Financial Accounting Study Notes: Chapters 1–3 (Financial Statements, Transaction Analysis, Accrual Accounting & Income)

Chapter 1: The Financial Statements

Introduction to Accounting and Financial Statements

Accounting is an information system that measures business activities, processes data into financial statements and reports, and communicates results to decision makers. Financial statements are essential tools for internal and external users to assess a company's financial health and make informed decisions.

• Definition: Accounting provides information for decision making by various stakeholders.

• Users: Internal (managers, employees) and external (investors, creditors, government agencies).

• Regulatory Bodies: SEC (Securities and Exchange Commission), FASB (Financial Accounting Standards Board), IASB (International Accounting Standards Board).

Types of Business Organizations

• Proprietorship: Owned by one individual; easy to form; owner has unlimited liability.

• Partnership: Owned by two or more individuals; partners share profits and liabilities.

• Corporation: Separate legal entity; owners (shareholders) have limited liability; can raise capital by issuing stock.

• Limited Liability Company (LLC): Combines benefits of partnership and corporation.

Understanding Accounting Concepts, Assumptions, and Principles

• GAAP (Generally Accepted Accounting Principles): Standardized guidelines for financial reporting in the U.S.

• IFRS (International Financial Reporting Standards): Global standards issued by the IASB.

• Key Principles: Entity, historical cost, continuity (going concern), reliability, comparability.

Fundamental Qualities of Accounting Information

• Relevance: Information must be useful for decision making.

• Reliability: Information must be accurate and verifiable.

• Comparability: Enables users to compare financial statements across periods and entities.

The Accounting Equation

The accounting equation forms the basis of all accounting:

• Assets = Liabilities + Owner's (Stockholders') Equity

This equation must always be in balance and is the foundation for preparing financial statements.

Elements of Financial Statements

• Assets: Resources owned by a business expected to provide future benefits.

• Liabilities: Obligations owed to outsiders (creditors).

• Equity: Owner's claim on assets after liabilities are paid.

• Revenue: Inflows from delivering goods/services.

• Expenses: Outflows from using resources to generate revenue.

Constructing Financial Statements

Financial statements summarize a company's financial position and performance:

• Income Statement: Reports revenues and expenses for a period.

• Statement of Retained Earnings: Shows changes in retained earnings.

• Balance Sheet: Reports assets, liabilities, and equity at a specific date.

• Statement of Cash Flows: Summarizes cash inflows and outflows from operating, investing, and financing activities.

Example: Income Statement Equation

• $\text{Net Income} = \text{Total Revenue} - \text{Total Expenses}$

Example: Balance Sheet Equation

• $\text{Assets} = \text{Liabilities} + \text{Stockholders' Equity}$

Classification of Assets and Liabilities

• Current Assets: Expected to be converted to cash or used within one year (e.g., cash, accounts receivable, inventory).

• Long-Term Assets: Held for more than one year (e.g., property, plant, equipment).

• Current Liabilities: Obligations due within one year (e.g., accounts payable, short-term loans).

• Long-Term Liabilities: Obligations due after one year (e.g., bonds payable, long-term loans).

HTML Table: Example Balance Sheet Classification

Current Assets	Long-Term Assets	Current Liabilities	Long-Term Liabilities
Cash	Equipment	Accounts Payable	Bonds Payable
Accounts Receivable	Land	Short-term Loans	Long-term Loans
Inventory	Buildings	Accrued Expenses	Mortgage Payable

Evaluating Business Performance

• Liquidity: Ability to meet short-term obligations.

• Solvency: Ability to meet long-term obligations.

• Profitability: Ability to generate income.

Ethical Considerations in Accounting

• Follow professional codes of conduct (e.g., AICPA).

• Consider honesty, fairness, and impact on stakeholders.

Chapter 2: Transaction Analysis

The Accounting Cycle

The accounting cycle is a series of steps to record and process financial transactions:

1. Analyze transactions

2. Journalize transactions

3. Post journal entries to ledger accounts

4. Prepare trial balance

5. Adjust entries

6. Prepare adjusted trial balance

7. Prepare financial statements

8. Close temporary accounts

Recognizing Business Transactions

• Transactions affect the accounting equation and must be recorded reliably.

• Each transaction impacts at least two accounts (double-entry system).

Types of Accounts

• Asset Accounts: Cash, accounts receivable, inventory, equipment.

• Liability Accounts: Accounts payable, notes payable, accrued expenses.

• Equity Accounts: Common stock, retained earnings.

• Revenue Accounts: Sales, service revenue.

• Expense Accounts: Rent, salaries, utilities.

Analyzing the Impact of Transactions

• Every transaction must keep the accounting equation in balance.

• Debits and credits are used to record increases and decreases in accounts.

HTML Table: Rules of Debit and Credit

Account Type	Increase by	Decrease by
Assets	Debit	Credit
Liabilities	Credit	Debit
Equity	Credit	Debit
Revenue	Credit	Debit
Expenses	Debit	Credit

Journalizing Transactions

• Specify accounts affected and classify by type.

• Determine whether each account is increased or decreased.

• Record transactions in the journal using debits and credits.

Posting to the Ledger and Preparing Trial Balance

• Ledger: Collection of all accounts and their balances.

• Trial Balance: List of all accounts with their balances; used to prepare financial statements.

Correcting Accounting Errors

• Search for missing or incorrect entries by tracing transactions from journal to ledger.

• Common errors include transposition and incorrect account classification.

Chapter 3: Accrual Accounting & Income

Accrual vs. Cash Accounting

Accrual accounting records revenues and expenses when they are earned or incurred, regardless of when cash is received or paid. Cash accounting records only transactions involving cash.

• Accrual Accounting: Provides a more accurate picture of financial position.

• Cash Accounting: May misstate income and expenses.

Revenue and Expense Recognition Principles

• Revenue Recognition: Revenue is recorded when earned, not when cash is received.

• Expense Recognition (Matching Principle): Expenses are recorded when incurred, matched to related revenues.

Adjusting the Accounts

• Adjusting entries are made at the end of an accounting period to update account balances.

• Types include prepaid expenses, accrued expenses, depreciation, and unearned revenue.

Depreciation Formula (Straight-Line Method)

• $\text{Depreciation Expense} = \frac{\text{Asset Cost} - \text{Salvage Value}}{\text{Useful Life in Years}}$

Net Book Value Formula

• $\text{Net Book Value} = \text{Cost} - \text{Accumulated Depreciation}$

Closing the Books

• Temporary accounts (revenues, expenses, dividends) are closed to retained earnings at period end.

• Permanent accounts (assets, liabilities, equity) carry balances into the next period.

Classifying Assets and Liabilities

• Assets and liabilities are classified as current or long-term on the balance sheet.

• Current assets/liabilities: Expected to be used or paid within one year.

• Long-term assets/liabilities: Held or owed for more than one year.

Evaluating Debt-Paying Ability

• Net Working Capital: $\text{Net Working Capital} = \text{Total Current Assets} - \text{Total Current Liabilities}$

• Current Ratio: $\text{Current Ratio} = \frac{\text{Total Current Assets}}{\text{Total Current Liabilities}}$

• These ratios measure a company's liquidity and ability to pay short-term obligations.

HTML Table: Debt-Paying Ability Ratios

Ratio	Formula	Purpose
Net Working Capital	Total Current Assets - Total Current Liabilities	Measures liquidity
Current Ratio	Total Current Assets / Total Current Liabilities	Measures ability to pay short-term debts

Summary

• Financial accounting provides essential information for decision making.

• Understanding the accounting cycle, financial statements, and accrual principles is fundamental.

• Proper classification and analysis of transactions ensure accurate financial reporting.

Additional info: These notes expand on brief points from the original file, providing definitions, formulas, and examples for clarity and completeness.