Financial Accounting
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Financial accounting is the process of documenting, assessing, and recording various transactions arising from a company’s operations over time. The Balance sheet, Profit & Loss, and Cash flow statement represent the company’s long-term operating performance.
Financial accounting is the preparation of financial statements that is helpful to measure the financial performance and position of the entity. Financial accounting aims to provide information about financial health to the potential users of financial statements. Financial accounting helps with decision-making for internal as well as external users. It works as a baseline for the potential investor before making any investment decision.
Financial Accounting includes various components that are explained below:
1. General Accounting and Book Keeping: –
Although the terms bookkeeping and accounting may appear identical, they serve various purposes. Bookkeeping involves recording financial transactions, while accounting gives insights into your business’s financial health based on accounting data.
Bookkeeping is more operational and also administrative in nature. Accounting is more subjective. Bookkeeping is regarded to be the foundation of accounting, whereas accounting is a part of finance.
The stages in the bookkeeping process are as follows:
- Determining the existence of a financial transaction
- Keeping a record of a financial transaction
- Setting up a ledger account
- Preparing a trial balance
Accounting
Accounting is the systematic process of recording, summarizing, analysing, and reporting financial transactions and information of an individual, business, organization, or other entity. It serves as the language of business, providing a clear and structured way to understand the financial health and performance of an entity through the systematic maintenance of books of accounts and access to them as and when required, it also provides various information to the company and its stakeholders such as creditors, banks, tax officials, investors, and suppliers.
The steps of the accounting process are listed below: –
- Financial transactions identification
- Keeping track of financial transactions
- Creating a trial balance
- Financial Statements Preparation
- Financial Statement Analysis
2. Finalization of Accounts and Reporting
- Record of financial transactions: Recording of financial transactions is the basic objective of accounting. It covers all the financial aspects that help to identify the financial condition of the business.
- Adjusting Entries: Before finalization of accounts, some adjustments entries are required to be made like for accrued expenses, prepaid expenses, depreciation, provisions if any, and other entries that may not have been recorded in the regular course of business. These adjustment entries help to ensure that the financial data adheres to the accrual accounting principle.
- Closing Entries: Closing entries means shifting accounting data from a temporary account to a permanent account like from an income statement to a balance sheet. At the end of the accounting period, temporary accounts like revenue and expense accounts are closed and their balance is transferred to retained earnings accounts.
- Preparation of Financial Statements: The next step is to prepare the financial statements that include the Income statement, Balance sheet, cash flow, notes to accounts, and other reports. The income statement shows the revenue, expenses, and net loss/profit for the period. The balance sheet provides information about the assets, liabilities, and equity at the end of the period. Cash flow statements present the company’s cash inflow and outflow during the period.
- Auditing (if required): If any entity is required for an external audit, the external auditor verifies and analyses the financial statements and expresses an opinion on whether the financial statements are free from material misstatement and represent a true and fair opinion.
- Financial Position: The main object of accounting is to record the financial transactions systematically and ascertain the financial position of the business based on management information regarding profit and loss, balance sheet, cash flow, past data, and by analysing trends.
- Decision Making: Accounting provides valuable financial information that helps managers, executives, investors, and other stakeholders make informed choices that can impact the company’s performance, growth, and overall success.
- Filing and Distribution: After verification and analysis of the financial statements, these are required to be filed with the relevant authorities such as tax authorities or any other regulatory bodies. These statements are also shared with shareholders, investors and other stakeholders.
3. Accounts Reconciliation
This is a process to reconcile two accounts that help to confirm the accuracy and consistency. Reconciliation is helpful to identify the discrepancies or errors between two accounts that might have occurred during data recording or processing. The primary types of accounts reconciliation include bank reconciliation and general ledger reconciliation.
Bank Reconciliation
Bank Reconciliation is a process of matching the balance between a company’s bank statement and its accounting records. The difference can arise due to the reasons like timing differences, outstanding cheques, deposits in transit, bank fees, or errors.
General Ledger Reconciliation
It is a process of ensuring that the balances and transactions recorded in the company’s general ledger are accurate and consistent with other supporting documentation, such as sub-ledgers, bank statements, invoices, receipts, and other financial records.
4. Closing Process
The closing process in accounting refers to the steps taken at the end of the accounting period to finalize the financial records and prepare the accounts for the next period. The primary objective of the closing process is to transfer the balances of temporary accounts to permanent accounts and reset the temporary accounts to zero for the new accounting period.
This process includes the following steps:
- Identify Temporary Accounts: Temporary accounts include all income statement accounts such as revenues and expenses.
- Close Revenue Accounts: The first step is to close the revenue accounts. The total revenue earned during the period is transferred to the income summary account.
- Close Expense Accounts: In this, the total expenses incurred during the period are transferred to the income summary account.
- Calculate Net Income or Loss: After closing the revenue and expenses accounts, the income summary account’s balance reflects the net income or net loss for the period.
- Close Income Summary Account: The balance in the income summary account is now moved to the retained earnings account. The income summary account is closed by debiting it for a net loss or crediting it for a net income.
- Verify The Closing Entries: It is crucial to verify that the closing entries have been accurately recorded to ensure the temporary accounts are reset to zero and the balances are transferred correctly.
- Prepare Post Closing Trial balance: After the closing entries have been made, a post-closing trial balance is prepared. This trial balance includes only permanent accounts with their updated balances after the closing process. All the temporary accounts should be closed at zero balances.
5. Fixed Asset Accounting
Fixed Asset Accounting is a crucial aspect of a company’s financial management. Properly managing fixed assets ensures accurate financial reporting, helps optimize asset usage, and facilitates decision-making regarding asset acquisitions and dispositions. Fixed Assets accounting includes the following steps:
- Asset Classification: Fixed Assets can be categorized into different groups based on their nature, use, and materiality. It Can be classified into common groups like Property, Plant and Equipment, Vehicles, Other Equipment, etc.
- Valuation: Determining the initial cost of the asset like purchase price and other costs directly attributable to bringing the asset into use.
- Depreciation: Choosing an appropriate depreciation method and calculating the depreciation periodically. Different methods can be used to calculate depreciation like the Straight-Line method, Written Down value method.
- Record Keeping: Maintaining proper records of all fixed assets transactions, including acquisitions, disposals, and any other changes in the asset value.
6. Inter-Company Accounting: It refers to the processes and procedures that a company uses to manage financial transactions and relationships between its various subsidiaries, divisions, or entities that are part of the same corporate group. It involves the transfer of goods, services, or money between different subsidiaries, divisions, or branches of the same parent company. Inter-company accounting is essential for several reasons:
- Consolidated Financial Statements: Inter-company accounting is important for preparing consolidated financial statements that present the financial position, results of operations, and cash flows of the entire corporate group as a single economic entity.
- Eliminating Inter-Company Transactions: During the consolidated process, the inter-company transactions are eliminated to avoid double-counting.
- Reconciliation: Periodic reconciliation is essential to ensure that the inter-company balances are consistent and discrepancies are identified and resolved promptly.
- Transfer Pricing Documentation: Inter-company transactions involve the transfer of goods, services, or intellectual property between different entities within the same group. Proper inter-company accounting ensures that transfer prices are set at arm’s length.
- Compliance and Reporting: Inter-company transactions may be subject to specific tax regulations and transfer pricing guidelines in different jurisdictions. Companies must comply with these regulations and report inter-company transactions accurately in tax filings.
