Learn how to understand Financial Statement of a company (with examples)

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AAHAcademy
Finance Management Course
AllAssignmentHelp Academy
  • 12 lessons
  • 6 quizzes
  • 1 week duration

1.3 Fundamental Concepts of Accounting

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Before I tell you about the fundamental concepts of accounting, you should know that different countries use different accounting standards.

Accounting standards require the companies operating in a country to a common rule to record their finances.

Mainly there are two standards, GAAP and IFRS.

GAAP stands for Generally Accepted Accounting Standards used in USA. IFRS refers to International Financial Reporting Standards, which is used by many countries in its abridged forms.

Few nations are using their own standards. But they are not entirely different and pulls rules from IFRS too.

Below are some of the accounting standards used by different nations:

  • China: Chinese Accounting Standards
  • Canada: GAAP
  • France: GAAP
  • Germany: GAAP
  • Indian: Indian Accounting Standards
  • Luxembourg: Luxembourg GAAP
  • Nepal: Nepal Financial Reporting Standards
  • Russia: Russian GAAP
  • United Kingdom: GAAP UK
  • United States: GAAP US

In US companies that are domestic uses GAAP, whereas foreign companies trading in US uses IFRS format.

Now, let us know the key accounting concepts.

The Entity

The Entity refers to the business unit for whom the financial statement has been prepared. It can be a small mom and pop store, a mid-size business, or a conglomerate. Financial report for large entity, like conglomerate, can be a combined report for all its sister companies.

Cash and Accrual Accounting

Cash and Accrual are two methods used to record transactions. Most common and preferred method used by companies is accrual accounting.

Generally, smaller businesses and store owners use ash accounting is used by smaller businesses and store owners.

In cash accounting, accounts record transactions when cash transfer takes place between buyer and seller. For example, if a store owner pays rent for three years in 2019, then all the rent will be recorded in 2019.

On the other hand, in accrual accounting, transaction is recorded when the goods or services transfer take place. It is independent of cash transaction. If the store owner uses accrual accounting, then she will record the rent item in her accounting every month for the next three years. A major benefit of this method is that it helps know the financial effect of the activity on an ongoing basis.

In accrual accounting cash and activity does not necessarily take place at the same time. It gives way for two issues: Allocations and Matching.

Three common scenarios you face while recording transaction in accrual accounting are:

Scenario A: Amount x to be paid in future by the company.

Recording: X will be recorded as expense in Income Statement and the same amount will be recorded in current or long term liability in the balance sheet.

Scenario B: Amount x has been prepaid by the company

Recording: X will be recorded as expense in Income statement and the same amount will be recorded in current or long term asset in the balance sheet.

Scenario C: Company made 50% sales of value x in cash and rest in credit.

Recording: Both the sales, credit and cash, will be recorded as sales in Income Statement. The 50% of the sales value will be recorded as accounts receivables in Current Assets in Balance Sheet.

You may have not understood the above three scenarios if you do not have understanding of Income Statement and Balance Sheet. Do not worry. Come back to it after the course completes. You will get it. J

Objectivity

Accounts record only those transactions that can be quantified and traced back. Without reasonable and verifiable evidence, no record it done. Sales of 50 motor bikes can be recorded, but a brand value of company cannot be recorded. You cannot define the brand value in monetary terms.

Conservatism

Accountants are conservatives. They record expected future cost to the company, but do not record expected future profits or earning. All transactions are recorded at the historical costs.

Benefit of this way of recording?

Financial Statement users can know likely expenses of company and where the company is heading with it. But if accounts record expected profits, then companies may end up manipulating the financial statement by showing inflated future sales volume.

Historical costs can be termed as what the company paid for the supplies when it purchased it. It does not matter if price escalates or falls down after some time. The record will always be at what was paid.

Going Concern

Accountants assume that the company will survive till eternity and it will have time in hand to fulfil all its obligations and goals. It means, accountants never think that a company can ever be liquidated or go bankrupt.

They record all the transactions based on this thinking. This is the reason you see two records in the Asset and Liability section of a balance sheet: Current Asset or Current Liability, and Long Term Asset or Long Term Liability.

Assets or Liabilities of a company are separated into two types. Some of them are valued at the current market price (in a sense), and the rest are left out.

For example, take two liabilities, salaries of employees, and $50 million bank loan.

Accountants will tag employees’ salaries as current liability because company has to pay it soon. Company cannot say it that it will pay it up after few years. On the other hand, $50 million loan is paid gradually after several years of business.

If accountants will not follow Going Concern, they will record that $50 million at current market value.

Consistency

The company is expected to follow the same accounting rules year after year. The valuing of the inventory of the company should be done as per one selected method only.

The two popular methods are FIFO and LIFO.

FIFO stands for First in First out
LIFO stands for Last in First out

Suppose you purchased two houses, one at $1000 in 2006 and another at $5000 in 2015. Now assume that you sold one house to a buyer at $10,000.

For accounting record, it does not matter which house you sold. What matters is the cost you select from the two to make the entry.

If you use FIFO method, you will record sale of $1000 and a profit of $9,000.

If you use LIFO method, you will record sale of $5000 and a profit of $5,000.

You cannot change method every now and then. If you have used FIFO for the past five years, and want to use LIFO, then you have to make it clear in your financial statement.

Add a footnote with the justification on why the method was changed and its impact on the profit and asset values.

Materiality

Financial statements are not exact, because it does not record everything happening in within a business in monetary terms. It records only those activity that can be quantified and can be traced with transaction proof.

For example, brand value cannot be quantified and written in asset column of balance sheet, despite being a fact that brand value is an asset.

So financial statements provide material and fair view of the current position of the company only.

In this section, we have covered basic concepts of accounting and learned who uses financial statement and why. Now in the next three sections we will learn about the three statements, starting with The Balance Sheet.