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📈Financial Accounting II

📈financial accounting ii review

1.1 Financial Statements and Accounting Cycle

4 min readLast Updated on July 30, 2024

Financial statements are the backbone of accounting, providing a snapshot of a company's financial health. They include the balance sheet, income statement, cash flow statement, and statement of stockholders' equity, each offering unique insights into a company's financial position and performance.

The accounting cycle is a step-by-step process that ensures accurate financial reporting. It involves recording transactions, making adjusting entries, preparing financial statements, and closing the books. This systematic approach helps maintain the integrity of financial data and supports informed decision-making.

Financial Statements: Purpose and Components

The Four Primary Financial Statements

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  • Balance sheet reports a company's financial position at a specific point in time (December 31, 2022)
  • Income statement reports a company's financial performance over a period of time (fiscal year 2022)
  • Statement of cash flows reports a company's cash inflows and outflows from operating, investing, and financing activities over a period of time (Q1 2023)
  • Statement of stockholders' equity reports changes in the company's equity accounts over a period of time (January 1 to March 31, 2023)

Key Components and Interrelationships

  • Balance sheet includes assets (cash, inventory), liabilities (accounts payable, loans), and stockholders' equity (common stock, retained earnings)
  • Income statement includes revenues (sales), expenses (salaries, rent), gains (sale of assets), and losses (write-offs)
  • Statement of cash flows categorizes cash flows into operating activities (cash sales, payments to suppliers), investing activities (purchase of equipment, sale of investments), and financing activities (issuance of stock, repayment of loans)
  • Statement of stockholders' equity includes common stock, additional paid-in capital, retained earnings, and treasury stock
  • Financial statements are interrelated and provide a comprehensive view of a company's financial health and performance
    • Net income from the income statement increases retained earnings on the balance sheet
    • Changes in balance sheet accounts are reflected in the statement of cash flows
    • Statement of stockholders' equity provides details on changes in equity accounts summarized on the balance sheet

Accounting Cycle: Steps and Significance

Recording and Posting Transactions

  • Analyze and record transactions in the general journal using the double-entry bookkeeping system (debit accounts receivable, credit sales revenue)
  • Post transactions from the general journal to the general ledger, which organizes financial data by account (accounts receivable ledger, sales revenue ledger)
  • Prepare a trial balance to ensure the debits and credits in the general ledger are equal

Adjusting Entries and Financial Statement Preparation

  • Make adjusting entries to update accounts and ensure they reflect the correct balances at the end of the period
    • Accruals (record interest expense on a loan)
    • Deferrals (record prepaid rent expense)
    • Depreciation (record depreciation expense on equipment)
  • Prepare an adjusted trial balance to verify the equality of debits and credits after adjusting entries have been posted
  • Prepare financial statements using the information from the adjusted trial balance

Closing the Books

  • Make closing entries to transfer the balances of temporary accounts to the retained earnings account and prepare the accounts for the next period
    • Close revenue accounts to income summary (debit sales revenue, credit income summary)
    • Close expense accounts to income summary (debit income summary, credit salaries expense)
    • Close income summary to retained earnings (debit income summary, credit retained earnings)
    • Close dividends to retained earnings (debit retained earnings, credit dividends)
  • Prepare a post-closing trial balance to ensure the debits and credits are equal after the closing entries have been posted

Financial Statement Relationships

Balance Sheet and Income Statement

  • Retained earnings account links the balance sheet and income statement
    • Net income from the income statement increases retained earnings
    • Net losses and dividends decrease retained earnings
  • Non-cash transactions (depreciation, amortization) appear on the income statement but not on the statement of cash flows

Statement of Cash Flows

  • Reconciles the change in cash and cash equivalents from the beginning to the end of the period
  • Uses information from the balance sheet and income statement
  • Changes in balance sheet accounts (increases or decreases in assets, liabilities, and equity) are reflected in the statement of cash flows

Statement of Stockholders' Equity

  • Provides details on changes in equity accounts summarized on the balance sheet
  • Shows beginning balances, additions (issuance of stock, net income), subtractions (dividends, net losses), and ending balances

Basic Financial Statement Preparation

Balance Sheet

  • Prepared using the accounting equation: Assets = Liabilities + Stockholders' Equity
  • Assets listed in order of liquidity (cash, accounts receivable, inventory, property, plant, and equipment)
  • Liabilities listed in order of maturity (accounts payable, short-term loans, long-term loans)

Income Statement

  • Prepared using the formula: Revenues - Expenses + Gains - Losses = Net Income
  • Follows a multi-step format, separating operating and non-operating items
  • Operating section includes sales revenue, cost of goods sold, and operating expenses
  • Non-operating section includes other revenues, gains, losses, and income tax expense

Statement of Cash Flows

  • Prepared using either the direct or indirect method
    • Direct method reports cash receipts and payments
    • Indirect method starts with net income and adjusts for non-cash transactions and changes in balance sheet accounts
  • Categorizes cash flows into operating, investing, and financing activities

Statement of Stockholders' Equity

  • Shows beginning balances of equity accounts (common stock, additional paid-in capital, retained earnings, treasury stock)
  • Additions include issuance of stock and net income
  • Subtractions include dividends and net losses
  • Ending balances of equity accounts are calculated

GAAP Compliance

  • Financial statements must be prepared in accordance with generally accepted accounting principles (GAAP)
  • GAAP ensures consistency and comparability across companies
  • Key principles include revenue recognition, expense matching, and full disclosure

Key Terms to Review (23)

Accruals: Accruals are accounting adjustments made to recognize revenues and expenses that have been incurred but not yet recorded in the financial statements. This principle is part of the accrual basis of accounting, which focuses on recording transactions when they occur rather than when cash is exchanged. Accruals ensure that financial statements reflect the true financial position and performance of a business, allowing for a more accurate representation of its activities during an accounting period.
Assets: Assets are resources owned by a business that have economic value and can provide future benefits. They play a crucial role in assessing the financial health of a company, influencing decisions related to investments, liabilities, and overall financial performance. Understanding assets is essential for analyzing financial statements, as they are key components that affect profitability and liquidity, and also come into play when translating foreign currency statements.
Balance Sheet: A balance sheet is a financial statement that provides a snapshot of a company's assets, liabilities, and equity at a specific point in time. It shows what the company owns and owes, offering insight into its financial health and stability.
Closing entries: Closing entries are journal entries made at the end of an accounting period to transfer the balances of temporary accounts to permanent accounts. This process resets the temporary accounts, such as revenues and expenses, to zero for the next accounting period, ensuring that the financial statements reflect only the transactions of that period. Closing entries are essential for preparing accurate financial statements and maintaining the integrity of the accounting cycle.
Creditors: Creditors are individuals or institutions that extend credit or lend money to a business or individual, expecting repayment in the future. They play a crucial role in the financial ecosystem by providing the necessary funds for operations, investments, and growth. Creditors can be classified into two main categories: secured and unsecured, depending on whether they have a legal claim to specific assets in case of default.
Current ratio: The current ratio is a financial metric that measures a company's ability to pay its short-term liabilities with its short-term assets. This ratio is important for assessing liquidity, as it indicates how well a firm can cover its obligations due within a year. A higher current ratio suggests better financial health and less risk of insolvency, making it essential in analyzing the relationship between asset management and liability structure.
Debt-to-equity ratio: The debt-to-equity ratio is a financial metric that indicates the relative proportion of a company's debt to its shareholders' equity, showing how much leverage a company is using to finance its assets. A higher ratio suggests more risk as the company relies more on borrowed funds compared to equity, impacting its financial stability and operational decisions.
Deferrals: Deferrals are accounting entries that delay the recognition of revenue or expenses to a future period, even though cash has already been exchanged. This concept is crucial in the accounting cycle as it ensures that financial statements accurately reflect a company's financial position by aligning revenues and expenses with the appropriate reporting period, adhering to the matching principle.
Double-entry accounting: Double-entry accounting is an accounting method where every financial transaction affects at least two accounts, ensuring that the accounting equation (Assets = Liabilities + Equity) remains balanced. This system enhances accuracy and accountability by requiring that for every debit entry, there is a corresponding credit entry, allowing for a comprehensive view of a company's financial position.
Equity: Equity represents the ownership value in a company after all liabilities have been subtracted from total assets. It reflects the residual interest of the owners in the company and is a critical component of financial health, showing how much value shareholders would receive if the company were liquidated. Equity also includes contributions from owners, retained earnings, and can fluctuate with the company's performance.
GAAP: GAAP, or Generally Accepted Accounting Principles, is a framework of accounting standards, principles, and procedures used in the preparation of financial statements. It ensures consistency and transparency in financial reporting, which is essential for stakeholders to make informed decisions based on comparable financial information across different organizations.
Gains: Gains refer to the increase in value or profit that arises from transactions, typically recognized when an asset is sold for more than its carrying amount. This concept is crucial in understanding how financial performance is reflected in financial statements, highlighting the impact of various activities on overall profitability.
IFRS: International Financial Reporting Standards (IFRS) are a set of accounting standards developed by the International Accounting Standards Board (IASB) that aim to bring transparency, accountability, and efficiency to financial markets around the world. IFRS provides a common global language for business affairs, ensuring consistency in the financial reporting and making it easier for investors to compare financial statements from different countries.
Income Statement: An income statement is a financial report that summarizes a company's revenues, expenses, and profits or losses over a specific period, typically a quarter or a year. It provides key insights into the company's operational performance, allowing stakeholders to assess profitability and efficiency in generating income.
Investors: Investors are individuals or entities that allocate capital with the expectation of receiving financial returns. They play a vital role in the economy by providing the necessary funds for businesses to grow, which in turn impacts financial statements and the overall accounting cycle as they seek transparency and accountability in their investments.
Journal entries: Journal entries are the fundamental records in accounting that capture all financial transactions of a business. Each entry is made in the company's journal, detailing the date, accounts affected, amounts, and a brief description of the transaction. They serve as the first step in the accounting cycle and are essential for preparing accurate financial statements.
Ledger posting: Ledger posting refers to the process of transferring journal entries to the general ledger, where they are categorized and summarized. This process is crucial because it helps in organizing financial data systematically, making it easier to create financial statements and maintain accurate records throughout the accounting cycle.
Liabilities: Liabilities are obligations that a company owes to external parties, which can include loans, accounts payable, and other debts that must be settled in the future. They play a crucial role in financial accounting as they represent claims against the company’s assets and are essential for assessing the financial health of an organization. Understanding liabilities helps in analyzing how a business finances its operations and the risks involved in its capital structure.
Losses: Losses refer to the decrease in value or the negative impact on financial performance experienced by a business or individual over a specific period. In the context of financial statements, losses can arise from various activities such as declining sales, increased expenses, or asset write-downs. Understanding losses is essential for evaluating the overall health of an entity and determining its profitability and financial stability.
Management: Management refers to the process of planning, organizing, leading, and controlling resources, including financial resources, to achieve specific organizational goals. In the context of financial statements and the accounting cycle, management is crucial as it involves the analysis and interpretation of financial data to make informed decisions that drive business success. Effective management ensures that resources are allocated efficiently and that financial statements accurately reflect the organization's performance.
Matching Principle: The matching principle is an accounting concept that requires expenses to be recorded in the same period as the revenues they help generate. This principle ensures that a company's financial statements accurately reflect its financial performance, linking income and related expenses for a clearer view of profitability over specific time frames.
Statement of stockholders' equity: The statement of stockholders' equity is a financial statement that summarizes the changes in the equity section of the balance sheet over a specific period. It provides a detailed account of the components that contribute to stockholders' equity, including common stock, preferred stock, additional paid-in capital, retained earnings, and treasury stock, highlighting how these elements have changed due to various transactions such as issuing shares, dividends, and net income.
Trial balance: A trial balance is an internal report that lists the balances of all general ledger accounts at a specific point in time, ensuring that total debits equal total credits. This document plays a crucial role in the accounting cycle by helping to identify any discrepancies or errors in the accounting records before financial statements are prepared.
Accruals
See definition

Accruals are accounting adjustments made to recognize revenues and expenses that have been incurred but not yet recorded in the financial statements. This principle is part of the accrual basis of accounting, which focuses on recording transactions when they occur rather than when cash is exchanged. Accruals ensure that financial statements reflect the true financial position and performance of a business, allowing for a more accurate representation of its activities during an accounting period.

Term 1 of 23

Accruals
See definition

Accruals are accounting adjustments made to recognize revenues and expenses that have been incurred but not yet recorded in the financial statements. This principle is part of the accrual basis of accounting, which focuses on recording transactions when they occur rather than when cash is exchanged. Accruals ensure that financial statements reflect the true financial position and performance of a business, allowing for a more accurate representation of its activities during an accounting period.

Term 1 of 23



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AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.