Financial accounting is a complicated subject with many principles that companies use to manage their financial accounting process. However, even with its complexity, individual investors and small business owners should understand basic concepts. Obtaining knowledge about accounting fundamentals helps business owners detect errors and fraudulent activity, as well as remain in compliance with standard accounting principles. Understanding basic financial accounting concepts help individuals choose investments that possess the best possible chance of providing a return on their investment.
A basic equation exists within accounting that shows the relationship of the three major sections of a balance sheet. The accounting equation is stated as assets = liabilities + owners' equity. Valuable resources owned by a company are classified as assets. Companies acquire assets through creditors’ and investors’ financing. Debt obligations owed to creditors are called liabilities and shareholders’ equity relates to the capital of a firm. When a transaction occurs on the right side of the equation, a corresponding transaction must occur on the left side of the equation. Two accounting entries made for a single business transaction is known as double-entry bookkeeping.
A debit and a credit are made for a single economic transaction when companies use double-entry bookkeeping. For example, if a company sells its product for $500 cash, the company must make two basic transactions. A debit is made for $500 to an asset account called cash, and a credit is made for $500 to a shareholders’ equity account called revenue. Double-entry bookkeeping follows the concept of the accounting equation. Debits cause regular asset accounts to increase and credits cause liability and shareholders’ equity accounts to increase. Double-entry bookkeeping offers several advantages to companies, including accurate financial records, a reduction in accounting errors and financial statement preparation.
Accrual vs. Cash Basis
Companies use two basic methods to record revenue and expenses: the accrual and cash basis methods. The accrual method recognizes income on the transaction dates a sale is made and an expense is incurred. The cash basis method records a business transaction when a company receives cash as revenue and when it spends cash on expenses. Many companies use the accrual method of accounting because it follows the matching concept listed in the generally accepted accounting principles (GAAP). However, some smaller companies use the cash basis method because of its simplicity.
The primary financial statements constructed in financial accounting that list the major financial transactions of a company include the income statement, balance sheet and statement of cash flows. The income statement reports the revenues and expenses accounted for by a company. The balance sheet follows the accounting equation by listing a company’s asset, liability and shareholders’ equity accounts. The statement of cash flow lists transactions that affect a company’s cash balance.
Financial reporting is an important concept within financial accounting. It deals with reports a company creates to distribute to external users. Lenders, creditors and individual investors use financial reports to determine if a company is a good investment opportunity. Public companies that issue stock must make their financial reports accessible to everyone. The Securities and Exchange Commission regulates the financial reports of public companies.
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