introduction to financial accounting

introduction to financial accounting

Introduction to Financial Accounting

1. I. The Importance of Financial Accounting

The financial statements are discrete entities, and management’s ability to manage its way to more favorable numbers or to outright falsify the results can be controlled by maintaining the integrity of those who prepare financial statements. Many times firms are forced to report information by the rules of external parties. All companies are required to prepare financial statements. In the United States, external parties use these statements to make credit decisions, stock investments, and similar choices. Since the great majority of corporations are owned by unrelated shareholders, the preparation of a set of financial statements is also required by the shareholders in order that the affairs of the entity may be presented fairly. By mailing the reports to the homes of the stockholders, the ownership group can follow the guidance of the Federal Trade Commission when it initiated rule adherence requirements in the 1940s. Financial accounting was developed to eliminate secret financial reporting and to maintain control over revenues and expenses.

There are a myriad of decisions that must be made by management, investors, creditors, and management on a day-to-day basis. These decisions are made in both the short term (e.g., is a company able to pay its short-term obligations) and the longer term (e.g., should a company invest in a new asset). Financial accounting provides data these groups can use in making good decisions. Basically, there are two types of data that financial accounting provides: financial statements (income statement, balance sheet, public disclosures…) and underlying data (depreciation schedules, fuel usage reports, etc.).

2. II. Basic Principles and Concepts in Financial Accounting

Accounting is the system of recording, analyzing, and summarizing the results of a business’s activities and then reporting the results to decision makers. It is sometimes called the “language of business” because it serves to communicate the financial state of the business to both external users and internal users. Accounting can be easily understood if you think back to balancing a checkbook. In balancing a checkbook, deposits and checks are recorded as they occur. Then, the sum of these transactions is compared with the actual balance in the account. If they match, your records are accurate. If not, you need to find and correct the errors. Superior management of a company requires the same type of financial information, only on a more sophisticated, consistent, and timely basis. In summary, the primary challenge of financial accounting is to give correct, consistent, and useful information on a timely basis for use in making investment, credit, and other business decisions.

In this chapter, we are going to consider the financial picture of a single firm. We need a language in order to communicate the information about a firm in a consistent way. The financial statements of a firm provide such a method of communicating. The accounting profession has developed a sophisticated set of standards to guide the preparation and presentation of these financial statements. Thus, financial accounting has come to play a major role in binding the firm and stockholders together.

3. III. Financial Statements and Reporting

A significant aspect of the process of determining a company’s financial performance and financial position is the preparation of four general-purpose financial statements. These financial statements are interrelated and are the means by which we communicate the financial information about the business enterprise to those with whom we are concerned, primarily the investors and the creditors. On the basis of published financial statements, investors and others who are interested in a company’s financial affairs invest in the company’s ordinary shares, and financial institutions and other creditors are prepared to lend to the enterprise. These financial statements must be relevant and reliable, consistent and comparable, understandable and verifiable. Information is relevant if it makes a difference in a decision-making context, and it is reliable if it is dependable and is a faithful representation of the economic transactions, events, and circumstances it purports to represent.

III. Financial Statements and Reporting

In this chapter, we discuss what the financial statements are, who creates them, and why they are important. We introduce the four key financial statements – income statement, statement of stockholders’ equity, balance sheet, and statement of cash flows – and briefly explain what each statement tells us. Finally, we examine how the transactions are recorded in the accounting system and how financial statements are created from this information.

4. IV. Analyzing Financial Data

Financial accounting is a combination of many closely related activities. The most important of these is the preparation of financial statements. Accountants prepare these statements at regular intervals. These statements summarize all the financial data of the enterprise at the date of preparation. The preparation of these reports involves a study of accounting principles. Finally, financial accounting is an art that is influenced by the changing conditions and requirements of the enterprise. The accountant must apply managerial judgment and accounting principles to the recording of business events and reporting of financial transactions. The accountant is required to recognize any weaknesses and inefficiencies in the systems. The accountant is also required to suggest alternatives for improvement.

In making investment decisions, capital providers and others analyze an enterprise’s financial data. This analysis is the essence of financial accounting. Investment decisions are made based on the relationship between amounts related by the financial data. The purpose of this chapter is to discuss the types of reports in which an enterprise provides such data to the capital provider and others. The next chapter discusses analytical tools such as ratio and trend analysis. These tools are used to assist in the making of investment decisions and to demonstrate the activities of the enterprise.

5. V. Ethical Considerations in Financial Accounting

It is therefore no surprise that various stakeholders, both narrow and wide, and some accounting researchers, attribute ethical characteristics to accounting and its functions. Whether overlapping with concerns of income distribution and societal advance on the one hand, or protection of individual interests and rights on the other, accounting can be seen as a leading contributor to the values and ethics of a populace. It is small wonder that Weber, often seen as a founding figure in the exploration of social science, saw accountability and statistical reporting as essential business activities. That accountability term carried the additional and important meaning of responsibleness. It is interesting that the term generally invoked with Weber in a contemporary context relating to accounting ethics is not accountability but stewardship and protection of trust. It is this notion of trust that constitutes an underpinning of accounting as a moral art.

Classical accounting theory has held that the decision usefulness of financial statements is derived mainly from their figures representing what is taken as objective reality for an enterprise, leading to viewing accounting as more of a science, rather than as a social science. However, this view has long been critiqued from within various religious and philosophical perspectives and has come under more direct challenge from accounting researchers who take eclectic, critical, or interpretive perspectives. Points both historical and current lead to the conclusion that at best, financial accounting can only be neutral towards users – individual aims and biases of special interest groups or management stakeholders may well be facilitated or even substantially influenced by current accounting concepts, purposes, and rules. Distributional effects have consequences beyond wealth transfer.