Accounting plays a critical role in the success of any business both in referencing past financial performance and planning the future. However, the numerous accounting scandals that have recently hit the news headlines have emphasized the need for all accountants to judiciously understand the effects of all financial transaction to all financial statements.
The double entry concept is the basis of accounting transaction recordings. It is a simple concept which when clearly understood, an individual can effortlessly deduce and record even the most complicated financial transactions. Subsequently, the trial balance should always be prepared first using information from the general ledger as it reflects this concept. All the financial statements should then be prepared from information contained in the trial balance.
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Below is an example of how a transaction affects the financial statements. A case of a company that has $20,000 cash on hand. This amount will be recorded as an asset in the balance sheet. If the company spends $10,000 to purchase a piece of land, this transaction will be recorded as a cash outflow on the credit side of the statement of cash flow. Additionally, a cash entry will be recorded in the balance sheet on the credit side, and another entry on the asset side as land. Further, if the company was to sell the piece of land at a profit in the same financial period, other entries will be made with one being recorded to the income statement. Generally, all the financial statements are related.
Elements and Purpose of each Financial Statement
Balance Sheet
The balance sheet has three elements; assets, liabilities and owners’ equity. Assets depict all the economic resources that a company has, for example, cash, buildings, and equipment. They are recorded on the debit side. Contrary, liabilities, and equity represent all the claims to a business’s assets by creditors and owners respectively. They are both recorded on the credit side of the balance sheet. Summation of the two should be equal to total assets on the debit side. Hence the balance sheet should always be balanced.
The purpose of the balance sheet is to show the financial position of a business as per the specified date.
Statement of Cash Flow
Statement of cash flow has three elements each with debit and credit side. The first element is cash flow from operating activities which depict the flow of cash from the primary revenue generating operations, for example, salaries and sales. Cash flow from Investing activities show capital expenditures (sale and purchase of real assets), and purchase and disposal of financial assets ( Užík, n.d.) . Cash flow from financing activities, on the other hand, involve net cash flow from repurchase and issue of equity, payment and issue of debt, and dividend payments ( Užík, n.d).
Its purpose is providing insight on cash usage and sources (inflow and outflow) during the accounting period.
Income Statement
Elements of the income statement are revenues and expenses. According to Užík (n.d), revenues are upsurges in an entity’s economic benefit in the form of inflows or growth in assets or decrease in liabilities due to increased equity. On the contrary, expenses are decreases in the economic benefit due to cash outflows, increased liabilities, or diminution of assets.
The purpose of the income statement is to show how much income a business earned during the accounting period.
Components and Use of Financial Analysis
Financial analysis is a complex method used to scrutinize financial statements. It is divided into two components: Horizontal analysis, which involves analysis of financial statements by comparing them with those from previous periods, and vertical analysis which involves analysis of different components using ratios, for example, debt to equity ratio (Ravinder & Anitha, 2013). Some of the tools used in conducting financial analysis include; Comparative statement analysis, trend analysis, common-size analysis, cost, volume, and profit analysis, and cash flow analysis among others.
Financial analysis is used to assess the possibility of future growth of a business, assess a firm’s ability to pay debts, determine the financial stability of a business, gauge the earning capacity of a business, and evaluate the administrative efficiency of an entity among others.
References
Ravinder, D., & Anitha, M. (2013, December). Financial Analysis – A Study . Retrieved from http://www.iosrjournals.org/iosr-jef/papers/vol2-issue3/B0231022.pdf
Užík, M. (n.d.). Financial Statement Analysis . Retrieved from http://www.ekf.tuke.sk/files/uzik/Valuation_2%20Financial_Statement_Analysis.pdf
