Part I
Getting Started with Financial Accounting
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In this part . . .
Understand why financial accounting is so important to many different individuals and businesses.
Come to grips with the key characteristics of financial accounting.
Chart a career in financial accounting.
Get a handle on the primary financial statements.
Go to
www.dummies.com/extras/financialaccounting for online bonus content, including an extra Part of Tens chapter: ‘Ten Differences Between Some National Standards and IFRS’.
Chapter 1
Seeing the Big Picture of Financial Accounting and International Accounting
In This Chapter
Knowing why financial accounting matters
Introducing key financial accounting characteristics
Accepting ethical responsibilities
I assume that you have a very good reason for buying this book; most people don’t randomly buy a title like Financial Accounting For Dummies. The chances are you’re embarking on your first accountancy course and want to be sure you do well in it, but it might be the case that you’re a business owner wanting to get a better grip on the way your financial statements are prepared or to improve your bookkeeping. Whatever your reasons, this chapter is your key to the car to start the journey on the road of financial accounting.
I explain what financial accounting is and why it’s so important to many different individuals and businesses. I identify the various users of financial information and explain why they need that info. Finally, I briefly introduce four all-important characteristics of financial information: relevance, reliability, comparability and understandability. Whether you’re a financial accounting student or a business owner, you need to understand these crucial financial accounting terms from the very beginning as they underpin everything to do with financial statements right from the word ‘go’. For those of you reporting under IFRSs, these principles are also relevant but are split between fundamental qualitative characteristics and enhancing qualitative characteristics; I offer a run through of these for you too.
Knowing the Objective of Financial Accounting
Broadly speaking, accounting is the process of organising facts and figures and communicating the results of that organisation to any parties interested in that information. This process doesn’t just relate to numbers churned out by a computer software program; it pertains to any type of reconciliation.
Here’s an example that a parent could possibly relate to that doesn’t involve numbers or money: a teenager sneaks in after a curfew set by his parents, and his parents ask for a complete account of why he’s late. When the teenager tells them the facts, we have information (his car broke down in an area with no mobile phone signal), the individual producing the information (the mischievous teenager) and the interested party, also known as the user of the information (the worried parents).
The subject of this book, financial accounting, is a subset of accountancy. Financial accounting involves the process of preparing financial statements for a business. (Not sure what financial statements are? No worries – you find an overview of them in the next section.) Here are the key pieces of the financial accounting jigsaw:
Information: Any accounting transactions taking place within the business during the accounting period. These include generating revenue from the sales of company goods or rendering of services, paying business-related expenses, buying company assets and incurring debt to run the company.
Business entity: The company incurring the accounting transactions.
Users: The persons or businesses that need to see the accounting transactions organised into financial statements to make informed decisions of their own. (You can find more about these users in the ‘
Getting to Know the Users of Financial Statements’ section of this chapter.)
Preparing financial statements
If you’re starting an accountancy course, your entire course could well centre on the proper preparation of financial statements: the income statement (profit and loss account), balance sheet (statement of financial position) cash flow statement (statement of cash flows) and statement of changes in equity. Financial accountants can’t just stick accounting transaction information in the financial statements wherever they feel like. Many, many rules exist that dictate how financial accountants must organise the information in the financial statements; these rules are called generally accepted accounting practice (GAAP), and I discuss them in Chapter 4. The rules pertain to both how the financial accountant shows the accounting transactions and in which financial statements the information relating to the transactions appears.
Curious about the purpose of each financial statement? Here’s a run through of each one:
Income statement: This financial statement shows the results of business operations consisting of revenue, expenses, gains and losses. The end product is net profit or net loss. I talk about the income statement again in
Chapter 3, and then I cover it from start to finish in
Chapter 10. For now, here are the basic facts on the four different income statement components:
• Revenue: Sales earned by the company selling its goods or services.
• Expenses: The costs to the company to earn its revenue.
• Gains: Income from non-operating-related transactions, such as selling a company asset.
• Losses: The flip side of gains, such as losing money when selling a company car.
A lot of accountants call the income statement a
statement of profit or loss, especially when they’re working to international standards (International Financial Reporting Standards), or simply a
P&L (as it’s commonly known in the UK).
These terms are fine to use because they address the spirit of the statement.
Balance sheet: This statement has three sections: assets, liabilities and equity. Standing on their own, these sections contain valuable information about a company. However, a user has to see all three interacting together on the balance sheet to form a reasonably reliable opinion of the company.
Part III of this book is all about the balance sheet, but for now here are the basics about each balance sheet component:
• Assets: Resources owned by a company, such as cash, equipment and buildings.
• Liabilities: Debt the business incurs for operating and expansion purposes.
• Equity: The amount of ownership left in the business after deducting total liabilities from total assets.
Statement of cash flows: This statement contains certain components of both the income statement and the balance sheet. The purpose of the statement of cash flows is to show cash sources and uses during a specific period of time – in other words, how a company brings in cash and for what costs the cash goes back out the door.
Statement of changes in equity: This statement shows any movements in the equity accounts of the statement of financial positio...
