The objective of this essay is to assess the basics of financial accounting, its significance, and how this information is relevant to understanding the performance of the business. The focus is to recognize how management at its discretion, identifies and classifies assets and liabilities and to discuss the implications of this process to the financial statements. This essay is organized as follows: the first section describes financial accounting and assesses different types of business activities; in the next section, it classifies some accounting terms that are accounts payable, cash, property, plant and equipment, note payable, and inventory; lastly, it defines financial statements and analyzes how to measure business performance through ratio analysis, providing an illustration on how to compute net income from the information provided for ABC Corp.
Definition of Accounting, Users, and Purpose
Accounting is the systematic process in which financial transactions are recorded and updated, while the related data is classified, analyzed to extract meaningful information, and then compiled into a report. A financial statement is one of the fundamental ways by which organizations communicate financial information to individuals outside the company (Kimmel et al.). The main users are shareholders, investors, competitors, lenders, suppliers, and employees of a business. Such document indicates the profitability, cash flows, and potential risks, all of which are significant to these interested parties when making choices regarding the organization.
Financial accounting standards are created to improve the nature of financial data in generating accounting information. This information is useful in the formulation of long-term and short-term goals, understanding business performance, and managing resources to achieve more profit.
Forms of Business Activities
Business activities in every organization are mainly divided into three groups; financing activities, investing activities, and operating activities. Financing activities involve transactions carried out to source capital from outside the business. The main sources of funds for business are debt and equity. Debt financing entails bank borrowing and buying goods on credit, which are usually referred to as liabilities. On the other hand, equity is obtained through dividends and the selling of shares, which are commonly known as share capital.
Investing activities involve purchasing resources needed to operate the business identified as assets. Once a business has enough assets, it starts operating. Proceeds from operations are known as revenue, while expenses are the costs incurred in these transactions. All these activities are recorded and classified in the financial statements based on their economic characteristics.
Classifications of Some Accounting Terms Used in the Balance Sheet
- Accounts payable – the amount that the business owes its suppliers and is obligated to pay; refers to liabilities.
- Cash – an asset since it keeps the business afloat and is used in investing activities such as purchasing equipment.
- Property, plant, and equipment – a fixed asset since it is a resource needed for a business to operate. Example: a sewing machine for a textile company.
- Note payable – is issued when a business borrows from a credit company or a financial institution: hence, it is a liability.
- Inventory – consists of raw materials, work in progress, and finished goods available for sale in the future: classified as assets.
Assets, liabilities, expenses, and revenues are the main elements of financial statements, which comprise of:
- Income statement – records revenues and expenses of a business and shows the performance of that business over a specified time. If the revenue was more than the expenses, it reports a profit; also identified as the profit and loss statement.
- Statement of retained earnings – shows how previous net income was shared through dividends and the proportion that was reinvested back into the business.
- Balance sheet – illustrates the company’s assets and liabilities over a given period.
- Statement of cash flows – summarizes the amount of cash and cash equivalents that move in and out of the business in a certain period. It demonstrates how a business manages its cash and debt obligations.
Net income is regularly used as an indicator of business performance. However, the most accurate way to measure this is through ratio analysis. It involves comparing data in financial statements that evaluate an organization’s liquidity, returns on investment, and efficiency of operation. This data is mainly derived from the income statement and balance sheet.
Profitability ratios show the ability of a business to generate profit in proportion to its revenue, assets, operating activities, and shareholders’ equity. They measure how an entity utilizes its assets and how much value the shareholders get and are mainly used by investors, competitors, employees, and the government. Liquidity ratios, on the other hand, illustrate a company’s ability to honor its debt obligations, determining whether it can take advantage of its assets to settle current liabilities hence they are mostly applied by creditors and shareholders. Lastly, efficiency ratios measure how well a company is utilizing its assets and resources. They are used by shareholders, creditors, and competitors.
ABC Corp’s Net Income
Net income is fundamentally the difference between the total revenues generated by a business less the total expenses.
Sales: $260,000 Cost of Goods Sold: $100,000
Salaries and Wages: $20,000
Rent Expense: $15,000
Advertising Expense: $35,000
Cost of repairs resulting from fire: $50,000
Net Income=Total Revenue – Total Expenses
= (Sales – Cost of Goods Sold) – Total Expenses
= $ (260,000 – 100,000) – (35,000 + 20,000+ 50,000+ 15,000)
= $ 40,000
Kimmel, Paul D., et al. Financial Accounting: Tools for Business Decision Making. John Wiley & Sons, 2018.