Unlike majority of the vastly superior European upper-secondary schools, students in 🇨🇦 have to enrol in pointless electives to get their dispensable certificate of achievement. As part of the university’s scheme to increase revenue, they use this tactic to tack on an extra year of useless schooling, crank out more tuition, and complete the capitalist fetish.

Sometimes I wanna shatter an improvised incendiary grenade at the unoccupied office of the Secretary of Education.

Nevertheless, Financial Accounting is an elective I’ve enrolled in as something completely unrelated to my program of programming. As part of my motivation of getting through this shithole, I wrote this post summarizing why everyone should learn the basics of accounting, despite being rather self-explanatory: counting things.

Financial accounting is understanding businesses through accounting, unlike regular accounting which can focus on personal finances.

Why is it important to understand a business? Let’s say you’re like me and don’t want to become an accountant; instead, you wanna invest in a business.

If you want to invest in Tesla because you like Tesla, that’s a poor way to invest. Instead, how about you read their quarterly balance sheet, income statement, and cash flow statement?

They answer questions like:

• How much debt is Tesla in?
• How much assets can they liquidate in order to pay off their debt in case of a crisis?
• How much profit are they making?
• What do they do with excess cash? (does it go to you, the shareholder, or is it reinvested?)
• How much cash flows in and out of their business?
• What is their net profit margin over the last 10 years? Are they consistently profitable?
• How much of their net earnings is due to operational expenses, rather than lawsuits and acquisitions?
• How much of their assets are financed by your equity and how much is financed by creditors like a bank?

There’s much more, but you get the gist of why reading the financial statements above is useful. We also learn about a “Statement of Changes in Equity”, which I can’t see as being useful to anyone but the accountants who close the books at the end of a reporting period.

You don’t need to know what that means, but if you do (you masochist), just CMD/Ctrl + F: “closing entries” on this page

Anyway, that’s about it. You can read on if you want, but honestly, this is all useless as an external investor since the common financial advice I hear nowadays is this:

👶 If you’re young, buy the S&P 500 ETF

🧑 If you’re older, mix that ETF with a bond ETF

🧓 If you’re old, buy gold or something for your grandkids like a bond

🏩 If you’re kinky, get a robo-investor to do essentially the same thing, and pay them a fee for some reason

🤫 If you’re really kinky, commit some insider trading on your own company (then join go to jail where they feed you for free)

WLU Intro to Financial Accounting - BU127

1: 📰 Financial Statements

1. The Balance Sheet reports the assets, liabilities, and shareholder’s equity at a point in time

   • Current assets
     • Cash
     • Accounts/Trade Receivables
     • Inventory
     • Prepaid Expenses (Insurance < 12 months)
   • Non-current assets
     • Plant, Property, and Equipment (PPE)
     • Prepaid Expenses (Insurance ≥ 12 months)
   • Liabilities like short term (current) or long terms (non-current) accounts/notes payable
   • Shareholder Equity (contributed capital + retained earnings)

2. The Income Statement reports revenues - expenses = profit over a period of time

   • Expenses include “Cost of Sales”

3. The Statement of Changes in Equity reports how the distribution of dividends - net income from the income statement affects shareholder equity (R/E) over a period of time

4. The Cash Flow Statement [insert explanation here]

   • +/- Investing cash flow (purchasing/selling long-term assets and lending money)
   • +/- Financing cash flow (taking loans, paying them back, issuing/repurchasing stock, and paying dividends)
   • +/- Operating cash flow (everything else)

Note: the statements can come with notes which aren’t necessary but do provide supplementary knowledge for interpretation

For the balance sheet:

• Current assets can be converted into cash within 1 year and current liabilities will be paid off within 1 year
  • Non-current assets/liabilities are therefore self-explanatory
• The order of assets listed are sorted by descending orders of liquidity, or how readily the assets can be converted into cash

These powerpuff girls are used by internal/external investors to judge companies using some set of ratios.

Here are the relationships, bitch:

2: 💱 Investing and the Accounting System

Useful Information for Investors

Useful information is considered:

• Relevant
• Faithful
• Verifiable
• Timely
• Understandable

Financial Info Assumptions

1. Seperate Entity: transactions of the shareholders are not confused with transactions from the business
2. Monetary Unit: information is reported without taking inflation into account
3. Continuity/Going Concern: the business is expected to operate (so there is a point to analyzing the information)

Recording Transactions

1. A journal entry is a transaction with more than 2 accounts being credited or debited.

2. A T-account summarizes journal entries over a period a time for 1 account.

3. A Trial Balance summarizes the ending balances of multiple t-accounts over a period of time.

The general rule for all three of these: Debits are on the left, and Credits are on the right.

🏭️ 3: Operating Decisions

Ratios

The current ratio is useful because it measures a company’s liquidity, or how much of its debt can be paid off with assets if need be

The Total Asset Turnover Ratio is useful because it measures the sales/revenue generated from the use of assets, and thus, the efficiency of the assets

The ROA Ratio is useful because it measures how much profit was earned by using assets

The NPM Ratio is useful because it measures the percentage of profit earned per revenue. If NPM goes up, we know revenues and expenses are being managed efficiently.

Accrual Basis Accounting

Cash basis accounting isn’t used according to GAAP, since it drastically fluctuates statements where cash is received before or after delivery of goods.

Instead, we use accrual basis accounting which uses the RRP and ERP to recognize revenues and expenses.

• The RRP says that we recognize revenues when goods are delivered, not when they’re paid for
• The ERP says that we incur expenses when generating revenue

📪️ 4: Adjustments/Closing Entries

Adjusting Journal Entries

To correct any errors and measure earnings properly throughout the accounting period, we use 4 types of adjusting entries:

↩ Skip to Chapter 8 to learn how we resolve deferred revenues as current/non-current liabilities

Closing the Books

Temporary accounts like revenue/gains and expenses/losses, or those seen on the income statement, must be closed to a zero balance at the end of the accounting period.

The accumulation of these temporary accounts are moved into the permanent Retained Earnings account.

In the extremely brief example above, the company’s net worth dropped by $300.·

📈 5: Revenue, Cash, and Receivables

Bad Debt and Contra Accounts Receivable

Net Realizable Value, is the market value of our items and is calculated with

⚠ Notice how this is different than the formula for gross profit:

Some customers cannot pay their AR (their trade receivable balance), so we must write off the bad-debt taken on.

💡 If we originally expected $80k from a customer, but they are only able to pay $76k, we’d write-off (decrease) our accounts receivable balance by $4k. That means, the NRV = $76k (or our AR balance - write off).

We also have the allowance method which opens an “Allowance for Doubtful Accounts” contra-asset account. A contra-asset account is used to reduce the value of a related asset.

The reason we do this is for companies to have a more accurate picture of the net value of an asset, since we work on estimates anyway.

💡 If the company predicted the customer wouldn’t pay $7k, they would have Allowance for Doubtful Accounts = $7k, effectively “allowing” them that wiggle room out of expectation.

Here are the journal entries:

↓ DR: $4k Allowance for Doubtful Accounts ↓ CR: $4k Accounts Receivable

Our allowance account is now $7k - $4k = $3k (since the customer exceeded expectations).

Since NRV is our expected value, and we’re allowing them an additional $4k of wiggle room, it will be $73k NRV = $76k AR - $4k Allowance.

Receivables Turnover

Receivables turnover tells us how efficiently the company collects its trade receivables (now that we know some customers don’t like paying).

Or, the shorter form

The higher the percentage, the more money the company collects from creditors.

Safeguarding Cash

As borrowers, the company keeps track of two statements:

1. The Book Balance, or how much we think we’ve borrowed and payed from the bank
2. The Bank Balance, or how much the bank thinks we’ve borrowed and payed to them

Sometimes, these two can get out of sync, requiring a bank reconciliation. If an error occurred on the bank’s side, the bank is responsible for correcting the bank statement, and vice versa for company reporting errors.

📦️ 6: Cost of Sales and Inventory

Identifying Inventory and Cost of Goods Sold Amounts

Inventory is a current asset that is either:

1. Held for sale in the normal course of business (like a personal computer)
2. Used to produce goods or services for sale (the hard drives)

There are many types of inventory:

• Merchandise which is finished inventory acquired and held for resale by a retailer

• Raw materials which is unfinished inventory; the parts to be processed into items for sale

• Work in Process inventory which is self explanatory

• Finished goods inventory which is used by merchandisers

The cost of inventory is usually the sum of the costs incurred in bringing an item into a usable or saleable condition and location. Think of manufacturing costs, repair costs, shipping costs, etc.

The reason we care about assets manufactured is because it manipulates our beginning inventory during the accounting period, adding inventory while it is being sold.

This makes sense, since we’re trying to figure out how much inventory was sold. We can’t just subtract beginning and ending inventory, since that would be misreporting how much inventory we have.

💡 For example is if we’re trying to find the sales for a company where: - Beginning inventories (WIP + Finished) = $90500 - Ending inventory (WIP + Finished) = $115000 - Cost of Goods Manufactured = 360000 - Gross Profit = 135000

According to the Gross Profit formula Sales = Gross Profit + COGS. According to our formula above: Sales = $135000 + $90500 + $360000 - $115000 = $470500

Example Invoice for the Cost of Merchandise Inventory

In general, companies should not accumulate purchasing costs until either:

• Raw materials are ready for use
• Merchandise inventory is ready to ship

Inventory costs flow from different statements during from acquisition to sale of materials/merchandise.

💡 For example, if the selling expense for a year was $255k, and the ending inventory was $480k, the COGAS would be $255k + $480k = $735

From the Merchandiser (Reseller) POV

The flow of inventory cost from the merchandiser is rather simple:

From the Manufacturer POV

We can record COGS in a fiscal period using either of the inventory systems:

The Perpetual inventory system: COGS and Inventory are updated as soon as inventory is sold, and detailed records are maintained. Getting and retaining this information is costly, but it allows managers to view it right away.

The Periodic inventory system: COGS and Inventory are updated at the end of the year by multiplying inventory units by the cost of goods. Obviously, this is a much cheaper system to compute.

The 3 Inventory Costing Methods

How do we know the cost of the inventory we’ve sold? Ordinarily, if Walmart purchases 3 shipments of socks at x value, the COGS would be x * units sold.

What if the 3 shipments varied in price? For example:

• $3: DR: ↑ Inventory CR: ↑ Accounts Payable

• $5: DR: ↑ Inventory CR: ↑ Accounts Payable

• $1: DR: ↑ Inventory CR: ↑ Accounts Payable

The Walmart shopper pays the same price no matter the socks bought, but its now difficult for Walmart to determine the value of the goods walking out the door.

1. FIFO

FIFO declares that we sell off inventory as soon as it is received, like fresh fruit. Remember the COGS equation? According to FIFO:

• The oldest units are allocated to cost of goods sold
• The newest units are allocated to ending/remaining inventory

Going along with our Walmart example, the COGS would be $3 because that was the oldest units (or the first to be purchased).

2. LIFO

LIFO declares that we sell off inventory as late as possible, like crude oil.

At Walmart, the COGS would be $1 because that was the newest units (or the last to be purchased).

3. Average Cost

Average cost is where we calculate the ending inventory and COGS as average of the cost of goods available for sale and the amount of units available.

At Walmart, the COGS would be ($3 + $5 + $1) ÷ 3 = $3, or the average of the three purchases.

⚠️ When calculating the ending inventory, COGS, or gross profit using perpetual inventory systems, we must recompute the average cost on every sale of inventory rather than all at the end.

Lower of Cost and Net Realizable Value

But how do we actually value our inventory? Is it worth how much we paid for it, or how much the market values it? The cost of the inventory, is how much we paid for it

The lower of cost rule says that to avoid overstating the value of our inventory, we must report the lower of cost and NRV.

• If we paid more for our item than we can sell it for, we report how much the market values it
• If the market values it more than its cost, we report how much we paid for it

Who Gives a Fuck?

You’re right! Up until this point, we’ve understood the cost of inventory as how much we paid for it. That’s why, using the lower of cost rule, we must write down the value of devalued units.

In the case of oranges, we will:

(+) Debit cost of goods sold by the valuation amount we’ve written down 300 * ($22 - $17) = $1500 (written down value)

(-) Credit inventory for the same amount, as we’ve lost $1500 in our reported value

Inventory Turnover

Lets say a manager of a clothing store wants to know how many times the store was emptied throughout the year (aka. when did the store sell all of its inventory)

To find the inventory turnover ratio that the manager is looking for, we take the COGS ($120K), beginning inventory ($17.5K), and ending inventory ($22.5K) to calculate the following:

  ($17.5 + $22.5)
/ 2
= $20

  $120
/ $20
= 6 # The inventory turned over 6 times

Now, the manager wants to know how long it takes to sell inventory, or the average days to sell inventory.

  365 days
/ Inventory turnover
= Average days to sell inventory

Following our previous example: 365 / 6 = 60.8 days on average for the inventory to turnover.

🚛 7: Long-Lived Assets

Long lived assets depreciate in value! There are two types of depreciation: 1. Accumulated depreciation which is depreciation over the life of the asset 2. Depreciation expense which is depreciation over the recorded period (whether it be a month, a quarter, a year, etc.)

There is also Depletion which refers to allocating costs of natural resources being used up like oil reserves.

Any time the depreciation expense goes up, we know the lifetime depreciation has also gone up. To understand how much an asset depreciates, we take into account two factors: 1. Useful life which is an estimate of how long we expect the asset to last 2. Salvageable or Residual Value which is how much the asset will be worth after the end of its useful life

The total amount the asset will depreciate is its original value - residual value. The net worth of the asset is called the Net Book Value (NBV) calculated by:

To determine periodic depreciation, we use three methods:

Disposal before End of Life

If an asset is prematurely disposed of before the end of its estimated useful life, we sell it and take that cash to the bank. Sometimes, we can make gains/losses on the sale of long-lived disposed assets.

Changing Depreciation Estimates

If the depreciation rate changes (meaning a change in an assets useful life), the depreciation expense must be adjusted for the current and future period.

💡 I machine costing $850k with a salveagable value of $50k and useful life of 8 years is re-evaluated on the beginning of the 6th year to have a useful life of 10 years with a residual value of 0, the new depreciation expense should be ___ .

Depreciated Expense per Year = 800/8 = 100k Carrying Amount = 850 - 5 * 100k = 350 Remaining Life = 3 years New Depreciation Expense = 350/3 = 116

💸 8: Current Liabilities

Warranty is an example of a current liability, and we should calculate the amount current liabilities change throughout accounting periods.

Warranty Expense = Changes in Warranty Liability - Charges Incurred. This is not LaTeX formatted because it isn’t a formula, just an example for a current liability.

So, if a company has: - Starting warranty liability of $126 - Ending warranty liability of$96 - Charges incurred during the year of $109

Their change in warranty liability is $96 - $126 = -$30, and their warranty expense is -$30 + $109 = $79.

The warranty expense entry looks like:

• DR: $79 ↑ Warranty Expense

• CR: $79 ↑ Estimated Warranty Liability

The warranty settlements/payments entry looks like:

• DR: $109 ↑ Estimated Warranty Liability

• CR: $109 ↓ Cash

And, if given the net revenues for the year, we can find the warranty expense to net revenue ratio for it (by dividing the warranty expense by net revenues obviously). This tells you what percentage of your net revenue is dedicated to paying warranty claims.

To determine the recognized revenue at the end of a year, we can use this formula:

Accrued Interest Notes Payable

🪙 9: Non-Current Liabilities

Bonds Payable

A bond is issued by a company as a form of borrowing money from its investors. Unlike stock, the company promises to pay back the principal amount/face value at the maturity date while making periodic interest payments.

The interest rate the bond pays out periodically is known as the coupon rate. The interest rate the company agrees to pay is different than the demand from the market, known as the market rate.

if Interest Rate > Market Rate: "Bond is sold at a premium"
elif Interest Rate = Market Rate: "Bond is sold at par"
elif Interest Rate < Market Rate: "Bond is sold at a discount"

Determining How Much to Sell the Bond For

To determine a good selling price, we need to find the bond’s face value and present interest rates payments

The formula for determining the present value of interest payments is:

$$ \begin{align} PMT & = \text{Payment} \ r & = \text{Market Interest Rate} \ n & = #\;\text{of Payments} \ \

PV & = PMT\left( \frac{1-(1+r)^{-n}}{r} \right) \end{align} $$

The formula for determining the present value of face value is:

$$ \begin{align} r & = \text{Market Interest Rate} \ n & = #\;\text{of Payments} \ \

PV & = \frac{\text{Face Value}}{(1+r)^n} \end{align} $$

💡 For example, if a company issues a $1 mil bond with a 5 year maturity, a 9% coupon rate, a 8% market rate and pays semi-annually (twice/year), the journal entry for the bond will be __

1. Annual interest payment = $90k (9% of $1 mil)
2. Semi annual interest payment = $45k ($90k/2)
3. Semi annual market interest demand = 8% / 2 = 4%
4. Total # of payments = 10 (5 years to maturity × 2 payments/year)
5. PV of Interest = 45 000(( 1 - (1 + 0.04 )^-10) / 0.04) = 421 200
6. PV of Face Value = 1 000 000 / (1 + 0.04)^10 = 675 564
7. Total Present Value = 421 200 + 675 564 = 1 096 764)

↑ DR: Cash 1 096 764 ↑ CR: Bonds Payable 1 096 764

Interest Payable

Other Non-Current Liabilities

Debt to Equity Ratio

🥧 10: Shareholder’s Equity

🔃 In Progress

🌊 11: Statement of Cash Flows

🔃 In Progress

💬 12: Communication and Analysis

🔃 In Progress