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About 5 min read · 9 pages
The first 8 lectures of this course cover financial accounting, which provides financial information for external users like investors and creditors to give them insight into a company's performance and financial position.
The core goal of financial reporting is to provide decision-useful financial information to investors, lenders, and other creditors for making resource allocation decisions. Accounting is often called the language of business because it presents a true and fair view of an entity's financial position and performance.
Two key approaches to valuing a company:
Value in exchange: What the company could be sold for (possibly in parts)
Value in use: What the company can generate through operations.
The higher of the two is the economic value of the firm. Economic value is the discounted value of all future net benefits that the firm is expected to generate. Since economic value is difficult to determine precisely, financial accounting produces estimates:
Accounting value approximating economic value.
Accounting net income approximating economic net income.
Simply put, the people who provide money for the company want to know what the company owns or owes and how much the company makes or loses.
For financial information to be useful, it must meet certain qualitative characteristics: it should be relevant and faithfully represented and ideally possess enhancing characteristics.
Relevance means that the provided information can influence decisions, also known as decision-useful.
Predictive Value: Information has predictive value if it helps users form expectations about the future, such as forecasting earnings or evaluating likely financial trends.
Confirmatory Value: Information has confirmatory value if it helps users confirm or correct prior expectations, such as comparing actual results to forecasts.
Materiality: Information is material if omitting or misstating it could influence a decision.
Faithful Representation (Reliability): Information must be:
Complete
Neutral
Free from error
Comparability: Enables comparisons across companies and periods.
Verifiability: Independent observers should reach similar conclusions.
Timeliness: Information must be available before it loses relevance.
Understandability: Information must be presented clearly and concisely.
Cost Constraint: Benefits of information must justify the costs of providing and using it.
In accounting, there is a tradeoff between relevance and reliability. If you want to make a piece of information more reliable, it usually comes at the cost of relevance.
Records revenue when cash is received.
Records expenses when cash is paid.
This method can distort the financial position when income and expenses occur in different periods.
Records revenue when earned and expenses when incurred.
Records transactions when they occur, regardless of cash flow.
Aligns with the revenue recognition and expense recognition (matching) principles.
In the long run, both cash accounting and accrual accounting lead to the same value. The main difference is that cash inflows and outflows do not represent the actual activity of a business in the given period. For example, reinvesting profits into machinery should not imply the business made no profit that year. Therefore, accrual accounting is preferred for financial reporting because it provides a more accurate view of financial performance.
3 questions
Historical Cost Principle: Record assets at original purchase price.
Fair Value Principle: Report certain assets at market value.
Revenue Recognition Principle: Recognize revenue when the performance obligation is satisfied.
Expense Recognition (Matching Principle): Recognize expenses in the same period as related revenues.
Full Disclosure Principle: Disclose all information relevant to users’ decisions.
The revenue and expense recognition principles are the heart of this course. If you understand and apply this, the rest of financial accounting should flow naturally.
Asset: A resource (1) controlled by the company, (2) resulting from past events, and (3) expected to provide future economic benefits.
Liability: A present obligation (1) arising from past events and (2) expected to result in an outflow of resources.
Equity: The residual interest in the assets after deducting liabilities. In mathematical form, it is:
| Total assets | Total liabilities and equity |
|---|---|
| Current assets | Current liabilities |
| Non-current assets | Non-current liabilities |
| Share capital | |
| Retained earnings |
The basic accounting equation is really what drives all financial accounting. It also serves as the basis for the Balance Sheet or the Statement of Financial Position. It explains where the company got the money it spent on acquiring machinery and other assets.
Then, Equity is made up of two components:
Expanding the Retained Earnings:
From this, we derive the expanded accounting equation:
We use the expanded accounting equation to break down the components of the change in the company’s financial position. Dividends, revenues, and expenses are the flow variables that drive the changes on the balance sheet (more on that later)
These categories, such as Retained Earnings and Dividends, are called accounts. Accountants record transactions in these accounts. We’ll explain each of the categories later on. By now, you should be familiar with the criteria for assets, liabilities, equity, and the revenue and expense recognition principle.
Stock Variable: Measured at a specific point in time (e.g., assets, liabilities).
Flow Variable: Measured over a period of time (e.g., revenue, expenses).
Imagine an empty bathtub. The amount of water in the bathtub at any specific moment is the stock variable, and the flow of water into or out of the tub over a period of time is the flow variable. Flow variables explain changes in stock variables, like the amount of water added to the bathtub over a period of time.
Now we explore the first three steps of the accounting cycle. The accounting cycle describes a step-by-step process accountants follow each period (usually quarters) to prepare the financial statements. The first 3 steps are:
Identify and analyze transactions.
Journalize: Record them in a general journal.
Post to Ledger: Transfer journal entries to individual accounts in the general ledger.
For this, you need to ask yourself:
What happened?
Which accounts are affected and by how much?
What is the effect on the accounting equation?
If Tesla buys one machine, the PP&E (asset) account increases, while the Cash (asset) account decreases by the same amount. The overall accounting equation remains unchanged.
To record transactions, we use a double-entry bookkeeping system. Every transaction:
Affects at least one debit and one credit.
Must maintain debits equal to credits.
The normal balance of an account is the side (debit or credit) that increases its value.
| Account Type | Increases With | Normal Balance |
|---|---|---|
| Assets | Debit | Debit |
| Liabilities | Credit | Credit |
| Equity | Credit | Credit |
| Revenues | Credit | Credit |
| Account Type | Increases With | Normal Balance |
|---|---|---|
| Expenses | Debit | Debit |
| Dividends | Debit | Debit |
There is a handy acronym for remembering this table: DEALER: Dividends, Expenses, Assets (Debit side) / Liabilities, Equity, Revenues (Credit side).
Your company buys a new computer for €1,000 cash to run an online shirt store and buys 40 shirts for €5 cash per shirt. Then your company sells 10 shirts via the online store for €10 cash per shirt.
There are 3 separate events, so there must be 3 journal entries: the first for buying the computer, the second for buying the shirts, and the third for selling some of the shirts.
Transaction 1: Your company buys a new computer for €1,000 cash.
The company acquires an asset (Computer/Equipment). Assets increase.
The company pays with an asset (Cash). Assets decrease.
So, the first journal entry would be:
| Account | Debit | Credit |
|---|---|---|
| Buys a computer for €1,000 cash | ||
| Equipment | €1,000.00 | |
| Cash | €1,000.00 | |
| Total | €1,000.00 | €1,000.00 |
Transaction 2: Your company buys 40 shirts for €5 per shirt (total cost €200).
The company acquires an asset (Inventory of shirts). Assets increase.
The company pays with an asset (Cash). Assets decrease.
So, the second journal entry would be:
| Account | Debit | Credit |
|---|---|---|
| Buys 40 shirts at €5 each, for cash | ||
| Inventory (shirts) | €200.00 | |
| Cash | €200.00 | |
| Total | €200.00 | €200.00 |
Transaction 3: This is actually two transactions at once. Your company sells 10 shirts for €10 per shirt (total sales €100). This affects the following accounts:
The company receives an asset (Cash). Assets increase (debit side).
The company earns revenue (Sales Revenue). Revenue increases equity (credit side).
The company records an expense (Cost of Goods Sold or COGS). Expenses decrease equity (debit side).
The company transfers an asset (Inventory = shirts). Assets decrease (credit side).
So, the third journal entry would be:
| Account | Debit | Credit |
|---|---|---|
| Sells 10 shirts at €10 each, for cash | ||
| Cost of goods sold | €50.00 | |
| Inventory (shirts) | €50.00 | |
| Cash | €100.00 | |
| Sales revenue | €100.00 | |
| Total | €150.00 | €150.00 |
3 questions
This first lecture established that the objective of financial reporting is to provide useful information to external and internal users for decision-making. Financial accounting aims to give a true and fair view of the company's finances. One of the biggest challenges facing financial reporting is the trade-off between relevance and reliability (faithful representation).
The difference between accrual accounting and cash accounting is the timing of revenues and expenses. Under accrual accounting, we use the revenue and expense recognition principles. We recognize revenues and expenses in the period when they are earned or incurred.
The foundation of accounting is the accounting equation (Assets = Liabilities + Equity), which can be expanded. Simply put, assets will earn the company money, liabilities will cost them money, and equity is the difference between the two.
Double-entry bookkeeping is what ensures that this equation is held up. Each transaction involves changes in at least one credit and one debit account. The lecture introduced the initial steps of the accounting cycle: analyzing transactions, journalizing them using debits and credits, and posting them to the general ledger.