Basic Consept of financial Accounting

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 

Below is a portion of Exxon Mobil Corporation's (XOM) balance

sheet as of September 30, 2018. 

 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.