Financial accounting basics
/What are the Basics of Financial Accounting?
This article gives an overview of financial accounting basics for the non-accountant. Its orientation is toward recording financial information about a business. First, what do we mean by "financial" accounting? This refers to the recordation of information about money. Thus, we will talk about issuing an invoice to someone, as well as their payment of that invoice, but we will not address any change in the value of a company's overall business, since the latter situation does not involve a specific transaction involving money.
Transactions
A "transaction" is a business event that has a monetary impact, such as selling goods to a customer or buying supplies from a supplier. In financial accounting, a transaction triggers the recording of information about the money involved in the event. For example, we would record in the accounting records such events (transactions) as:
The receipt of an expense report from an employee
The receipt of an invoice from a supplier
Selling goods to a customer
Remitting sales taxes to the government
Paying wages to employees
Remitting payroll taxes to the government
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Accounts
We record this information in "accounts." An account is a separate, detailed record about a specific item, such as expenditures for office supplies, or accounts receivable, or accounts payable. There can be many accounts, of which the most common are:
Cash. This is the current balance of cash held by a business, usually in checking or savings accounts.
Accounts receivable. These are sales on credit, which customers must pay for at a later date.
Inventory. This is items held in stock, for eventual sale to customers.
Fixed assets. These are more expensive assets that the business plans to use for multiple years.
Accounts payable. These are liabilities payable to suppliers that have not yet been paid.
Accrued expenses. These are liabilities for which the business has not yet been billed, but for which it will eventually have to pay.
Debt. This is cash loaned to the business by another party.
Equity. This is the ownership interest in the business, which is the founding capital and any subsequent profits that have been retained in the business.
Revenue. This is sales made to customers (both on credit and in cash).
Cost of goods sold. This is the cost of goods or services sold to customers.
Administrative expenses. These are a variety of expenses required to run a business, such as salaries, rent, utilities, and office supplies.
Income taxes. These are the taxes paid to the government on any profits earned by the business.
Transaction Data Entry
How do we enter information about transactions into these accounts? There are two ways to do so, which are noted below:
Software module entries. If you use accounting software to record financial accounting transactions, there will probably be on-line forms that you can fill out for each of the major transactions, such as creating a customer or invoice or recording a supplier invoice. Every time you fill out one of these forms, the software automatically populates the accounts for you.
Journal entries. You can access a journal entry form in your accounting software, or create a journal entry by hand. There is a great deal to journal entries. In brief, a journal entry must always impact a minimum of two accounts, with a debit entry being recorded against one account and a credit entry against the other. There can be many more than just two accounts, but the total dollar amount of debits must equal the total dollar amount of credits.
The General Ledger
The accounts are stored in the general ledger. This is the master set of all accounts, in which are stored all of the business transactions that have been entered into the accounts with journal entries or software module entries. Thus, the general ledger is your go-to document for all of the detailed financial accounting information about a business.
If you want to understand the detail for a particular account, such as the current amount of accounts receivable outstanding, you would access the general ledger for this information. In addition, most accounting software packages provide a number of reports that give you better insights into the business than just reading through the accounts. In particular, there are aged accounts receivable and aged accounts payable reports that are useful for determining the current list of uncollected accounts receivable and unpaid accounts payable, respectively.
The Financial Statements
The general ledger is also the source document for the financial statements. There are several financial statements, which are noted below. Other less-used elements of the financial statements are the statement of retained earnings and a large number of accompanying disclosures.
Balance sheet. The balance sheet lists the assets, liabilities, and equity of the business as of the report date. This report shows the financial position of a business as of the final day of the reporting period. The information on it can be used to derive a variety of ratios that reveal the liquidity of the business, and which can provide a view of its financial structure.
Income statement. The income statement lists the revenues, expenses, and profit or loss of the business for a specific period of time. This report shows the efficiency of an organization in selling goods at a reasonable margin, and how well it controls its administrative costs. This report can be structured to present results for multiple periods, so that you can spot trendlines in sales and expenses - which may trigger management actions to improve the situation.
Statement of cash flows. The statement of cash flows lists the cash inflows and outflows generated by the business for a specific period of time. It may be formatted using the direct method or the indirect method. This is a useful report for obtaining an understanding of the cash flow health of a business. This is especially important when a business is operating with very little cash on hand, and you want to better understand whether it can continue to operate in this manner.
In summary, we have shown that financial accounting involves the recording of business transactions in accounts, which in turn are summarized in the general ledger, which in turn is used to create financial statements.