Financial accounting is the accounting discipline that looks at manipulating and presenting financial information for external users. These users include investors and creditors and other lendors, who use this information to make resource allocation decisions. Financial accounting must conform to applicable accounting standards, such as IFRS or US GAAP. These accounting standards require that companies prepare four financial reports every fiscal period: a balance sheet, an income statement, a statement of cash flows, and a statement of owner's equity. The standards are developed with the ultimate goal of improving the decision-usefulness of a firm's financial information.
The discipline of financial accounting began with the invention and proliferation of the double entry book-keeping system in the mid-fifteenth centruy. The double entry bookkeeping system is a system of accounting for transactions that requires two equal entries for every transaction. When the system was first developed, business operators used it to record transactions such as accounts receivable. These transactions were conceptually easy, since cash and accounts receivable have a physical and legal basis. When an account was collected, there would be an increase in cash equal to the decrease in the accounts receivable.
By 1494, a complete description of accounting had appeared, written by an Italian monk and mathematician Luca Paciolo. By Paciolo’s time, the double entry bookkeeping system had expanded to be able to handle transactions such as sales. When a good is sold, there is an increase in accounts receivable and a decrease in cost of goods sold - but what about the difference? Abstract concepts such as “income” had to be developed to handle this conceptual difficulty. (1) Paciolo defined income as the rate of change of capital in a business (we often call capital owners' equity). Using this definition, Paciolo outlined the Golden Rule of Accounting, that held that all transactions must be recorded in a way that balance, and that follow the accounting equation Assets = Liabilities + Owners' Equity.
Paciolo did not invent the system, but he did record in detail the double-entry bookkeeping system that had been developing over time. His work was eventually translated into English, and continued developing with the advent of the joint-stock company. As a result, external users began asking for accounting information to inform their investment decisions.
Other external users followed. In 1909, the United States introduced the corporate income tax. As a result, the government became an important stakeholder in the corporation, and required financial information to determine income and income taxes.
Another important external user is the US regulatory body the Securities and Exchange Commission. Founded in 1934 following the stock market collapse and Great Depression, the SEC is responsible for ensuring that financial reports meet disclosure-based standards in order to protect investors. However, the actual accounting standards required for reporting are delegated by the SEC to the Financial Accounting Standards Board (FASB) who are responsible for determining authoritative generally accepted accounting principles (GAAP) in the United States.
Since the 1970s, accountants have been working to harmonize accounting standards internationally, a project known as International Financial Reporting Standards (IFRS). Furthermore, since the financial scandals surrounding Enron, WorldCom and Arthur Anderson, we now see ethics, integrity and conflict of interest issues as paramount to address in order to preserve the reputation and value of the accounting profession.
(1) Paciolo on Accounting, by R. Gene Brown and Kenneth S. Johnston (1963)
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Financial Accounting & Bookkeeping
BrainMass Categories within Financial Accounting & Bookkeeping
Accounting Standards
Accounting standards involve four levels of guidance for the preparation of financial accounting statements. The first level of general guidance comes from the conceptual framework of accounting. The second level of guidance is a series of basic GAAP, which are a number of assumptions, conventions, and principles derived from the conceptual framework of accounting that accountants follow. The third level of guidance is US GAAP, which is a codified set of rules and procedures determined by the Financial Accounting Standard Board (FASB) in the US. The third level of guidance comes from conventions developed as a part of generally accepted industry practices in accounting.
The Accounting Cycle
The accounting cycles shows how accounting information is collected, manipulated and presented on the financial statements. When a transaction occurs, accounting information is recorded as a journal entry and posted into the ledger accounts. At the end of the period, accountants prepare the unadjusted trial balance, record adjusting entries, prepare the adjusted trial balance, prepare the financial statements, record the closing entries, prepare a post-closing trial balance, and the cycle begins again.
Journal Entries
The general journal is a chronological record used to record all of the firm's transactions. When a transaction occurs, the first step in the accounting cycle is to record the transaction in the company's general journal.
Posting to Ledger Accounts (T-Accounts)
Every asset, liability and owners' equity account has what we call a
Trial Balance
Trial balances are prepared to ensure that we have made no errors in recording our transactions over the period and that we've posted each transaction correctly to the general ledger. The balances of all of the T-accounts are added together in the trial balance to ensure that the total debit balances equal the total credit balances at the end of the period.
Correcting Accounting Errors
If the trial balance does not balance, a number of tools and techniques are used to help us determine where an error may have been made. If necessary, correcting entries can be done to bring the T-accounts to the correct balances after the errors are found.
The Adjusting Process
Because we use an accrual basis, some accounts need to be reconciled at the end of the period. These accounting adjustments fall into three basic categories: deferrals, depreciation and accruals.
The Closing Process
Closing the books refers to preparing the books for the beginning of the next period in the accounting cycle. We do this by setting the revenue, expense and withdrawals accounts back to zero.
The Financial Statements
The financial statements are prepared to present financial information in an aggregate form to make it useful for external users. Preparing the financial statements is the sixth step in the accounting cycle and is done with the help of the worksheet.
Financial Ratios
Financial ratios are calculated based on information found in the financial statements. They help communicate the meaning behind the information presented on the financial statements and help users better evaluate the performance of the firm. Most financial ratios fall into one of four categories: solvency ratios, activity ratios, profitability ratios, and market value ratios.
Revenue Recognition
When accounting is done on a cash-basis, revenue is recognized when cash is received, regardless of when the sale of goods occurs. However, most accounting is done on an accrual basis. Under accrual accounting, according to the revenue recognition principle, revenues are recognized when they are realized, or realizable and earned. This makes the issue of when to recognize revenue one of the constant dilemmas in accrual accounting.
Cash
This section looks at the accounting treatment of cash. Cash is the most liquid asset. It is the standard medium of exchange for business transactions (except in bartering transactions). As well, since cash is currency, it is the basis for measuring and accounting for all business transactions and the related items that appear on the financial statements of a business.
Investments in Securities
This section looks at the accounting treatment of short-term investments in items such as cash equivalents and debt and equity securities.
Receivables
This section looks at the accounting treatment of financing receivables. Financing receivables (or simply receivables) are claims that a company has against customers and others for money, goods, or services. Understanding the proper accounting for receivables is especially important considering the ease by which receivables information can be manipulated for fraudulent purposes.
Purchases, Inventory and Cost of Goods Sold (COGS)
This section looks at the accounting treatment of purchases, inventory, and cost of goods sold. It includes inventory-measurement systems such as FIFO, LIFO, specific-unit cost and weighted average costs. It also looks at estimating inventories as well as writing down the value of inventories based on the lower of cost or net realizable value rule.
Accounting for Long-Term Assets
This section looks at the accounting treatment of long-term assets including property, plant and equipment, natural resources, and intangible assets such as goodwill and research and development costs. It also looks at depreciation methods.
Accounting for Liabilities
This section looks at the accounting treatment of liabilities including current and long-term liabilities.
Accounting for Corporations
This section looks at the accounting treatment of transactions relating to corporations including issuing and repurchasing shares, paying dividends and accounting for corporate income tax.
Accounting for Partnerships
This section looks at the accounting treatment of transactions relating to proprietorships and partnerships including contributions and withdrawals from owner’s equity and special considerations for partnership accounting.
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