Financial Accounting

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. read more 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.

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 That means if cash is withdrawn from the bank, in the company’s book under the double-entry system, both cash and bank would be affected.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

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 –

AccountDebitCredit
Cash A/c ………………….Dr$20,000
To Capital A/c$20,000

Ledger Entry

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  

Trial balance

From ledger, we can create a trial balance. Here’s a snapshot and the format of a trial balanceFormat Of A Trial BalanceTrial Balance has a tabular format that shows details of all ledger's balances in one place. As every organization must analyze its financial condition over a specific period of time, it contains transactions done during the year as well as the opening and closing balances of ledgers.read more of the example we took above.

Trial Balance of MNC Co. for the year-end

ParticularsDebit (Amount in $)Credit (Amount in $)
Cash Account20,000
Capital Account20,000
Total20,00020,000

Financial Statements

There are four financial statements that every company prepares and every investor should look at –

Let’s understand each of them briefly.

Income statement:

The purpose of the income statementPurpose Of The Income StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more 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 –

ParticularsAmount
Revenue*****
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.read more(*****)
Gross Margin****
Labour(**)
General & Administrative ExpensesAdministrative ExpensesAdministrative expenses are indirect costs incurred by a business that are not directly related to the manufacturing, production, or sale of goods or services provided, but are necessary for the smooth functioning of business operations, such as information technology, finance & accounts.read more(**)
Operating Income (EBIT)***
Interest Expenses(**)
Profit Before Tax***
Tax Rate (% of Profit before tax)(**)
Net Income***

Balance Sheet:

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 + Liabilitiesread more – “Assets = Liabilities + Shareholders’ Equity”. Here’s a simple snapshot of balance sheetSnapshot Of Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more so that you can understand how it is formatted.

Balance Sheet of ABC Company

2016 (In US $)
Assets 
Cash45,000
Bank35,000
Prepaid Expenses25,000
Debtor40,000
Investments100,000
Equipment30,000
Plant & Machinery45,000
Total Assets320,000
Liabilities 
Outstanding expenses15,000
Creditor25,000
Long-term debt50,000
Total Liabilities90,000
Stockholders’ Equity
Shareholders’ equity210,000
Retained Earnings20,000
Total Stockholders’ Equity230,000
Total liabilities & Stockholders’ Equity320,000

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 –

Shareholders’ Equity
Paid-in Capital: 
Common Stock***
Preferred Stock***
Additional Paid-up CapitalAdditional Paid-up CapitalAdditional paid-in capital or capital surplus is the company's excess amount received over and above the par value of shares from the investors during an IPO. It is the profit a company gets when it issues the stock for the first time in the open market.read more: 
Common Stock**
Preferred Stock**
Retained Earnings***
(-) 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.read more (which can be calculated using a direct and indirect method of cash flow), cash flow from financing activitiesCash Flow From Financing ActivitiesCash flow from financing activities refers to inflow and the outflow of cash from the financing activities like change in capital from securities like equity or preference shares, issuing debt, debentures or repayment of a debt, payment of dividend or interest on securities.read more, 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.read more. 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.

Accounting principles

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.read more 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.read more, 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

 

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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 –

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  1. Eceny Robert says

    Thanks for educating us

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