Financial Accounting: An Overview

• Financial accounting is a specialized branch focusing on recording, summarizing, and reporting financial transactions through financial statements.
• Standardized guidelines ensure transparency and comparability for external users.
• External users include investors, creditors, regulators, and the general public.
• Financial accounting contrasts with managerial accounting, which serves internal decision-makers.

Financial Statements

• These are structured summaries of a company's financial performance and position.
• They convey information to external stakeholders.
• Core financial statements include the income statement, balance sheet, statement of cash flows, and statement of retained earnings.
• The income statement, or profit and loss (P&L) statement, reports financial performance over time.
• It details revenues, expenses, and net income or loss, with the formula: Revenues - Expenses = Net Income (or Net Loss).
• The balance sheet, or statement of financial position, presents assets, liabilities, and equity at a specific time.
• It follows the accounting equation: Assets = Liabilities + Equity.
• Assets represent what a company owns like cash, accounts receivable, inventory, and equipment.
• Liabilities represent what a company owes to others, such as accounts payable, salaries payable, and loans payable.
• Equity represents the owners’ stake, including common stock and retained earnings.
• The statement of cash flows tracks cash movement into and out of a company over time.
• Cash flows are categorized into operating, investing, and financing activities.
• Operating activities relate to normal day-to-day business operations.
• Investing activities involve purchasing and selling long-term assets like property, plant, and equipment (PP&E).
• Financing activities concern how the company is funded, covering debt and equity.
• The statement of retained earnings reconciles the beginning and ending balances of retained earnings.
• Retained earnings are accumulated profits not distributed as dividends.
• The formula is Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings.

Journal Entries

• Journal entries are initial records of financial transactions.
• They document the date, affected accounts, and debit/credit amounts.
• Each journal entry uses the double-entry accounting system, affecting at least two accounts.
• Debits increase asset, expense, and dividend accounts but decrease liability, equity, and revenue accounts.
• Credits increase liability, equity, and revenue accounts but decrease asset, expense, and dividend accounts.
• The sum of debits must equal the sum of credits to maintain the accounting equation's balance.
• A typical journal entry includes the date, account names/explanations, and debit/credit amounts.

Ledger Accounts

• Ledger accounts summarize all transactions affecting a specific asset, liability, equity, revenue, or expense.
• The general ledger is the master set of all ledger accounts for a company.
• Each ledger account typically has debit and credit sides.
• A running balance is calculated after each entry.
• Ledger accounts provide transaction history for each account, used to prepare financial statements.

Accounting Principles

• Accounting principles are the fundamental rules and concepts governing financial accounting practices.
• Generally Accepted Accounting Principles (GAAP) are the common standards, procedures, and guidelines followed in the U.S.
• The Financial Accounting Standards Board (FASB) establishes GAAP.
• International Financial Reporting Standards (IFRS) are international accounting standards used globally.
• The International Accounting Standards Board (IASB) issues IFRS.
• The historical cost principle states assets should be recorded at their original purchase price.
• The revenue recognition principle dictates when revenue should be recognized (when earned and realized or realizable).
• The matching principle requires expenses to be recognized in the same period as the revenues they helped generate.
• The full disclosure principle requires companies to disclose all relevant information that could affect users' decisions.
• The going concern assumption assumes the business will continue to operate in the foreseeable future.
• The economic entity assumption keeps business transactions separate from those of its owners.
• The monetary unit assumption requires transactions be measured in a stable monetary unit (e.g., U.S. dollars).
• The time period assumption allows companies to report financial information over specific periods (e.g., monthly, quarterly, annually).

Financial Analysis

• Financial analysis evaluates a company's financial performance and position using financial statements and related data.
• Ratio analysis involves calculating and interpreting financial ratios.
• Liquidity ratios measure a company’s ability to meet short-term obligations (e.g., current ratio, quick ratio).
• Solvency ratios measure a company’s ability to meet long-term obligations (e.g., debt-to-equity ratio, times interest earned ratio).
• Profitability ratios measure a company’s ability to generate profits (e.g., gross profit margin, net profit margin, return on equity).
• Efficiency ratios measure how efficiently a company uses its assets to generate sales (e.g., inventory turnover ratio, accounts receivable turnover ratio).
• Trend analysis involves analyzing financial data over time to identify patterns.
• Common-size analysis involves expressing financial statement items as a percentage of a base amount (e.g., total assets for balance sheet items, net sales for income statement items).
• This allows for comparison of companies of different sizes.
• Financial analysis helps investors, creditors, and stakeholders make informed decisions about a company.