Profit, it has been said often, is the sole objective of business. Therefore, for those running a business, information about the financial performance of the enterprise is a most important requirement.
This information is not available easily and can be obtained only by systematically recording, classifying, and summarising all the business transactions. The branch of accounting that accomplishes these tasks under internationally standardised procedures is called financial accounting.
However, financial accounting is not limited to recording, classifying, and summarizing information about business transactions. It also deals with reporting this information to stakeholders outside the organisation, such as investors and creditors, who are the important, primary recipients of the information.
There may be secondary recipients, too, such as competitors, customers, employees, and stock-market analysts, but the information generated by financial accounting is mainly aimed at external stakeholders who are not part of the business organisation per se.
Therefore, to put together a formal definition of financial accounting, it is a specialized branch of accounting that records and reports information about the financial position and performance of a company, mainly for use by the business entity’s external stakeholders.
How does financial accounting achieve its tasks? Financial accounting mainly generates three financial statements to provide the information required—the balance sheet, income statement, and cash flow statement.
These documents provide the stakeholders a clear idea about the performance of the business during a particular period and its financial position at a specific time. The objective of the financial accountants is not to estimate the value of a company but to facilitate this valuation by others.
According to the International Financial Reporting Standards, financial accounting provides information about a business organisation that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the organisation.
The objectives of financial accounting can be put in four categories, as follows:
- Record financial transactions as and when they occur (bookkeeping), so that the data can be analysed for preparing financial statements
- Calculate profit or loss, to enable management to take course-correction strategies if required
- Ascertain the financial strength of the company by determining its assets and liabilities
- Communicate the information to stakeholders through statements and reports, so that these stakeholders can take appropriate decisions on their investments in the business
For meeting these objectives, financial accountants mainly prepare three types of documents, as briefly mentioned in the introduction above—the balance sheet, which reflects the assets and liabilities; income statement, which shows the profit and loss; and, cash flow statement, which charts the cash inflow and outflow.
The external users of financial statements look at the balance sheet to find out how strong the business is, financially (assets vs. liabilities), and at the income statement to find out how well the business is doing (profit vs. loss).
Creditors and other lenders would be happy to see a positive balance sheet so that they know their investments are safe, and investors would like to see an income sheet with profit so that they know some money would be coming to them from the company in the form of dividend or interest.
Almost all stakeholders want to see the cash flow statement to know the cash availability with the company and whether it will be able to clear its liabilities.
Among the internal users of financial statements are managers, who can take decisions on the basis of the financial statements, and among the external users are government authorities, who can initiate tax measures.
Here are some additional notes on the three financial statements mentioned above.
Balance sheet: The balance sheet of a company shows its assets, liabilities, and stockholders’ equity as on the last day of the accounts-reporting period. Assets include cash, stocks, buildings, and machinery, while liabilities include loans, interest, and wages. Stockholders’ equity is the difference between the assets and the liabilities. Read more about balance sheets.
Income statement: The income statement (issued quarterly or annually) reports the company’s profitability in a given period. It presents the revenues (sales and service revenues), expenses (operating expenses, such as wages and rent, and non-operating expenses, such as loan interest), gains, and losses. Read more on Profilt and Loss.
Cash flow statement: The cash statement shows the inflow and outflow of cash and its use for operating, financing, and investing activities. Here are some details on the cash flow statement.
Principles of Financial Accounting
As discussed in the post “Accounting basics,” the rules of accounting, including financial accounting, have been standardised to achieve the following goals:
- Objectivity: Financial statements should be free from bias, and financial accountants should scrupulously follow the principle of objectivity.
- Usability: Users of financial documents should be able to depend on them—the documents should facilitate decision-making.
- Materiality: Omission of data from financial statements will mislead financial decision-makers; therefore, all important data should be recorded and misstatement of facts avoided.
- Comparability: Financial statements should enable users to compare the performances of companies, and the documents should follow the standards set internationally.