Bab 2 Basic Consept of financial Accounting
1.1 What is Financial Accounting
Financial accounting is the
process of recording, summarizing and reporting the myriad of transactions
resulting from business operations over a period of time. These transactions
are summarized in the preparation of financial statements, including the
balance sheet, income statement and cash flow statement,
that record the company's operating performance over a specified period.01:35
Financial
Accounting
BREAKING DOWN Financial Accounting
Financial accounting utilizes a
series of established accounting principles. The selection of accounting
principles to use during the course of financial accounting depends on the
regulatory and reporting requirements the business faces. For U.S. public
companies, businesses are required to perform financial accounting in
accordance with generally accepted accounting
principles (GAAP). International public companies also frequently report financial
statements in accordance to International Financial Reporting Standards. The
establishment of these accounting principles is to provide consistent
information to investors, creditors,
regulators and tax authorities.
Accrual Method vs. Cash Method
Financial accounting may be
performed using either the accrual method, cash method or a combination of the
two. Accrual accounting entails recording transactions when the transactions
have occurred and the revenue is recognizable. Cash accounting entails
recording transactions only upon the exchange of cash. Revenue is only recorded
upon the receipt of payment, and expenses are only recorded upon the payment of
the obligation.
Financial Accounting Reporting
Financial reporting occurs through
the use of financial statements. The financial statements present the five main
classifications of financial data: revenues, expenses, assets, liabilities and
equity. Revenues and expenses are accounted for and reported on the income
statement. Financial accounting results in the determination of net income at
the bottom of the income statement. Assets, liabilities and equity accounts are
reported on the balance sheet. The balance sheet utilizes financial accounting
to report ownership of the company's future economic benefits.
Financial Accounting Vs. Managerial Accounting
The key difference between
financial and managerial
accounting is that financial accounting aims at providing information
to parties outside the organization, whereas managerial accounting information
is aimed at helping managers within the organization make decisions. Financial
statement preparation using accounting principles is most relevant to
regulatory organizations and financial institutions. Because there are numerous
accounting rules that do not translate well into business operation management,
different accounting rules and procedures are utilized by internal management
for internal business analysis.
Accounting Certifications
The most common accounting
designation demonstrating an ability to perform financial accounting within the
United States is the Certified Public Accountant (CPA) license.
Outside of the United States, holders of the Chartered Accountant (CA) license
demonstrate the ability as well. The Certified Management Accountant (CMA) designation
is more demonstrative of an ability to perform internal management functions
than financial accounting.
2.2 Income Statement
What is an Income Statement
An income statement is one of the
three important financial statements used
for reporting a company's financial
performance over a specific accounting period, with the other two key
statements being the balance sheet and
the statement of cash flows.
Also known as the profit and loss
statement or the statement of revenue and expense, the income
statement primarily focuses on company’s revenues and expenses during a
particular period.
An Introduction
To The Income Statement
BREAKING DOWN Income Statement
Income statement is an important
part of the company’s performance reports that must be submitted to the Securities and Exchange Commission (SEC).
While a balance sheet provides the snapshot of company’s financials as of a
particular date (like, as on 30 September 2018), the income statement reports
income through a particular time period and its heading indicates the
duration which may read as “For the (fiscal) year/quarter ended September 30, 2018,”
(See also, What is the
difference between an income statement and a balance sheet?)
The income statement focuses on
the four key items - revenue, expenses, gainsand losses.
It does not cover receipts (money
received by the business) or the cash payments/disbursements (money paid by the
business). It starts with the details of sales, and then works down to
compute the net income and
eventually the earnings per share (EPS).
Essentially, it gives an account of how the net revenue realized by the
company gets transformed into net earnings (profit or loss).
The following are covered in the
income statement, though its format may vary depending upon the local
regulatory requirements, the diversified scope of the business and the
associated operating activities:
Revenues and Gains:
1.
Operating Revenue:
Revenue realized through primary activities is often referred to as operating revenue.
For a company manufacturing a product, or for a wholesaler, distributor or
retailer involved in the business of selling that product, the revenue from
primary activities refers to revenue achieved from sale of the product.
Similarly, for a company (or its franchisees) in the business of offering
services, revenue from primary activities refers to the revenue or fees earned
in exchange of offering those services.
2.
Non-operating Revenue:
Revenues realized through secondary, non-core business activities are
often referred to as non-operating recurring revenues. These revenues are
sourced from the earnings which are outside of purchase and sale of goods and
services, and may include income from interest earned on business capital lying
in the bank, rental income from business property, income from strategic
partnerships like royalty payment
receipts or income from an advertisement display placed on business property.
1.
Gains:
Also called as other income, gains indicate the net money made from other
activities, like sale of long-term assets. These include the net income
realized from one-time non-business activities, like a company selling its old
transportation van, unused land, or a subsidiary company.
Revenue should not be confused
with receipts. Revenue is usually accounted for in the period when sales are
made or services are delivered. Receipts are the cash received, and are
accounted for when the money is actually received. For instance, a customer may
take goods/services from a company on 28 September which will lead to the
revenue being accounted for in the month of September. Owing to his good
reputation, the customer may be given a 30-day payment window. It will give him
time till 28 October to make the payment which is when the receipts are
accounted for.
Expenses and Losses:
1.
Expenses linked to primary
activities: All expenses incurred for earning
the normal operating revenue linked to the primary activity of the business.
They include cost of goods sold
(COGS), selling, general and administrative
expenses (SG&A), depreciation or amortization,
and research and
development (R&D)expenses. Typical items that make up
the list are employee wages, sales commissions, and expenses for utilities like
electricity and transportation.
2.
Expenses linked to secondary
activities: All expenses linked to non-core
business activities, like interest paid on loan money.
3.
Losses:
All expenses that go towards loss-making sale of long-term assets, one-time or
any other unusual costs, or expenses towards lawsuits.
While primary revenue and expenses
offer insights into how well the company’s core business is performing, the
secondary revenue and expenses account for the company’s involvement and its
expertise in managing the ad-hoc, non-core activities. Compared to the income
from sale of manufactured goods, a substantially high interest income from
money lying in the bank indicates that the business may not be utilizing the
available cash to its full potential by expanding the production capacity, or
it is facing challenges in increasing its market share amid competition.
Recurring rental income gained by hosting billboards at the company factory
situated along a highway indicates that the management is capitalizing upon the
available resources and assets for additional profitability.
Income Statement Structure - From Revenues to
Net Income
Mathematically, the Net Income is
calculated based on the following:
Net Income = (Revenue + Gains) –
(Expenses + Losses)
To understand the above details
with some real numbers, let’s assume that a fictitious sports merchandise selling
business which additionally provides training is reporting its income statement
for the most recent quarter.
2.3 Financial Statements - Definition
What Are Financial Statements
Financial statements are written
records that convey the business activities and the financial performance of a
company. Financial statements include the balance sheet,
income statement, and cash flow statement. Financial statements are often
audited by government agencies, accountants, firms, etc. to ensure accuracy and
for tax, financing, or investing purposes.
Financial
Statements
What Do Financial Statements Tell You
Investors and financial analysts
rely on financial data to analyze the performance of company and make
predictions about its future direction of the company's stock price. One of the
most important resources of reliable and audited financial data is the annual
report, which contains the firm's financial statements.
The financial statements are used
by investors, market analysts, and creditors, to evaluate a company's financial
health and earnings potential. The three major financial statement reports
are the balance sheet, income statement, and statement of cash flows.
Balance Sheet
The balance sheet provides an
overview of assets, liabilities, and stockholders' equity as a snapshot in
time. The date at the top of the balance sheet tells you when the snapshot was
taken, which is generally the end of the fiscal year.
How To Calculate and Identify the Balance Sheet
The balance sheet totals will be
calculated already, but here's how you identify them.
1.
Locate total assets on the balance
sheet for the period.
2.
Total all liabilities, which should be
a separate listing on the balance sheet.
3.
Locate total shareholder's equity and
add the number to total liabilities.
4.
Total assets should equal the total of
liabilities and total equity.
What Does the Balance Sheet Tell You?
The balance sheet identifies how
assets are funded, either with liabilities, such as debt, or stockholders'
equity, such as retained earnings and additional paid-in capital. Assets are
listed on the balance sheet in order of liquidity. Liabilities are listed in
the order in which they will be paid. Short-term or current liabilities are
expected to be paid within the year, while long-term or noncurrent liabilities
are debts expected to be paid in over one year.
Example
of items on a Balance Sheet
Below are examples of items listed
on the balance sheet:
Assets
- Cash
and cash equivalents are liquid assets,
which may include Treasury bills and certificates of deposit.
- Accounts
receivables are the amount of
money owed to the company by its customers for the sale of its product and
service.
- Inventory
Liabilities
- Debt
including long-term debt
- Rent, tax, utilities
- Wages payable
- Dividends payable
Shareholders'
equity
- Shareholders' equity is a company's total
assets minus its total liabilities. Shareholders' equity
represents the amount of money that would be returned to shareholders if
all of the assets were liquidated and all of the company's debt
was paid off.
- Retained
earnings are part of
shareholders' equity and are the percentage of net
earnings that were not paid to
shareholders as dividends.
Real World Example of a Balance Sheet
- We can total assets were $354,628
(highlighted in green).
- Total liabilities were $157,797 (1st red
highlighted area).
- Total equity was $196,831 (in red).
- Total liabilities and equity were
$354,628, which equals the total assets for the period.
Income Statement
Unlike the balance sheet, the
income statement covers a range of time, which is a year for annual financial
statements and a quarter for quarterly financial statements. The income
statement provides an overview of revenues, expenses, net income and earnings
per share. It usually provides two to three years of data for comparison.
How To Calculate the Income Statement
1.
Total all revenue or sales for the
period.
2.
Total all expenses and costs of
operating the business.
3.
Subtract total expenses from revenue
to achieve net income or the profit for the period.
What Does the Income Statement Tell You?
An income statement is one of the
three important financial statements used for reporting a
company's financial
performance over a specific accounting period. Also known as the profit and loss
statement or the statement of revenue and expense, the income
statement primarily focuses on a company’s revenues and expenses during a
particular period. Once expenses are subtracted from revenues, the statement
produces a company's profit figure called net income.
Types
of Revenue
Operating revenue is the revenue
earned by selling a company's products or services. The operating revenue for
an auto manufacturer would be realized through the production and sale of
autos. Operating revenue is generated from the core business activities of a
company.
Non-operating revenue is the
income earned from non-core business activities. These revenues fall
outside the primary function of the business. Some non-operating revenue
examples include:
- interest earned on cash in the bank,
- rental income from a property,
- income from strategic partnerships
like royalty payment receipts,
- income from an advertisement display
located on the company's property.
Other income is the revenue earned
from other activities. Other income could include gains from the sale of
long-term assets such as land, vehicles, or a subsidiary.
Types
of Expenses
Primary expenses are incurred
during the process of earning revenue from the primary activity of the
business. Expenses include cost of goods sold (COGS), selling,
general and administrative expenses (SG&A), depreciation or amortization,
and research and development (R&D). Typical expenses include employee
wages, sales commissions, and utilities such as electricity and transportation.
Expenses that are linked to
secondary activities include interest paid on loans or debt. Losses from the
sale of an asset are also recorded as expenses.
The main purpose of the income
statement is to convey details of profitability and the financial results of
business activities. However, it can be very effective in showing whether sales
or revenue is increasing when compared over multiple periods. Investors can
also see how well a company's management is controlling expenses to determine
whether a company's efforts in reducing the cost of sales might boost profits
over time.
Real
World Example of an Income Statement
Below is a portion of Exxon Mobil
Corporation's (XOM) income statement as of September 30, 2018.
- We can see total revenues were $76,605
for the period.
- Total costs were $67,525 for the period.
- Net income or profit was $6,240 for the
period.
Cash Flow Statement
The cash flow statement
(CFS) measures how well a company generates cash to pay its debt
obligations, fund its operating expenses, and fund investments. The
cash flow statement complements the balance sheet and income statement.
What Does the Cash Flow Statement Tell You?
The CFS allows investors to
understand how a company's operations are running, where its money is coming
from, and how money is being spent. The CFS also provides insight as to
whether a company is on a solid financial footing.
There is no formula, per se for
calculating a cash flow statement, but instead, it contains three sections that
report the cash flow for the various activities that a company has used its
cash. Those three components of the CFS are listed below.
Operating
Activities
The operating activities on the
CFS include any sources and uses of cash from running the business and selling
its products or services.
Cash from operations includes any
changes made in cash, accounts receivable, depreciation, inventory,
and accounts payable.
These transactions also include wages, income tax payments, interest payments,
rent, and cash receipts from the sale of a product or service.
Investing
Activities
Investing activities include
any sources and uses of cash from a company's investments into the long-term
future of the company. A purchase or sale of an asset, loans made to vendors or
received from customers or any payments related to a merger or acquisition are
included in this category. Also, purchases of fixed assets such
as property, plant, and equipment (PPE) are included in this section. In
short, changes in equipment, assets, or investments relate to cash from
investing.
Financing
Activities
Cash from financing activities include
the sources of cash from investors or banks, as well as the uses of cash paid
to shareholders. Financing activities include debt issuance, equity issuance,
stock repurchases, loans, dividends paid, and repayments of debt.
The cash flow statement reconciles
the income statement with the balance sheet in three major business activities.
Real World Example of a Cash Flow Statement
Below is a portion of Exxon Mobil
Corporation's (XOM) cash
flow statement as of September 30, 2018. We can see the three areas of the
cash flow statement and their results.
- Operating activities generated a positive
cash flow of $27,407 for the period.
- Investing activities generated negative
cash flow or cash outflows of -$10,862 for the period. Additions to
property, plant, and equipment made up the majority of cash outflows,
which means the company invested in new fixed assets.
- Financing activities generated negative
cash flow or cash outflows of -$13,945 for the period. Reductions in
short-term debt and dividends paid out made up the majority of the cash
outflows.
Key Takeaways
- Financial statements are written records
that convey the business activities and the financial performance of a
company.
- The balance sheet provides an overview of
assets, liabilities, and stockholders' equity as a snapshot in time.
- The income statement primarily focuses on
a company’s revenues and expenses during a particular period. Once
expenses are subtracted from revenues, the statement produces a company's
profit figure called net income.
- The cash flow statement
(CFS) measures how well a company generates cash to pay its debt
obligations, fund its operating expenses, and fund investments.
Limitations of Financial Statements
Although financial statements
provide a wealth of information on a company, they do have limitations. The
statements are open to interpretation, and as a result, investors often draw
vastly different conclusions about a company's financial performance. For
example, some investors might want stock repurchases while other investors
might prefer to see that money invested in long-term assets. A company's debt
level might be fine for one investor while another might have concerns about
the level of debt for the company. When analyzing financial statements, it's
important to compare multiple periods to determine if there are any trends as
well as compare the company's results its peers in the same industry.
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