financial accounting fundamentals
Branches of Accounting
There are two major branches of accounting: financial accounting and management accounting. Financial accounting refers to a business's practice of maintaining financial reports for its stakeholders. Such reports take the form of financial statements, such as the income statement, balance sheet, and statement of cash flows. Lenders and investors need such financial data to decide whether they want to fund a given business. Management accounting caters to the accounting needs of a business's management. It is primarily concerned with the preparation of a business's sales forecasts and budgets (projected incomes and expenses). This branch of accounting helps a business's management analyze information, assess risks, reduce costs, and make financially sound decisions.
Long-Term Liabilities
Owners' Equity Owners' equity is a business's value after considering its liabilities. Simply put, it is the owner's share of the assets in a business. It includes these items: Personal investment: This component of the balance sheet includes the money that a business's owner personally invests in the business. Shareholders' money: The money that shareholders invest in the business is owner's equity. Net profit/loss: Any net profit that a business makes in the current year adds to the owners' equity. However, if a business suffers a net loss, it needs to deduct this amount from the total owners' equity. Retained earnings: Owners' equity also includes a business's retained earnings. Retained earnings refer to the portion of a business's profits that it has saved over the years. A business may choose to reinvest this amount for its growth.
Fixed Assets
Fixed or long-term assets are resources that a business does not plan to sell within a year. Businesses use such assets to carry out daily business operations. Further, fixed assets are of two types: tangible and intangible assets. Tangible fixed assets, such as equipment, machinery, land, buildings, automobiles, and furniture, have a physical presence. On the other hand, copyrights, patents, goodwill, and so on are assets that have a monetary value, but lack a physical presence. Therefore, all forms of intellectual property are intangible assets. Most businesses include long-term investments under the category of fixed assets. However, they may appear as an independent item on the debit side of a business's balance sheet
Balance Sheet
A balance sheet summarizes what a business "owns" and what it "owes." It shows the financial health of a business on a given day. As you can see to your right, a balance sheet's left hand side, or "debit side," shows what a business owns, that its, its assets. The right hand side, or "credit side," shows what a business owes, that is, its liabilities. This side also shows owners' equity, or the capital invested in a business. According to accounting standards, both sides of a balance sheet should actually be in balance. This gives rise to the fundamental accounting equation: Assets = Liabilities = Owner's Equity If a business's assets exceed its liabilities, it is in sound financial health. It simply means that the business owns more than it owes at a certain point in time. Therefore, it has more resources than financial obligations. This positive difference shows that a business is capable of paying off its debts.
Need for Accounting in Business
Accounting is of prime importance to all business types. Businesses need accounting in order to record, report, and analyze financial transactions. Further, they need accounting to keep track of their cash inflows and outflows, expenses, and profits. For example, financial statements show a business's profitability and financial condition. Both branches of accounting are important for entrepreneurs. Management accounting helps a business make forecasts and develop a strong business plan. Similarly, financial accounting is necessary to record and evaluate a business's financial data.
Accounting in Business
Accounting is the process of identifying, recording, analyzing, and reporting a business's financial data. Such data includes the business's income, expenses, profits/losses, assets, owners' equity, and liabilities. Accounting ultimately helps a business understand and report its financial status. Creating financial statements is part of the accounting function. These statements help investors and lenders decide whether they want to fund a business. Accounting also helps a business calculate and pay taxes, and carry out its responsibility toward the economy.
Basic Accounting Terms
Accounting period: An accounting period is the duration for which a business prepares its financial statements. This duration varies from company to company. For example, it could be a year, six months, or a quarter (four months). Generally Accepted Accounting Principles (GAAP): GAAP is a set of accounting rules and guidelines that all US businesses need to follow. Public and private businesses, not-for-profit organizations, and other businesses need to adhere to these principles. GAAP thus governs the accounting procedures of a business. Other countries in the world follow another format called International Financial Reporting Standards (IFRS) Ledger accounts: A ledger account is a format to record financial transactions. A business maintains a ledger account for each asset, liability, expense, income, and capital (equity). Debit and credit: Ledger accounts are also called T-accounts, because they are in the shape of the letter T. A ledger account has two sides: debit and credit. All asset and expense accounts have debit balances. On the other hand, all liability, income, and capital (equity) accounts have credit balances. Double entry bookkeeping: Under this system of bookkeeping, every recorded transaction results in a double entry. Thus, every transaction affects one or more accounts. Businesses record transactions in the form of journal entries. Journal entries follow the golden accounting rule of debit what comes in and credit what goes out. Let's assume that a business has bought computers worth $15,000 in cash. You can see the journal entry (double entry) for this transaction in the image to your right. In this example, the business debits computers (asset) as they are "coming into" the business. On the other hand, the business credits cash (asset) since it is "going out" of the business. According to this system, every debit has a corresponding credit. Chart of accounts: A chart of accounts is a list of a business's ledger accounts. A business adds or removes such accounts depending on its changing requirements. Revenues: Accounting keeps track of the inflow of money in a business. Revenues refer to a business's incomes. Businesses primarily earn revenue through sales. They can also earn money in other forms, such as interest on a given investment. Expenses: A business needs to spend money to carry out its operations. Such outflow of money takes the form of expenses. Profit: A business makes a profit when its revenues exceed its expenses. Profits are crucial, as they hint at a company's success in the market. Further, investors and lenders consider a business's profits before making decisions about financing the business. Similarly, shareholders (part owners) of a company can earn returns on their investments only if the business makes profits. Loss: If a business's expenses exceed its revenues, it suffers a loss. A business operating at a loss cannot survive long. Investors might not show interest in a loss-making business.
Corporate Taxation
All for-profit businesses in the United States incur an expense in the form of corporate taxes. Corporate income tax is a percentage of a business's profits payable to the government of the country in which the business operates. The profit that a business considers for tax purposes is the amount left after deducting expenses from total revenues. A business needs to pay corporate tax on the profits of its previous financial year. For example, a business would pay corporate tax for the year 2015 in 2016. Corporate taxes vary among countries. Such differences depend on a country's economy, government policies, political stability, and other such factors. On an average, most countries in the world levy a corporate tax rate of 22.6 percent. However, the United States has a corporate tax rate of 39.1 percent for businesses that earn a taxable income over $100,000. The federal government of the United States earns a major part of its income in the form of corporate taxation.
Bookkeeping
Bookkeeping, often confused with accounting, is an important aspect of accounting. It refers to the recording part of the accounting process. The process involves recording and storing a business's transactions in financial books. Bookkeeping is concerned with collecting, organizing, and storing accurate financial data. It is an ongoing process, as a business carries out financial transactions every day. Whether it is a small travel expense or a big investment, every financial transaction forms a part of bookkeeping. The process of bookkeeping involves the use of a journal. "Journal" is a French word that means daybook. In terms of accounting, it is a book in which businesses record their financial transactions in chronological order. A business thus refers to its journal to find details about a particular business transaction on a given date. Owing to this feature, the accounting world refers to a journal as the businessperson's diary.
Current Liabilities
Current liabilities are financial obligations that a business needs to pay off within a year. Let's look at some examples of such liabilities. Short-term loans: Short-term loans that a business has borrowed in the past are its current liability. Accounts payable: Future payments that a business needs to make to its vendors (for credit purchases) are termed accounts payable. Outstanding/payable expenses: Any outstanding or payable expenses, such as salaries, rent, interest, and insurance, are a business's current liabilities.
Financial Statements
Businesses need to prepare two crucial financial statements: the income statement and the balance sheet. Let's start by taking a closer look at the income statement. The income statement is the tabular representation of a business's revenues and expenses. This financial statement has different names based on its users. For example, if the users are internal, such as management authorities and directors, it is called the statement of operations or earnings. If a business prepares this statement for external parties, such as investors, it is termed a profit and loss statement. Businesses prepare such a statement for a month, a quarter, or a year. To your right is an example of one such income statement. It begins by listing a business's revenues, such as sales, interest on investments, and so on. Next, the statement lists the expenses that a business incurs. You'll find that the statement shows the cost of goods sold, operating expenses, depreciation, and taxes. In this example, the revenues exceed expenses. The difference between the two amounts, $240,000, is the business's net profit.
Current Assets
Current or short-term assets include cash or assets that can convert into cash in less than a year. Let's look at some examples of current assets. Accounts receivable: Let's say that a business sells goods to a customer on credit. The customer plans to make the payment a few months later. A business recognizes this amount as a current asset called accounts receivable until it receives the payment. Inventory: Inventory or stock includes the amount of goods that a business plans to sell soon. Since the stock is bound to turn into cash in the future, it is the business's current asset. Prepaid expenses: A business may pay the next three months' office rent in advance. Such advance payments or prepaid expenses are current assets, since the business is yet to receive the benefits or service.
Role of Tax Accountants
Tax accountants file a business's tax returns according to new laws and requirements. They also document the returns in the standard format. Tax accountants are well aware of any legal consequences that may result from certain business transactions. Therefore, they provide suitable advice to their clients. Tax accountants also help a business prepare a strategy that will help lower a business's income tax. The strategy is based on the business's nature as well as its financial needs.
Relationship between the Income Statement and Balance Sheet
The income statement and balance sheet of a company are interrelated. An income statement shows a business's inflow and outflow of money over a period. On the other hand, a balance sheet shows a business's financial standing on a given day. Further, the current year's income statement plays a major role in the preparation of the balance sheet for a given day. Consider the example of a balance sheet that you see on your right. Let's say that the business incurs certain expenses and earns revenue in the next three months. If the business pays salaries worth $5,000 during this time, its liability (salaries payable) would decrease to $5,000 (from $10,000). Similarly, as the business is paying money, its cash would decrease from $10,000 to $5,000. If the business recovers $2000 from its customers, its accounts receivable would reduce to $13,000 from $15,000. However, its cash would also increase by the same amount. If the business makes a profit, it would add to the owners' equity. However, a loss would reduce the owners' equity by the same amount. Therefore, the current year's income statement and the previous year's balance sheet are necessary to prepare the latest balance sheet for a given day.
