financial accounting book

financial accounting book

The Essential Guide to Financial Accounting

1. Introduction to Financial Accounting

In society today, the main form of business is a corporation. When a business transition occurs or ends, that business must have accurate and complete financial records prepared to enable owners and outside parties to properly assess the financial condition of the business. In addition, there must be an accurate and complete accounting of the resources a business has at hand and how it has utilized those resources. Accounting and financial tools are used to report a business’s financial position as well as its past performance and current condition. Near-continuous reporting of the financial position and performance of business entities is termed financial accounting. Businesses can vary in size, activities, and objectives, but every business must adapt these types of responsibilities. Well-operated businesses describe good accounting. With efficient accounting, businesses can understand their weaknesses and strengths in the most helpful areas. To record accounting, a company employs financial and managerial accounting. Financial accounting includes making financial reports about the internal and external information of the business.

This first section includes an overall introduction to the field, and is key to understanding broader concepts and issues discussed throughout the book. In particular, it covers the purposes of accounting, financial accounting, business forms, and many of the transactions found in a business. In the business world, identifying the form that a company will take is important. The needs of a company regarding financing choices, liability risk, and the abilities of managers are of immediate concern in planning a business. There are several forms of businesses. These are sole proprietorships, partnerships, limited liability partnerships, corporations, and limited liability companies.

2. Fundamental Principles and Concepts

To ensure that financial statements meet these essential requirements, there are a number of fundamental accounting principles and assumptions that ensure that accounts are comparable, reliable, relevant, and understandable. The most important of these are the historical cost accounting convention and the separate entity rule. The commercial boundary convention and the realization convention also play major roles in financial accounting. In addition, there are the going concern and the consistency assumptions. These principles and concepts apply at both the detailed and the overall level of financial accounting. They provide the framework within which the financial statements are usually prepared, and they help accountants to apply the standards in an appropriate manner.

– Understandability – Reliability – Comparability – Relevance

GAAP recognizes a number of different qualitative characteristics of accounting information. Some of the most important of these are:

Accounting Principles and Assumptions

In this chapter, we will outline the basic principles of accounting and the underlying concepts. We will then establish some of the key conventions that are used in preparing financial statements. It is important to get a clear idea of the overall framework of financial accounting in order to ensure that what is produced is comprehensible, widely acceptable, consistent, and reliable.

3. Financial Statements and Reporting

However, because the main indicators of the results of the business have been subsumed within the balance sheet and the income statement, the focus of the financial statements is to be of how those financial statements reflect real business operations far more explicitly.

The essential elements in the balance sheet ensure that the accounting equation holds at all times during the period. Thus, the accumulation of profits over the long term for the business should be shown in the increase in the asset investment the business can show and because of this, the profit and loss account have been subsumed into the balance sheet model.

A profit and loss account for a particular time period can easily fit into the balance sheet model in double-entry accounting. The profit of the business is the difference between the assets invested and the liabilities at the end of the period and the assets invested and the liabilities at the beginning of the period. In accounting terms, a profit equals the unwinding of the liability balance generated by the dividends paid by the business to the owners of the business before the profits of the business machinery are divided between everybody associated with the business and sector.

To determine the profitability of the business, it is necessary to measure the profit that has been generated by the business over a period of time. This is done by constructing a profit and loss account.

Profit and Loss Account

Thus, the balance sheet shows the assets and the liabilities of the business at a particular point in time.

This balance sheet shows that the car is a long-term asset, value equal to the cost and financed by capital invested in the business.

Assets (Liabilities) Equity = Value of car (Liability) Capital =

Balance Sheet as at a particular date

Using this basic model, we could produce a basic balance sheet that looks like this:

An example of this arises when starting a business and putting some money in for a car or office equipment. To acquire the car in the first place, you use your command of the resource of money which you are invested in the business (your capital), (shown as a negative in value equal to the cost of the car) and offset that with a new type of asset called a car. The new types introduced in this example are capital, an equity type (showing owners’ equity) and fixed asset, an asset type.

There has to be some form of liability attached to any asset, since assets minus liabilities will always be equal to the capital or equity of the business. Often, the liability is represented by the fact that an asset has been acquired by means of a liability (usually a bank overdraft) and this is the way in which liabilities arise. Every transaction recorded in accounting records creates new information and is a balance of resources made by the business and resources provided by creditors or owners of the business.

A business has an objective to create value for its constituents and requires resources to do this. In essence, it has to make an investment in resources now which will yield benefits later. The value that it has created is in the form of something (physical or non-physical), represented by assets which the business owns.

Balance Sheet

4. Analysis of Financial Statements

The most common type of financial analysis performed is perhaps the examination of the impact of past and present operations on the future requirements and income-producing capabilities. The users of this information consider such questions as what dollar volume of sales is necessary to earn a fair return on investment, whether the firm can repay the principal at maturity of a loan or debt security, and whether adequate resources are available to sustain and improve operating capacity. These types of questions ask about a firm’s solvency, liquidity, and operating capacity. Information about a firm that might provide answers is often sought in a general way from the financial statements and accompanying notes and schedules. The problem becomes clear when we try to develop specific measurements and conclude that reliable and useful data is not contained in the basic financial statements.

Having learned how financial statements are made and studied the accounting concepts and methods used to prepare them, you are now ready to learn what they mean. Financial analysis is one of the keys to effective decision making. Managers, investors, regulators, vendors, customers, and employees all depend in some way on meaningful financial information to make important decisions. Consequently, some of the essential concepts and techniques for financial statement analysis that follow should be familiar to you. But as a manager, you will need to apply these ideas, often as a part of financial management, to old and new problems.

5. Advanced Topics in Financial Accounting

This is an important principle, as it tells us that while profits may be valuable, it is the ability of the company to generate cash, rather than profits per se, that is important.

There are two cash entries on the right-hand side of the balance sheet, one for liabilities and the other for equity. Hence, the change in cash satisfies: change in cash = change in liabilities + change in equity + profit – dividends paid (5.1).

Chapter 5 covers several more advanced topics in financial accounting. The first is concerned with cash flows. It develops the concept of free cash flows, which many value investors believe is the most important financial number of all. The principle behind free cash flows is to do with the change in cash. This is better understood if we start once again from the accounting equation, which we are parsing in the form: assets on right-hand side of balance sheet = liabilities on left-hand side + capital and profits on left-hand side. The mathematical equivalent of this is: assets = liabilities + capital + profits.