frauds that may occur. If all business transactions are recorded on a timely basis, it becomes difficult for people to engage in fraud. However, if fraud is still conducted using sophisticated techniques like recording complex business transactions and fictitious journal entries, etc., it can be detected during the audit with the help of a maintained accounting record.
3. Financial Position of a business
Financial accounting reveals the true financial position of a business. Financial information is provided to the internal management from time to time to analyze what is the true financial position of an entity for a specific period. Managers make decisions based on the data supplied by financial accounting departments, e.g., if the business needs to arrange some financing for meeting the working capital requirements.
4. Preparation of Financial Statements
Financial accounting facilitates the process of forming a financial statement as it provides all relevant accounting data necessary for the preparation.
5. Facilitates loan arrangements
Financial institutions provide loans to companies after ascertaining a company’s financial health by looking at the financial statements provided by those entities. Likewise, banks may require collateral for the assets, and the company must provide ownership documents.
6. Performance analysis
Accounting data is used to assess the results of a business in comparison to previous years and the industry average. For example, the profit and expenses ratios are compared with the industry average and last year to ascertain if the business is doing well or there is a need to take corrective action.
7. Control over Assets
Financial accounting enables control over a business’s assets. It provides information regarding balances of cash, debtors, other assets, etc.
Proper books of accounts are crucial for determining the tax liability of a business. If a business doesn’t have proper financial data, it can be difficult to determine profit figures. Usually, a specified profit percentage is paid as a tax expense to the government.
9. Assists management in Decision making
Management needs financial accounting data to make managerial decisions. For example, suppose there is a shortage of cash. In that case, management makes decisions for arranging some loan facilities by looking at financial data to ascertain how much cash resources are needed to run business operations.
10. Act as legal evidence
Business disputes can be settled by presenting accurate accounting records in the courts. So financial accounting records act as legal evidence to settle business disputes with other parties. Therefore, it becomes a need to maintain proper accounting records to avoid any disputes in business.
11. Facilitates payments to creditors and debt collection
Accounting departments of companies properly maintain aging reports of debtors and creditors. In the case of debtor’s aging lists, the customers whose debts become due are sent a notice to pay the amounts. In this way, the debt collection process is accelerated.
Similarly, creditors, aging reports elaborate the company to pay the suppliers or other payables on a timely basis; otherwise, a penalty may have to be paid in addition to the original amount.
12. Budget formation
Financial record is the main input in the process of budgeting. It helps keep business on track and provides certain control in terms of revenue and expenses. Multiple figures are extracted from financial records and used in the process to form a budget. This leads to greater command over business management and a solid foundation for business success.
13. Strategy formation
A sound understanding of financial trend and data analytics help to make informed decisions. This understanding can be achieved by a thorough analysis of financial patterns and business records produced by financial accounting.
14. Public faith and goodwill
The companies have to publish their audited financial statements to facilitate all stakeholders. These stakeholders use presented financial information and make a decision.
The investors and other stakeholders are interested in ascertaining the current business position. So, companies must publish their financial statements to assist stakeholders.
Financial accounting is about identifying, recording, and reporting economic events. The business needs to identify each and every economic event. The economic event occurs when an event can be measured in terms of money. Once the economic event is identified, it’s recorded in the books of account on a day-to-day basis. Once the specific period is complete, all the transactions are summarized and presented in a useful manner (financial statement).
Further, financial accounting has multiple advantages that include proper record maintenance, fraud detection, control over assets, compliance, decision-making, etc.
Frequently asked questions
Why is financial accounting important for businesses?
The business needs to continuously track its financial performance to ensure expected business profitability. Further, there are multiple legal and constructive obligations that businesses need to comply with that require financial information (input). Hence, a business must have a sound accounting function.
How financial accounting helps in internal communication?
Financial accounting can be helpful for internal communication as well. For instance, management may want employees to understand the business’s financial status to negotiate compensation. For instance, bonus and profit-based payments are dependent on business performance. However, it’s normally restricted to key employees.
How is financial accounting helpful in taxation?
Financial information like revenue, profit, and expenses are the main inputs in the process of calculating taxes. Further, transaction-wise details may be needed in case of complex tax-related matters. Hence, financial accounting is taxation.