Double-Entry Bookkeeping
The first standardization accountants follow in financial accounting is to use double-entry bookkeeping. Double-entry bookkeeping is a system whereby each transaction creates two (double) entries. For example, if a business pays $1,000 in cash for rent, the accountant adds $1,000 to a rent account and subtracts $1,000 from the cash account.
Accountants enter those entries on what we call T accounts. There is a T account for rent and one for cash. On the left side of the T account are debit entries and on the right side of the T account are credit entries. Some accounts increase with a debit, while some decrease with a credit and vice versa.
GAAP, FASB, & SEC
Mr. Wade points to a poster on his classroom wall that shows the acronym GAAP. He asks Juan if he knows what the acronym represents. GAAP refers to Generally Accepted Accounting Principles, which are standards publicly traded companies must follow to report financial data.
The Financial Accounting Standards Board (FASB) established GAAP and makes continual revisions. FASB is a non-profit organization comprised of seven main board members. They, along with their staff, establish standards in reporting to increase confidence in the financials of companies for lenders, investors, and other external users.
Companies are categorized as privately or publicly owned. Privately held companies seek financing through loans, donations, and private investments when they want to expand and grow. They do not necessarily follow a set of standards in reporting. However, companies who seek financing from the public are required to follow GAAP to provide a level of confidence in the reported information.
When a company has maximized their ability to borrow money and seek private investments, they turn to the public by offering stock. Stock represents a portion of company ownership. Investors purchase stock with cash and the company uses the cash for expansion and growth initiatives.
To ensure investor confidence and protection in trading stock, the Securities and Exchange Commission (SEC) regulates the purchase and sale of stocks. While the SEC ensures laws are enforced, they do not guarantee profitable investments.
Mr. Wade asks Juan if he knows why these principles are important to external users. Juan says external users include lenders, investors, and suppliers. They rely on the financial accounting reports to make important decisions on loaning money or investing in the company.
Financial Statements
Mr. Wade explains that after consolidating all the transactions based on GAAP, the transactions are created into four main financial statements: balance sheet, income statement, the statement of cash flow, and statement of owner's equity. These statements are also called financial accounting statements.
The balance sheet shows the company's worth, while the income statement shows profit. The statement of cash flow provides a solid picture of how the company reports cash, incoming and outgoing. Lastly, the statement of owner's equity shows changes in the owner's investment.
Lesson Summary
Financial accounting differs from managerial accounting. Financial accounting provides external users with information to make important decisions. If the company is publicly held, they must follow GAAP, or standards in reporting financial data. The FASB also provides another level of protection and confidence for investors. The Securities and Exchange Commission enforces the purchase and sale of stocks. Based on the guidelines from GAAP and the SEC, companies construct financial statements to help external users make informed decisions.
