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Financial Accounting
Introduction
The purpose of accounting is to provide the information that is
needed for sound economic decision making. The main purpose of
financial accounting is to prepare financial reports that provide
information about a firm's performance to external parties such as
investors, creditors, and tax authorities. Managerial accounting
contrasts with financial accounting in that managerial accounting is
for internal decision making and does not have to follow any rules
issued by standard-setting bodies. Financial accounting, on the
other hand, is performed according to Generally Accepted Accounting
Principles (GAAP) guidelines.
CPA's
The primary accounting professional association in the U.S. is the
American Institute of Certified Public Accountants (AICPA). The
AICPA prepares the Uniform CPA Examination, which must be completed
in order to become a certified public accountant. To be eligible to
become a CPA, one needs an undergraduate degree in any major with
150 credit hours of course work. Of these 150 credit hours, a
minimum of 36 credit hours must be in accounting. Only about 10% of
those taking the CPA exam pass it the first time.
Accounting Standards
In order that financial statements report financial performance
fairly and consistently, they are prepared according to widely
accepted accounting standards. These standards are referred to as
Generally Accepted Accounting Principles, or simply GAAP. Generally
Accepted Accounting Principles are those that have "substantial
authoritative support".
Accrual vs. Cash Method
Many small businesses utilize an accounting system that recognizes
revenue and expenses on a cash basis, meaning that neither revenue
nor expenses are recognized until the cash associated with them
actually is received. Most larger businesses, however, use the
accrual method.
Under the accrual method, revenues and expenses are recorded
according to when they are earned and incurred, not necessarily when
the cash is received or paid. For example, under the accrual method
revenue is recognized when customers are invoiced, regardless of
when payment is received. Similarly, an expense is recognized when
the bill is received, not when payment is made.
Under accrual accounting, even though employees may be paid in the
next accounting period for work performed near the end of the
present accounting period, the expense still is recorded in the
current period since the current period is when the expense was
incurred.
Underlying Assumptions, Principles, and Conventions
Financial accounting relies on the following underlying concepts:
*
Assumptions: Separate entity assumption, going-concern assumption,
stable monetary unit assumption, fixed time period assumption.
*
Principles: Historical cost principle, matching principle, revenue
recognition principle, full disclosure principle.
*
Modifying conventions: Materiality, cost-benefit, conservatism
convention, industry practices convention.
Financial Statements
Businesses have two primary objectives:
* Earn a profit
* Remain solvent
Solvency represents the ability of the business to pay its bills and
service its debt.
The four financial statements are reports that allow interested
parties to evaluate the profitability and solvency of a business.
These reports include the following financial statements:
* Balance Sheet
* Income Statement
* Statement of Owner's Equity
* Statement of Cash Flows
These four financial statements are the final product of the
accountant's analysis of the transactions of a business. A large
amount of effort goes into the preparation of the financial
statements. The process begins with bookkeeping, which is just one
step in the accounting process. Bookkeeping is the actual recording
of the company's transactions, without any analysis of the
information. Accountants evaluate and analyze the information,
making sense out of the numbers.
For the reports to be useful, they must be:
* Understandable
* Timely
* Relevant
* Fair and Objective (free from bias)
Double Entry Accounting
Financial accounting is based on double-entry bookkeeping procedures
in which each transaction is recorded in opposite columns of the
accounts affected by the exchange. Double entry accounting is a
significant improvement over simple and more error-prone single-entry
bookkeeping systems.
Fundamental Accounting Model
The balance sheet is based on the following fundamental accounting
equation :
Assets = Liabilities + Equity
This model has been used since the 18th century. It essentially
states that a business owes all of its assets to either creditors or
owners, where the assets of a business are its resources, and the
creditors and owners are the sources of those resources.
Transactions
To record transactions, one must:
1.
Identify an event that affects the entity financially.
2.
Measure the event in monetary terms.
3.
Determine which accounts the transaction affects.
4.
Determine whether the transaction increases or decreases the
balances in those accounts.
5.
Record the transaction in the ledgers.
Most larger business accounting systems utilize the double entry
method. Under double entry, instead of recording a transaction in
only a single account, the transaction is recorded in two accounts.
The Accounting Process
Once a business transaction occurs, a sequence of activities begins
to identify and analyze the transaction, make the journal entries,
etc. Because this process repeats over transactions and accounting
periods, it is referred to as the accounting cycle.
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