Financial accounting is a core accounting function specifically concerned with maintaining a company’s economic transactions. Record-keeping guidelines are used to summarize and classify all transactions, and this also includes preparing the financial statements that give investors an overview of a company’s financial stability.
Financial accounting relies on the same conceptual framework of double-entry record-keeping to record, analyze, and report transactional data at the end of a given period, regardless of which specific accounting method is applied.
The Role of Financial Accounting
Financial accounting serves as a form of control within an organization and helps business owners make vital monetary decisions based on accurate, consistently recorded data.
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The Two Core Methods of Financial Accounting
Financial accounting is built on two core recording methods, cash accounting and accrual accounting, distinct from the financial statements these methods ultimately produce, covered further below.
Cash Accounting Method
Businesses using the cash accounting method focus solely on transactions that involve actual cash movement. Transactions with no direct monetary exchange don’t appear in the financial statements under this method. Cash-related debits and credits are recorded based on the number of actual cash transactions made.
Accrual Accounting
Under the accrual method, transactions are recorded regardless of whether cash has actually changed hands yet. This includes recognizing income and expenses when they’re earned or incurred, not only when the related cash transaction takes place. The accrual method accumulates and records an item at the point the underlying transaction genuinely occurs, matching income and expenses to the period they relate to.
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Worked Example: Cash vs. Accrual Accounting for the Same Transaction
A UAE consulting firm completes a project in March and issues an invoice for AED 50,000, but the client doesn’t actually pay until May. Under cash accounting, the firm records no revenue in March, the AED 50,000 is only recognized in May when the cash is actually received. Under accrual accounting, the firm records the AED 50,000 as revenue in March, when the work was completed and the invoice issued, regardless of when the cash actually arrives. This is exactly why the two methods can show a materially different financial picture for the same underlying business activity in any given period, and why UAE Corporate Tax generally requires accrual-based reporting rather than cash-based reporting for most businesses above the applicable threshold.
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The Financial Statements Produced Through Financial Accounting
Separate from the accounting method used, financial accounting produces a set of financial statements, prepared quarterly and annually and made available to shareholders and, where the company is public, to prospective investors.
Income Statement
Also known as the profit and loss statement, this reflects a company’s revenues, expenses, and gains over a period, including both operating and non-operating items.
Balance Sheet
The balance sheet is divided into three parts as of a specific date: assets, liabilities, and stockholders’ equity.
- Assets include items such as cash, accounts receivable, inventory, prepaid insurance, and equipment.
- Liabilities include the company’s outstanding obligations, often recorded under accounts payable and similar categories.
- Equity reflects the residual interest in the company’s assets after liabilities are deducted, essentially what shareholders actually own.
Statement of Cash Flows
This statement explains the change in a company’s cash position over the period indicated, divided into three parts:
- Operating activities
- Investing activities
- Financing activities
Statement of Retained Earnings
This statement covers dividends paid to shareholders alongside the amount of profit retained within the company rather than distributed.
Frequently Asked Questions (FAQs)
What are the different types of accounting?
What is the main purpose of financial accounting?
What's the difference between accounting generally and financial accounting specifically?
Are financial statements the same thing as accounting methods?
Which accounting method does UAE Corporate Tax generally require?
What are the three components of the statement of cash flows?
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How Farahat & Co. Can Help
Farahat & Co., a trusted Accounting Firm in the UAE, provides financial accounting and bookkeeping services, ensuring quality reporting and full transparency across your company’s financial statements.
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