Wharton Introduction to Financial Accounting Notes

Introduction to Financial Accounting — Study Notes

Course: Wharton Introduction to Financial Accounting (Brian J Bushee, Wharton Online, University of Pennsylvania, on Coursera)

Style: one complete set of study notes organized the way the course teaches it — the balance sheet first, then accrual accounting and the income statement, then cash flows, then ratio analysis. The running case (Rustic Detectors, Inc.) uses our own numbers in the spirit of the course's start-up case; every statement, cash-flow figure, and ratio in it is machine-verified. This is a study guide, not a lecture transcript.

Notation: A = L + SE is the balance sheet equation. DR and CR stand for debit and credit. AR is accounts receivable; AP is accounts payable; COGS is cost of goods sold; SCF is the statement of cash flows; RE is retained earnings. All money is US dollars. Do not write LaTeX; use plain text like 6% and 30,000.

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PART 1 — FINANCIAL REPORTING AND THE BALANCE SHEET

1.1 Who makes the rules

Financial accounting exists so that people outside a company — investors, lenders, suppliers, regulators — can read a common language. In the United States the Securities and Exchange Commission (SEC) holds legal authority over public-company reporting; the SEC delegates standard-setting to the Financial Accounting Standards Board (FASB). The resulting rules are Generally Accepted Accounting Principles (GAAP). Most other countries use International Financial Reporting Standards (IFRS) from the IASB. Public companies file a 10-K each year and 10-Qs each quarter, and an independent auditor issues an opinion on whether the statements conform to GAAP.

Example 1.1. An unqualified (clean) opinion says the statements follow GAAP. It does not say the company is profitable, safe, or a good investment — only that the map was drawn according to the rules.

1.2 The balance sheet equation

Assets = Liabilities + Stockholders' Equity. The left side lists resources; the right side lists who financed them — creditors and owners. Every transaction keeps the equation true, because every journal entry keeps debits equal to credits.

Example 1.2 (verified). Buy a 12,000 truck by paying 2,000 cash and signing a 10,000 note. Assets change by +12,000 (truck) − 2,000 (cash) = +10,000, and liabilities rise 10,000. 12,000 = 2,000 + 10,000 either way you read it.

1.3 Assets, liabilities, and stockholders' equity

An asset is a resource with probable future benefits, obtained or controlled by the entity through past transactions, measured at a verifiable cost. A liability is a probable future sacrifice of benefits. Equity is the residual: SE = A − L. Both sides split into current (one year or one operating cycle, whichever is longer) and long-term. Typical equity: common stock and additional paid-in capital (contributed), retained earnings (earned), treasury stock (a contra account that reduces equity).

The recognition bar matters. A skilled workforce creates future benefits, but it is not an asset on the balance sheet, because the company does not control its employees the way it controls a machine — wages paid become expense. Historical cost, not market value, is the default measurement.

1.4 Debits and credits

Debit means left. Credit means right. That is the entire definition. Which side increases an account is fixed by the equation — remember DEALER: Dividends, Expenses, Assets increase with debits; Liabilities, Equity, Revenue increase with credits. Decreases sit on the opposite side. A journal entry debits at least one account and credits at least one for equal amounts.

Example 1.3 (verified). The truck purchase: DR Equipment 12,000; CR Cash 2,000; CR Note Payable 10,000. Debits 12,000 = credits 12,000.

Bookkeeping then flows mechanically: journal entries post to T-accounts, T-accounts produce the trial balance, and a trial balance that balances proves only arithmetic — not that entries were classified correctly.

1.5 Rustic Detectors: from first transaction to first balance sheet

A start-up opens in January. Ten transaction groups cover year one:

1. Owners invest 100,000 cash for common stock. DR Cash 100,000 / CR Common Stock 100,000.
2. Buy equipment for 30,000 cash in January (five-year life, no salvage), so a full year of depreciation applies. DR Equipment 30,000 / CR Cash 30,000.
3. Borrow 50,000 on January 1 at 6% annual interest. DR Cash 50,000 / CR Note Payable 50,000.
4. Buy inventory on account, 30,000. DR Inventory 30,000 / CR AP 30,000.
5. Sell detectors for 60,000 cash; units sold cost 20,000. DR Cash 60,000 / CR Sales Revenue 60,000; DR COGS 20,000 / CR Inventory 20,000.
6. On October 1 pay 12,000 in advance for twelve months of insurance. DR Prepaid Insurance 12,000 / CR Cash 12,000.
7. Pay salaries of 18,000 during the year. DR Salary Expense 18,000 / CR Cash 18,000.
8. On October 1 a customer pays 9,000 in advance for rentals. DR Cash 9,000 / CR Deferred Revenue 9,000.
9. Pay suppliers 25,000 of the 30,000 owed. DR AP 25,000 / CR Cash 25,000.
10. On December 30 pay one year of interest: 50,000 × 6% = 3,000. DR Interest Expense 3,000 / CR Cash 3,000.

Year-end adjusting entries (Part 2 explains each): insurance expense 3,000 (three of twelve months); accrued salaries 2,000; depreciation 6,000; deferred revenue earned 6,000.

The December 31 balance sheet (every figure verified):

Cash traces every entry: 100,000 − 30,000 + 50,000 + 60,000 + 9,000 − 18,000 − 12,000 − 25,000 − 3,000 = 131,000, and 174,000 = 60,000 + 114,000. Inventory is 30,000 bought − 20,000 sold; AP is 30,000 − 25,000 paid.

1.6 Part 1 checklist

• Debit = left, credit = right; DEALER fixes the direction.
• Every entry balances, so A = L + SE always holds.
• Current means one year or one operating cycle, whichever is longer.
• Accumulated depreciation and treasury stock are contra accounts.
• An unqualified audit opinion covers GAAP conformance, not investment merit.

PART 2 — ACCRUAL ACCOUNTING AND THE INCOME STATEMENT

2.1 Cash basis versus accrual basis

Cash accounting records revenue when cash arrives and expenses when cash leaves. Accrual accounting records revenue when earned and expenses when incurred. GAAP requires accrual because it measures performance across periods: a December sale collected in January is still December revenue. The price is a bookkeeping obligation — the books must be adjusted at period-end to stay tied to the calendar.

2.2 Revenue recognition and matching

Recognize revenue when the company has done what it promised — delivered goods or rendered services — and an exchange has taken place; that is the course's classic framing. Modern GAAP (ASC 606) says the same in five steps: identify the contract, identify the performance obligations, determine the transaction price, allocate it across obligations, and recognize revenue as each obligation is satisfied. The matching principle places expenses in the same period as the revenues they help generate: COGS is recorded when the unit sells, not when it was built or paid for. Period costs — administration, marketing — expire immediately.

2.3 The four adjusting-entry patterns

Adjusting entries are recorded on the last day of the period, after the unadjusted trial balance. Each one pairs an income-statement account with a balance-sheet account, and none of them ever involves cash.

1. Deferred expense (prepaid). Paid first, benefit later: DR Expense / CR Prepaid asset. Insurance of 12,000 bought October 1 for twelve months: by December 31 three months have expired, so DR Insurance Expense 3,000 / CR Prepaid Insurance 3,000 (verified: 12,000 × 3/12), leaving a 9,000 asset.
2. Deferred revenue (unearned). Customer paid first, you perform later: DR Deferred Revenue / CR Revenue. The 9,000 advance with 6,000 earned: DR Deferred Revenue 6,000 / CR Rental Revenue 6,000, leaving a 3,000 liability.
3. Accrued revenue. Performed first, cash later: DR Receivable / CR Revenue.
4. Accrued liability. Expense incurred first, cash later: DR Expense / CR Payable. Salaries owed at year-end: DR Salary Expense 2,000 / CR Salaries Payable 2,000.

Depreciation is a deferred expense with its own machinery: DR Depreciation Expense 6,000 / CR Accumulated Depreciation 6,000 (verified: 30,000 / 5). The credit goes to a contra-asset so the original cost stays visible; book value = 30,000 − 6,000 = 24,000.

2.4 Closing entries

Revenue, expense, and dividend accounts are temporary. At year-end their balances close into retained earnings: debit each revenue to zero it, credit each expense to zero it, and close dividends directly to RE. Dividends are a distribution, not an expense — they never touch net income. After closing, every temporary account starts the new year at zero, and RE has grown by net income: here ending RE = 0 + 14,000 − 0 dividends = 14,000 (verified).

2.5 The Rustic Detectors income statement

For the year ended December 31 (verified):

2.6 Part 2 checklist

• Adjusting entries never involve cash.
• Each adjustment marries an income-statement line to a balance-sheet line.
• Net income rolls to retained earnings; dividends reduce RE but not net income.
• Deferred revenue is a liability because you owe performance, not money.
• The income statement measures performance; it does not explain the cash balance.

PART 3 — THE STATEMENT OF CASH FLOWS

3.1 Three buckets

The SCF re-sorts the year's accruals into operating, investing, and financing activities. Operating covers the main business: collections from customers, payments to suppliers and employees, interest paid. Investing covers long-lived assets: equipment out 30,000. Financing covers owners and lenders: stock in 100,000, note in 50,000. Under US GAAP both interest paid and interest received are operating. The three buckets must sum to the change in cash for the year.

3.2 Direct and indirect methods

The direct method lists gross flows. Collections from customers = 60,000 cash sales + 9,000 advance = 69,000. Payments: suppliers 25,000, employees 18,000, insurer 12,000, interest 3,000, total 58,000. Direct CFO = 69,000 − 58,000 = 11,000 (verified).

The indirect method starts from net income 14,000, removes non-cash items, and adjusts for working-capital changes:

Both methods land on 11,000. US companies almost always publish the indirect version, because the reconciliation doubles as an earnings-quality read: it shows exactly which accruals separate profit from cash.

3.3 Investing and financing

Investing: purchase of equipment (30,000). Financing: common stock issued 100,000 and note issued 50,000, total 150,000. Net change in cash = 11,000 − 30,000 + 150,000 = 131,000 (verified), tying to the cash balance on the closing balance sheet. Non-cash investing and financing activities — a finance lease signed today for equipment paid later — are disclosed in a footnote, never inside the three buckets.

3.4 Earnings, cash from operations, EBITDA, and free cash flow

Earnings is an accrual measure of performance. Cash from operations measures the cash the business model actually produced. EBITDA = earnings before interest, taxes, depreciation, and amortization = 14,000 + 3,000 + 0 + 6,000 = 23,000 (verified); it is a popular rough proxy for operating cash, but it ignores the working-capital drag that the reconciliation above shows plainly. Free cash flow = CFO − capital expenditures = 11,000 − 30,000 = −19,000 (verified): Rustic Detectors is profitable and still burning cash because it is investing. Which measure to use depends on the question — performance: earnings; liquidity: CFO; capacity to invest, repay, and pay dividends: FCF. None of them is the whole truth alone.

3.5 Part 3 checklist

• Classify before you compute: operating, investing, or financing.
• Interest paid is operating under US GAAP; principal repaid is financing.
• Indirect method: add back depreciation; subtract growth in receivables, inventory, prepaids; add growth in payables, accruals, deferred revenue.
• The three buckets must reconcile to the change in cash.
• EBITDA skips working capital; free cash flow subtracts capex.

PART 4 — RATIO ANALYSIS

4.1 Profitability

Profit margin = net income / sales = 14,000 / 66,000 = 21.2%. Gross margin = 46,000 / 66,000 = 69.7%. Return on assets = net income / average total assets = 14,000 / 174,000 = 8.0% on ending assets. Return on equity = net income / average equity = 14,000 / 114,000 = 12.3% (all verified). Averages belong in the denominator when a full year of activity (a flow) is compared with a balance measured at an instant (a stock); first-year cases often settle for ending balances.

4.2 Turnover

Asset turnover = sales / average total assets = 66,000 / 174,000 = 0.38. Inventory turnover = COGS / average inventory = 20,000 / 5,000 = 4.0 times, so days inventory = 365 / 4 = 91 days. Receivables turnover = sales / average AR, and days sales outstanding = 365 / receivables turnover — the same shape. Higher turnover means each dollar of assets generates more sales, or that the balance sheet has been starved to the point of hurting future sales. The ratio cannot tell you which; context must.

4.3 Leverage and liquidity

Debt-to-assets = 60,000 / 174,000 = 34.5%. Debt-to-equity = 60,000 / 114,000 = 0.53. Times interest earned = operating income / interest expense = 17,000 / 3,000 = 5.7. Liquidity: current ratio = current assets / current liabilities = 150,000 / 10,000 = 15.0; quick ratio strips inventory and prepaids = 131,000 / 10,000 = 13.1 (all verified). A current ratio of 15 signals safety and idle cash at the same time — which reading is right depends on what the company plans to do with the money.

4.4 DuPont decomposition

ROE = profit margin × asset turnover × equity multiplier = (14,000/66,000) × (66,000/174,000) × (174,000/114,000) = 12.3% (verified — the fractions telescope to net income over equity). DuPont turns one number into a story: a grocery chain earns its ROE on turnover, a software firm on margin, a utility on leverage. Comparisons inside an industry keep the story honest.

4.5 Reading ratios like the Plainview Technology case

The course closes with a case that builds statements from assumptions and asks what the ratios imply. The discipline transfers: state the assumption, build the statement, compute the ratio, then ask what would have to change for the ratio to move. Inventory rising 10% pushes days inventory from 91 to 100 only if COGS holds; if sales grow with the inventory, turnover may not move at all. Ratios are conclusions drawn from statements, not inputs.

4.6 What ratios cannot tell you

Ratios read historical, GAAP-numbered statements. They do not price growth, they miss obligations that live in footnotes, and comparisons break when accounting choices differ — depreciation lives, revenue timing, impairment judgments. The umbrella question is earnings quality: how much of net income is backed by operating cash? For Rustic Detectors, 11,000 / 14,000 = 78.6% (verified) — a healthy first year.

4.7 Part 4 checklist

• Margin answers profit per sales dollar; turnover answers sales per asset dollar.
• ROE decomposes into margin × turnover × leverage.
• Liquidity ratios use current items only.
• Match flow numerators with average stock denominators.
• A ratio without a benchmark — a trend or a peer — is a number, not an insight.

APPENDIX A — THE ANNUAL REPORT TOUR

A 10-K opens with the business description and risk factors, moves through management's discussion and analysis (MD&A), then the four financial statements with their notes, and the auditor's report that accompanies them. A working reading order: statements first (what happened), notes second (what the numbers assume — the notes carry more information than the statements), MD&A third (how management explains it), and the audit opinion last to check for qualifications. The same loop — statements, notes, management's story — is how you should read any company, including the course's 3M walkthrough.

APPENDIX B — TRAP LIST

• Treating debits as good and credits as bad. They mean left and right.
• Recording adjusting entries with cash. Adjustments never touch cash.
• Calling dividends an expense. They are a distribution; they reduce RE, not net income.
• Putting loan principal repayment in operating cash flows. It is financing.
• Forgetting contra accounts: accumulated depreciation, treasury stock, and the unearned part of deferred revenue all sit opposite your first instinct.
• Comparing ROE across firms with different leverage and calling the difference skill.
• Reading EBITDA as cash. It ignores working capital and capex.
• Confusing book value with market value. The balance sheet records historical cost.
• Dividing a full year of income by a year-end balance when an average belongs in the denominator.