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Financial accounting is a branch of accounting concerned with the summary, analysis and reporting of financial transactions related to a business. This involves the preparation of financial statements available for public use. Stockholders, suppliers, banks, employees, government agencies, business owners, and other stakeholders are examples of people interested in receiving such information for decision making purposes.
Financial accountancy is governed by both local and international accounting standards. Generally Accepted Accounting Principles (GAAP) is the standard framework of guidelines for financial accounting used in any given jurisdiction. It includes the standards, conventions and rules that accountants follow in recording and summarizing and in the preparation of financial statements.
On the other hand, International Financial Reporting Standards (IFRS) is a set of accounting standards stating how particular types of transactions and other events should be reported in financial statements. IFRS are issued by the International Accounting Standards Board (IASB). With IFRS becoming more widespread on the international scene, consistency in financial reporting has become more prevalent between global organizations.
While financial accounting is used to prepare accounting information for people outside the organization or not involved in the day-to-day running of the company, managerial accounting provides accounting information to help managers make decisions to manage the business.
Financial accounting and financial reporting are often used as synonyms.
1. According to International Financial Reporting Standards: the objective of financial reporting is:
To provide financial information that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the reporting entity.
2. According to the European Accounting Association:
Capital maintenance is a competing objective of financial reporting.
Financial accounting is the preparation of financial statements that can be consumed by the public and the relevant stakeholders. Financial information would be useful to users if such qualitative characteristics are present. When producing financial statements, the following must comply: Fundamental Qualitative Characteristics:
Enhancing Qualitative Characteristics:
The statement of cash flows considers the inputs and outputs in concrete cash within a stated period. The general template of a cash flow statement is as follows: Cash Inflow - Cash Outflow + Opening Balance = Closing Balance
Example 1: in the beginning of September, Ellen started out with $5 in her bank account. During that same month, Ellen borrowed $20 from Tom. At the end of the month, Ellen bought a pair of shoes for $7. Ellen's cash flow statement for the month of September looks like this:
Example 2: in the beginning of June, WikiTables, a company that buys and resells tables, sold 2 tables. They'd originally bought the tables for $25 each, and sold them at a price of $50 per table. The first table was paid out in cash however the second one was bought in credit terms. WikiTables' cash flow statement for the month of June looks like this:
Important: the cash flow statement only considers the exchange of actual cash, and ignores what the person in question owes or is owed.
The statement of profit or income statement represents the changes in value of a company's accounts over a set period (most commonly one fiscal year), and may compare the changes to changes in the same accounts over the previous period. All changes are summarized on the "bottom line" as net income, often reported as "net loss" when income is less than zero.
The net profit or loss is determined by:
– cost of goods sold
– selling, general, administrative expenses (SGA)
– depreciation/ amortization
= earnings before interest and taxes (EBIT)
– interest and tax expenses
The balance sheet is the financial statement showing a firm's assets, liabilities and equity (capital) at a set point in time, usually the end of the fiscal year reported on the accompanying income statement. The total assets always equal the total combined liabilities and equity. This statement best demonstrates the basic accounting equation:
Assets = Liabilities + Equity
The statement can be used to help show the financial position of a company because liability accounts are external claims on the firm's assets while equity accounts are internal claims on the firm's assets.
Accounting standards often set out a general format that companies are expected to follow when presenting their balance sheets. International Financial Reporting Standards (IFRS) normally require that companies report current assets and liabilities separately from non-current amounts. A GAAP-compliant balance sheet must list assets and liabilities based on decreasing liquidity, from most liquid to least liquid. As a result, current assets/liabilities are listed first followed by non-current assets/liabilities. However, an IFRS-compliant balance sheet must list assets/liabilities based on increasing liquidity, from least liquid to most liquid. As a result, non-current assets/liabilities are listed first followed by current assets/liabilities.
Current assets are the most liquid assets of a firm, which are expected to be realized within a 12-month period. Current assets include:
Non-current assets include fixed or long-term assets and intangible assets:
Owner's equity, sometimes referred to as net assets, is represented differently depending on the type of business ownership. Business ownership can be in the form of a sole proprietorship, partnership, or a corporation. For a corporation, the owner's equity portion usually shows common stock, and retained earnings (earnings kept in the company). Retained earnings come from the retained earnings statement, prepared prior to the balance sheet.
This statement is additional to the three main statements described above. It shows how the distribution of income and transfer of dividends affects the wealth of shareholders in the company. The concept of retained earnings means profits of previous years that are accumulated till current period. Basic proforma for this statement is as follows:
Retained earnings at the beginning of period
+ Net Income for the period
= Retained earnings at the end of period.
One of the basic principles in accounting is “The Measuring Unit principle”:
The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.”
Historical Cost Accounting, i.e., financial capital maintenance in nominal monetary units, is based on the stable measuring unit assumption under which accountants simply assume that money, the monetary unit of measure, is perfectly stable in real value for the purpose of measuring (1) monetary items not inflation-indexed daily in terms of the Daily CPI and (2) constant real value non-monetary items not updated daily in terms of the Daily CPI during low and high inflation and deflation.
The stable monetary unit assumption is not applied during hyperinflation. IFRS requires entities to implement capital maintenance in units of constant purchasing power in terms of IAS 29 Financial Reporting in Hyperinflationary Economies.
Financial accountants produce financial statements based on the accounting standards in a given jurisdiction. These standards may be the Generally Accepted Accounting Principles of a respective country, which are typically issued by a national standard setter, or International Financial Reporting Standards (IFRS), which are issued by the International Accounting Standards Board (IASB).
Financial accounting serves the following purposes:
The accounting equation (Assets = Liabilities + Owners' Equity) and financial statements are the main topics of financial accounting.
The trial balance, which is usually prepared using the double-entry accounting system, forms the basis for preparing the financial statements. All the figures in the trial balance are rearranged to prepare a profit & loss statement and balance sheet. Accounting standards determine the format for these accounts (SSAP, FRS, IFRS). Financial statements display the income and expenditure for the company and a summary of the assets, liabilities, and shareholders' or owners' equity of the company on the date to which the accounts were prepared.
Asset, expense, and dividend accounts have normal debit balances (i.e., debiting these types of accounts increases them).
Liability, revenue, and equity accounts have normal credit balances (i.e., crediting these types of accounts increases them).
0 = Dr Assets Cr Owners' Equity Cr Liabilities . _____________________________/\____________________________ . . / Cr Retained Earnings (profit) Cr Common Stock \ . . _________________/\_______________________________ . . . / Dr Expenses Cr Beginning Retained Earnings \ . . . Dr Dividends Cr Revenue . . \________________________/ \______________________________________________________/ increased by debits increased by credits Crediting a credit Thus -------------------------> account increases its absolute value (balance) Debiting a debit Debiting a credit Thus -------------------------> account decreases its absolute value (balance) Crediting a debit
When the same thing is done to an account as its normal balance it increases; when the opposite is done, it will decrease. Much like signs in math: two positive numbers are added and two negative numbers are also added. It is only when there is one positive and one negative (opposites) that you will subtract.
However, it is important to note that there are instances of accounts, known as contra-accounts, which have a normal balance opposite that listed above. Examples include:
See also: Cost accounting
Many professional accountancy qualifications cover the field of financial accountancy, including Certified Public Accountant CPA, Chartered Accountant (CA or other national designations, American Institute of Certified Public Accountants AICPA and Chartered Certified Accountant (ACCA).