Financial accounting Study Guide

📖 Core Concepts Financial Accounting – records, summarizes, and reports a company’s financial transactions for external users. Financial Statements – the public‑facing outputs: Cash Flow Statement, Income Statement, Balance Sheet, Statement of Retained Earnings, and Statement of Changes in Equity (the “DIRTI 5”). Users – investors, lenders, suppliers, employees, governments, and owners who need the information to make decisions. Accounting Standards – IFRS (issued by the IASB) dictate how transactions are presented; GAAP governs U.S. reporting. Fundamental Accounting Equation – $Assets = Liabilities + Equity$; the backbone of the balance sheet. Current vs. Non‑Current – assets/liabilities expected to be realized or settled within one year vs. longer‑term. Retained Earnings – cumulative net income not paid out as dividends; shown in equity. 📌 Must Remember DIRTI 5 = Cash Flow, Income, Balance Sheet, Retained Earnings, Changes in Equity. Income Statement bottom line = Net profit (or loss). EBIT formula: $Sales - COGS - SG\&A - Depreciation/Amortization = EBIT$. Profit/Loss after interest & tax: $EBIT - Interest\ Expenses - Tax\ Expenses = Profit/Loss$. Balance‑sheet ordering: GAAP – assets & liabilities listed decreasing liquidity (most liquid first). IFRS – assets & liabilities listed increasing liquidity (least liquid first). Retained Earnings equation: $$RE{ending}=RE{beginning}+Net\ Income - Dividends$$ Objective of financial reporting (IFRS) – provide useful information to investors, lenders, and creditors. 🔄 Key Processes Preparing the Income Statement Gather revenues, subtract COGS → Gross profit. Subtract SG&A and depreciation/amortization → EBIT. Subtract interest → EBT (Earnings before tax). Subtract tax expense → Net profit/loss (bottom line). Building the Balance Sheet List current assets (cash, receivables, inventory). List non‑current assets (property, plant, equipment). List current liabilities (payables, short‑term debt). List non‑current liabilities (long‑term debt). Compute Equity = Assets – Liabilities (or use detailed equity accounts). Statement of Retained Earnings Start with beginning RE. Add Net Income (from Income Statement). Subtract Dividends declared. Result = ending RE (carried to equity section). 🔍 Key Comparisons GAAP vs. IFRS balance‑sheet ordering GAAP: most liquid → least liquid. IFRS: least liquid → most liquid. Current vs. Non‑Current Current: expected cash flow/settlement ≤ 12 months. Non‑Current: > 12 months horizon. Income Statement vs. Cash Flow Statement Income Statement: accrual basis, measures profitability. Cash Flow Statement: cash basis, shows actual cash inflows/outflows. ⚠️ Common Misunderstandings “Profit = Cash” – Profit includes non‑cash items (depreciation, accruals); cash flow is separate. Equity = Owner’s Investment only – Equity also includes retained earnings and other comprehensive income. All assets are “liquid” – Only current assets are considered readily convertible to cash. 🧠 Mental Models / Intuition Equation Balance – Think of the balance sheet as a seesaw: whatever you add to assets must be matched by an equal increase in liabilities or equity. DIRTI 5 as a “Financial Snapshot” – Imagine a 5‑panel comic strip: cash flow (movement), income (performance), balance sheet (position), retained earnings (history), changes in equity (ownership shifts). 🚩 Exceptions & Edge Cases IFRS classification of “current” can differ for assets with contractual repayment terms longer than 12 months but intent to settle within a year. Dividends may be paid in cash or stock; only cash dividends reduce retained earnings directly. 📍 When to Use Which Choosing GAAP vs. IFRS format – Use GAAP when the exam specifies U.S. reporting; use IFRS when the question mentions international standards or IFRS compliance. When to compute EBIT – Use EBIT to evaluate operating performance before financing and tax effects. When to refer to the cash flow statement – When the problem asks about liquidity, ability to pay debts, or cash generation. 👀 Patterns to Recognize Liquidity ordering swap – If a balance‑sheet list goes from cash → inventory → property, it’s GAAP; if it goes from property → inventory → cash, it’s IFRS. DIRTI 5 cue words – Any question mentioning “five statements” or “complete financial picture” points to listing all five components. Retained earnings change – Look for a “Net Income – Dividends” pattern in equity‑section questions. 🗂️ Exam Traps Distractor: “Net profit = cash flow” – Wrong because cash flow includes financing and investing activities, not just operating profit. Misreading “current” – A choice that classifies a 13‑month loan as current is a trap; the cutoff is 12 months. Mixing GAAP vs. IFRS ordering – Selecting “least liquid first” for a GAAP balance sheet is incorrect. Including dividends twice – Some options add dividends to net income and subtract them again; only one subtraction is correct for retained earnings.