Basics of Financial Accounting

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The article will give you an overview of financial accounting basics and provide you with an overview of the broad accounting terminologies that serve as the foundation for your accounting education.

What Is Financial Accounting?

Accounting is frequently regarded as a sophisticated collection of business rules and an infinite amount of numbers. Accounting is, at its core, a set of extremely simple concepts and principles. Once you've mastered the fundamentals of accounting, you'll be able to grasp almost any business or accounting idea.

This article covers accounting principles such as establishing company operations, documenting transactions, and comprehending the double entry accounting system. We will go through the fundamentals of accounting, journals, and ledgers, as well as the components of financial statements. Essentially, the fundamentals part will provide you with an overview of the common accounting words that will serve as the foundation for your accounting expertise.

Financial Accounting Definition?

Accounting in general is concerned with recognizing company activities, such as client sales, recording these transactions, such as journalizing, and communicating these events to individuals outside the firm through financial statements.

Financial accounting, on the other hand, is a subset of accounting that focuses on acquiring and organizing data in order to deliver it to public in a useful format. So, what does this imply? The primary goal of financial accounting is to offer valuable financial information to persons or organizations outside of enterprises, referred to as external users.

Financial accounting, in its most basic form, is the sharing of information about a corporation or other sort of organization (such as a charity or government) so that users may assess its financial health and prospects. "Information" is probably the most important word in financial accounting. Financial accounting is coiled with information, whether it is collecting financial information on a specific business, putting that information into a framework meant to improve communication, or striving to comprehend the information being given.

In today's society, information reigns supreme. Financial accounting establishes the standards and framework for the transmission of financial data about enterprises (and other organizations). Some firms are positioned to thrive at any given time, while others are on the edge of failing. Many stakeholders are very interested in assessing an organization's level of performance as well as its future potential. They are looking for information. Financial accounting delivers the information that these people want and desire.

Who Makes Use of Financial Accounting?

External stakeholders of financial information, unlike firm management or internal users, are not actively engaged in the operation of the business or organization. They are outsiders to the firm and have minimal knowledge of its operations, financial situation, and well-being. In other words, external users want financial information about enterprises in order to make sound financial decisions.

Financial accounting's ultimate objective is to integrate company transactions and other documents such as invoices and sales receipts into financial statement that can be interpreted by external users.

The fundamental idea here is that external stakeholders must be able to interpret and utilize this financial information when making business choices. If the information cannot be utilized, it is useless. As a result, the FASB has established a set of accounting standards and principles to ensure that financial statements are comparable and intelligible.

What Does the Accounting Equation Entail?

All accounting systems are built on the accounting equation, commonly known as the fundamental accounting equation. In reality, the basic accounting equation serves as the foundation for the whole double entry accounting approach. This straightforward equation depicts two facts about a company: what is owned by it and what it owes.

The accounting equation compares the assets of a corporation to its liabilities and equity. This demonstrates that all corporate assets are obtained through debt or equity financing. For example, when a firm is formed, its assets are first acquired with cash obtained from loans or cash obtained from investors. As a result, all of the company's assets are derived from lenders and investors, i.e. liabilities and equity.

The fundamental accounting equation is as follows.

Assets = Liabilities + Equity

As can be seen, the sum of liabilities and owner's equity equals assets. When you think about it, liabilities and equity are in reality just sources of capital for businesses to acquire assets.

Because creditors must usually be compensated before investors in a bankruptcy, the equation is commonly presented with liabilities appearing before owner's equity. In this regard, the liabilities are more current than the equity. This is compatible with financial reporting, which requires that current assets and liabilities be stated first, followed by long-term assets and liabilities.

This equation applies to all commercial activity and transactions. Liabilities and owner's equity will always equal assets. If assets grow, either liabilities or owner equity must grow to balance the equation. If liabilities or equity rise, the inverse is true.

Accounting Equation Components

Assets

An asset is a resource that a firm owns or controls that will be used for future advantages. Some assets are physical, such as cash, while others, such as goodwill or copyrights, are theoretical or intangible. Receivables are another typical asset. This is a guarantee that you will be compensated by the other party. When a business delivers a service or sells a product to someone on credit, receivables are formed.

The following are some examples of popular asset types:

Current Assets include Cash, Account Receivable and Prepaid Expense.

Fixed Assets include Vehicle and Buildings.

Intangible Assets include Goodwill, Patents and Copyrights.

Liabilities

In its most basic form, a liability is a sum of money owed to another person or organization. Liabilities, on the other hand, are creditors' claims on corporate assets since this is the amount of assets creditors would hold if the firm went bankrupt.

A payable is a typical type of liability. Receivables are the polar opposite of payables. When a business buys products or services on credit from another company, a payable entry is generated to demonstrate that the company commits to pay for the assets of the other firm.

Few examples of liabilities are:

  • Accounts payable

  • Personal Loans

  • Bank loans

  • Unearned income

  • Officer Loans

  • Lines of Credit

Equity

Shareholders or partners possess a percentage of the company's assets, which is referred to as equity. In other words, once all of the liabilities have been paid off, the shareholders or partners have the remaining assets.

By contributing funds to the firm, owners can raise their ownership share, or by withdrawing corporate cash, they can diminish their equity. Similarly, income boost equity while costs deplete it.

The following are some examples of common equity accounts:

  • Owner’s Capital

  • Owner’s Withdrawals

  • Common stock

  • Unearned income

  • Officer Loans

  • Paid-In Capital

What is an Account?

Accounts are the bedrock of financial accounting. Each business transaction raises or lowers the balance in one or more accounts. The whole accounting idea is built around keeping a chart of accounts.

A simple account is a record of all alterations to a given asset, debt, or equity item. Consider an account to be a notepad. Each accounting item has its own notepad, which is used to record all of the changes to that item throughout time. Accounts are usually named and numbered to help organize and monitor them. Sub-accounts can be created within accounts. The automobile account, for example, is a sub-account within the main asset account.

The general ledger is where all accounts are maintained or documented.

Types of Accounts

The chart of accounts or general ledger divides all accounting into three categories: asset, liability, and equity.

Asset Accounts:

These accounts contain a debit balance and show a company's available resources.

Liability Accounts:

These accounts have a credit balance and indicate the money owed to other businesses by a corporation.

Equity Accounts:

They also have a credit balance and reflect the stake of owner in the company.

Revenue Accounts:

The assets earned by a company's operations and business activities are known as revenues. To put it another way, revenues are the funds or receivables received by a business for the sale of its goods or services.

Revenue accounts have two types:

Operating Revenue - The revenue generated by a company's primary business function. Rents, sales, consultancy services, and so forth.

Non-operating Revenue - All revenues generated by a firm that are not related to its core activity. Interest income, for example.

Expense Accounts:

Expenses are the costs that are spent in order to create revenue. In other words, a company records an expense when it pays for or promises to pay for an asset or service that generates revenue.

Two types of expense accounts are:

Operating Expense - All costs incurred to earn operational revenues, such as goods sales, are included in operating expenses. Rents, salaries/wages, marketing expense etc are included in operating expense.

Non-operating Expense - Costs that cannot be directly attributed to operational revenues are classified as non-operating expenditures. The most prevalent non-operating expenditure is interest.

General Ledger

A general ledger (GL) is a system of numbered accounts that a company uses to manage its financial activities and create financial reports. Each account is a discrete record that sums up each asset, liability, equity, revenue, and expenditure type.

Debits and Credits

Every dollar that enters an account is recorded as a debit (dr), whereas every dollar that leaves an account is recorded as a credit (cr).

The principle of debits and credits underpins the double entry accounting system. The double-entry technique of accounting is now used by the majority of firms. Your whole firm is organized into individual accounts under this structure.

Double Entry Accounting

The accounting method of double entry accounting, often known as double entry bookkeeping, mandates that every company transaction or activity be documented in at least two accounts. The accounting equation follows the same logic. Every debit must be equaled by a credit of the same amount. In other words, in every accounting transaction, debits and credits must be equal.

Managerial Accounting vs Financial Accounting

The techniques used to collect and track a company's financial data are referred to as managerial accounting. Professionals can use this sort of accounting to review, fix, and improve a company's financial systems.

Because operational reports are often created for the benefit of stakeholders rather than for general public, managerial accounting serves an internal function. Strategic planning is frequently aided by managerial accountants, who assist executives and stakeholders in making informed decisions.

Financial accounting is concerned with the documenting of transactions, which are generally presented in the form of financial statements. Because both stakeholders and members of the public may see these financial accounts, this style of accounting has both internal and external aims.

Financial statements, in the end, affirm an organization's performance, which is why regulators and investors frequently use them to analyze an organization's financial standing.

You can better comprehend the major aims of each form of accounting by looking at the differences between financial vs managerial accounting. A few key distinctions/differences between financial and managerial accounting are:

Audience

Financial accounting is for both internal and external stakeholders. Financial statements are relied on by an organization's management teams, regulators, and creditors. On the other hand, the reports and statements that management accountants generate are targeted for an internal audience, and the general public does not read them.

Reporting Frequency

Financial accountants prepare financial statements at the conclusion of each accounting period, which may occur once a month, quarterly, or on a more regular basis. Management accountants, on the other hand, produce reports at irregular intervals, frequently to assist stakeholders in making decisions or changing procedures.

Level of Detail

Managerial accounting frequently entails reporting on more specific parts of the business. Management accountants, for example, may provide statistics on earnings from various product lines or client segments to assist executives with strategic planning. Financial accounting, on the other hand, includes the whole business and does not produce such specialized reports.

Standards

Financial accounting must adhere to recognized standards since it is used for both internal and external needs. Financial accountants commonly adhere to the Financial Accounting Standards Board's (FASB) generally accepted accounting principles (GAAP) and the International Financial Reporting Standards Foundation's (IFRSF) standards (IFRS).

Because management accounting is intended for internal use, it is not required to adhere to industry norms. Organizations might instead create their own reporting guidelines.