Financial accounting is the process of recording, summarizing, and reporting a company's financial transactions to external users. These users include investors, creditors, and other stakeholders who need to make informed decisions about the company.
There are a number of basic financial accounting concepts that are essential for understanding how financial statements are prepared and interpreted. These concepts provide the foundation for financial reporting and help to ensure that financial statements are accurate and reliable.
In this blog post, we will discuss some of the most important basic financial accounting concepts. By understanding these concepts, you will be better equipped to read and analyze financial statements and make informed decisions about the companies you invest in or do business with.
Let’s begin with understanding the objectives of financial accounting.
Objectives of financial accounting
- Provide information about a company's financial performance and position. This includes information about the company's income, expenses, assets, liabilities, and equity.
- Help users assess a company's liquidity, profitability, and solvency. Liquidity refers to a company's ability to meet its short-term financial obligations. Profitability refers to a company's ability to generate profits. Solvency refers to a company's ability to meet its long-term financial obligations.
- Assist users in making informed decisions about investing in, lending to, or doing business with a company. For example, investors use financial accounting information to assess the risk and potential return of an investment. Creditors use financial accounting information to assess a company's ability to repay its debts. And suppliers use financial accounting information to assess a company's ability to pay its bills.
- Enhance transparency and accountability. Financial accounting information helps to ensure that businesses are transparent and accountable to their stakeholders.
- Support informed financial regulation. Financial accounting information is used by government agencies to regulate businesses and to assess the overall health of the economy.
- Provide a basis for research and analysis. Financial accounting information is used by researchers and analysts to study the performance of businesses and to develop economic models.
- Promote efficiency and effectiveness in capital markets. Financial accounting information helps to ensure that capital markets are efficient and effective.
11 Financial Accounting Concepts
1. Accrual concept
The accrual concept is one of the most important financial accounting concepts. It states that transactions should be recorded when they occur, regardless of when cash is received or paid. This allows for a more accurate and complete picture of a company's financial performance.
For example, if a company sells goods on credit, the sale should be recorded when the goods are delivered, even if the customer does not pay for them until later. This is because the company has already earned revenue, even though it has not yet received cash.
Similarly, if a company incurs expenses on credit, the expenses should be recorded when they are incurred, even if the company does not pay for them until later. This is because the company has already used up resources, even though it has not yet paid for them.
2. Concept of an economic entity
The concept of an economic entity states that the business is a separate entity from its owners and other businesses. This means that the business's financial transactions should be kept separate from the personal transactions of its owners.
For example, if a business owner uses company funds to purchase a personal item, this transaction should not be recorded in the company's financial statements. This is because the purchase is a personal transaction, not a business transaction.
3. Concept of a going concern
The concept of a going concern states that the business is assumed to continue operating indefinitely. This assumption allows businesses to use certain accounting methods that would not be appropriate if the business was expected to cease operations in the near future.
For example, businesses can use the accrual basis of accounting and record depreciation expense, even if they are not expecting to sell the assets that are being depreciated.
4. Concept of matching
The concept of matching states that expenses should be matched with the revenues they generate in the same accounting period. This helps to ensure that the company's financial statements accurately reflect its profitability.
For example, if a company incurs expenses to produce goods that are sold in the next accounting period, the expenses should be matched with the revenues from the sale of those goods in the next accounting period.
5. Materiality concept
The materiality concept states that only material transactions should be reported in the financial statements. Material transactions are those that are significant enough to influence the decisions of users of the financial statements.
For example, a small company may not need to report the sale of a single item of inventory in its financial statements. However, a large company would need to report the sale of a single item of inventory if it was a significant sale.
Recommended Read: A Guide to Managerial Accounting and the Ways It Can Streamline Your Business
6. Dual aspect concept
The dual aspect concept states that every financial transaction has two effects, one on an asset or liability account and the other on an income or expense account. This means that every transaction must be balanced, and that the total of all asset accounts must equal the total of all liability and equity accounts.
For example, if a company purchases goods on credit, the transaction will increase the company's asset account (inventory) and increase the company's liability account (accounts payable).
7. Conservatism
The conservatism concept states that when there is uncertainty about the value of an asset or liability, it should be recorded at the lower of cost or market value. This means that businesses should err on the side of caution and record assets and liabilities at a lower value than they may actually be worth.
For example, if a company has a piece of equipment that is worth less than it originally cost, the company should record the equipment at its current market value. This is because it is more likely that the market value of the equipment will decrease in the future than it will increase.
8. Consistency concept
The consistency concept states that the same accounting principles should be used from period to period. This helps to ensure that financial statements are comparable over time.
For example, if a company changes its accounting method for inventory valuation, it must disclose the change in its financial statements. This allows users of the financial statements to compare the company's performance over time and to understand the impact of the change in accounting method.
9. Historical cost principle
The historical cost principle states that assets are recorded at their historical cost, which is the amount paid to acquire them. This principle is used because it is considered to be a reliable measure of the value of an asset.
For example, if a company purchases a piece of equipment for $100,000, the equipment would be recorded in the financial statements at $100,000. This is regardless of whether the market value of the equipment has increased or decreased since it was purchased.
10. Revenue recognition principle
The revenue recognition principle states that revenue is recognized when it is earned, even if cash has not yet been received. This principle is used because it is considered to be a fair measure of the company's profitability.
For example, if a company sells goods on credit, the revenue from the sale would be recognized in the financial statements when the goods are delivered, even if the customer does not pay for them until later. This is because the company has already earned the revenue, even though it has not yet received cash.
11. Full disclosure principle
The full disclosure principle states that all relevant information that could affect a user's understanding of the financial statements must be disclosed. This includes information about the company's financial performance, financial position, and risk factors.
For example, if a company has a significant lawsuit pending, it must disclose this information in its financial statements. This is because the lawsuit could have a significant impact on the company's financial performance and financial position.
How Accounting Automation Help Comply with Financial Accounting Concepts
Accounting automation can be used to help businesses comply with financial accounting concepts. For example, accounting automation software can be used to:
- Accurately record transactions in real-time, regardless of when cash is received or paid.
- Separate business transactions from personal transactions.
- Assume that the business will continue operating indefinitely.
- Match expenses with revenues in the same accounting period.
- Identify and report material transactions.
- Balance all accounts and ensure that the total of all asset accounts equals the total of all liability and equity accounts.
- Record assets and liabilities at their historical cost.
- Recognize revenue when it is earned, even if cash has not yet been received.
- Disclose all relevant information that could affect a user's understanding of the financial statements.
Accounting automation can help businesses to improve the accuracy and efficiency of their financial reporting. This can free up accountants to focus on more strategic tasks, such as analyzing financial data and providing insights to management.
Automation tools like Suvit can perform complex data entries swiftly and accurately, freeing up your managerial accountants from repetitive tasks.
How to Get Started
So, how can you bring this digital magic into your business? Here are some steps:
- Choose the Right Software: Look for accounting software that suits your business needs. There are many options out there, so find one that's user-friendly and fits your budget. Suvit is one great accounting automation tool created especially for businesses in Bharat.
- Training: Make sure your bookkeeper or accountant gets proper training on the software. It's like teaching them how to use a new tool.
- Integration: Connect your software with your bank accounts, invoicing systems, and other financial tools. This way, everything works together smoothly.
- Routine Checks: Even though automation is smart, it's still a good idea to regularly review the results and reports to catch any oddities.
Ready to Embrace Accounting Concepts and Automation?
Financial accounting concepts are essential for understanding how financial statements are prepared and interpreted. By understanding these concepts, you can make more informed decisions about the companies you invest in or do business with.
Accounting automation can be a valuable tool for businesses that want to comply with financial accounting concepts and prepare accurate and reliable financial statements.
Want to try out accounting automation and take the first step towards better accounting management? Try out Suvit for free today.
