Financial Accounting: Systems, Statements, and Key Concepts

Why Companies Create and Maintain Accounting Systems

Accounting is the language of business. The ability to record transactions is critical for companies in terms of tracking key performance metrics, and the subsequent management of revenues and expenses is essential for long-term sustainability. Accounting systems are therefore needed for an accurate assessment of business progress, and businesses create these systems to help facilitate their overall strategic objectives.

For instance, if accounts receivable are high, management may be inclined to tighten credit terms to discourage customers from borrowing. A natural result of this strategic move could be an increase in customers paying in cash. By tightening credit, management is able to avoid potential delinquencies while increasing cash on hand — a decision made possible through accurate and timely accounting systems.

In addition, accounting systems help businesses identify methods by which to improve operations. Metrics such as inventory turnover and expense ratios can be tracked using these systems. In many instances, investors demand a required rate of return on their investment. Through proper accounting systems, management can better identify areas that need improvement, ultimately helping to generate higher returns. For example, many large financial firms use accounting systems to reduce their overall cost structure, leading to announcements of job cuts, expense reductions, or divestitures — all of which help drive earnings and investor returns. Accounting systems are essential in these situations to facilitate informed decision-making.

Assets, Liabilities, and Stockholders' Equity

Assets are resources used to generate cash for a business — economic resources that help create positive economic value. In accounting, assets can be both tangible and intangible. Intangible assets often include elements that cannot be readily quantified, such as a brand name. Liabilities are generally considered debts or obligations owed to other entities, and they typically take the form of loans from banks or other financial institutions. In some instances, liabilities such as loans are used to finance the acquisition of assets such as real estate, which is particularly advantageous when interest rates are low. For example, firms may borrow at low interest rates to fund projects that offer a high rate of return.

Stockholders' equity represents the claim on earnings by the most junior class of investor. The common shareholder holds an interest in the assets of the company after liabilities have been subtracted. This proportional interest in the earnings of the business is called stockholders' equity. Lower liabilities — including outstanding loans — generally leave more earnings available for common shareholders. Additionally, some companies engage in the practice of repurchasing their own shares using low-cost debt, which enhances earnings per share for the remaining shareholders.

The Four Basic Financial Statements

1) Balance Sheet: A balance sheet gives an overall picture of a company's financial position by showing its total assets, liabilities, and shareholders' equity. The balance sheet begins with current assets — those that can easily be converted into cash — ordered by liquidity, with cash and cash equivalents listed first. It also includes accounts receivable, inventory, and prepaid expenses such as insurance. Fixed assets are assets the business expects to retain for longer than one year; these can be illiquid and include property and capital equipment. Short-term liabilities encompass accounts payable, wages, and taxes due within one year. Long-term liabilities are obligations to be paid after one year, such as mortgages and bonds. Equity refers to an owner's stake in the business — owner's equity in the case of a sole proprietorship or partnership, and stockholders' equity in the case of a corporation.

2) Income Statement: An income statement reports revenues and the expenses incurred to generate those revenues over a specified period of time, typically a quarter. The bottom line of the income statement is net income — the profit remaining after all expenses have been paid. Company expenses generally include product acquisition, wages, advertising, taxes, and capital losses. Most corporations also include earnings per share (EPS) on their income statements.

3) Cash Flow Statement: A cash flow statement shows the net increase or decrease in a company's cash position during a given quarter. This statement is particularly important for investors assessing the financial health of a company. Firms report cash flows from three categories: operating activities (such as the sale of products and services), investing activities (such as the purchase or sale of capital equipment and property), and financing activities (such as the issuance of stocks and bonds or borrowing from a lender).

4) Statement of Stockholders' Equity: In some cases, companies prepare a separate equity statement that shows the equity of shareholders or owners at the end of a financial period. This statement includes the value of each share, plus any gains or minus any losses, as well as withdrawals from or additions to company funds on the part of owners and shareholders.