Financial Accounting: Meaning, Working & Principles

What is Financial Accounting 

Financial Accounting is the process of preparing a business’s financial statements – a comprehensive record of all the business’s transactions over a period of time. 

These statements give insight into the financial performance of a business and help business owners and stakeholders identify pain points and work toward improvement. 

Financial statements include the income statement, balance sheet, cash flow statement and more. Financial accounting is used by companies, governments and NGOs – any organization that requires money to run operations will need a financial accounting structure in place to analyze the flow of money in and out.

 How Financial Accounting Works 

The process of financial accounting begins with recording every single financial transaction made by the company. These transactions are recorded in the form of journal entries.

These entries are then posted to the appropriate accounts in the general ledger, which is a record of all the financial transactions of the organization. From the ledger, it is then transferred to the main three financial statements which are analyzed by financial accountants and other stakeholders:

• Income Statement

The Income Statement is also called the Profit and Loss Statement, or Statement of Operations. It lists each and every income and expense of the business. This gives deep insight into how much money is being earned and spent from every single transaction the business engages in. 

This statement gives insight into the incomes and expenditures of the business. This financial statement will, in the end, give a net profit or net loss. This net profit or loss is generated by deducting total expenses from the total income of the business. 

Read more: Income Statement Explained

The net profit/loss is determined by:

Revenue + Other income

= Total Revenue

– Cost of Goods Sold (COGS)

– Selling, General & Administrative Expenses

– Depreciation & Amortization

– Interest & Taxes

= Profit/Loss

For a lossmaking business, the profit and loss account is the most important of all statements, since it gives important insight into how the business can improve its operations and reduce expenses. 

For example, the owner of a Bakery wants to know why her business made a loss this quarter – to do this, she takes a look at her business’s Income Statement and realizes that her cost of production is too high (COGS). 

This means that even though the bakery brought in good revenue in the quarter, the cost of making the bread and cookies that the Bakery sold was too high. This could include the electricity bill, the cost of raw materials like flour and sugar, the cost of labor, and others. 

By cutting down on these costs – maybe by switching to the most cost-efficient ovens, or cheaper alternatives for flour, the Bakery will be a profit-making business once again! 

• Balance Sheet

The Balance Sheet shows the business’s financial position, in terms of how many assets and liabilities it holds. 

Assets include any property that is owned by the business and adds value – these could be the building that the business operates in, the machines that help the business, or even trademarks and patents that the business owns. 

Liabilities indicate the responsibility of the business to pay back a debt to third-party creditors. These could be loans, accounts payable, and more. 

The Balance Sheet also shows the Owner’s Equity in the business – the amount of money invested into the business as a capital contribution. Depending on the kind of business (sole proprietorship, partnership, registered company) the Owner’s Equity is different. 

The Balance Sheet, as the name suggests, will balance at the end. The formula used is: 

Assets = Liabilities + Equity 

The logic behind this formula is the “double entry principle”. This principle is the foundation of modern financial accounting. 

Read more: Double Entry System of Accounting 

Cash Flow Statement

The cash flow statement shows the cash position of the business at the end of the financial period. By deducting expenses and adding income from the opening cash balance, we can see how much cash the business is left with at the end of the reporting period. 

This is an important metric because it tells us the cash burn of the business, and shows pain points that can be improved. 

Read more: Cash Flow Statement

Principles of Financial Accounting 

Modern financial accounting follows certain principles. It is important to know these concepts to better understand why financial statements are structured and prepared the way that they are. 

Double Entry Principle 

This principle says that there are two sides to every transaction and that both sides must be recorded in the financial statements of the business. 

For example, the purchase of flour has two aspects: deduction of cash, and the addition of flour. 

Making sure that both sides are recorded ensures mathematical accuracy. 

Accrual or Cash Principle

This principle states that even if actual cash is not exchanged, the transaction must be recorded. For example, lets say Razor Bakery purchases flour from its supplier on credit, with the promise to pay for the flour at the end of the month. 

Even though the flour has not yet been paid for, the transaction will be recorded and included as a part of the financial statements. 

Once the actual cash payment is made, another entry will be made. 

The alternative to this method is called the “cash method”, where transactions are only recorded when cash is exchanged. 

The cash method is used by smaller businesses since their financial statements are not as widely analyzed or read as bigger companies. 

Matching Principle 

This principle states that revenues and expenses should be recorded in the same accounting period in which they were earned or made. 

For example, if Razor Bakery earned Rs 5000 from one day of sales in November of 2022, that revenue should be included in the fourth quarter of 2022 financial statements, and not in the first quarter of 2023 or any other period. 

Basically, this principle ensures that the revenue and cost of generating that revenue match. 

Benefits of Financial Accounting

Financial Accounting is the single most important indicator of a business’s health. This is important to all stakeholders of the business:

1. Business founders
2. Investors
3. Auditors
4. Regulatory Agencies
5. Suppliers
6. Banks
7. Customers

All these stakeholders look to a business’s financial accounts to determine if the business is doing well or not. 

Only public companies are required to disclose their financial statements to the public, but even for private companies, maintaining a good track record of profit is very important. 

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