Most people have heard the word Accounting. But, many people do not know what it means and how it is carried out. Accounting is the procedure for gathering, recording and reporting the financial data of a company in a format that is concise, comprehensive and easily understandable.
The reason why business organizations carry out their operations is to maximize their profits. For a shareholder of the company who is not involved in the daily operations of the business, finding out how much profit his company is making, is not an easy task. For this very purpose, he would hire an accountant who will not only record the financial activities of the company but also report them on a regular basis.
The accountant responsible for preparing and presenting this data would use financial accounting methods and present reports that will show how efficient the management has been in running the affairs of the company.
The books of accounts of a company are printed and also posted on the website of the company regularly. These reports are made public only after an independent auditor has audited them. Managerial accounting vs financial accounting is a phrase that differentiates between these two phenomena. However, when it comes to the presentation of reliable figures, financial accounting is the best tool available with the shareholders of the company.
The books of accounts prepared by the accountant also serve to provide the shareholders with the right perspective regarding the future course of action to be taken for growth and stability.
The Double Entry System of Financial Accounting
The double entry system is the basis of financial accounting. This involves recording every financial transaction in two parts with each part hitting a specific account in the company’s ledger.
An example of the double-entry system is as follows:
Company ABC borrows an amount of 5,000 from Bank DEF. The amount disbursed by the bank will be recorded in the cash ledger on the debit side. Debit means an increase in assets.
However, the double-entry system requires another entry. For this purpose, a simultaneous entry will be posted in the company’s liabilities accounts on the credit side. This would mean that the liability of the company towards Bank DEF has increased by the same amount.
The sum of all debits and credits in the Trial Balance of the company must match with each other after every entry. If the final debts and credits of the Trial Balance are different, it would mean that the accounting entries were not properly posted.
Income and Expenses
An accountant also records incomes of the company, and all the expenses incurred by it during any given time period.
Whenever the company makes a sale, it is recorded in the ledger in the sales account. Its other leg is posted either as a debit in the cash account, or the accounts receivable account.
Similarly, when the company incurs an expense, cash or bank is credited, and the specific expense account is debited. For example, if the company is paying an electricity bill through cash, it will credit the cash account and debit the electricity account.
The Accrual Concept of Accounting
This is a unique concept that requires the accountant to record all those expenses that have not been paid as yet but will have to be paid by the company in the future.
For example, if the company receives its electricity bill after the end of the month, the accountant will record the electricity expense in the ledger account but will not credit the cash account. Instead, he will post an equal amount in the payable accounts of the company. This would mean that the expense has been incurred, but its payment will be made at a later date.
In this way, the expense will be charged in the electricity head at the end of the month, and when the reports have been generated for the month, they will also incorporate these expenses although they have not been paid yet.
Accrual entries are passed for all recurring expenses.
Preparation of the Income statement of the business
The income statement of the business is the most important report from the shareholder’s perspective.
It accounts for the company’s total revenue collection during the period. And it also shows how much expense was incurred during the same period. Roughly, the difference between the two is the income generated through the operations of the business during that same period. If the difference between revenue and expenses results in a negative number, it would mean that the company is making losses rather than profits.
The income statement is the report that allows the management and the shareholders of the company whether they are successfully running the business, or do they need to carry out a few drastic changes in order to become profitable once again.
The Balance Sheet of the Company
The balance sheet is a document that is regarded as the company’s final report. From the accountant’s perspective, it is the single most document pertaining to any company.
Typically, a balance sheet shows the Total Assets of the company. Corresponding to these assets, all the liabilities are listed along with the owner’s equity. The two sides of the balance sheet must always be equal.
With the proper listing of assets and liabilities, the shareholder can arrive at the actual financial position of the company including how much liability it has at hand, and how much assets the business has in hand in order to cover those liabilities.
The Cash Flow Statement
There is always cash flowing into the company from different sources. Simultaneously, some cash is also flowing out of the company for several different purposes. The cash flow statement provides information regarding this cash inflow and outflow.
Moreover, the cash flow statement also provides the same information regarding cash equivalents.
Cash flow statement records all the cash-related activities in an appropriate manner so that the reviewer is able to comprehend them and see if there is a chance that the company might need cash injection in the future.
The Final Word.
With the help of financial accounting principles, an account is able to properly record and then report all the financial activities of any business. Due to the use of the double-entry system of accounting, there is very little chance of erroneous reporting. Once the financials of a company are prepared and audited, they become potent tools for analyzing the strengths and weaknesses of the company. This analysis and the resultant numbers are the basis of manage MT’s decision-making process. This means that, in a way, the foundations of any successful business is always laid down through financial accounting.