Financial accounting is concerned principally with financial information prepared for distribution outside an organization. This Note contains an introduction to financial accounting and the statements used to present financial accounting information. It also provides some guidance for undertaking a preliminary analysis of a set of financial statements. The learning objectives for this Note are contained in Exhibit 1.
Exhibit 1. LEARNING OBJECTIVES
Upon completing this Note, you should know about:
- The balance sheet and what it measures, including:
- owners' equity
- Some specific assets and liabilities, including:
- accounts receivable
- accounts payable
- loans payable
- interest payable
- The income statement and what it measures, including:
- net income
- The creation of owners' equity, and the basis for changes in it
- Five of the nine fundamental accounting concepts.*
- the entity concept
- the dual aspect concept
- the money measurement concept
- the cost concept
- the realization concept
* The four remaining concepts are going concern, conservatism, materiality, and matching
- Some basic accounting and finance concepts, including:
- the distinction between levels and flows
- the nature of an account
- the accounting period
- the current vs. non-current distinction
- working capital and the current ratio
- unmeasured value
- the accounting cycle
- interest expense
ROLE OF FINANCIAL ACCOUNTING
Accounting’s roots can be traced to the Italian Renaissance and the then-emerging city states. At that time, as commerce among the city states was becoming increasingly significant, merchants began to recognize a need for improved record keeping, both to avoid mistakes in keeping track of financial information, and to provide them with better information on the financial performance of their businesses.
The breakthrough came when a Franciscan monk, Fra. Luca Pacioli, devised the system of double-entry bookkeeping that remains the cornerstone of accounting today. Fra. Pacioli, a mathematician, reasoned that if, instead of making a single entry to the accounts each time a transaction took place, a merchant made two entries, there could be a system of checks and balances. His insight gave rise to the dual aspect concept of accounting, which underlies the balance sheet. The dual aspect concept will be discussed later in this Note.
Financial accounting information plays an important role in society. It is used by managers, investors, financial analysts, creditors, regulators, and even employees and customers on occasion. All of these people need to understand the current financial status of an organization, and the events that caused a change in that status from some prior point. As such, the purpose of an accounting system is to collect, summarize, and report information about an organization’s financial performance, and the impact of various business events upon its financial status.
The Fundamental Financial Accounting Statements
Organizations periodically report their financial status as of a certain date, and their financial performance for some period of time preceding that date, called the accounting period. They do this on three separate financial statements: the balance sheet, the income statement, and the statement of cash flows. The balance sheet is a . . .