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Financial Accounting Unit 1: The Accounting Equation and Transactions

Financial accounting reports a company's resources and the claims on them to outside users. The accounting equation, Assets = Liabilities + Equity, is the logic behind every transaction you will record in this course.

Covers: Users of accounting and GAAP, Assets, liabilities and equity, The accounting equation, Transaction analysis, Revenue, expenses and dividends, Assumptions and principles, Ethics and Sarbanes-Oxley

Study guide

Accounting is the system that identifies, records and communicates the economic events of an organization. Financial accounting produces general-purpose statements for external users such as investors, lenders, suppliers and regulators, while managerial accounting serves people inside the company. In the United States, public companies follow generally accepted accounting principles (GAAP), which are issued by the Financial Accounting Standards Board (FASB) under the oversight of the Securities and Exchange Commission (SEC). Most other countries use International Financial Reporting Standards (IFRS) from the IASB. The goal of both systems is the same: information that is relevant to decisions and that faithfully represents what really happened.

Every company's position can be summarized by the accounting equation: Assets = Liabilities + Stockholders' Equity. Assets are resources the company controls that are expected to bring future benefits, such as cash, accounts receivable, supplies, inventory, equipment and land. Liabilities are present obligations to outsiders, such as accounts payable, notes payable, salaries payable and unearned revenue. Stockholders' equity is the owners' residual claim, equal to assets minus liabilities. Equity has two main parts in a corporation: contributed capital, mainly common stock issued to owners, and retained earnings, which are the profits the company has earned and kept rather than paid out as dividends.

Each transaction changes at least two items, and after every transaction the equation still balances. Buying supplies for cash swaps one asset for another. Buying equipment on account increases an asset and a liability together. Issuing stock increases assets and contributed capital. Revenue, earned by providing goods or services, increases retained earnings, while expenses, the costs of earning revenue, decrease it. Dividends also reduce retained earnings, but they are distributions to owners, not expenses, so they never appear on the income statement. A useful roll-forward is: ending retained earnings = beginning retained earnings + net income − dividends.

Several assumptions and principles shape what gets recorded. The economic entity assumption keeps the business separate from its owners. The monetary unit assumption records only events that can be measured in money. The going concern assumption presumes the company will keep operating, which justifies reporting assets at cost rather than liquidation value. The historical cost principle records assets at what was paid, and most assets are not written up when market values rise. The periodicity assumption divides the company's life into months, quarters and years. Finally, only actual exchanges or events are recorded: a promise on both sides with nothing yet performed usually is not a transaction.

Four main statements come out of this system. The income statement reports revenues minus expenses for a period. The statement of retained earnings (or of stockholders' equity) shows how equity changed. The balance sheet lists assets, liabilities and equity at a point in time, built directly on the accounting equation. The statement of cash flows shows cash from operating, investing and financing activities. Because so many people rely on these reports, ethics matters: managers sign off on the numbers, independent auditors examine them, and the Sarbanes-Oxley Act of 2002 added penalties and internal-control requirements after major frauds such as Enron and WorldCom.

Key ideas

• Assets always equal liabilities plus stockholders' equity, after every single transaction.
• Revenue raises equity, and expenses and dividends lower it, but dividends are not expenses.
• Revenue is recorded when it is earned, not necessarily when cash is received.
• Cash received before work is done creates unearned revenue, a liability.
• The entity, monetary unit, going concern and periodicity assumptions define what goes in the books.
• Assets are recorded at historical cost, and land is not written up to market value under GAAP.
• The FASB sets U.S. GAAP, with the SEC holding legal authority over public company reporting.

Formulas and rules

Common mistakes

• Treating dividends as an expense, which wrongly reduces net income.
• Recording revenue when cash is collected instead of when the service is performed.
• Calling cash received in advance revenue instead of unearned revenue, a liability.
• Forgetting that buying an asset on account increases both assets and liabilities.
• Writing assets such as land up to market value instead of keeping them at historical cost.

Before the test, make sure you can

• Classify any account as an asset, liability, common stock, revenue, expense or dividend.
• Analyze a transaction's effect on assets, liabilities and equity and show the equation still balances.
• Calculate equity, liabilities or assets when the other two are given, including year-to-year changes.
• Calculate ending retained earnings from beginning balance, net income and dividends.
• Solve for a missing net income, dividend or stock issue using changes in equity.
• Explain the entity, monetary unit, going concern and historical cost concepts and spot violations.
• Identify who sets GAAP and who uses financial statements.

Words to know

Asset

A resource controlled by the company that is expected to provide future economic benefits, such as cash, receivables or equipment.

Liability

A present obligation to transfer assets or provide services to others in the future, such as accounts payable or notes payable.

Stockholders' equity

The owners' residual claim on assets after liabilities are subtracted; contributed capital plus retained earnings.

Accounting equation

Assets = Liabilities + Stockholders' Equity; it balances after every transaction.

Revenue

The increase in assets (or decrease in liabilities) from delivering goods or services to customers; it increases retained earnings.

Expense

The cost of assets used up or services consumed to earn revenue; it decreases retained earnings.

Dividend

A distribution of company assets, usually cash, to stockholders; it reduces retained earnings but is not an expense.

Retained earnings

Cumulative net income kept in the business after subtracting all dividends declared.

Common stock

Contributed capital received when the corporation issues ownership shares to investors.

Accounts receivable

Amounts customers owe the company for goods or services already provided on credit.

Accounts payable

Amounts the company owes suppliers for purchases made on credit.

Unearned revenue

A liability for cash received from customers before the related goods or services are delivered.

GAAP

Generally accepted accounting principles: the rules U.S. companies follow for financial reporting, issued by the FASB.

FASB

Financial Accounting Standards Board, the private body that sets U.S. GAAP.

Economic entity assumption

The business's records are kept separate from the personal affairs of its owners and other businesses.

Going concern assumption

The assumption that a business will continue operating long enough to use its assets and meet its obligations.

Historical cost principle

Assets are recorded at the cash or cash-equivalent price paid to acquire them.

Sarbanes-Oxley Act

A 2002 U.S. law that tightened corporate financial reporting, auditor independence and internal-control requirements.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.