Basics of Financial Accounting

What is Financial Accounting?

Financial accounting is a sub-category of the general scope of accounting that is concerned with collecting and organizing financial data for the purpose of presenting it to the external users in an understandable format.

Financial accounting’s core objective is to give necessary financial information to the party or people outside the company or more specifically to the external users. These external users are not directly engaged in operating the business organization like the internal users or the management. They require the financial data of different companies to make a viable investment or financing decisions. The most common external users include investors or shareholders, creditors or lenders, suppliers, customers, unions, regulators, competitors, press, brokers or analysts, etc.

Basic Accounting Equation:

The basic accounting equation portrays two particulars of a company: its ownings and its owings. This equation is the base of the double-entry accounting concept. The mentioned equation is as follows:

Assets= Liabilities + Owner’s Equity

This equation shows that you can get assets by adding the liabilities and owner’s equity which is meaningful because companies acquire assets by using funds and liabilities and owner’s equity are the sources of this funding.

Here, liabilities appear before owner’s equity because the company has to pay the creditors before the company becomes bankrupt. For this reason, current assets and liabilities are mentioned before long-term assets and liabilities in financial statements. A business or company always has to make a balance between the both sides of this equation.

Components of the Basic Accounting Equation:

Assets:

The resource controlled or owned by the business for future use or benefit is called an asset. Assets can be tangible such as cash and intangible such as copyrights or goodwill.

Receivables are another type of common asset which implies a promise that a payment will be paid from a party to which a service has been provided or a product has been sold on credit.

Some common types of assets are mentioned below:

Current Assets

• Cash
• Accounts Receivables
• Prepaid Expenses

Fixed Assets

• Machine and vehicles
• Land and buildings

Theoretical or Intangible Assets

• Goodwill
• Patents
• Copyrights

Liabilities:

Liabilities refer to the amount of money owed to another institution or company or person. Payable is the most common form of liability which is the exact opposite of receivable. It is a promise to pay the other party from which a service is received or an asset is obtained on credit.

Some common types of liabilities are mentioned below:

• Accounts payables
• Lines of Credit
• Bank Loans
• Officer Loans
• Personal Loans
• Unearned Income

Owner’s Equity:

The part of the company’s assets owned by the owners or partners or stockholders refers to owner’s equity. Owners can expand their share by investing money in the company or reduce their equity by quitting funds of the business. Similarly, revenues expand equity and expenses reduce equity.

Equity accounts consist the following common items:

• Owner’s Capital
• Owner’s Withdrawing
• Unearned Income
• Officer’s Loan
• Paid-in Capital
• Common stock
• Preferred stock

The Expanded Accounting Equation:

The Owner’s Equity portion of the basic accounting equation is divided into four parts: Owner’s Capital, Owner’s Withdrawing, Revenues, and Expenses, other things remaining the same. The expanded equation will be different for different business entities such as corporations, sole-proprietorships, and partnerships.

The expanded equation for a corporation:

Assets= Liabilities + Common Stock – Dividends + Paid-in Capital - Treasury stock + Revenues - Expenses

Where, Common Stock - Dividends+ Paid-in Capital - Treasury stock + Revenues - Expenses= Stockholder’s Equity

The expanded equation for a sole-proprietorship:

Assets= Liabilities + Owner’s Capital – Withdrawals + Revenues – Expenses

Where Owner’s Capital – Withdrawals + Revenues – Expenses= Owner’s Equity

The expanded equation for a partnership:

Assets= Liabilities + Partners’ Capital – Distributions + Revenues - Expenses

Where, Partner’s Capital – Distributions + Revenues – Expenses= Partners’ Equity

Accounts & Types of Accounts:

Accounts are the base of financial accounting. Any financial transaction expands or reduces balances in one or more account/s. The changes in any particular asset, liability or equity item are recorded time to time in the general ledger which are called accounts. Such as Asset accounts, Liability accounts, Equity accounts. Again accounts also have sub-accounts. For example, Asset accounts have sub-accounts like current assets and fixed assets, Liability accounts have Current Liabilities and Long-term Liabilities and so on.

Asset accounts: These accounts show a debit balance and record the disposal of a company’s resources.

Liability accounts: These accounts show a credit balance and record the money that a business owes to other companies or institutions.

Equity accounts: These accounts also show a credit balance and record owner’s share in the company.

The Format of Accounts:

The most common format used in accounting is the T-accounts. In the T-account format, debits are kept on the left side and credits are kept on the right side and the total account balance is calculated at the bottom. The T-accounts also have a title and number at the top.

Example:

Accounts can also be listed according to the financial transactions i.e. the listing of the financial transactions which affected the cash balance. The listing formats are used frequently but the T-accounts are the simplest and the easiest format and T-accounts also help to make the trial balance in the accounting cycle.

Contra Account and Types of Contra Accounts:

Contra accounts are applied to decrease normal accounts on a balance sheet. Contra accounts are mentioned with the particular accounts in a balance sheet and are subtracted from these accounts. Mainly there are three types of contra accounts:

Contra Asset Account: An asset showing a credit balance and reducing the balance of another asset on the balance sheet is called a contra asset account. Such as accumulated depreciation reduces the balance of the fixed-asset.

Contra Liability Account: A liability showing a credit balance and reducing the balance of another liability on the balance sheet is called a contra liability account. Such as bonds payable.

Contra Equity Account: An account showing a debit balance and reducing a standard equity account is called a contra equity account. Such as Treasure stock.

Revenue Account and Types of Revenue Accounts:

The assets obtained by a company’s business operation are called revenue. The revenue account shows a credit balance.  The revenue accounts are mainly divided into two types:

Operating Revenues: The revenue earned from a business’s core business function. Such as Rents, sales, consulting services, etc.

Non-operating Revenues: All revenues earned by a company outside its usual business functions. Such as interest income.

Expense Account and Types of Expense Accounts:

The costs caused to earn revenues are called expenses. The expense account shows a debit balance. The expense accounts are mainly divided into two types:

Operating Expenses: All costs which are caused to earn operating revenues. Such as rent, wages, utilities, advertising, etc.

Non-operating Expenses: All costs which are not associated with the operating revenues. Such as interest expense.

The General Ledger:

The general ledger records the account summaries for accounts of a company’s business transactions. Often a ledger is called the second book of entry as business transactions are entered in the journals first.

Debit Vs Credit:

The concept of debits and credits is the foundation of the double entry accounting system. A debit, in short, Dr. is a posting on the left side of the T-account or accounting ledger. A credit, in short, Cr. is a posting on the right side of the T-account or accounting ledger.

This left side and right side concept are generated from the basic accounting equation where debits always have to be equal to the credits to make balance in the equation.

      Debits= Credits + Credits

i.e. Assets= Liabilities + Owner’s Equity.

Double Entry Accounting:

Accounting is referred to double entry system because here each business transaction has to be posted in at least two accounts. The foundation of this double entry system is the basic accounting equation because all debits and credits must be equal.

General Journal:

The general journal records a business transaction for a particular account.  Different companies use different journals based on their accounting system and business but they all use a general journal.

The format of a general journal is as follows:

Trial Balance:

A trial balance is the listing of the ending balances of all the accounts in the order of a balance sheet. Trial balance has four columns: account no., account name, debit and credit balance. A format is shown below:

Objectives:

There are mainly four objectives of financial accounting:

• Recording transactions while they occur to use them during preparing a financial statement
• Computing profit and loss so that management can take proper marketing strategies
• Determine the financial position of the company by keeping proper track of its assets and liabilities
• Provide the financial information to the shareholders through financial statements so that they can take a proper decision regarding their investments.

Financial Statements:

Financial accountants mainly prepare three kinds of statements the balance sheet representing the assets and liabilities; the income statement reflecting the profit and loss; and the cash flow statement depicting the cash inflows and outflows.

The external users examine the balance sheet to find the financial strength of the company (Assets vs Liabilities) and the income statement to find out the profitability (Profits vs Loss). If the balance sheet shows a positive balance, the lenders and creditors will be happy because their investments are safe. Investors will be happy to see an income statement showing a profit because then they will get some money as dividend or interest from the company.

Principles of Financial Accounting:

The rules of accounting, as well as financial accounting, are standardized to attain the following criteria:

• Impartiality: Financial statements should not be biased and follow the principles of objectivity strictly.
• Beneficial: Financial statements should be usable by the users to make proper financial decisions.
• Applicability: All information should be mentioned properly and no data should be omitted in the financial statements.
• Connectivity: The users should be able to connect the performance of one company to the performance of the other in other words the information should be comparable.

Financial Accounting Standards:

The “Generally Accepted Accounting Principles” or GAAP is followed internationally to prepare financial statements.