Core Financial Accounting Concepts and Principles

Chapter 1: Core Accounting Fundamentals

Key Financial Statements Equations

• Balance Sheet (BS) Equation: Assets = Liabilities + Stockholders' Equity (SHE)
• Income Statement (IS) Equation: Revenues - Expenses = Net Income (NI)
• Retained Earnings (RE) Equation: Beginning RE + Net Income - Dividends = Ending RE

Debit and Credit Rules

• A Debit increases: Expenses, Assets, Dividends (DEAD)
• A Credit increases: Liabilities, Revenues, Equity (CLEAR)

Objective of Financial Reporting

1. Provide information useful to equity investors and creditors.
2. Maintain the Entity Perspective (separating the company from its owners/people).
3. Ensure Decision Usefulness.

Adjusting Entries: Deferrals and Accruals

Deferrals (Cash Paid/Received Before Recognition)

Prepaid Expenses

Meaning: Paid before use (e.g., Prepaid Rent).

Adjustment: Debit Expense, Credit Prepaid Expense.

Depreciation

Meaning: Spreading the cost of an asset over its useful life.

Adjustment: Debit Depreciation Expense, Credit Accumulated Depreciation.

Accruals (Recognition Before Cash Paid/Received)

Accrued Interest

Meaning: Interest owed but unpaid.

Adjustment: Debit Interest Expense, Credit Interest Payable.

Salaries and Wages

Meaning: Work done but not yet paid.

Adjustment: Debit Salaries Expense, Credit Salaries Payable.

Bad Debts

Meaning: Estimate of uncollectible accounts receivable.

Adjustment: Debit Bad Debt Expense, Credit Allowance for Doubtful Accounts.

The Closing Process

The closing process resets temporary accounts (Revenues, Expenses, Dividends) to zero and transfers their balances to Retained Earnings.

1. Close Revenues: Debit Revenues, Credit Income Summary.
2. Close Expenses: Debit Income Summary, Credit Expenses.
3. Close Net Income/Loss: Debit/Credit Income Summary, Credit/Debit Retained Earnings.
4. Close Dividends: Debit Retained Earnings, Credit Dividends.

Influencers and Regulatory Frameworks

FASB Influencers

The Financial Accounting Standards Board (FASB) is influenced by various groups:

• Business Entities
• Financial Community
• Preparers (Accountants)
• Government Agencies
• Industry Associations
• Investing Public
• Academicians
• AICPA, CPAs, and Accounting Firms

Risk and Investor Return

If a company has a greater risk, its investor will demand a higher rate of return.

Basic Accounting Assumptions

Economic Entity

Keep business activities separate from personal or other businesses.

Going Concern

Assume the business will continue operating indefinitely in the future.

Monetary Unit

Use a stable currency (like dollars) in financial statements, ignoring inflation effects.

Periodicity

Split business activities into regular time periods (e.g., months, quarters, years).

Key Accounting Principles

Measurement Principle

Historical Cost: Record assets at their original purchase price.

Fair Value: Sometimes, use the current market price.

Fair Value Levels

• Level 1: Exact market price (observable inputs).
• Level 2: Similar items' prices (market-corroborated inputs).
• Level 3: Best estimate (unobservable inputs, if no market data).

Revenue Recognition

Record revenue when it is earned (when the product or service is delivered).

Expense Recognition (Matching Principle)

Record expenses in the same period they help generate revenue.

Full Disclosure Principle

Share all important information relevant to financial statement users.

FASB’s Conceptual Framework

Purpose: Helps set future accounting rules and standards.

Users: Primarily investors and creditors who rely on financial statements.

Regulation and Standard Setters

• GAAP (Generally Accepted Accounting Principles): Rules for accounting in the U.S., set primarily by FASB.
• SEC (Securities and Exchange Commission): Government body that oversees public companies and capital markets.
• Sarbanes-Oxley Act (SOX): Law enacted to improve financial reporting quality and reduce corporate fraud.