This introduction to financial accounting is meant to introduce financial accounting topics to beginners. Students learning a business administration subject in a university can also benefit from this introduction to financial accounting. First, let us clear the question, what financial accounting is all about. Well, financial accounting is about the chronological and systematic recording of all business transactions that occur in a firm. Chronological recording means that all transactions are ordered by period and time, while systematic recording means that there are accounting categories and rules to be observed.
Why your Business needs Financial Accounting
Secondly, for which reasons do we carry out financial accounting in Business Administration?
- Self-information: As a business owner, manager, or employee, we would like to self-inform ourselves about business performance and the situation in our firm. Let us start with the basic strategic questions. What is the value of assets, equity, and liabilities in your firm? Is your business earning a profit or a loss? Do you have enough liquidity to serve all liabilities that your business owes the creditors? You will need to answer these basic as well as other strategic questions. All your analysis will start with the evaluation of the financial statement.
- Record of Evidence and Accountability: We should also consider the need to actively provide adequate evidence of all activities of the firm. That means that by providing evidence of business activities, we can be held accountable for the outcomes. Our Balance Sheet and Income Statements provide evidence of the resulting outcomes of our business activities. For instance, creditors may want to know the company´s valuation of Assets, Liquidity, Equity, Liabilities, Expenditure, Sales, …, etc. By doing this creditors may decide whether they want to continue to have a business relationship or not.
- Regulatory and transactional purposes: Governments may require us to do a tax review, while other third-parties (Banks, business partners) may require us to provide information during certain transactions, e.g. Creditors want to know whether we have securities to cover the credit applied for.
Basic Structure of Accounting
Further introduction to financial accounting looks at the basic structure of accounting. While doing accounting, you will come across the term “double-entry accounting”. The term “double-entry” means that you will carry out financial accounting as a record on stocks and as a record of income. On the one side, you will set up a record of the stock valuation of assets, equity, and liability in a Balance Sheet. On the other side, you will also have a record of outflow through expenditure and inflow of revenue in an Income Statement (Profit and Loss Account). But that is not way the end of financial accounting. We need to account for the flow of liquidity using a cash flow statement. Cash flow statements provide information about the flow of liquidity in and out of your business in the short-, medium- and long-run.
A Balance Sheet provides information about the value of assets, equity, and liabilities of a firm on a specific date (point in time). Therefore, the balance sheet only shows the stocks on a specific date, e.g. “Balance Sheet as of 31.12.2020”. The balance sheet is drawn as a T-account with two sides, left and right. The (left) debit side of a balance sheet shows the value of assets, both long-term and short-term assets. The (right) credit side of a balance sheet shows the value equity owned by the firm and both long-, medium-, and short-term liabilities. In practice, you will generally record the entry and exit of all assets, and liabilities. The reason why you record the value of assets and liabilities is to enable you to estimate the value of equity in your firm.
Income Statement, Profit and Loss Account
Now, equity is also affected by revenue-generating activities like sales of merchandise and revenue-consuming activities like expenditure für employees. That requires you to also keep a record of sales of goods and services as well as expenditure incurred. Afterward, you summarize the net outcomes in the income statement (or profit and loss account).
Cash Flow Statement
Finally, it is unaviodable to create a cash flow statement of your business, if you want to have an overview of the flow of liquidity in your firm. You can observe the short-, medium- and long-term liquidity cash-flows. The short-term focuses on immediate in- and outflows (daily, weekly and monthly). On the other side, the medium-run observes the expected flow of liquidity between 2 to 3 Months. Lastly the long-term liquidity cash flow statement can be designed for more than 3 months.