what is financial accounting

what is financial accounting

Understanding the Fundamentals of Financial Accounting

1. Introduction to Financial Accounting

3) Describe the three basic forms of business and compare how accounting information is provided to each form of business.

2) Identify the users and uses of accounting. Accounting information is submitted to a wide variety of users in different paths. The users of financial accounting are those who are connected with the enterprise for use in decision-making techniques, including external and internal users. External users are parties external to the organization, such as shareholders, prospective shareholders, bankers, creditors, customers, suppliers, employees (related to labor unions), governmental agencies, the stock exchange, the public, and news reporters. Conversely, internal users are the management involved in planning, evaluating, and efficiently conducting business to assist their own objectives. Internal users of accounting information include individuals from all parts of the organization. Though accounting plays an important role in providing information to assist decision-making, managers use accounting information in everyday planning and performance evaluation. Generally, modern managers require a comprehensive set of financial and nonfinancial information to fulfill their duties. For example, a manager frequently will review financial reports and analysis that relates to the company’s past performance, present position, strategies, and environmental happenings to measure the financial health of the organization.

1) Define accounting and describe accounting as the language of business. Accounting is a system that collects and processes financial information about an organization and reports that information to decision makers. The person in charge of accounting is known as an accountant, and this individual has specific roles, including performing accounting and providing information to users. Accounting is often referred to as the language of business.

Learning Objective 1

2. Key Concepts and Principles in Financial Accounting

The balance sheet is formally known as “statement of financial position.” The income statement is formally known as “statement of comprehensive income” because it combines income and other comprehensive income into one statement. A cash flow statement is often presented separately but may also be combined with the income statement as in a statement of cash flows. The objective of financial reporting is the foundation of the conceptual framework. Its purpose is to provide financial information about an entity that is useful to existing and potential investors, lenders, and other creditors in making decisions – investment, credit, re-lending, etc.

A business sets out, in a formal manner, the financial statements it will produce. These statements will present its financial position, results of its operations, comprehensive income, and its cash flows. It will do this in response to its stated objectives. The statements produced are designed for internal as well as external use. Different user groups “read” these statements in order to satisfy varying degrees of detail, which users require in the statements, either singly or in combinations, include comparisons with other businesses, which are often specific businesses linked to the reporting one in differing ways. For example, subsidiary statements bear a different set of relationships to parent statements than company statements do to one another.

3. Financial Statements and their Components

Components of the Balance Sheet: The asset component of the balance sheet tells you a great deal about the operating activities of the company and has several line items or classifications. The first classification is cash and short-term investments. These are assets that the company will either use up or convert into other assets in less than a year. Marketable securities are short-term investments, and they appear in the current assets section of the balance sheet. The second classification contains accounts receivable, loans receivable, and notes receivable. These are expected to be converted into cash within a year and, as such, are assets. The third classification contains inventory. Inventory is what is produced and held for sale in the ordinary course of business. The fourth classification contains prepaid expenses. These are assets paid in advance that will provide future benefits and are believed to be self-liquidating. The fifth classification is long-term investments and, as the name suggests, represents predominantly investments in other enterprises that are expected to be held for more than a year. Finally, the balance sheet lists the physical assets that a company uses in its productive efforts. These items, like land, building, and equipment, are the tangibles of production and are identified as property, plant, and equipment.

Three fundamental financial statements provide much of the information you need about a firm for financial accounting purposes. These are the balance sheet, the income statement, and the cash flow statement. A balance sheet provides information at a moment in time about what a firm owns (its assets), what it owes (its liabilities), and what leftover equity in the company belongs to its stockholders. An income statement provides information over a period of time about how much a company earned and where those earnings were spent. Lastly, a cash flow statement provides information over a period of time about how much cash went into and was received by the company and how much cash went out of and was paid by the company. Each of these statements tells an interesting story about the activities and successes of, and the needs and claims against, the firm.

4. Analyzing Financial Data and Ratios

In summary, interpreting accounting data requires a historical, root cause, total system, and creative behavior perspective involving a multifaceted model based around the firm’s strategic competitive behavior and stability, flexibility, current operating performance, and strategic potential. High-performance levels on traditional financial analysis seem to reflect fundamental management principles based on how successful organizations have been managed over time. Successful firms are lean; invest in the future; have integrated, high-performance operating systems; are customer, marketing, and information technology-driven; centralize strategic control; and decentralize operations. Concerted organizational systems thinking and managerial empowerment via renewal accounting, including the use of key implementation models, pay-as-you-go options, real performance evaluation criteria, and a proper balance between exceed and value validation, implemented in a global, total organization paradigm, seem to be needed.

When analyzing financial statements, one of the most important goals is to identify and then use key financial data to compute ratios, which are then compared to industry and historical norms to highlight the firm’s unique strengths and weaknesses. Trend or time-series analysis may be used to compare financial statement data across years, while cross-sectional analysis is used to compare the financial statement data of different firms at the same point in time. Ratios are classified as either short-term solvency, liquidity, or working capital ratios; long-term solvency, or financial leverage ratios; asset management, or turnover, ratios; or profitability ratios. Furthermore, in analyzing these ratios, the relationship among ratios needs to be respected. Caution should be exercised when interpreting the meaning of accounting ratios. Financial leverage may increase the return to shareholders, but also may increase the firm’s risk.

5. The Role of Financial Accounting in Decision Making

The financial statements in the appendices to this book provide abstractions of the components of a complete financial report. In a comprehensive financial accounting system, many other financial and non-financial pieces of data are used in developing cost-volume-profit models, variance analyses, and forecasts of future projects. These secondary management functions require reports that highlight the relevant strategic, competitive, and feedback perspectives. In general, the data used to prepare these other reports are either grounded in the same source data that produce the financial statements or can be aggregated or disaggregated to arrive at specific records in the accounting system.

The primary responsibility for the design, operation, and maintenance of the financial accounting system rests with the organization’s accounting and finance personnel. It is important that non-accounting managers understand the source of the data that is necessary to generate the financial statements they use for decision-making purposes. Consequently, accounting and finance personnel should establish methodologies that allow for the periodic communication of this source data to managers and employees throughout the organization. This communication can take the form of periodic training sessions that reinforce the transaction-related input data that the accounting and finance managers need to accumulate.

Accounting information provides essential input to an organization’s decision-making activities. In the case of for-profit organizations, the primary outputs of the financial accounting system are financial statements. Financial statements are management’s summary of the impact of an organization’s recent transactions on the organization’s ability to generate future cash flows and its financial condition.

Chapter 1: Understanding the Fundamentals of Financial Accounting