Financial Accounting

1. Accounting: The Language of Business

To be good at your business, you have to know the numbers—cold.

Essential Activities. Accounting is the financial information system that identifies, records, and communicates the economic events of an organization to interested users. This involves:

• Identifying relevant economic events
• Recording events systematically and chronologically in monetary units
• Communicating information through financial statements

Users of Accounting Data. Both internal and external users rely on accounting data. Internal users, such as managers, use it for planning, organizing, and running the business. External users, like investors and creditors, use it to make informed decisions about investing or lending.

Analysis and Interpretation. A vital element in communicating economic events is the accountant’s ability to analyze and interpret the reported information. Analysis involves use of ratios, percentages, graphs, and charts to highlight significant financial trends and relationships. Interpretation involves explaining the uses, meaning, and limitations of reported data.

2. Ethical Conduct: The Bedrock of Financial Reporting

Repeated disclosures about questionable accounting practices have bruised investors’ faith in the reliability of earnings reports, which in turn has sent share prices tumbling.

Ethical Imperative. Ethical behavior is fundamental to effective financial reporting. Without it, information lacks credibility, and the entire economic system suffers. Recent financial scandals have underscored the importance of ethical conduct in maintaining investor trust.

Analyzing Ethical Dilemmas. When faced with ethical dilemmas, it is useful to:

• Recognize the ethical situation and the issues involved
• Identify and analyze the principal elements in the situation
• Identify alternatives and weigh the impact of each on stakeholders
• Select the most ethical alternative, considering all consequences

Ethical Considerations. Effective financial reporting depends on sound ethical behavior. To sensitize you to ethical situations in business and to give you practice at solving ethical dilemmas, we address ethics in a number of ways in this textbook.

3. The Accounting Equation: Foundation of Financial Position

Assets ⫽ Liabilities ⫹ Equity

Core Relationship. The accounting equation (Assets = Liabilities + Equity) is the cornerstone of accounting. It reflects the fundamental relationship between what a business owns (assets) and what it owes to others (liabilities) and to its owners (equity).

Components Defined.

• Assets are resources a business owns, providing future services or benefits.
• Liabilities are claims against assets, representing existing debts and obligations.
• Equity is the ownership claim on total assets, often referred to as residual equity.

Equity's Components. Equity is further divided into share capital—ordinary (amounts paid in by shareholders) and retained earnings (accumulated profits not distributed as dividends). Retained earnings are influenced by revenues (increases in equity), expenses (decreases in equity), and dividends (distributions to shareholders).

4. Transaction Analysis: Decoding Business Activities

Each transaction must have a dual effect on the accounting equation.

Economic Events. Transactions are a business's economic events recorded by accountants. They can be external (between the company and an outside entity) or internal (occurring entirely within the company).

Dual Effect. Every transaction must have a dual effect on the accounting equation, ensuring that assets always equal the sum of liabilities and equity. This can involve:

• Increasing one asset and decreasing another
• Increasing an asset and increasing a liability or equity
• Decreasing an asset and decreasing a liability or equity

Expanded Equation. The basic accounting equation can be expanded to illustrate the impact of transactions on equity: Assets = Liabilities + Share Capital—Ordinary + Revenues − Expenses − Dividends.

5. Financial Statements: A Comprehensive View

These statements provide relevant fi nancial data for internal and external users.

Key Statements. Companies prepare five financial statements to communicate their financial performance and position:

• Income statement: Reports revenues, expenses, and net income/loss for a specific period.
• Retained earnings statement: Summarizes changes in retained earnings for a specific period.
• Statement of financial position: (Balance sheet) Reports assets, liabilities, and equity at a specific date.
• Statement of cash flows: Summarizes cash inflows and outflows for a specific period.
• Comprehensive income statement: Presents other comprehensive income items not included in net income.

Interrelationships. These statements are interrelated, with net income flowing from the income statement to the retained earnings statement, and ending retained earnings flowing to the statement of financial position. Cash from the statement of financial position is reported on the statement of cash flows.

6. Adjusting Entries: Refining Financial Accuracy

Effective fi nancial reporting depends on sound ethical behavior.

Timing is Key. Adjusting entries are made at the end of an accounting period to ensure that revenues are recognized when earned and expenses are recognized when incurred, regardless of when cash changes hands.

Deferrals and Accruals. Adjusting entries fall into two main categories:

• Deferrals: Prepaid expenses (assets) and unearned revenues (liabilities)
• Accruals: Accrued revenues (assets) and accrued expenses (liabilities)

Adjusted Trial Balance. After adjusting entries are made, an adjusted trial balance is prepared to prove the equality of debits and credits before financial statements are prepared.

7. Internal Controls: Safeguarding Assets and Ensuring Reliability

Effective fi nancial reporting depends on sound ethical behavior.

Fraud Prevention. Internal control is a process designed to provide reasonable assurance regarding the achievement of objectives related to operations, reporting, and compliance. It helps prevent fraud and errors.

Principles of Internal Control. Key principles include:

• Establishment of responsibility
• Segregation of duties
• Documentation procedures
• Physical controls
• Independent internal verification
• Human resource controls

Cash Controls. Cash controls are crucial for safeguarding this liquid asset. They include controls over cash receipts (e.g., cash registers, mail receipts) and cash disbursements (e.g., voucher systems, petty cash funds).

8. Inventory Costing: Impact on Profitability and Financial Position

In general, even though IFRS allows companies to revalue property, plant, and equipment and other long-lived assets to fair value, most companies choose to use cost.

Inventory Systems. Merchandising companies use either a perpetual inventory system (continuous tracking) or a periodic inventory system (physical count at the end of the period).

Cost Flow Assumptions. When determining the cost of goods sold and ending inventory, companies use cost flow assumptions such as:

• First-In, First-Out (FIFO): Assumes the first units purchased are the first sold.
• Average-Cost: Uses a weighted-average unit cost.

Lower-of-Cost-or-Net Realizable Value (LCNRV). When the value of inventory falls below its cost, companies must write down the inventory to its net realizable value.

9. Financial Statement Analysis: Unveiling Business Performance

To be good at your business, you have to know the numbers—cold.

Key Areas of Analysis. Financial statement analysis involves evaluating a company's:

• Liquidity: Ability to meet short-term obligations
• Profitability: Income or operating success
• Solvency: Ability to survive over a long period

Tools of Analysis. Common tools include:

• Horizontal analysis: Comparing data over time
• Vertical analysis: Expressing items as a percentage of a base amount
• Ratio analysis: Expressing relationships among selected items

Ratio Analysis. Ratio analysis expresses the relationship among selected items of financial statement data. It is used to evaluate liquidity, profitability, and solvency.

10. Corporate Structure: Advantages and Disadvantages

“Whether you are looking at a large multinational company like TSMC or Apple or a single-owner software consulting business or coffee shop, knowing the fundamentals of accounting will help you understand what is happening.”

Characteristics of a Corporation. The corporate form of organization offers several advantages:

• Separate legal existence
• Limited liability of shareholders
• Transferable ownership rights
• Ability to acquire capital
• Continuous life

Disadvantages of a Corporation. The corporate form also has disadvantages:

• Separation of ownership and management
• Government regulations
• Additional taxes

Types of Corporations. Corporations can be classified by purpose (profit or non-profit) and by ownership (publicly held or privately held).

11. Share Transactions: Capitalizing the Corporation

“Whether you are looking at a large multinational company like TSMC or Apple or a single-owner software consulting business or coffee shop, knowing the fundamentals of accounting will help you understand what is happening.”

Share Issuance. When a corporation issues shares, it receives cash or other assets in exchange. The accounting for share transactions depends on whether the shares have a par value or no-par value.

Treasury Shares. Treasury shares are a corporation's own shares that it has reacquired but not retired. The purchase and resale of treasury shares affect equity but not net income.

Preference Shares. Preference shares have certain preferences over ordinary shares, such as priority in dividend distributions and asset distribution upon liquidation.

12. Navigating Liabilities: Current and Non-Current

Liabilities are claims against assets—that is, existing debts and obligations.

Current vs. Non-Current. Liabilities are classified as current (due within one year or the operating cycle) or non-current (due beyond one year). This classification is crucial for assessing a company's liquidity.

Types of Liabilities. Common current liabilities include notes payable, accounts payable, sales taxes payable, unearned revenues, and accrued liabilities. Non-current liabilities often take the form of bonds payable or long-term notes payable.

Bond Accounting. Bonds are a form of debt financing that can be issued at face value, a discount, or a premium, depending on the relationship between the contractual interest rate and the market interest rate.

Last updated: April 3, 2025