Financial Accounting: Principles and Statements

• Financial accounting focuses on providing financial information to external users
• External users include investors, creditors, regulators, and the general public

Purpose of Financial Accounting

• The primary aim is to generate standardized financial statements
• These statements should accurately reflect a company's financial situation and performance
• The statements must comply with Generally Accepted Accounting Principles (GAAP)

Key Financial Statements

• Balance Sheet: Details a company's assets, liabilities, and equity at a specific time, based on (Assets = Liabilities + Equity)
• Income Statement: Summarizes a company's revenues, expenses, and calculates net income (or net loss) over a reporting period
• Statement of Cash Flows: Tracks cash movement, both inflows and outflows, categorized into operating, investing, and financing activities
• Statement of Retained Earnings (or Statement of Changes in Equity): Tracks changes in a company's retained earnings (or overall equity) over a period

Generally Accepted Accounting Principles (GAAP)

• GAAP comprises a standard set of accounting rules, standards, and procedures that companies follow for financial statements
• GAAP enhances the clarity, consistency, and comparability of financial information

Core Principles of GAAP

• Historical Cost Principle: Assets are recorded at their original cost, not market value
• Revenue Recognition Principle: Revenue is recognized when earned and realizable, not solely upon cash receipt
• Matching Principle: This dictates that expenses are recognized in the same period as the related revenues
• Full Disclosure Principle: All relevant information affecting users' decisions must be disclosed

Accounting Equation

• This is the base of the balance sheet; 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

Accrual Accounting vs. Cash Accounting

• Accrual Accounting: Revenue is recognized when earned, and expenses when incurred, irrespective of cash flow; required under GAAP
• Cash Accounting: Revenue is recognized when cash is received, and expenses when cash is paid; generally not permitted under GAAP

Key Financial Ratios

• Profitability Ratios: Measure a company's ability to generate profits; examples include gross profit margin, net profit margin, and return on equity
• Liquidity Ratios: Assess a company's ability to meet short-term obligations with ratios like the current ratio and quick ratio
• Solvency Ratios: These gauge a company's ability to meet long-term obligations using the debt-to-equity ratio
• Efficiency Ratios: These measure how well a company utilizes assets; examples are the inventory turnover ratio and accounts receivable turnover ratio

The Accounting Cycle

• Companies use this series of steps to record, classify, and summarize accounting data for financial statements
• Analyzing transactions
  • Journalizing transactions
  • Posting to the general ledger
  • Preparing a trial balance
  • Making adjusting entries
  • Preparing an adjusted trial balance
  • Preparing financial statements
  • Closing the books

Debits and Credits

• The basics of double-entry bookkeeping
• Debits increase assets, expenses, and dividends, while decreasing liabilities, equity, and revenue
• Credits increase liabilities, equity, and revenue, while decreasing assets, expenses, and dividends
• The accounting equation must always be balanced; total debits must equal total credits in any transaction

Depreciation

• This process allocates the cost of a tangible asset over its useful life
• Common methods are straight-line, declining balance, and units of production

Inventory Valuation Methods

• Determines the cost of goods sold and ending inventory value
• Common methods are FIFO (First-In, First-Out), LIFO (Last-In, First-Out), and weighted-average cost

Internal Controls

• Policies and procedures ensuring the achievement of company objectives
• Objectives include:
  • Reliability of financial reporting
  • Effectiveness and efficiency of operations
  • Compliance with laws and regulations

Role of the Securities and Exchange Commission (SEC)

• The SEC is a U.S. agency overseeing accounting and financial reporting for publicly traded companies
• It can set accounting standards but typically relies on the Financial Accounting Standards Board (FASB)

Financial Accounting Standards Board (FASB)

• The primary standard-setting body in the U.S.
• FASB establishes and improves GAAP

International Financial Reporting Standards (IFRS)

• A set of global accounting standards
• They are maintained by the International Accounting Standards Board (IASB)
• While GAAP dominates in the U.S., IFRS has growing global usage

Differences Between GAAP and IFRS

• GAAP is more rules-based with specific transaction guidance
• IFRS is more principles-based, emphasizing broader concepts/professional judgment

Fair Value Accounting

• Assets and liabilities are recorded at their current market value
• Fair value is used when reliable market prices exist

Contingencies

• Events with uncertain outcomes that can financially impact a company
• They are disclosed when probable and reasonably estimable

Related Party Transactions

• These are transactions involving a company, its owners, management, and other related entities
• They require specific financial statement disclosure

Earnings Management

• It involves using financial reporting judgment to alter financial results
• Tactics range from aggressive to fraudulent reporting

Sarbanes-Oxley Act (SOX)

• SOX was enacted in response to accounting scandals
• SOX increased corporate management/board responsibilities and enhanced internal controls
• SOX created the Public Company Accounting Oversight Board (PCAOB)

Analysis of Financial Statements

• This uses ratios and techniques to evaluate a company's financial performance and condition
• It helps compare performance across periods or against other companies

Importance of Ethics in Financial Accounting

• Ethical conduct maintains the integrity and reliability of financial data
• Accountants must follow a code of ethics to ensure objectivity and trustworthiness