Financial Accounting Overview

Study Notes

Definition and Purpose

Financial accounting is the process of recording, classifying, summarizing, and reporting a company's financial transactions.
It aims to provide a fair and accurate picture of a company's financial position, performance, and cash flows.
These financial statements are used by investors, creditors, and other stakeholders to make informed decisions.
The key purpose is to communicate financial information to external stakeholders, not internal managers.

Key Financial Statements

Income Statement: Presents a company's revenues and expenses over a period of time, typically a quarter or a year. It results in a net income or loss.
Balance Sheet: Reports a company's assets, liabilities, and equity at a specific point in time. It adheres to the fundamental accounting equation (Assets = Liabilities + Equity).
Statement of Cash Flows: Summarizes the sources and uses of cash over a period of time. It categorizes cash flows into operating, investing, and financing activities.
Statement of Changes in Equity: Shows the changes in a company's equity during a period of time, often reflecting retained earnings, and other changes.

Accounting Principles and Standards

Generally Accepted Accounting Principles (GAAP): A set of accounting rules and standards used in the United States to prepare financial statements. These guidelines ensure consistency and comparability across companies.
International Financial Reporting Standards (IFRS): A globally recognized set of accounting standards. Companies often adopt IFRS, and these standards differ from GAAP in several areas.
Accrual accounting: Recognizes revenue when earned and expenses when incurred, regardless of when cash is exchanged. This differs from cash-based accounting.
Matching principle: Expenses are matched with the revenues they generate during the same period.

Key Concepts

Assets: Resources owned or controlled by a company that have future economic value.
Liabilities: Obligations of a company to external parties.
Equity (or Shareholders' Equity): Represents the residual interest in the assets of a company after deducting liabilities.
Revenue: Inflows of assets or settlements of liabilities from delivery of goods or services.
Expenses: Outflows of assets or incurrence of liabilities from delivering goods or services.
Duality/Double-Entry bookkeeping: Every transaction has a dual effect, increasing one account and decreasing another. This ensures that the accounting equation always remains balanced.

Accounting Cycle

Analyzing transactions: Identifying and recording business events.
Journalizing: Recording transactions in the general journal.
Posting: Transferring information from the general journal to the general ledger.
Preparing an unadjusted trial balance: Summarizing balances from general ledger accounts.
Adjusting entries: Making necessary adjustments to reflect accrual accounting principles.
Preparing an adjusted trial balance: Summarizing adjusted balances from the general ledger.
Preparing financial statements (income statement, balance sheet, statement of cash flows, and changes in equity): Reporting financial position and performance.
Closing Entries: Resetting revenue and expense accounts to zero prior to the next accounting period, summarizing their final results.
Post-closing trial balance: Ensuring the accounting equation balances after all adjustments and closing entries.

Important Considerations

Objectivity: Financial information should be free from bias and based on verifiable evidence.
Comparability: Financial statements should be comparable across different companies and different periods for meaningful analysis.
Consistency: Accounting methods should be consistently applied over time.
Materiality: Only significant items that could affect a user's decision should be accounted for; financial reporting often includes materiality level thresholds.
Conservatism: When in doubt, it's better to err on the side of caution.

Accounting Equation

The fundamental relationship in accounting is Assets = Liabilities + Equity. This equation must always balance.
This is the foundation of every accounting transaction.

Description

This quiz covers the definition, purpose, and key financial statements of financial accounting. Understand how financial information is communicated to external stakeholders and analyze the components of income statements, balance sheets, and cash flow statements.