What Is Basic Financial Accounting?

Financial accounting is a system of tracking transactions that affect the financial position of a company. This tracking provides managers with the information they need to make sound decisions and provides a basis for stockholders to compare one company's performance with that of other companies. Financial accounting is essentially the process of recording and then reporting the financial position of the company to all interested parties. The financial reports created during this process serve as a snapshot of a company's financial state at a given time.

Information

Throughout the year, a company records data about financial transactions involving the company. These transactions encompass a wide variety of events including sales, sales returns, inventory purchases, supplies purchases, labor expenses and operating expenses. Every event that occurs is recorded; these events then become the basis for the financial statements prepared by the company at the end of the year.

Statement Types

The ultimate goal of financial accounting is to produce four statements detailing the company's financial position. These statements are the income statement, balance sheet, statement of owner's equity and the cash flow statement. The income statement matches revenues with expenses to determine the company's profit or loss. The balance sheet is a listing of a company's assets, liabilities and the amount of equity held by the owners of the company (owner's equity). Owner's equity is broken down into parts such as outstanding stock and retained earnings. These parts are shown in the owner's equity statement. As the name suggests, the cash flow statement shows how cash has been received and used by the company.

Methods

Financial accounting allows for two accounting basics: the cash method and the accrual method. Under the cash method, a company recognizes a transaction as having occurred whenever money is taken in or paid out. Under the accrual method of financial accounting, revenues and expenses are recognized when they're incurred. For example, under an accrual system, the electric bill for the month of December would be counted as a December expense even if the bill isn't paid until January. American companies who publicly trade stock on an open exchange, such as the New York Stock Exchange, fall under the jurisdiction of the United States Securities and Exchange Commission and are required to use the accrual method.

Assumptions

Financial accounting is based on several assumptions. The going concern assumption assumes that a company plans on continuing operations and will be able to do so. The separate entity assumption presumes that the finances of the company are separate from the individual finances of the company's owners. Because we break a company's finances into periods such as months or years, financial accounting operates under a fixed time assumption that presumes it's possible to break a company's activities down in this way. Finally, there's a stable monetary unit assumption, which allows us to measure a company's financial health in dollars, yen or other currencies without having to continually adjust the value of the currency used.

Criticisms

Many people argue that financial accounting may not accurately reflect a company's position because it's difficult to assign monetary value to intangible assets. These assets may include employee satisfaction, a positive public image, large customer bases, benefits of holding a patent, and other difficult-to-measure assets. Companies try to assign a value to intangible assets, but it's a difficult process and often requires a company to make judgments that can be less than subjective.

Resources

• Basic Accounting Concepts