Basics of Financial Accounting
Financial accounting involves the preparation of financial statements for an organization. It follows certain principles and standards to ensure accuracy and consistency across businesses. Here are some basic principles and concepts that are fundamental to financial accounting:
- Double-Entry Bookkeeping: Each financial transaction impacts at least two accounts – one account is debited (increased), and another is credited (decreased). This system helps maintain the accounting equation (Assets = Liabilities + Equity).
- Accrual Accounting: Revenues are recognized when earned, and expenses are recognized when incurred, not necessarily when cash is received or paid. This principle makes sure that financial statements reflect the company’s financial performance over a specific period, regardless of cash movements.
- Consistency Principle: The methods, practices, and procedures a company uses to prepare its financial statements should remain consistent from one period to another. This allows for meaningful comparisons over time.
- Going Concern Principle: It is assumed that the business will continue its operations for the foreseeable future and has no intention or need to liquidate or significantly curtail its operations.
- Materiality Principle: Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity.
- Revenue Recognition Principle: Revenue should be recognized and recorded when it is realized or realizable, and when it is earned, not necessarily when cash is received.
- Matching Principle: This principle requires that expenses should be matched with revenues. That is, the costs incurred to earn revenues should be recognized in the same reporting period as the related revenues.
- Cost Principle: This principle requires that assets are recorded at their original cost. It indicates that the asset should be shown at the price at which it was purchased.
These basic principles guide the preparation and presentation of financial statements. Understanding these principles can help in comprehending how a company’s financial health is represented in its financial reports.
Example of the Basics of Financial Accounting
Let’s consider an example of a small business, Sam’s Bike Shop, which sells bicycles, to demonstrate some of these financial accounting basics:
- Double-Entry Bookkeeping: Sam purchases $5,000 worth of bicycles from a manufacturer. He pays in cash. In his accounting system, he will debit (increase) his inventory account by $5,000 and credit (decrease) his cash account by the same amount.
- Accrual Accounting: A customer buys a bicycle for $1,000 but does not pay immediately and is given 30 days to pay. Despite not yet receiving the cash, Sam records a debit to Accounts Receivable and a credit to Sales Revenue, both for $1,000, recognizing the revenue immediately.
- Consistency Principle: If Sam uses the straight-line method to depreciate his shop equipment, he should continue using this method in future accounting periods unless there’s a compelling reason to change and he adequately discloses this change in his financial statements.
- Going Concern Principle: Sam’s financial statements are prepared under the assumption that his shop will continue in operation for the foreseeable future, allowing him to defer some expenses and spread them over future periods.
- Materiality Principle: Sam makes a small purchase of office supplies for $50. Instead of capitalizing the cost as an asset, he expenses it immediately. The amount is so small that it would not affect the decision-making of the users of the financial statements.
- Revenue Recognition Principle: If a customer orders a custom-made bicycle and pays $500 in advance, Sam does not record this as revenue immediately. He recognizes the revenue only when the bicycle is finished and ready for delivery.
- Matching Principle: When Sam makes a sale of a bicycle that he had purchased for $700, he records the cost of goods sold (COGS) of $700 in the same period he recognizes the sale, ensuring the expense is matched with the revenue.
- Cost Principle: Sam buys a piece of shop equipment for $2,000. He records the equipment in his balance sheet at $2,000, not at its current market value, which may be different.
These examples showcase how these basic accounting principles work in practice and underline the importance of these rules in providing accurate, reliable, and consistent financial information.