An Introduction to Financial Accounting

Accounting is a very important/critical process with the help of which the management of an organization attempts to manage and control its performance. For an organization, its success and performance is a combined effect of its resources, people (i.e. labor), capital, opportunities (i.e. market) and management. For any person outside the organization, the success or performance of the organization may not mean anything until they are measured and represented in terms of profits. Thus, it becomes necessary to translate the effects of opportunities, efforts of labor, management etc. into some accounting numbers which will help measure financial performance, success and profitability of an organization.

Thus, accounting has become a language of business as well as non-business (e.g. charitable trusts) entities, with the help of which they interact with the outside world. It helps in achieving internal and external reporting of resources, capital etc. and also in managing them for earning better profits for the entity. Accounting thus provides necessary information to the investors and management and helps them in making important decisions for the entity.

Financial accounting is a process of reporting through financial statements to external world such as investors, government authorities etc. Financial accounting must follow constraints such as accounting principles, accounting standards and ground rules etc.

Basic Accounting Concepts

To understand any process we need to follow and understand certain concepts relating to that process. Similarly, there are some basic concepts which are very important to understand the process of accounting.

The Entity Concept: A business and its proprietor(s) are considered to be distinct entities. A business is nothing but an economic entity that has its own assets and obligations. Similarly, the person/entity owning the business has its own assets (bank accounts, land and other assets), obligations etc., and which are not considered as the assets and obligations of the business.

Money Measurement Concept: For any transaction or event to be considered for accounting purposes, it must be expressible in monetary terms. If it is not possible to express the event or transaction in monetary terms, it cannot be considered for accounting purposes.

The Cost Concept: Any asset (such as land, real estate, machinery, vehicles etc.) and obligation (such as liability towards investors, loans etc.) owned by a business, should be recorded at the historical or original cost (i.e. the cost at the time of acquisition) irrespective of its current cost.

The Going Concern Concept: This is one of the fundamental concepts in accounting. According to this concept an entity is considered to be a going concern if there is no plan or intention of liquidation of the entity or reduction in any of its operations. This means, it is assumed that the entity and its operations will last for a very long time period.

The Periodicity Concept: Although the going concern concept asks to consider the entity and its operations as continuous, there exists a need for periodic appraisals of the entity to judge its performance as it is not possible to wait for so long (probably for eternity). The period used to measure the performance of the entity is called as accounting period. The performance of an entity and its operations is measured for each accounting period.

The Accrual Concept: According to this concept, the incomes and expenses of an entity should be noted or identified as and when they are earned or incurred by the entity irrespective of when the actual payment or receipt of money for the same are performed.

The Matching Concept: Matching concept is important to help calculate and understand the profitability of a business. In matching concept, revenue earned during a financial period is counterbalanced against all the expenses, liabilities etc. which are used to earn the revenue.

Concept of Prudence: Concept of prudence can be thought of as the most mature way of letting the business to be carried out with utmost caution. The concept of prudence means always counting on all the liabilities and losses and never anticipating any profit; in short, all the assets, income are not overstated and liabilities and losses are not understated. The profits and income are doubtful, but losses are certain.

The Realization Concept: It states that the revenue needs to be realized in order to recognize it. That means, there should not be any kind of uncertainty regarding the realization of the revenue when a product/service is sold to the customer through sales.

Financial Statement

A financial statement is nothing but the final output of the accounting process which consists of a balance sheet, and a profit and loss account for the financial year. Financial statement helps users (who are decision makers for an organization) in understanding financial position and performance of an organization. It represents the variance in financial position of an organization for a specific time frame.

The Accounting Equation

There are three main elements in a balance sheet: Assets, Liabilities and Equity. Asset is nothing but a resource owned by the business entity, liability represents an obligation of the business entity towards external entity for the business it has done with it and Equity is the surplus of total assets against total liabilities (also known as owner’s share of the profit). And so we can represent the relationship between these three elements as:

Assets (A) = Liabilities (L) + Equity (E)