Financial Accounting Overview and Module Summary

Introduction to Financial Accounting

1. Understanding Terminology: Essential for grasping concepts in financial statements.
2. Six Key Terms: Assets, Liabilities, Shareholders' Equity, Revenues, Expenses, Dividends.

Key Concepts

Assets

• Common Student Assets: Cell phones, textbooks, cars.
• General Definition: Anything of value owned or controlled providing future economic benefit.
• Measurement: Reliable valuation (e.g., cars, phones with known prices).
• Examples on Financial Statements: Cash, accounts receivable, inventory, property, plant, equipment (PPE).

Liabilities

• Definition: Future obligations (e.g., student loans, phone bills, mortgages).
• Common Liabilities: Accounts payable, notes payable, wages payable.

Shareholders' Equity

• Explanation: The leftover value after liabilities are subtracted from assets.
• Example Concept: Home equity (house value minus the mortgage).
• Related Formula: Assets = Liabilities + Shareholders' Equity.
• Key Accounts: Common shares, preferred shares, retained earnings.

Revenues, Expenses, and Dividends

• Revenues: Earned from business operations (e.g., sales revenue).
• Expenses: Costs incurred to earn revenue (e.g., salary expenses).
• Dividends: Earnings distributed to shareholders, impacting retained earnings.

Financial Statements

Income Statement

• Purpose: Summarizes revenues and expenses to determine profit or loss.
• Formula: Revenues - Expenses = Net Income.
• Other Names: Statement of Operations, Profit and Loss (P&L) Statement.

Statement of Changes in Equity

• Purpose: Tracks changes in equity accounts (common shares, retained earnings).
• Format: Beginning balance + Net Income - Dividends = Ending balance.

Balance Sheet

• Purpose: Lists assets, liabilities, equity showing financial position.
• Formula: Assets = Liabilities + Shareholders' Equity.

Cash Flow Statement

• Focus: Cash activities showing inflows and outflows (operating, investing, financing).
• Importance: Highlights liquidity and solvency, necessary for survival.
• Example: Cash flows from investing show purchase and sale of long-term assets.

Adjusting Journal Entries

• Necessity: Adjust for accurate financial reporting at period end.
• Types: Prepaid expenses, depreciation, accrued expenses/revenues, unearned revenues.

Prepaid Expenses

• Initial Entry: Debit prepaid expense account, credit cash/account payable.
• Adjustment Entry: Debit actual expense account, credit prepaid expense account.

Depreciation

• Entry: Debit depreciation expense, credit accumulated depreciation.
• Purpose: Adjusts asset value over useful life.

Accrued Expenses

• Definition: Expenses incurred but not yet paid or recorded.
• Entry: Debit expense, credit payable.

Accrued Revenues

• Definition: Revenues earned but not yet received in cash or recorded.
• Entry: Debit receivable, credit revenue.

Unearned Revenues

• Definition: Money received but services not yet rendered.
• Entry: Debit unearned revenue, credit actual revenue when earned.

Journal Entries and Ledgers

Importance and Practice

• Record Transactions: Reflect company’s financial activities accurately.
• Example Transactions: Purchase/sell assets, accrue expenses, record revenues.
• Goals: Understand debits/credits, prepare accurate T-accounts and trial balances.

Financial Statement Example

Income Statement Preparation

• Components: Revenues, expenses, and profit/loss determination.
• Income Statement Goal: Show net income after all expenses.

Balance Sheet Preparation

• Components: Assets, liabilities, equity to show financial position.
• Preparation: Summarize all accounts, ensure balance (Assets = Liabilities + Equity).

Cash and Internal Controls

Bank Reconciliation

• Purpose: Ensure cash records match with bank statements.
• Process: Adjust for outstanding checks, deposits in transit, bank/service errors.
• Example: Identify discrepancies, correct errors, ensure accurate cash balance.

Receivables and Collection

Accounting for Uncollectible Accounts

• Challenge: Some customers do not pay; estimate and account for bad debts.
• Methods: Percentage of Sales, Aging of Receivables.
• Bad Debt Expense: Recorded to match sales in current period with related expenses.

Example

• Percentage of Sales Method: Calculate bad debts as a percentage of credit sales.
• Aging of Receivables Method: Estimate uncollectible accounts based on age.

Inventory Accounting

Inventory Purchase and Sales

• Process: Purchase (debit inventory, credit payable), sale (record revenue, COGS).
• Discounts/Returns: Adjust inventory and payable/accounts receivable balances accordingly.
• Example: Record transactions reflecting purchases, sales, returns, discounts.

Inventory Costing Methods

• FIFO: First-In-First-Out, sell oldest inventory first, ending inventory at recent costs.
• LIFO: Last-In-First-Out, sell newest inventory first, ending inventory at older costs.
• Weighted Average: Average cost of units available for sale.

Depreciating Assets

Methods of Depreciation

• Straight Line: Equal depreciation each year.
• Units of Production: Depreciate based on usage (e.g., miles driven for vehicles).
• Double Declining Balance: Accelerated depreciation, more in early years.

Example

• Calculations and Adjustments: For accurate presentation of asset value, expense.

Liabilities and Bonds

Overview

• Known vs. Estimated: Loans (known), warranties/estimates (uncertain liabilities).
• Bond Issuance and Accounting: At premium, discount, and related amortization.
• Effective Interest Rate Method: Used to account for bond-related expenses.

Shareholders' Equity

Components

• Common Shares, Preferred Shares: Common for growth, preferred for stability/dividends.
• Stock Dividends: Issuing shares instead of paying cash dividends.
• Changes in Equity: Track through statement of changes in equity.

Statement of Cash Flows

Importance

• Vital for Investors: Cash flow movements provide insight into company's liquidity.
• Sections: Operating, Investing, Financing activities with direct/indirect method for operating.

Examples

• Direct Method: Actual cash collections/payments from operations.
• Indirect Method: Adjust net income for non-cash transactions like depreciation.

Financial Ratios

Purpose

• Analyze Company: Efficiency, profitability, liquidity, and market performance.
• Uses: Compare with industry benchmarks, historical performance.

Key Ratios

• Liquidity: Current ratio, acid test ratio.
• Turnover: Inventory turnover, receivables turnover.
• Debt: Debt ratio, times interest earned
• Profitability: Gross profit margin, return on sales/assets/equity.
• Market Performance: Price/Earnings ratio, dividend yield.

Example Analysis

• Horizontal Analysis: Year-over-year comparison of financial data.
• Vertical Analysis: Common-size financial statements for intra-company and competitive comparisons.
• Ratio Analysis: Interpret company performance, financial health.