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 That means if cash is withdrawn from the bank, in the company’s book under the double-entry system, both cash and bank would be affected.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

Cash A/c ………………….Debit $20,000
To Capital A/c…………………………….Credit $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 balance of the example we took above.

Trial Balance of MNC Co. for the year-end

Particulars Debit (Amount in $) Credit (Amount in $)
Cash Account 20,000
Capital Account 20,000
Total 20,000 20,000

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 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 –

Particulars Amount
Revenue *****
Cost of Goods Sold (*****)
Gross Margin ****
Labour (**)
General & Administrative Expenses (**)
Operating Income (EBIT) ***
Interest Expenses (**)
Profit Before Tax ***
Tax Rate (% of Profit before tax) (**)
Net Income ***

Balance Sheet:

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 $)
Assets  
Cash 45,000
Bank 35,000
Prepaid Expenses 25,000
Debtor 40,000
Investments 100,000
Equipment 30,000
Plant & Machinery 45,000
Total Assets 320,000
Liabilities  
Outstanding expenses 15,000
Creditor 25,000
Long-term debt 50,000
Total Liabilities 90,000
Stockholders’ Equity
Shareholders’ equity 210,000
Retained Earnings 20,000
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 –

Shareholders’ Equity
Paid-in Capital:  
Common Stock ***
Preferred Stock ***
Additional Paid-up Capital:  
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 activities (which can be calculated 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.

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 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 the same always. GAAP is updated based on the complexities that arise in the world of accounting.

Financial Accounting Video

Recommended Articles

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. AvatarEceny Robert says

    Thanks for educating us

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