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 accounting is to showcase an accurate and fair picture of financial affairs of the company. To understand the fundamentals of financial accounting well, first, we should start with 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 Statements
Let’s start with the double-entry system.
This is the essence of 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 That means if cash is withdrawn from the bank, in the company’s book under the double entry system, both cash and bank would be affected.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 into the company in the form of cash.
Under double entry 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 a liability will increase, we will credit the account.
In this example, both the asset and the 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 ………………….Debit||$20,000||–|
|To Capital A/c…………………………….Credit||–||$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 Statement
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 into account all the financial transactions (including non-cash ones) and do a “revenue – expense” analysis to find out the profit for the year. Here’s the format of income statement –
|Cost of Goods Sold||(*****)|
|General & Administrative Expenses||(**)|
|Operating Income (EBIT)||***|
|Profit Before Tax||***|
|Tax Rate (% of Profit before tax)||(**)|
Balance Sheet is based on the equation – “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 which 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 activities (which can be computed using a direct and indirect method of cash flow), cash flow from financing activities, and cash flow from investing activities. 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 a 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 basic principles of accounting that must be followed by companies. These principles include going concern concept, 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 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, definition and fundamentals of financial accounting. Here we discuss 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 –