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Financial accounting is the systematic process of identifying, recording, classifying, summarising and reporting business transactions in monetary terms. Its main output is financial statements—primarily the Trading Account, Profit & Loss Account and Balance Sheet—which show performance (profitability) and position (assets, liabilities and capital). The accounting equation is the foundation of the double-entry system and explains why every transaction affects at least two aspects of the business.
Financial accounting records transactions and summarises them into financial statements. It focuses on historical, objective and monetary information. Transactions are first recorded in books of original entry and then classified into ledger accounts, finally resulting in a trial balance and financial statements.
Financial accounting aims to:
The scope includes:
Accounting information is used by both internal and external stakeholders.
The business is treated as a separate entity from its owner. Owner’s investment is treated as capital (a liability from business point of view), and drawings reduce capital.
Only transactions measurable in money are recorded. For example, employee honesty is important but is not recorded in accounts because it cannot be measured reliably in money.
Accounts are prepared assuming the business will continue. Therefore, assets like machinery are shown at cost less depreciation rather than at forced-sale value.
Income and expenses are recorded when earned/incurred. Example: if rent for March is unpaid, it is still recorded as rent expense for March and shown as outstanding rent liability.
Business life is divided into equal periods (year/quarter) for reporting profit and financial position.
Assets are recorded at their purchase cost. Over time, cost is allocated through depreciation.
Expenses are matched with related revenues of the same period to determine correct profit.
Anticipate losses but do not anticipate profits. Example: closing stock is valued at cost or net realisable value (NRV), whichever is lower.
Once an accounting method is adopted (e.g., depreciation method), it should be consistently used to make comparison meaningful.
Insignificant items may be treated in a simplified way. Example: small stationery items may be expensed immediately instead of capitalised.
The accounting equation shows the relationship between assets, liabilities and capital: This equation is always true because:
Since capital increases with income and decreases with expenses and drawings, an expanded form is:
Every transaction affects the equation but does not break it. The effect is observed by identifying:
Assume the following transactions in a new business:
The equation can be shown as:
Correct classification is important because it affects profit and the balance sheet.
Capital expenditure is incurred to acquire or improve a fixed asset and provides benefit for more than one accounting period.
Examples: purchase of machinery, furniture; installation charges; major repairs that increase asset life/capacity.
Revenue expenditure is incurred for day-to-day operations and its benefit is consumed within the same accounting period.
Examples: rent, wages, salaries, carriage inward, electricity, normal repairs.
Transactions are recorded and processed through a sequence:
The above flow ensures that transactions are properly recorded, classified and summarised into financial statements.
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Financial accounting is the systematic process of identifying, recording, classifying, summarising and reporting business transactions in monetary terms. Its main output is financial statements—primarily the Trading Account, Profit & Loss Account and Balance Sheet—which show performance (profitability) and position (assets, liabilities and capital). The accounting equation is the foundation of the double-entry system and explains why every transaction affects at least two aspects of the business.
Financial accounting records transactions and summarises them into financial statements. It focuses on historical, objective and monetary information. Transactions are first recorded in books of original entry and then classified into ledger accounts, finally resulting in a trial balance and financial statements.
Financial accounting aims to:
The scope includes:
Accounting information is used by both internal and external stakeholders.
The business is treated as a separate entity from its owner. Owner’s investment is treated as capital (a liability from business point of view), and drawings reduce capital.
Only transactions measurable in money are recorded. For example, employee honesty is important but is not recorded in accounts because it cannot be measured reliably in money.
Accounts are prepared assuming the business will continue. Therefore, assets like machinery are shown at cost less depreciation rather than at forced-sale value.
Income and expenses are recorded when earned/incurred. Example: if rent for March is unpaid, it is still recorded as rent expense for March and shown as outstanding rent liability.
Business life is divided into equal periods (year/quarter) for reporting profit and financial position.
Assets are recorded at their purchase cost. Over time, cost is allocated through depreciation.
Expenses are matched with related revenues of the same period to determine correct profit.
Anticipate losses but do not anticipate profits. Example: closing stock is valued at cost or net realisable value (NRV), whichever is lower.
Once an accounting method is adopted (e.g., depreciation method), it should be consistently used to make comparison meaningful.
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Financial accounting has the following objectives:
Capital expenditure is incurred to acquire or improve a fixed asset and its benefit extends beyond one accounting period (e.g., purchase of machinery). It is shown as an asset and depreciation is charged.
Revenue expenditure is incurred for day-to-day operations and its benefit is consumed within the same accounting period (e.g., rent, wages). It is charged to the Profit & Loss Account.
Thus, capital expenditure affects the balance sheet as an asset, while revenue expenditure directly affects profit.
The basic accounting equation is:
[\text{Assets} = \text{Liabilities} + \text{Capital}]
It shows that assets (resources) are financed either by liabilities (outsiders’ claim) or capital (owner’s claim).
Every transaction changes at least two elements but does not disturb the equation.
Thus, the accounting equation remains true after every transaction.