patricia libby financial accounting

patricia libby financial accounting

The Importance and Fundamentals of Financial Accounting by Patricia Libby

1. Introduction to Financial Accounting

In this introductory chapter, we discuss what financial accounting is, the accounting cycle, and the basic accounting concepts needed to understand financial statements. First, we consider the role of financial accounting for investors and other stakeholders. Next, we explain the accounting process by walking through the steps in the accounting cycle. Finally, we discuss the basic concepts you need to understand, such as the difference between cash and credit transactions.

Why learn financial accounting? Why is financial accounting important in a business degree, whether or not you want to be an accountant? Quite simply, financial accounting reports to investors, creditors, and other external users the economic activities and financial condition of a business. When we finish this class, you will be prepared to understand these financial statements so that you can make informed investing decisions, process necessary information, and talk intelligently with loan officers and store managers. These statements are the product of accounting. In fact, all businesses, for-profit or not-for-profit, no matter their size or type, need to prepare financial statements at the end of the accounting period.

2. Key Concepts and Principles in Financial Accounting

The net income results from the revenue earned by providing goods or services and from the expenses incurred to operate the business. After each income period, the net income is added to retained earnings. The revenue earned from business operations (or the net income) increases the asset part of the accounting equation. Because net income increases assets, it also increases owner’s equity; increases in owner’s equity that result from profits are called retained earnings.

The Relationship Between Income Measurement and the Accounting Equation Net income is the difference between revenue and expenses. Revenues increase owner’s equity and net income. Revenues are the price of the goods or services provided by a business. Expenses decrease owner’s equity and net income. Expenses are the costs of doing business. The net income increases owner’s equity.

Assets = Liabilities + Owner’s Equity

Owner’s equity consists of the owner’s investment in the business and is sometimes referred to as “stockholders’ equity” or “capital.” At the time of investment, the owner’s equity includes cash contributed by the owners and the value of other property contributed by the owners as they transferred the property interests to the company. As the business earns and retains profits, owner’s equity is also increased, ending the revenue earned and the expenses incurred in operating the business.

Liabilities are amounts owed to creditors. Liabilities are a company’s obligations to pay cash or provide goods or services to others.

Resources owned by a business are called assets. Examples of assets are: cash, accounts receivable, notes receivable, land, buildings, and equipment.

The Accounting Equation The accounting equation shows the relationship among assets, liabilities, and owner’s equity. Assets = Liabilities + Ownership Equity

3. Financial Statements and Reporting

To facilitate comparison with other organizations in a manner that will be considered reliable and viable by users and preparers of financial statements, certain formats of financial statements and related financial information are required. A company’s financial statements must be prepared and presented in a particular format, generally following the financial accounting concepts, in order for the financial information to be presented in a meaningful and understandable form. Analysts and users compare the financial performance and health of a company with another. The financial information in the form in which it is used today is the result of modifications over time of business practices and theories of regulation. Historically, to improve and ensure comparability, the form and content of financial statements needed to be defined and codified.

Managers and other users of accounting information often compare the financial performance and health of their company with that of another. They do this to evaluate the current financial condition of their company or project future financial positions. These user groups are interested in the economic consequences of past decisions and the confidence with which they can forecast future results of the organization. Their common interest is to evaluate the past and future results of a decision made by the company’s management under differing management theories and motives. Such theories and motives can include concepts of optimal decision-making, agency theory, and others that impact the formulation and study of generally accepted accounting principles.

4. Analyzing and Interpreting Financial Data

Publicly held companies are required to publish annual reports and other financial filings, making their past performance available for analysis. Anyone in pursuit of lessons learned from others engaged in a form of instruction mixing finance and accounting and adding a dash of strategic planning to the brew. Ideally, with creative and industrious application of the skills learned, entrepreneurs assure themselves of more favorable financial fates with fewer painful lessons.

Before launching their entrepreneurial ventures, future business builders gain reinforcing, real-life lessons by analyzing and interpreting publicly held company financial statements already in existence. Entrepreneurs can determine the effect of key events by studying the aftermath of similar incidents that already occurred. Financial statements provide competitive intelligence accumulating from the experience of the business world. Companies in the same industry face similar competitive influences that a new entrepreneur is likely to experience. Financial data reveal whether a potential product or type of business typically generates a profit, how long it takes, which financial, marketing, and customer relationship strategies lead to success, and how those taking other approaches fare.

5. Ethical Considerations in Financial Accounting

In addition to the objective of good financial reporting, there are two basic principles that underlie a prudent approach to accounting. The first is that an organization is a separate economic unit. It is a legal entity with an identity separate and distinct from the owners, creditors, or other organizations with which it deals. This principle is systematically ignored. One major limitation is that accounting involves estimates and cannot always reflect the specific or unique circumstances of an organization. Any measure, such as the measure of a building, is an estimate that depends upon the context in which the estimate is made. These limitations, however, are no reason to ignore the basic principles of providing useful information to society in a manner that is prudent for the organization and its stakeholders. Since estimates and judgments are a fundamental part of accounting, accountants carry the responsibility of helping everyone understand the weaknesses of estimates. In other words, accountants serve to restore doubt.

A core concept of financial accounting is that money is not the only measure of an organization’s success; it must also serve the needs of society. The two major objectives of financial accounting are to provide useful economic information about the organization to external parties and to provide useful information for managers. Both of these objectives are intended to help the organization prosper in the future. Accountants are constantly reasoning about what course is most advantageous for all parties. As accounting information flows from the organization to external users, accountants must make judgments concerning the amount and type of information to present and whether to focus primarily on the present or the future. Balancing the various needs and wants of users can pose a significant ethical challenge.