Financial accounting aims to achieve operational management of accounting transactions related to business. It’s focused on collecting transaction-wise details, recording, summarizing, and reporting this information in structured and usable form.
Further, the process is designed to help businesses keep a detailed record that helps meet legal and constructive obligations.
Let’s discuss the objectives of financial accounting in detail.
1) Record keeping
The financial accounting process initiates when the bookkeeper enters transactions in the accounting record. At the time of entering transactions in the accounting system, it must be backed by relevant and reliable supporting evidence.
For instance, if the bookkeeper records a liability for receipt of goods, the journal voucher to record liability must be backed by a supplier invoice and goods receipt note.
Hence, all business transactions are backed by supportive evidence, and a complete set of financial records is created at the end of an accounting period. This accounting record can be used for multiple purposes including internal and external audits.
Internal auditors use accounting records to ensure the transaction was completed to fulfill procedural formalities. If that’s not the case, the responsible staff is inquired.
On the other hand, external auditors use financial records to obtain sufficient and appropriate audit evidence. So, business needs to ensure accounting records must be complete and free from material misstatement and omissions.
2) Profit/loss measurement
Profit/loss measurement is one of the prime functions of financial accounting. The business needs to ensure it has recorded complete economic activity to receive and pay economic benefits.
So, at the end of the accounting period – all transactions related to revenue (a receipt of economic benefits) and expenses (payment of economic benefits) are summarized in the profit and loss statement to assess if the business has generated profit or incurred loss.
3) Preparation of financial statement
Preparation of financial statements is the prime purpose of the financial accounting process. Financial statements are summarized from data entered into the accounting system.
So, it cannot be possible to prepare a financial statement without effective financial accounting operations.
It’s important to note that the financial statement is the main deliverable of the financial accounting function. So, if business operations related to bookkeeping, data entry, periodic adjustments, and closing are strong, it leads to a reliable set of financial statements.
It’s equally important to note that financial transactions can impact any financial statement component. For instance, dividend payment impacts cash balance (balance sheet) and equity (statement of changes in equity).
Likewise, an expense incurred in cash can impact the cash balance (assets) and equity (balance sheet). However, there must be two impacts of a financial transaction.
4) Cash flow management
Cash flow management is an essential business management skill. The companies must be able to predict and manage liquidity; otherwise, it can be fatal for the business.
Generally, the forecasted cash flow statement is prepared using past financial trends extracted from previous accounting records and data.
5) Understand the financing needs of the business
Financial accounting helps to understand if the business needs to raise finance. It can be done by analyzing the current financing structure and comparing available funds with the project needs.
If the business is expected to need additional funds, the decision can be made on a timely basis. On the other hand, if excess funds are available, they can be invested appropriately.
Likewise, management needs to ensure an appropriate mix of debt and equity balance based on the price difference and other managerial aspects.
6) Periodic reporting and financial analysis
Financial information is presented from period to period, which means the financial performance of one period can be compared with other periods to ascertain if things are on track. Likewise, industrial comparison can be a good idea to assess if the business is doing well.
In addition to periodic comparison, ratio calculation can help to enhance analytical understanding and identify specific areas of improvement.
For instance, if the business has higher gross profit and lowers net profit, the business needs to focus on controlling administrative activities rather than purchase and production functions.
7) Business valuation
Techniques to calculate business value require input from financial accounting and the financial record of the business.
For instance, a business valuation technique called price-to-earnings multiple uses current/historical earnings of the business, which is produced by financial accounting.
Similarly, the discounted cash flow model uses the past trend of cash obtained by a review of the cash flow statement.
8) Filing taxation
Tax liability is dependent on the profit earned by the business. So, the accurate tax liability can only be calculated if the business has calculated profit accurately.
Further, there are multiple technical complexities associated with calculating taxation expenses. For instance, provisions and estimates allowed by the accounting standard are added back in the profit as tax authorities do not accept it as a business expense.
On the other hand, tax authorities allow capital allowance and disallow depreciation. So, there is a need to adjust tax expenses on account of temporary differences.
Hence, to calculate accurate tax liability, the business needs to extract detailed financial records for income, expenses, liability, assets, equity, etc.
9) Operations management
Business managers need to make operational decisions from time to time. For instance, managers need to decide the timing of purchasing goods, incurring marketing expenses to boost sales, and sending a reminder for cash collection.
Managers need information before performing any of the given activities. For instance, managers need to review the due date of an invoice before sending a reminder to the customers. This input information is extracted from the financial record produced by financial accounting.
10) Meeting regulator’s expectations
Regulators require businesses to comply with certain operating standards. The regulating bodies are different for the different businesses.
For instance, banks and financial institutions are regulated by the country’s central bank. Similarly, companies in the United States are regulated by the Securities and Exchange Commission.
These regulators require businesses to provide them with financial and operational records from time to time, and non-compliance can lead to certain financial repercussions and penalties.
What is the nature and scope of accounting?
Accounting identifies, measures, records, and communicates financial information about an entity to various stakeholders.
The primary objective of accounting is to provide relevant and reliable financial information that can be used for decision-making purposes.
The nature of accounting can be understood by examining its various activities. These activities include:
- Identifying transactions and events: Accounting begins by identifying and recording transactions and events that affect the financial position of an entity. Transactions can include sales, purchases, and payments, among others.
- Measuring transactions: Once transactions have been identified, they need to be measured in monetary terms. This involves determining the trade’s value and its effect on the entity’s financial position.
- Recording transactions: Transactions need to be recorded in a systematic and organized manner. This involves creating and maintaining financial records such as ledgers, journals, and other accounting documents.
- Communicating information: The information recorded in accounting documents must be communicated to stakeholders such as investors, creditors, and regulators. This information can be communicated through financial statements such as the balance sheet, income statement, and cash flow statement.
The scope of accounting is broad and encompasses various fields and subfields. Some of the significant areas of accounting include:
- Financial accounting is the process of recording and communicating economic information to external stakeholders such as investors, creditors, and regulators.
- Managerial accounting involves providing financial information to internal stakeholders, such as management, to help them make informed decisions.
- Auditing: This involves verifying the accuracy and reliability of financial information recorded in accounting documents.
- Tax accounting involves preparing and filing tax returns for individuals and organizations.
- Cost accounting involves analyzing and managing the costs of producing goods and services.
- Forensic accounting involves using accounting and investigative skills to detect and prevent fraud.
Frequently asked questions
Why ratio analysis is an important part of financial analysis?
Ratio analysis helps to deeply analyze the financial performance of the business. It’s an effective way of assessing performance by comparing different figures in the financial statement.
For instance, profit is compared with implied equity in the business to calculate return on equity. This helps understand if the business has adequately utilized invested funds.
How financial accounting helps in meeting legal obligations?
The application of financial accounting ensures the business has a complete record of all the transactions posted in the accounting system.
This accounting record is used to prepare a financial statement and other details that are the requirements of the regulators. Hence, financial accounting is effective in meeting legal obligations.
Is bookkeeping covered in financial accounting?
The process of financial accounting starts with bookkeeping. So, the first step of the financial accounting process is data entry by identifying transactions involving monetary value. So, bookkeeping is one of the initial components of the financial accounting process.
What is the accounts closing process in financial accounting?
At the end of the accounting period, the business needs to ensure all the periodic transactions have been posted in the accounting system.
For instance, the business may need to manually add certain double entries for the depreciation, insurance, prepaid expenses, and other accounting items.
So, the process of adjusting accounts and ensuring all transactions have been posted is said to be financial statement closing.
At the end of an accounting period, it’s usually done to ensure prepared financial statements are free from omissions/misstatements.
Financial accounting is the process of identifying, recording, and reporting the business’s financial information. It aims to achieve multiple objectives that include appropriate record-keeping, profit/loss measurement, financial statement preparation, cash flow management, business valuation, tax filing, financial analysis, etc.
Financial accounting achieves its objectives via three different stages that include data entry, record keeping, and reporting.
Data entry is about recording all financial transactions in the accounting system; the business needs to ensure no transactions remain unrecorded.
This disciplined system of data entry/system updates results in comprehensive record management, which can be used to satisfy constructive and legal obligations.