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An Introduction to Financial Accounting

An Introduction to Financial Accounting
Accounting is a very important/critical process, with the help of which, the management of an organization attempts to manage and control its economic performance. If you are an accounting student, or aspire to pursue your career in the field of financial accounting, here are some basics that you would need to know before you make your decision.
Nilesh Parekh
Last Updated: May 31, 2018
For an organization, its success and performance is a combined effect of its resources, people (labor), capital, opportunities (market), and management. For any person outside the organization, the success or performance of the organization may not mean anything until they are measured and represented in terms of profits. Thus, it becomes necessary to translate the effects of opportunities, efforts of labor, management, etc., into some accounting numbers, which will help measure financial performance, success, and profitability of an organization.

Thus, accounting helps in achieving internal and external reporting of resources, capital, etc., and also in managing them for earning better profits for the company. Accounting provides necessary information to the investors as well as the management, and helps them in the process of decision-making. So, financial accounting is a process that must follow regulations such as accounting principles, standards, and ground rules.

Basic Accounting Concepts

Because different people and entities use these financial accounts for their respective purposes, the Financial Accounting Standards Board (FASB) has set up a list of rules known as accounting standards and generally accepted accounting principles (GAAP), which all the financial account statements need to take into consideration. These are as under:
  • The Entity Concept: A business and its proprietor(s) are considered to be distinct entities. A business is nothing but an economic entity that has its own assets and liabilities. Similarly, the person/entity owning the business has its own assets (bank accounts, land and other assets), obligations, etc., and both of these have an individual existence. The assets and liabilities of the proprietor are not considered to be same as the assets and liabilities of the business.
  • Money Measurement Concept: If any transaction or deal needs to be considered for the purpose of accounting, it must be expressible in monetary terms, i.e. in US dollars. If this is not possible, then such a transaction cannot be considered for accounting purposes.
  • The Cost Concept: Any tangible asset (such as land, real estate, machinery, vehicles, etc.) and liability (such as liability towards investors, loans, etc.) owned by a business, should be recorded at the historical or original cost (i.e. the cost at the time of acquisition), irrespective of its current cost.
  • The Going Concern Concept: This is one of the fundamental concepts in accounting. According to this concept, an entity is considered to be a going concern if there is no plan or intention of liquidation of the entity or reduction in any of its operations. This means, it is assumed that the entity and its operations will last for a very long period of time.
  • The Periodicity Concept: Although the going concern concept states that the entity and its operations would be considered to be functional unless any plans are put forth for the liquidation or reduction of operations, there exists a need for periodic appraisals in order to judge the performance of the entity. This is because it is not possible to wait for a long period of time. This period during which the performance of the entity is measured is called the accounting period, and the performance of an entity and its operations is measured for each accounting period.
  • The Accrual Concept: According to this concept, the incomes and expenses of an entity should be noted or identified as and when they are earned or incurred by the entity, irrespective of when the transactions for the actual payment or receipt of money for the same are performed.
  • The Matching Concept: Matching concept helps to calculate and understand the profitability quotient of a business. In this, revenue earned during a financial period is counterbalanced against all the expenses, liabilities, etc. which were incurred for earning the revenue.
  • Concept of Prudence: This concept is also known as conservatism. It states that all the expenses and liabilities that a business has incurred should be recorded then and there with immediate effect. But, on the other hand, all the revenue or income that the business is earning should only be documented when the actual money is received. This is an important concept of accounting, as it makes sure that neither there is an overstatement of assets/income, nor an understatement of liabilities/expenses.
  • Concept of Revenue Recognition: This concept deals with the immediate recognition of revenue whenever a product is sold or a service is imparted. It states that any income earned has to be recognized immediately, even in the case of credit sales.
The Financial Statement

A financial statement is a final output of the entire accounting process. It consists of a profit and loss account and a balance sheet for that particular financial year, and it is released either at the end of the given financial year or at the beginning of the next financial year. A financial statement helps users (who are decision makers for an organization) to understand the financial position and performance of an organization. It is with the help of these financial statements, also known as final accounts, that an organization decides its business strategies for the upcoming financial year.

Preparing Financial Statements

There are essentially three basic financial statements that have to be prepared - the Income Statement, a.k.a. the profit and loss account, the Statement of Retained Earnings, and the Balance Sheet. The whole purpose of these financial statements is to ease the process of decision-making for their users.

The Income Statement:
  • The purpose of the income statement is to report the performance of the business for a given period of time.
  • This statement is based on the simple formula, Revenue - Expenses = Net Income.
  • Sometimes, people desire more information from their businesses than can be obtained from the above-mentioned simple formula. Hence, a more complex calculation needs to be made, which is Income from Sales - Cost of Goods Sold = Gross Profit - Operation Costs = Income from Operations +/- Non-operating costs = Income Before Taxes - Income Tax = Net Income.
  • This statement helps to determine the actual levels of profit or loss of the business.
The Statement of Retained Earnings:
  • This statement records the effect of net income and profits/losses that were incurred by a company, on its financial position.
  • Retained earnings are basically revenues that the company manages to retain with itself, and are carried forward as the opening balance for the subsequent financial year.
  • These are calculated as Opening Balance + Net Income - Dividends = Closing Balance.
  • As net income can be calculated through the Income Statement, it is mandatory to prepare the same before calculating the retained earnings.
The Balance Sheet:
  • The Balance Sheet is a summary of the company's performance during a financial year.
  • It comprises three main constituents, viz. Assets, Liabilities and Equity.
  • Assets are the economic resources which the company owns. These are of two kinds:
    Current assets, which are those intangible assets that can be converted into cash at any point in time.
    Fixed assets are those tangible assets which can be used repeatedly in the processes of production and manufacturing, and are not intended for sale in the long run.
  • Liabilities refer to company's debt or the expenses which a company is going to incur in the near future. These are again of two kinds, viz.
    Current liabilities, which are the liabilities that need to be paid off immediately in the coming financial year, either in cash or in the form or services.
    Long-term liabilities are those liabilities which need not be paid off immediately.
  • Equity, also known as owner's equity or shareholders' equity, is calculated as the difference between assets and liabilities.
  • So, we can represent the relationship between these three elements of the balance sheet as, Assets (A) = Liabilities (L) + Equity (E)
Apart from these three main statements of accounts, there are two more statements which are very important for a detailed overview of the company's financial performance during a given financial year. These are:

The Statement of Cash Flows:
  • It is an important statement that complements the final accounts of the company.
  • Also known as the cash-flow statement, it records the amount of money (in cash) generated and utilized during a given period of time in a financial year.
  • It identifies the cash that flows in and out of the company at a given point of time, and determines whether the company is gaining profits or is incurring losses.
  • It includes all the cash-related activities of the company such as depreciation, cash sales and purchases, payment of dividends or buying and selling of stocks.
The Statement of Changes in Stockholders' Equity:
  • This statement gives a detailed break-up of the equities, which are mentioned in the balance sheet.
  • It attempts to explain how the equity has changed over a period of time from the previous financial year to the current financial year.
  • It includes items such as retained earnings, value of shares, treasury stock of the company, and so on.
For all the aspiring financial accountants, there are a number of professional accountancy qualifications. Some of them are the Chartered Account (CA), the Certified Public Accountant (CPA), and the Chartered Certified Accountant (ACCA). Apart from these, there are also a number of recognized degree courses, which various universities offer in this field.