Financial Accounting: Key Concepts and Ratios for Students

Financial Statement Order

1. Income Statement (calculates Net Income) -> 2. Statement of Retained Earnings (uses Net Income to find Ending RE) -> 3. Balance Sheet (uses Ending RE to balance Assets = Liabilities + Equity)

Fundamental Accounting Equation

Assets = Liabilities + Equity. All accounts fall into these three categories; the equation must always balance.

Basis of Accounting

Cash basis records revenue/expenses when cash moves. Accrual basis (GAAP) records revenue when earned and expenses when incurred, regardless of cash movement.

Measurement Principle

Record assets at the actual cost paid to acquire them, including all costs to get the asset ready for use (Historical Cost).

Revenue Recognition

Revenue is recognized when the performance obligation is satisfied (when the service is provided or the good is delivered).

Net Income/Loss Calculation

Net Income = Total Revenue - Total Expenses.

Accounting Errors

Understand the logic of how errors impact the balance sheet and income statement (e.g., if an expense is missed, net income is overstated).

Accrued Expense Error Impact

Failure to record an accrued expense (like Wages Expense) results in: Expenses Understated, Net Income Overstated, Liabilities Understated, and Equity (Retained Earnings) Overstated.

Financial Statement Order

1. Income Statement (calculates Net Income) -> 2. Statement of Retained Earnings (uses Net Income to find Ending RE) -> 3. Balance Sheet (uses Ending RE to balance A=L+E).

Closing Entries Purpose

To reset temporary accounts (Revenue, Expenses, Dividends) to zero and transfer their balances to Retained Earnings.

Profit Margin Ratio

(Net Income / Net Sales) × 100. Interpreted as the percentage of each dollar of sales that results in profit.

Gross Profit Calculation

Net Sales - Cost of Goods Sold (COGS). This represents the profit before operating expenses.

Inventory Equation

Beginning Inventory + Net Purchases - Cost of Goods Sold = Ending Inventory.

Perpetual vs. Periodic Inventory

Perpetual updates inventory/COGS with every sale (barcode scan). Periodic only updates inventory at the end of the period via a physical count.

FIFO (First-In, First-Out)

Inventory cost flow where the first items purchased are the first ones sold. Ending Inventory reflects the most recent costs.

LIFO (Last-In, First-Out)

Assumes newest items are sold first. Benefit: Matches current costs against revenue; often used for tax advantages during inflation.

Lower of Cost or Market (LCM)

Rule stating that inventory must be reported at the lower of its original cost or its current replacement cost. JE: Debit Cost of Goods Sold; Credit Inventory.

Purchase Inventory on Account (JE)

Debit Inventory; Credit Accounts Payable. If paid within discount period: Debit AP (full), Credit Cash (discounted), Credit Inventory (discount amount).

Sales with Discounts (JE)

Debit Cash (discounted amount), Debit Sales Discounts (contra-revenue), and Credit Accounts Receivable (full amount).

Internal Controls

Processes to protect assets (especially cash) and ensure accuracy of records through separation of duties, authorization, and physical locks.

Bank Reconciliation

The process of adjusting the bank balance and the book balance to find the true cash balance (includes outstanding checks, deposits in transit, and fees).

Allowance for Bad Debts

Recording Bad Debt Expense by estimating uncollectible accounts using the Percentage of Sales or Aging of Receivables method.

Percentage of Sales Method (JE)

(Net Credit Sales × estimated %). Journal Entry: Debit Bad Debt Expense; Credit Allowance for Doubtful Accounts.

Notes Receivable & Interest

To record: Debit Notes Receivable; Credit Cash/AR. Interest = Principal × Annual Interest Rate × (Months / 12). JE: Debit Interest Receivable; Credit Interest Revenue.

PPE Definition

Property, Plant, and Equipment. Long-lived tangible assets used in operations (not for resale) like land, buildings, and machinery.

Straight-Line Depreciation

(Cost - Salvage Value) / Useful Life. Results in the same expense amount every year.

Double-Declining Balance

Book Value at Beginning of Year × (2 / Useful Life). An accelerated method where more expense is recorded in early years.

Book Value

The value of an asset on the balance sheet. Calculation: Original Cost - Accumulated Depreciation.

Lump Sum Purchase

When multiple assets are bought for one price, the cost is allocated based on their relative fair market values.

Repairs vs. Betterments

Repairs (revenue expenditures) are expensed immediately. Betterments (capital expenditures) are added to the asset's cost to extend life/productivity.

Disposal of Asset (JE)

Debit Cash (if sold), Debit Acc. Depreciation (to clear it), Credit Asset (original cost). Record Gain (Credit) or Loss (Debit) to balance.

Asset Turnover Ratio

Net Sales / Average Total Assets. Measures how efficiently a company uses its assets to generate revenue.