INTRODUCTION TO FINANCIAL ACCOUNTING

CHAPTER 1: INTRODUCTION TO FINANCIAL STATEMENTS

Financial accounting: specialized branch of accounting that keeps track of a company's financial
transactions, which are recorded, summarized, and presented to external parties in financial
statements such as an income statement, a retained earnings statement or a balance sheet

 FINANCIAL STATEMENTS
 Balance Sheet: Information on the financial condition of a business at a certain moment. (3)
 Income Statement: Information on the income/financial result (profit or loss) of a business
during a certain period. (1)
 Statement of retained earnings: Beginning retained earnings + net income – dividends (2)
 Statement of Cash Flows: Information on the origin and use of cash in the company.
 Statement of Shareholders’ Equity: Presents the individual components of Shareholders’
Equity and any changes during the last.
 Notes of Financial Statement

 ACTIVITIES AND USERS ASSOCIATED WITH ACOUNTING

Activities:

 Identification of the transactions (economic events)

 Recording, classification and summarizing the transactions
 Communicating the economic events of an organization to interested users (internal or
external).
Users:

 Internal: marketing, finance, management, human resources

 External: investors and creditors
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 ETHICS, PRINCIPLES AND ASSUMPTIONS OF ACCOUNTING

Generally Accepted Accounting Principles (GAAP): Standards that are generally accepted and
universally practiced. These standards indicate how to report economic events.
Standard-setting bodies:

 Financial Accounting Standards Board (FASB)

 Securities and Exchange Commission (SEC)
 International Accounting Standards Board (IASB)

Measurement principle: Selection of which principle to follow relates to trade-offs between

relevance and faithful representation

 Historical cost principle (or cost principle) dictates that companies record assets at their
cost.
 Fair value principal: states that assets and liabilities should be reported at fair value (the
price received to sell an asset or settle a liability)

Assumptions

 Monetary assumption requires that companies include in the accounting records only
transaction data that can be expressed in terms of money.
 Economic entity assumption requires that activities of the entity be kept separate and
distinct from the activities of its owner and all other economic entities.
 INTRODUCTION TO FINANCIAL ACCOUNTING

 THE ACCOUNTING EQUATION AND ITS COMPONENTS

 Provides the underlying framework for recording and summarizing economic events.
 Assets must equal the sum of liabilities and stockholders’ equity.
 If a business is liquidated, claims of creditors (liabilities) must be paid before ownership
claims (stockholders’ equity).

Assets

 Resources a business owns.

 Provide future services or benefits.
 Cash, Supplies, Equipment, etc.

Liabilities

 Claims against assets (debts and obligations).

 Creditors (party to whom money is owed).
 Accounts payable, notes payable, salaries and wages payable, sales and real estate taxes
payable, etc.

Stockholder’s equity (patrimony net)

 Ownership claim on total assets.

 Referred to as residual equity.
 Common stock and retained earnings.
 INTRODUCTION TO FINANCIAL ACCOUNTING

o Investments by stockholders: represent the total amount paid in by stockholders for the
shares they purchase.
o Revenues: they result from business activities entered into for the purpose of earning
income. Common sources of revenue are: sales, fees, services, commissions, interest,
dividends, royalties, and rent.
o Dividends: distribution of cash or other assets to stockholders. Dividends reduce retained
earnings. However, dividends are not an expense.
o Expenses: cost of assets consumed or services used in the process of earning revenue.
Common expenses are: salaries expense, rent expense, utilities expense, tax expense, etc.

 THE EFFECTS OF BUSINESS TRANSACTIONS ON THE ACCOUNTING EQUATION

Transactions: business’s economic events recorded by accountants. They may be external or
internal and they have a dual effect on the accounting equation. Not all activities represent

Analyse
Trial Adjusting
business Journalise Post
balance entries
transaction

Adjusted Post-closing
Financial Closing
trial trial
statements entries
balance balance

transactions

TRANSACTION ANALYSIS
Companies prepare four financial statements: income statement, retained earnings statement,
balance sheet and statement of cash flows
 INTRODUCTION TO FINANCIAL ACCOUNTING

 Income statement: Reports the profitability of the company’s operations over a specific
period of time. It lists revenues first, followed by expenses and shows net income (or net
loss). Does not include investment and dividend transactions between the stockholders and
the business.
 Retained earnings statement: Reports the changes in retained earnings for a specific period
of time. The time period is the same as that covered by the income statement. Information
provided indicates the reasons why retained earnings increased or decreased during the
period.
 Balance sheet: Reports the assets, liabilities, and stockholders’ equity at a specific date. Lists
assets at the top, followed by liabilities and stockholder’s equity. Total assets must equal
total liabilities and stockholder’s equity. It’s a snapshot of the company’s financial condition
at a specific moment in time (usually the month-end or year-end).
 Cash flow: Information on the cash receipts and payments for a specific period of time.
Answers the following: Where did cash come from? What was cash used for? What was the
change in the cash balance?

Notes:
On credit = on account  you don’t pay in the moment
Accrual basis: revenues – expenses  net income
Cash basis: Receipts – payments
Operating cycle is the average time it takes from the purchase of inventory to the collection of
cash from customers.

CHAPTER 1: EXTRA SLIDES ON FINANCIAL STATEMENTS

 INTRODUCTION TO FINANCIAL ACCOUNTING

 CLASSIFIED BALANCE SHEET

 Current assets: Assets that a company expects to convert to cash or use up within one year
or the operating cycle, whichever is longer. Operating cycle is the average time it takes from
the purchase of inventory to the collection of cash from customers.

 Long-term investments: Investments in stocks and bonds of other companies that are held
for more than one year. Investments in long-term assets such as land or buildings not
currently being used in operating activities.

 Property, Land and Equipment: Long useful lives, and currently used in operations.
Depreciation: allocating the cost of assets to a number of years Accumulated
depreciation: total amount of depreciation expensed thus far in the asset’s life.

 Intangible assets: assets that don’t have a physical substance

 Current liabilities: Obligations the company is to pay within the coming year. Usually list
notes payable first, followed by accounts payable. Other items follow in order of magnitude.
 INTRODUCTION TO FINANCIAL ACCOUNTING

 Long-term liabilities: Obligations a company expects to pay after one year

 Stockholder’s equity
o Common stock: investments of assets into the business by the stockholders (capital
social)
o Retained earnings: income retained for use in the business (reserves)

 RATIO ANALYSIS
 INTRODUCTION TO FINANCIAL ACCOUNTING

 Liquidity ratios: they measure the short-term ability of the company to pay its maturing
obligations and to meet unexpected needs for cash  Liquidity: the ability to pay

obligations expected to become due within the next year or operating cycle.

Working capital = current assets – current liabilities

When working capital is positive, there is greater likelihood that the company will pay its
liabilities.

current assets For every dollar of

Current ratio=
current liabilities current liabilities,
the company has x
dollars of current
assets

 Solvency ratios: they measure the ability of the company to survive over a long period of
time.  Solvency: the ability to pay interest as it comes due and to repay the balance of a
debt due at its maturity. Solvency ratios measure the ability of the company to survive over
a long period of time.
Debt to total assets ratio: it measures the percentage of total financing provided by
creditors rather than stockholders

total liabilities
Debt ¿ total assets ratio=
total assets

 Profitability ratios: they measure the income or operating success of a company for a
period of time.
Earnings per share (EPS) measures the net income earned on each share of common stock.

Net income−Preferred stock dividends

EPS =
Average common s h ares outstanding

 In the Statement of Cash Flows, cash provided by operating activities fails to consider that a
company must invest in new PP&E and must maintain dividends at current levels to satisfy
investors.
Free cash flow is a measurement to provide additional insight regarding a company’s cash-
generating ability.

Free cash Flow: Cash provided by operations – Capital expenditures - Cash dividends
 QUALITIES OF USEFUL INFORMATION
 INTRODUCTION TO FINANCIAL ACCOUNTING

According to the FASB, useful information should possess two fundamental qualities: relevance and
faithful representation.

 Relevance: Accounting information is considered relevant if it would make a difference in a

business decision. Information is considered relevant if it also provides information that has
predictive value (helps provide accurate expectations about the future) and confirmatory
value (confirms or corrects prior expectation).
 Faithful Representation: It means that information accurately depicts what really
happened. To provide faithful representation, information must be complete (nothing
important has been omitted), neutral (is not biased toward one position or another), and
free from error.

Enhancing Qualities

 Comparability: results when different companies use the same accounting principles
 Verifiability: Information is verifiable if we are able to prove that it’s free from error
 Information has the quality of understandability if it’s presented in a clear and concise way
 Consistency: it means using the same accounting principles and methods from year to year
 For accounting information to be relevant, it must be timely

 ASSUMPTIONS IN FINANCIAL REPORTING

 Monetary unit: Requires that only those things that can be expressed in money are included
in the accounting records.
 Economic entity: States that every economic entity can be separately identified and
accounted for.
 Periodicity: States that the life of a business can be divided into artificial time periods.
 Going concern: The business will remain in operation for the foreseeable future.
 Accrual – Basis: Transactions are recorded in the periods in which the events occur.

 PRINCIPLES IN FINANCIAL REPORTING

 INTRODUCTION TO FINANCIAL ACCOUNTING

 CONSTRAINTS IN FINANCIAL REPORTING