Financial Accounting Notes

Introduction to Financial Accounting

  • Module Overview
    • Focuses on the collection and processing of financial information.
    • Covers bookkeeping principles and accounting techniques.
    • Starts with data collection and processes through to the preparation of annual accounts.
  • Course Content
    • Introduction to financial accounting.
    • Principles of bookkeeping.
    • Processing of business transactions.
    • Preparing a balance sheet.

Examination Details

  • Type: Written exam
  • Duration: 120 minutes.
  • Percentage from Financial Accounting: Approximately 50% of the module exam.
  • Points: Maximum 100 points.
  • Passing Score: At least 50 points.
  • Permitted Examination Aids
    • Non-programmable calculator.
    • IFRS standard texts (bound volume) with underlinings, markings, and bookmarks.
    • Restrictions: No handwritten notes or paragraph references in the IFRS text or on bookmarks.

Basic Course Literature

  • Harrison W., Suwardy T., Tietz W., Horngren C., Thomas C. (2023): Financial Accounting, International Financial Reporting Standards, 12th Edition, Hoboken: Pearson.
  • Wiley VCH: International Financial Reporting Standards (IFRS) latest available version – EU- official standard text, bound volume.

Core Topics in Financial Accounting

  1. Introduction
    • What is Financial Accounting?
    • Introduction to Business Transactions
    • Financial Accounting Equation
    • Case Study: Northern Wall Ltd.
  2. Double-Entry Accounting
    • Financial Accounting Cycle
    • Accounting for Business Transactions
    • Journalize Business Transactions
    • Posting Journal Entries to the Ledger
    • The Trial Balance
    • Case Study: Northern Wall Ltd.
  3. Financial Accounting and Financial Reporting

Learning Objectives

  • Understand the function of financial accounting.
  • Understand the role of accounting in communicating financial information.
  • Understand business transactions and their effects.
  • Understand the basic financial accounting equation(s).

What is Accounting?

  • Accounting is an information system.
    • Documents activity through invoices, shipments, and internal production processes.
    • Records business activity systematically using double-entry accounting (debit-credit rules).
    • Processes information into a readable format, applying guidelines and aggregating data.
    • Communicates information concisely through financial statements to facilitate decision-making.

Perspectives in Accounting

  • Management Accounting (Internal)
    • Cost Accounting
    • Planning and Decision Support
    • Business statistics and performance evaluation
    • No legal regulation; designed according to company-specific criteria.
  • Financial Accounting (Internal & External)
    • Accounting and financial reporting.
    • Tax accounting/reporting.
    • Applies accounting regulations (IFRS or national GAAP).

Goal and Purpose of Financial Accounting

  • Goal: To inform about the firm’s current financial position.
  • Enable efficient management and monitoring.
  • Records all transactions with economic effect on the firm.
  • Financial Accounting System generates Financial Statements and Financial Reporting Information.

Purpose of Financial Reporting

  • Focuses on the information needs of investors.
  • Investors bear risk and have limited access to steering management activities.
  • Information suitable for investors covers most other stakeholders' needs.

Business Transactions

  • Exchanges with an external party (another firm or person).
  • Examples: Sale of goods, rendering of services, incurring a loan, issuing shares, buying supplies.
  • Involve the business of the firm and have a financial impact.

Analyzing Business Transactions

  • Possible financial effects:
    • Increase in the funds of the firm.
    • Decrease in the funds of the firm.
    • Change in the composition of the funds invested (uses).
    • Change in the composition of the funding (sources).

Funds of the Firm

  • Comprise all investments made by it and its financing.
  • Expressed in monetary units.
  • Investments (USES) are presented on the left side (Debit).
  • Financing (SOURCES) are presented on the right side (Credit).

Statement of Financial Position (Balance Sheet)

  • Presents the financial position at a point in time.
  • Uses are represented by Assets.
  • Sources are differentiated into Liabilities and Equity.
  • Financial Accounting Equation:
    • Assets=Liabilities+EquityAssets = Liabilities + Equity

Financial Accounting Equation

  • Equation 1: Financial Position of the firm
    • Assets=Liabilities+EquityAssets = Liabilities + Equity
  • Typical Assets: Cash, Accounts & Notes Receivable, Inventory, Prepaid Expenses, Land, Buildings, Equipment, Furniture & Fixtures
  • Typical Liabilities: Accounts payable, Notes payable, Accrued liabilities.
  • Typical Equity Positions: Share Capital, Dividends, Retained Earnings, Revenues, Expenses

Extended Financial Accounting Equation

  • Assets = [Cash + Accounts & Notes Receivables + Inventory + Prepaid Expenses + Land + Buildings + Equipment]
  • Liabilities = [Accounts payable + Notes payables + Provisions + Accrued liabilities]
  • Equity = [Share Capital + Share Premium + Retained Earnings – Dividends + Revenues – Expenses]

Real Life Example: BMW Group

  • Assets (202,550 m€) = Liabilities (145,674 m€) + Equity (56,875 m€)

Financial Accounting Equation (Performance)

  • Equation 2: Performance of the period:
    • Total Revenue & Gains - Total Expenses & Losses = Net Income (or Loss)
      *Real Life Example: BMW Group financial at Sept. 30th, 2018
      *Total Revenue & Gains (73,633 m€) - Total Expenses & Losses (67,845 m€) = Net Income/Profit (Loss) (5,788 m€)

Financial Accounting Equation (Retained Earnings)

  • Equation 3: Development of retained earnings:
    • OpeningBalanceofRetainedEarnings+Revenuesfortheperiod−Expensesfortheperiod−Dividendsfortheperiod=ClosingBalanceofRetainedEarningsOpening Balance of Retained Earnings + Revenues for the period - Expenses for the period - Dividends for the period = Closing Balance of Retained Earnings

Case Study: Northern Wall Ltd.

  • NW is a security agency that safeguards landscapes.
  1. NW is founded January 1st 2020, giving out € 100,000 of shares to Investors for cash.
  2. NW rents office space for the first quarter in 2020 is € 12,500 and pays cash.
  3. NW purchases a computer for € 5,000 and pays half of the price in cash. The remaining amount was paid on account.
  4. NW provides services to Stark Inc. € 30,000 and receives a cash payment of € 20,000; the remaining amount is received on account.
  5. NW pays salaries in cash, € 10,000.
  6. NW pays € 2,000 to reduce the debt from deliveries on account.
  7. NW pays dividends of € 2,000 in cash.

Double-Entry Accounting

  • Overview of the information system expressed by the financial accounting cycle.
  • Analyze the impact of business transactions on accounts.
  • Record (journalize and post) transactions to the Journal and the Ledger.
  • Construct and use a trial balance. Reformat the trial balance to receive the Balance Sheet and the Income statement.
  • Analyzing Transactions using T-Accounts (only)

Financial Accounting Cycle

  • I. Business Transaction

  • II. Journal Entry

  • III. The Ledger & Accounts

  • IV. Trial Balance

    • Financial accounting information process:
      *Transaction occurs
      *Transaction analyzed
      *Transaction journalized
      *Amounts posted to the ledger
      *Close the accounts of the ledger to the Trial Balance
      *Present Financial Information

Analyze Business Transactions

  • Possible financial effects on the firm:
    1. Increase in the funds of the firm.
    2. Decrease in the funds of the firm.
    3. Change in the composition of the funds invested by the firm: Uses of firms' funds.
    4. Change in the composition of the funding of the firm: Sources of firms' funds.

Business transactions effect on the firm

  • Analyze the financial effect on the firms funds:
    1. Increase in the funds of the firm (increase of debit and the credit side)
    2. Decrease in the funds of the firm (decrease of the debit and the credit side)
    3. Change in the composition of Assets (debit side composition changes)
    4. Change in the composition of Liabilities/Equity (credit side composition changes)

Examples of Business Transactions

  • Example 1: Merchant A gives a goat to merchant B and receives a silver coin in return:
    • Perspective A:
      • Receives the silver coin, Gives away the goat.
      • Portfolio of Assets changed due to this transaction.
      • The amount of silver coins is increased by 1.
      • The number of goats in the herd is reduced by 1.
    • Debit = Silver Coins, Credit = Inventory of Goats, Amount = 1 Silver Coin
    • Transaction results in a change of composition of the uses of the funds of merchant A.
  • Example 2: Firm C continuously provides a daily online back-up-service to the virtual trading platform of firm D based on a contract between C and D for five month. Based on the contract, D transfers 10.000€ each month in advance (total amount: 50.000€).

Account

  • In financial accounting, the account is used to follow-up all transactions of the reporting period.
  • It is applied to each assets, liabilities and equity-position!
  • Due to its appearance, it is called the “T-Account”:

Rules of Debit and Credit

  • Accounting Equation:
    • Assets: Debit (+), Credit (-)
    • Liabilities: Debit (-), Credit (+)
    • Equity: Debit (-), Credit (+)

Equity

Extending Equity Accounts

  • Revenues and Expenses Additional Shareholders Equity Accounts

Assets Liabilities Share Capital Retained Earnings Revenues Expenses Dividends
Equity Rules of Debit and Credit

  • Extended Accounting Equation, Rules of Debit and Credit
    *Assets Debit (+) Credit (-)
    *Liabilities Credit (+) Debit (-)
    *Share Capital Credit (+) Debit (-)
    *Retained earnings Credit (+) Debit (-)
    *Dividends Credit (+) Debit (-)
    *Revenue Credit (+) Debit (-)
    *Expenses Credit (+) Debit (-)

The Journal

  • Chronological record of transactions
  • Three steps for Journal entries:
    1. Specify each account affected and classify by type
    2. Determine if each account is increased or decreased
    3. Record in journal / Make the journal entry

Journal-entry process

Follow the three steps:

  • Example 1: NW is founded January 1st 2020, giving out € 100,000 of shares to Investors for cash.
    1. Specify each account affected by the transaction and classify by type
      • Cash (Assets) | Share capital (Equity)
    2. Determine if each account is increased or decreased (apply debit credit rules)
      • Cash increased | Share capital increased

Journal Entry

*Date Accounts & explanations Debit Credit
*1.1.2020 Cash 100,000
*Share capital 100,000

The Ledger

The Ledger
Ledger
Cash Accounts payable Share Capital
Individual asset accounts
Individual liability accounts
Individual equity accounts

Financial Accounting Cycle – IV Trial Balance

  • All individual accounts are held within the Ledger
  • The trial balance summarizes all the account balances for the financial statements and shows whether total debits equal total credits