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Purpose of Financial Accounting: Function, Importance, Principles [2023]

Financial management is vital to personal and corporate finance. It involves planning, arranging, and regulating financial resources to reach certain goals and objectives. The basic purpose of financial accounting is to optimise financial resources and processes to meet corporate goals and generate shareholder value. However, the particular aims of financial management may differ based on the organisation’s size, industry, and goals. This blog will explore the primary goal of financial management and its importance in achieving business success.

Primary Goal of Financial Accounting

The main purpose of financial accounting is to document, condense, and present the transactions arising from a company’s activities throughout a defined period. It presents a clear image of a company’s operational performance in that period. Financial accounting is a unique field focused on preparing financial statements, including the balance sheet, income statement, and cash flow statement.
Multiple organisations, including management, investors, creditors, and regulatory agencies, use these financial accounts to allocate resources. 

Financial accounting aims to verify that financial statements are generated correctly and represent the organisation accurately. Without financial accounting, a firm may run into cash flow issues and potential insolvency. 

Financial Accounting: An Overview

Financial accounting is a discipline that involves summarising, analysing, and reporting financial transactions associated with a firm. It focuses on recording, outlining, and reporting the variety of transactions arising from business operations over a period of time. Here are some basic concepts related to financial accounting:

  • Purpose: Financial accounting delivers financial information regarding a company’s operating performance. It encompasses the preparation of financial statements, such as the balance sheet, income statement, and cash flow statement, which indicate a company’s financial position and performance during a specific period.
  • External usage: Financial accounting is mostly aimed at external usage. It gives financial information to partners outside the firm, including investors, creditors, suppliers, and consumers. These stakeholders use financial statements to examine a company’s financial performance and make educated choices.
  • Compliance: Financial statements created via financial accounting must adhere to accounting standards and legal requirements. This maintains the uniformity and comparability of financial information across various firms.
  • Different from management accounting: Financial accounting is separate from management accounting, which focuses on creating complete reports and predictions for internal use by managers inside the firm. While financial accounting targets outward reporting, management accounting is more internally focused and assists with organisational decision-making.
  • Importance: Financial accounting is crucial for organisations as it helps them track their financial activity and allocate resources effectively. It also simplifies disclosing a company’s financial condition to external stakeholders, such as creditors and investors.

Understanding How Financial Accounting Works

Financial accounting is meant to transmit financial information on a company’s operating performance and is typically regarded as the way to prepare financial reports for external usage.

Here are some basic factors explaining how financial accounting works:

  • Recording transactions: Financial accountants document all company transactions, such as sales, purchases, costs, and investments, in a systematic way. These transactions are usually recorded in journals or computerised accounting systems. 
  • Summarising transactions: Financial accountants summarise the recorded transactions by categorising them into multiple accounts, such as assets, liabilities, equity, revenue, and costs. This technique is referred to as posting and is done in ledgers. 
  • External Reporting: Financial accounting often focuses on delivering financial information to external stakeholders, such as investors, creditors, suppliers, and customers. These stakeholders use financial statements to assess a company’s financial performance and make knowledgeable judgements.
  • Compliance and Regulation: Financial accounting must adhere to accounting standards and legal requirements imposed by regulatory agencies, such as the Financial Accounting Standards Board (FASB) in the United States. Compliance with these requirements offers transparency and reliability for financial reporting purposes.

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Providing Investors with Relevant and Up-to-Date Information

Financial statements are vital for investors in evaluating and crediting firms. They convey information about a firm’s performance to external stakeholders. This entails capturing, summarising, and reporting numerous transactions from company processes throughout time. Financial accounting aims to create financial statements used by numerous organisations and are frequently needed as part of agreements with the firm being prepared.

Understanding accounting is vital for investors as it helps assess asset value, comprehend a company’s funding sources, measure profitability, and predict risks on a balance sheet. Financial statements offer significant information, helping detect risk. Investors with excellent accounting backgrounds use financial reports to identify important risk areas and probable losses in asset prices.

A Comparative Study Between Accrual Method & Cash Method

Cash basis and accrual accounting are two techniques for keeping track of a business’s profits and spending. The fundamental difference between the two techniques is the timing of when income and costs are recognised.

Here is a brief overview of the two methods:

Accrual Method

The accrual method of accounting accurately depicts a company’s financial status and performance by recording revenue and costs when they are generated or incurred rather than when the actual payment is received or made. It is often needed for corporations reporting audited financial statements and is approved under GAAP by the Financial Accounting Standards Boards (FASB).

Cash Method

The cash method of accounting is a basic accounting approach suitable for smaller enterprises. Under this system, sales are recognised when cash is received from a client, and costs are recorded when payments are made to suppliers. This approach is widely used by people for personal accounting, as well as by small enterprises. The cash technique may be done using a simple single-entry system. Therefore, a complicated accounting programme is not necessary.

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What Are the Principles of Financial Accounting?

Eight general principles of financial accounting should be followed to ensure that the documents are accurate and reasonable and provide useful information to the readers. These principles are:

  • Principle of Conservatism
  • Principle of Accrual
  • Principle of Cost
  • Principle of Consistency
  • Principle of Materiality
  • Principle of Objectivity
  • Principle of Relevance
  • Principle of Reliability

A Brief Idea About the Purpose of Financial Statement Analysis

Providing information and statistics regarding a company’s financial condition and performance, including profitability and liquidity, is the main goal of financial reports. To make critical decisions, financial statement analysis measures a company’s performance and financial health. External stakeholders, including investors, creditors, and regulatory bodies, use financial statement analysis to assess an organisation’s general health, financial performance, and market value. It is a monitoring tool for managing the funds for internal stakeholders like management. Using financial statement analysis, one can:

  • Assess economic trends
  • Make a financial plan
  • Create long-term strategies for your firm
  • Find investment opportunities in projects or businesses.

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Why Financial Accounting Is Important

The importance of financial accounting can be summarised as follows:

  • Systematic record keeping: Financial accounting aids in systematically recording an organisation’s financial information, including transactions, performance, and cash flows. This compares current financial information with past data, enabling users to examine the company’s success over time.
  • Communication of outcomes: It plays a significant role in conveying a company’s financial outcomes to external customers who rely on relevant and trustworthy accounting information to make decisions, such as buying shares or assessing loan risk. Establishing credibility through correct accounting information is vital for creating confidence with external stakeholders.
  • Goal measurement: Financial accounting acts as a technique of keeping score for a corporation. By creating goals and examining the figures, financial accounting helps identify whether a firm is fulfilling its objectives or falling short. Key metrics, such as income, equity, and cash on hand, give insights into the company’s financial health and performance.
  • Transparency and compliance: Financial accounting fosters transparency in corporate operations by gathering and sharing crucial information with stakeholders. It helps maintain the firm’s transparency and enables stakeholders to understand its finances. Additionally, financial accounting plays a significant role in compliance with legal and regulatory obligations.
  • Decision-making: This accounting offers vital information for decision-making inside a corporation. It helps business owners and managers understand their choices’ financial repercussions and unlock improvement opportunities. Financial data may be used to analyse employee performance, allocate resources, and make strategic choices.

Comparing Financial Accounting and Managerial Accounting

Here is a tabular comparison of financial accounting and managerial accounting:

Aspect Financial Accounting Managerial Accounting
Purpose To record, summarise, and report financial transactions to external stakeholders such as investors, creditors, and regulators To provide financial information to internal stakeholders such as managers and executives for decision-making purposes
Timeframe Past Present and future
Focus Overall financial performance of the organisation Specific departments, products, or projects
Standards Must adhere to Generally Accepted Accounting Principles (GAAP) No specific standards
Reports Financial statements such as balance sheets, income statements, and cash flow statements Internal reports such as budgets, forecasts, and variance analyses
Users External stakeholders such as investors, creditors, and regulators Internal stakeholders such as managers, executives, and employees

Understanding Financial Accounting Through Example

An example of financial accounting is a public company’s income statement, which must follow particular advice on what transactions to report. The final result is a financial report indicating the revenue recognised in a specific period.

The income statement is reviewed from top to bottom, starting with revenues, sometimes dubbed the “top line.” Expenses and expenditures are removed, followed by taxes, and the statement’s literal “bottom line” generally indicates the company’s net earnings or losses.

Types of Financial Statements

The types of financial statements are as follows:

  • Balance Sheet: A balance sheet illustrates what a corporation possesses (assets) and what it owes (liabilities) at a certain moment. It presents a picture of the company’s financial position.
  • Income Statement: An income statement, sometimes termed a profit and loss statement, depicts a company’s sales, costs, and total profit or loss for a specific time. It displays how much income a firm made during a given time period, generally a year or some portion of a year, and also shows the expenditures and expenses connected with producing that revenue.
  • Cash Flow Statement: A cash flow statement tracks the money coming in and going out of a firm during a given time. It reveals how money is generated and spent, telling us about the company’s capacity to manage its finances.
  • Statement of Owner’s Equity: The statement of owner’s equity, commonly termed shareholders’ equity statement, illustrates changes in what the owners or shareholders possess over a particular time. It includes information regarding investments, earnings maintained in the firm, and dividends paid out.

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Conclusion

Financial accounting is crucial because it helps firms keep track of their financial operations, satisfy regulatory obligations, and make educated choices based on correct financial data. Firms may guarantee that their financial statements are accurate, dependable, and relevant to stakeholders by complying with financial accounting regulations. Hence, Sound financial accounting is indispensable to an organisation’s successful running.

FAQs

What is the purpose of preparing a balance sheet?

A balance sheet provides information about a company's assets and liabilities as of a specific date. This information can evaluate a company's financial standing and health, spot strengths and weaknesses, and make wise financial decisions.

What is the main purpose of financial accounting?

The main purpose of financial accounting is to offer meaningful financial information to outsiders such as investors, creditors, and regulators by documenting, summarising, and reporting company activities in financial statements.

How does financial accounting provide comparability?.

Financial accounting provides comparability by ensuring that information is measured and reported in a uniform manner across companies.

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