Study guide: Financial Accounting Fundamentals

📋 Course Outline

1. Purpose and Users of Accounting
2. Accounting Principles and Reporting
3. Business Entities and Ownership
4. Financial Statements
5. Balance Sheet and Accounting Equation
6. Transactions and Equity Changes
7. Asset Recognition and Classification
8. Liability and Equity Classification
9. Revenue, Expenses, and Net Income

📖 1. Purpose and Users of Accounting

🔑 Key Concepts & Definitions

• Accounting: The process of identifying, measuring, and communicating financial information about an entity to permit informed judgements and decisions by users.

★ Must-know

• Accounting links decision makers with economic activities and with the results of their decisions.

• Accounting provides information about:

  • profitability
  • financial position
  • cash flows

Further detail

• Accounting information users include:

  • investors
  • creditors
  • managers
  • owners
  • customers
  • employees
  • regulators

• Accounting information supports:

  • performance evaluations
  • stock investments
  • tax strategies
  • resource allocations
  • lending decisions
  • borrowing decisions

📖 2. Accounting Principles and Reporting

🔑 Key Concepts & Definitions

• Conceptual framework: A statement of principles that provides generally accepted guidance for developing new reporting practices and challenging or evaluating existing practices.
• Fair value: The amount for which an asset could be exchanged.

★ Must-know

• External reporting, also called financial accounting, reports to people who are not part of the day-to-day running of a business.

• Internal reporting, also called management accounting, uses special techniques for people managing a business on a day-to-day basis.

Further detail

• The listed accounting principles are:

  • going concern
  • accruals or matching
  • consistency
  • prudence
  • fair value
  • true and fair view

• External reporting discloses or involves:

  • income statement
  • statement of cash flows
  • balance sheet
  • Generally Accepted Accounting Principles (GAAP)
  • Financial Accounting Standards Board
  • Securities and Exchange Commission
  • internal control
  • audits

💡 Memory Hook

External reporting serves outsiders; internal reporting serves day-to-day managers.

📖 3. Business Entities and Ownership

🔑 Key Concepts & Definitions

• Business entity: Separate from the personal affairs of its owner.

★ Must-know

📌 A corporation is a limited company whose owners have limited liability, but the company faces obligations governing how it conducts its affairs.

Further detail

📌 A sole trader has one owner and is easy to set up and flexible to operate, but the owner has unlimited liability.

📌 A partnership has several owners, is easy to set up and spreads the burdens of ownership, but partners usually have unlimited liability and face ownership risks if partners are unsuitable.

💡 Memory Hook

Sole traders and partners face unlimited liability; corporation owners have limited liability.

📖 4. Financial Statements

🔑 Key Concepts & Definitions

• Balance sheet: Lists assets, liabilities, and owners’ equity at a specific date, usually the end of a month or year.
• Income statement: Summarizes revenue and expenses for a specific period, such as a month or a year.
• Statement of cash flows: Depicts how cash changed during a designated period.

📝 Essential Points

• Net income or net loss is the difference between revenues and expenses.

💡 Memory Hook

See the balance sheet as a snapshot and the income statement as a video of a period.

📖 5. Balance Sheet and Accounting Equation

🔑 Key Concepts & Definitions

• Asset: An economic resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
• Liability: A present obligation of the entity arising from past events, whose settlement is expected to result in an outflow of resources embodying economic benefits.
• Owners’ equity: The owners’ claim against the business’s assets and the residual amount after deducting all entity liabilities from all entity assets.
• Liquidity: Measures how quickly an item can be converted to cash.

★ Must-know

📐 Formula - The accounting equation is $\text{Assets} - \text{Liabilities} = \text{Owners' Equity}$.

Further detail

• A balance sheet presents assets as uses of funds and liabilities plus owners’ equity as sources of funds.

• The balance sheet lists assets in relative order of liquidity and liabilities in the order in which they are due.

📖 6. Transactions and Equity Changes

📝 Essential Points

• When Jill Jones and her family invested $8,000 in JJ’s Lawn Care Service for 800 shares on May 1, N, cash and capital stock each increased by $8,000.

• On May 2, JJ’s bought a riding mower for $2,500 cash, exchanging cash for tools and equipment without changing total assets.

• On May 8, JJ’s purchased a $15,000 truck by paying $2,000 cash and issuing a $13,000 note payable.

• On May 11, JJ’s purchased $300 of repair parts on account, increasing tools and equipment and accounts payable by $300.

• On May 18, JJ’s sold half of its repair parts to ABC Lawns for $150, equal to cost, to be received within 30 days, recording accounts receivable and reducing tools and equipment by $150.

• On May 25, ABC Lawns paid $75 as a partial settlement of its accounts receivable, increasing cash and reducing accounts receivable by $75.

• On May 28, JJ’s paid $150 of accounts payable, reducing cash and accounts payable by $150.

• On May 28, JJ’s had assets of $21,150, liabilities of $13,150, and book value of $8,000.

💡 Memory Hook

Investment, purchases, credit transactions, collections, and payments change the balance sheet.

📖 7. Asset Recognition and Classification

🔑 Key Concepts & Definitions

• Depreciation: The allocation of an asset’s cost to expense in the periods in which services are received from the asset.

★ Must-know

📌 An item is recognised as an asset only if future economic benefits are probable and its cost or value can be measured reliably.

📌 Current assets are cash or other assets expected to be converted into cash within the trading cycle, whereas fixed assets are retained to provide services to the business rather than for resale.

Further detail

• Examples considered in asset recognition are:

  • land and buildings
  • workforce
  • raw materials
  • advertising campaign

• Current asset categories include:

  • inventories: raw materials, work-in-progress, and finished goods
  • debtors: accounts receivable and prepayments
  • short-term investments
  • cash at bank

• Fixed asset categories include: intangible assets such as patents, trademarks, and brand name, tangible assets such as land, buildings, tools, and equipment, long-term investments in other companies

• When a company owns more than 50% of another company, the subsidiary’s accounts are consolidated with the parent company’s accounts.

💡 Memory Hook

Recognise measurable resources with probable benefits; do not recognise uncertain benefits without evidence.

📖 8. Liability and Equity Classification

🔑 Key Concepts & Definitions

• Provision: Sets aside funds for a future event likely to occur when the precise amount or timing is uncertain, such as division-closure costs or product-warranty repair costs.
• Retained earnings: The corporation’s total net income over its lifetime less amounts distributed to stockholders as dividends.

★ Must-know

📌 Current liabilities are expected to be repaid within a short period, usually within one year or the business’s operating cycle, whereas long-term or non-current liabilities are expected to be repaid after one year.

Further detail

• Current liability examples include creditors such as accounts payable and bank overdrafts.

• Long-term liability examples include long-term loans and provisions for likely future events whose precise cost or timing is uncertain.

• Owners’ equity comprises the original share capital invested by owners and the business’s cumulative retained earnings.

💡 Memory Hook

Current obligations are due within the operating cycle; non-current obligations are generally due after one year.

📖 9. Revenue, Expenses, and Net Income

🔑 Key Concepts & Definitions

• Revenue: The price for goods sold and services rendered during an accounting period that increases owners’ equity.
• Expense: The cost of goods and services used up in earning revenue that decreases owners’ equity.

★ Must-know

• Net income increases owners’ equity through business profits and is not itself an asset.

Further detail

• JJ’s earned $750 of lawn-care service revenue and incurred $50 of gasoline expense in May, producing net income of $700.

• JJ’s net income for May 2021 was $700, increasing the owners’ equity from its May 28 book value of $8,000 to $8,700.

💡 Memory Hook

Revenue increases equity, expenses decrease equity, and their difference is net income.