What is Financial Accounting?
Financial Accounting refers to the Bookkeeping of the Financial transactions by classifying, analyzing, summarizing, and recording financial transactions like Purchase, Sales, Receivables and Payables and finally preparing the Financial Statements which includes Income Statement, Balance Sheet & Cash Flows.
The main objective of financial accountingMain Objective Of Financial AccountingFinancial accounting discloses a company's profits and losses and offers an accurate and fair overview of the business. Its objectives are as follows: Compliance with statutory requirements, Safeguarding stakeholders, Measuring P&L, Periodic reporting, and Reliability and relevance. is to showcase an accurate and fair picture of the financial affairs of the company. To understand its fundamentals, first, we should start with a double-entry system and debit & credit, and then gradually should understand journal and ledger, Trial Balance, and four financial statements.
- Double Entry System
- Trial Balance
- Financial StatementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.
Let’s start with the double-entry system.
Double-entry system in Financial Accounting
In financial accounting, every financial transaction has two equal aspects. That means if cash is withdrawn from the bank, in the company’s book under the double-entry system, both cash and bank would be affected.
Under the double-entry system, we call these two aspects debit and credit.
Debit and credit
Understanding debit and credit is easy. You need to remember two rules –
- Debit the increase of assets and expenses and the decrease of liabilities and incomes.
- Credit the increase of liabilities and incomes and the decrease of assets and expenses.
Here’s an example to illustrate debit and credit –
Let’s say that around $20,000 worth of capital is being invested in the company in the form of cash.
Under the double entry accounting system, there are two accounts here – cash and capital.
Here cash is an asset and capital is a liability.
According to the rule of debit and credit, when an asset increases, we will debit the account and when liability will increase, we will credit the account.
In this example, both the asset and liability are increasing.
So, we will debit the cash since it is an asset and we will credit the capital since it is a liability.
Journal entry is based on the debit and the credit of the accounts. Taking the previous example into account, here’s how a journal entry will look like –
|Cash A/c ………………….Dr||$20,000||–|
|To Capital A/c||–||$20,000|
Once you know the essence of double-entry system, journal, and ledger, we need to look at ledger entry.
A ledger entry is an extension of the journal entry. Taking the journal entry from above, we can create a T-format for ledger entry.
Debit Cash Account Credit
|To Capital Account||$20,000|
|By balance c/f||$20,000|
Debit Capital Account Credit
|By Cash Account||$20,000|
|To balance c/f||$20,000|
From ledger, we can create a trial balance. Here’s a snapshot and the format of a trial balance of the example we took above.
Trial Balance of MNC Co. for the year-end
|Particulars||Debit (Amount in $)||Credit (Amount in $)|
There are four financial statements that every company prepares and every investor should look at –
- Income Statement
- Balance Sheet
- Shareholders’ Equity Statement
- Cash Flow StatementCash Flow StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities.
Let’s understand each of them briefly.
The purpose of the income statement is to find out the net income of the company for the year. We take all accounting transactions (including non-cash ones) and do a “revenue – expense” analysis to find out the profit for the year. Here’s the format of the income statement –
|Cost of Goods SoldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company.||(*****)|
|General & Administrative Expenses||(**)|
|Operating Income (EBIT)||***|
|Profit Before Tax||***|
|Tax Rate (% of Profit before tax)||(**)|
Balance Sheet is based on the equationBalance Sheet Is Based On The EquationBalance Sheet Formula is a fundamental accounting equation which mentions that, for a business, the sum of its owner’s equity & the total liabilities equal to its total assets, i.e., Assets = Equity + Liabilities – “Assets = Liabilities + Shareholders’ Equity”. Here’s a simple snapshot of balance sheet so that you can understand how it is formatted.
Balance Sheet of ABC Company
|2016 (In US $)|
|Plant & Machinery||45,000|
|Total Stockholders’ Equity||230,000|
|Total liabilities & Stockholders’ Equity||320,000|
Shareholders’ equity statement:
Shareholders’ equity statement is a statement that includes shareholders’ equity, retained earnings, reserves, and many such items. Here’s a format of shareholders’ equity statement –
|Additional Paid-up Capital:|
|(-) Treasury Shares||(**)|
|(-) Translation Reserve||(**)|
Cash flow statement:
The objective of cash flow statement is to find out the net cash inflow/outflow of the company. The cash flow statement is a combination of three statements – cash flow from operating activitiesCash Flow From Operating ActivitiesCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital. (which can be calculated using a direct and indirect method of cash flow), cash flow from financing activities, and cash flow from investing activitiesCash Flow From Investing ActivitiesCash flow from investing activities refer to the money acquired or spent on the purchase or disposal of the fixed assets (both tangible and intangible) for the business purpose. For instance, the purchase of land and joint venture investment is cash outflow, while equipment sale is a cash inflow.. All non-cash expenses (or losses) are added back and all non-cash incomes (or profits) are deducted to get exactly the net cash inflow (total cash inflow – total cash outflow) for the year.
As financial accounting is solely prepared for the right disclosure of financial information of a company, the statements, and reports company produce should be valid and credible. That’s why companies need to follow certain rules as per the Generally Accepted Accounting Principles (GAAP) or accounting standards.
GAAP covers the basic principles of accountingPrinciples Of AccountingAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts. that must be followed by companies. These principles include going concern conceptGoing Concern ConceptGoing Concern concept is an accounting principle which states that the accounting statements are formulated with a belief that the business will not be bankrupt or liquidated for the foreseeable future, which generally is for a period of 12 months., full disclosure concept, matching principle, cost principle and many others to produce the most accurate and reliable reports for the audience of the company.
However, GAAP doesn’t remain the same always. GAAP is updated based on the complexities that arise in the world of accounting.
Financial Accounting Video
This is a guide to what is Financial Accounting and its definition. Here we discuss the objectives and fundamentals of financial accounting including debit-credit, journals, ledgers and four financial statements (income statement, balance sheet, cash flow, and shareholders equity statement). You may have a look at these articles below to learn more –