Financial Accounting Framework: Chapter 1 Study Notes

Financial Accounting Framework

Introduction to Accounting

Accounting is the language of business, used by companies to communicate their financial story to various stakeholders. It involves recording, classifying, and summarizing business transactions to provide useful information for decision-making.

• Definition: Accounting is the systematic process of measuring and communicating financial information about economic entities.

• Example: Eagle Soccer Academy raises funds, invests in equipment, and distributes earnings, illustrating the flow of financial resources and the need for accounting.

Business Structures

Businesses can be organized in different legal forms, each with distinct characteristics and implications for accounting.

• Corporation: Legally separate from its owners (stockholders/shareholders). Offers limited liability and is managed by a board of directors and executives.

• Partnership: Owned by two or more persons, with shared responsibilities and liabilities.

• Sole Proprietorship: Owned and operated by one individual, with personal liability for business debts.

Types of Accounting

Accounting can be classified based on its purpose and users.

• Financial Accounting: Focuses on external users and the preparation of financial statements.

• Managerial Accounting: Provides information for internal decision-making.

• Tax Accounting: Relates to tax reporting and compliance.

• Regulatory Accounting: Fulfills regulatory requirements.

Financial Accounting Process

Measurement

Measurement in accounting involves converting business activities and transactions into numerical information, typically in a unit of currency. This process is guided by principles to ensure consistency and reliability.

• Measurement Categories: Assets, liabilities, stockholders' equity, revenues, expenses.

• Measurement Principles:

  • Accrual-Basis Accounting: Revenues and expenses are recorded when earned/incurred, not when cash is received/paid.

  • Conservatism: Recognize expenses and liabilities as soon as possible when uncertainty exists; recognize revenues only when assured.

  • Valuation: Assets and liabilities are recorded at historical cost or fair value.

Key Equations

• Basic Accounting Equation: $\text{Assets} = \text{Liabilities} + \text{Stockholders' Equity}$

• Expanded Accounting Equation: $\text{Stockholders' Equity} = \text{Stock} + \text{Retained Earnings}$

• Net Income: $\text{Net Income} = \text{Revenues} - \text{Expenses}$

Categories of Accounts

Accounts are used to classify and measure business activities.

• Assets: Resources owned by the company (e.g., cash, equipment).

• Liabilities: Amounts owed to creditors.

• Stockholders' Equity: Owners' claims to resources.

• Revenues: Earnings from providing goods/services.

• Expenses: Costs incurred to generate revenues.

• Net Income/Loss: Difference between revenues and expenses.

• Dividends: Distributions to shareholders (not an expense).

• Retained Earnings: Earnings retained in the company for future use.

Communication

Financial Reports and Statements

Financial accounting information is communicated to external users through financial reports, which include financial statements and other components.

• Balance Sheet: Presents the financial position at a specific date. $\text{Assets} = \text{Liabilities} + \text{Stockholders' Equity}$

• Income Statement: Reports financial performance over a period. $\text{Net Income} = \text{Revenues} - \text{Expenses}$

• Statement of Stockholders' Equity: Details changes in equity over time. $\text{Stockholders' Equity} = \Delta \text{Stock} + \Delta \text{Retained Earnings}$

• Statement of Cash Flows: Details changes in cash by business activities. $\Delta \text{Cash} = \text{Operating Cash Flows} + \text{Investing Cash Flows} + \text{Financing Cash Flows}$

Other Components

• Notes to Financial Statements: Provide additional explanations and information.

• Management Discussion and Analysis (MD&A): Management's views on financial results and future outlook.

Links Among Financial Statements

Financial statements are interconnected. For example, net income from the income statement affects retained earnings in the statement of stockholders' equity, which in turn impacts the balance sheet. The statement of cash flows explains changes in cash on the balance sheet.

Financial Accounting Standards

GAAP and IFRS

Financial accounting standards ensure consistency and comparability of financial information.

• US GAAP: Used in the USA, established by the FASB.

• IFRS: Used internationally, established by the IASB.

• Singapore: Adopts IFRS as SFRS, enforced by ACRA.

Both GAAP and IFRS are similar but have key differences. Standards are available online for reference.

Conceptual Framework

Standard setters use a conceptual framework to develop consistent financial reporting rules. Useful financial information must possess certain qualitative characteristics.

• Fundamental Characteristics: Relevance, Faithful Representation

• Enhancing Characteristics: Comparability, Verifiability, Timeliness, Understandability

• Cost Effectiveness: Benefits of information should outweigh the costs.

Qualitative Characteristics Table

Characteristic	Description
Relevance	Information must be capable of making a difference in decisions.
Faithful Representation	Information must be complete, neutral, and free from error.
Comparability	Users can compare information across companies and periods.
Verifiability	Information can be verified by independent parties.
Timeliness	Information is available when needed for decision-making.
Understandability	Information is clear and comprehensible to users.

Assumptions Underlying GAAP

• Economic Entity: Distinguish company activities from owners.

• Monetary Unit: Use a stable currency for measurement.

• Periodicity: Divide business life into time periods for reporting.

• Going Concern: Assume the business will continue operating indefinitely.

Auditors

Role of Auditors

Auditors are independent professionals who express an opinion on whether financial statements are prepared in compliance with GAAP and are free of material misstatement.

• Main Roles:

  • Ensure management has appropriately applied GAAP.

  • Add credibility to financial statements for users.

Role of Accounting in Decision-Making

Decision-Making Support

Accounting supports decision-making by measuring economic activity and communicating useful information to investors, creditors, and other stakeholders. It requires judgment and critical thinking.

• Example: Changes in net income can explain changes in stock prices. High levels of debt may indicate increased bankruptcy risk.

Financial Statement Analysis

Analysis and Ratios

Financial statement analysis evaluates a company's performance and position using comparisons and ratios. Ratios are most useful when compared to benchmarks.

• Example: $10M net income may be good or bad depending on the level of shareholders' equity.

Quick Review Questions

• Resources of a company are referred to as assets.

• Amounts recorded when selling products/services are revenues.

• Dividends are not an expense; net income = revenues - expenses.

• Accrual-basis accounting records revenues when earned, not when cash is received.

*Additional info: These notes expand on the original slides and text, providing definitions, examples, and academic context for key financial accounting concepts.*