Financial Accounting: Definition, Uses, Characteristics, and Importance


Accounting can be described as the recording, controlling, reporting, and analyzing of an entity’s business transactions that occur every day so that the related stakeholders could use that financial information for their own interest.

It is the channel through which parties interested in the business that is both the shareholders and stakeholders share information they are interested in and understand each other.

It is also the means of communication between and among accountants, i.e., noting the daily transactions of the firm and recording them in the daybooks, and then preparing the financial statements at the end of the financial year after summarizing them.

Accounting is the process of documenting, organizing, and summarizing business transactions and events which are monetary in nature, understanding them, and making conclusions.

It generally entails recording in an orderly manner useful information of economic worth. The interested parties in the business use this organized information to make decisions.

Accounting is a broad area and can be subdivided into the following key specializations:

  1. Financial Accounting
  2. Tax accounting
  3. Cost accounting
  4. Managerial Accounting
  5. Auditing

What is financial accounting?

Financial accounting is a branch of accounting that deals with the gathering, processing, and reporting of accounting data to both the shareholders and stakeholders of the company.

Financial accounting analysis and summarizes the transactions that occur daily in the entity’s business.

The financial accounting reporting framework is governed by the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP).

IFRS states how certain types of occurrences and transactions should be reported.

IFRS ensures consistency in financial reporting. GAAP is used in a given jurisdiction and contains the guidelines to follow.GAAP includes the rules accountants follow when preparing financial statements.

Financial accounting though closely related to management accounting differs in that management accounting provides accounting information to the internal users.

In contrast, financial accounting is mainly concerned with making information available to external users.

Users of financial information:

  1. Management –management needs accounting information to make informed decisions like investment, growth, and expansion. This is because the information shows the available funds. The management can also use accounting information to make forecasts and set targets.
  2. Investors –the present investors need financial information to estimate the risk levels and the returns they will get as a result of investing in the firm. They need the information to know whether to dispose of their shares or increase them. The potential investors use the financial accounting information to know how profitable the business it and make decisions whether to invest in the business or not.
  3. Employees. They are interested in how stable the business is to know how secure their jobs are. Employees also consider the profitability of the business to evaluate if they are remunerated fairly.
  4. Lenders. They need to know if the business is capable of meeting its obligations when due.
  5. Customers. They use financial accounting information to predict price fluctuations. If the price fluctuations don’t favor them then they may look for alternative supply sources.
  6. The government. They are interested in the accounting information of the firm to determine how to tax it. They can also consider this when giving subsidies or a set of policies such as price ceilings and floors.
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Characteristic of financial information:

Financial accounting is concerned especially with external users such as the government, investors, and creditors. Thus, information should be organized.

The information provided should have the following characteristics:

  • Understandability. The information should be clearly presented and organized for the users to understand it with ease. A lack of understanding will lead to bad decisions that can cost the users.
  •  Relevance. The information needs to be useful to the end-users so as to assist them in making their economic decisions. Different users require information for different purposes and therefore the information should meet the diverse needs of the end-users.
  •  Reliability. Accounting information should be credible, truthful, and actually represent what it claims to represent.
  •  Comparability. This means that information should be presented using the same methods in different financial years. This makes it easier to compare information from different sources.
  •  Timely: information should be made available to the end-users at the time they require it. Failure to provide information at the right time may render it useless.

Recording phases in accounting

Financial accounting, a branch of accounting, follows the same phases as general accounting, which are as follows;

  1. Recording phase: this refers to the process of mechanical writing of transactions of the businesses and daybook accounts. The other name for the recording phase is an original entry.
  2. Classifying phase: this refers to placing the same transactions into various classes and posting the transactions into the ledger. Ledger refers to accounts that are similar whereby the accounting records are recorded. Further, the decrease and increase in various assets, liability, and expense accounts.
  3. Summarizing phase: this refers to financial statement preparation and is basically done from time to time. For instance on an annual basis or monthly basis.
  4. Interpretation: This entails analysis of information regarding accounting. The financial information is communicated and assists the users in decision making and therefore this is the reason behind the name language of business.
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Importance of Financial Accounting:

Financial accounting plays a crucial role in business, providing essential information for decision-making and ensuring transparency and accountability.

Here are 12 key importance of financial accounting:

  1. Facilitates decision-making: Financial accounting provides timely and accurate financial information, enabling stakeholders to make informed decisions about investments, pricing, resource allocation, and business strategies.
  2. Ensures financial transparency: By maintaining comprehensive records and following standardized accounting principles, financial accounting promotes transparency and enables stakeholders to assess a company’s financial health and performance.
  3. Supports external stakeholders: Financial statements prepared through accounting practices help external stakeholders, such as investors, creditors, suppliers, and regulatory authorities, to evaluate the financial position and performance of a company.
  4. Meets legal and regulatory requirements: Financial accounting ensures compliance with various legal and regulatory obligations, including tax regulations, company laws, and financial reporting standards.
  5. Assists in obtaining financing: Lenders and investors rely on financial statements to evaluate a company’s creditworthiness and determine its eligibility for loans or investment opportunities.
  6. Enables benchmarking and performance evaluation: Financial accounting allows for comparing financial results across different periods, facilitating performance evaluation and benchmarking against industry standards and competitors.
  7. Enhances credibility and trust: Accurate and reliable financial reporting builds trust among stakeholders, fostering credibility and goodwill for the company.
  8. Enables risk assessment and management: Financial accounting provides critical information for identifying and assessing financial risks, helping businesses develop risk management strategies and safeguard their financial stability.
  9. Supports budgeting and forecasting: Historical financial data provided by financial accounting assists in budgeting and forecasting future financial performance, enabling effective planning and resource allocation.
  10. Facilitates valuation of assets and liabilities: Financial accounting practices ensure proper valuation of assets, liabilities, and equity, essential for determining the company’s net worth and financial position.
  11. Enables performance measurement: Financial accounting provides the foundation for measuring and evaluating the financial performance of a company, including profitability, liquidity, solvency, and efficiency.
  12. Supports compliance and auditing: Financial accounting ensures accurate and complete financial records, facilitating internal and external audits and enabling businesses to meet compliance requirements.
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These are some of the key importance of financial accounting, highlighting its role in providing reliable financial information and contributing to businesses’ overall success and credibility.

Financial Statements:

Financial accounting also produced the entity’s financial statements as required by management, directors, shareholders, and regulators.

There are five main financial statements: financial position, income statement, statement of change in equity, statement of cash flow, and note to financial statements.

These statements provide different entities ‘ financial information to the stakeholders. For example, the statement of financial position provides the entity’s financial position liabilities, assets, and equity.

The users could also know what the entity’s current assets and non-current assets are.

The income statement provides the entity’s financial performance, like how much an entity makes revenues and spends during the period.

And the users could understand how well the entity’s cash flow is. Users gain many benefits from the entity’s financial statements for making the correct decision.