Principles of Accounting, Volume 1: Financial Accounting

Citation

Franklin, M., Graybeal, P., & Cooper, D. (2019). Principles of Accounting, Volume 1: Financial Accounting. OpenStax, Rice University. Free official edition: https://openstax.org/details/books/principles-financial-accounting

Chapter Summary

The book is the first half of OpenStax's two-volume Principles of Accounting, which the preface describes as covering a two-semester course in financial and managerial accounting for both accounting and non-accounting majors. Its 16 chapters fall into three stages: the foundations and the full accounting cycle (Chapters 1–5), the accounts and systems of a working business (Chapters 6–13), and the forms of ownership and the cash flow statement (Chapters 14–16). Every chapter opens with a short "Why It Matters" story, often about a student or a young business owner, and several chapters end with an appendix section that carries a topic further. After the chapters, Appendix A covers financial statement analysis (horizontal and vertical analysis and a set of ratios) using a merchandising company, Banyan Goods; Appendix B introduces the time value of money; Appendix C lists suggested resources; and an answer key gives answers to odd-numbered Multiple Choice and Questions items.

Chapter 1: Role of Accounting in Society

The opening chapter presents accounting as the "language of business": organising, analysing and communicating financial information for decisions. It separates financial accounting, aimed at outside users such as investors and creditors, from managerial accounting, aimed at internal users; sorts organisations into for-profit, governmental and not-for-profit; and lists stakeholders, from stockholders and lenders to regulators and employees. It introduces the SEC and generally accepted accounting principles (GAAP), the three ways businesses raise money (profitable operations, equity and debt), and closes with career paths and certifications such as CPA, CMA, CIA and CFE.

Chapter 2: Introduction to Financial Statements

This chapter introduces the four financial statements (income statement, statement of owner's equity, balance sheet and statement of cash flows) and how they connect. It explains current versus noncurrent and tangible versus intangible items, the three legal forms of business, the accounting equation (Assets = Liabilities + Owner's Equity) and ten financial statement elements. It then shows the order and format for preparing the statements and introduces the first liquidity measures, working capital and the current ratio.

Chapter 3: Analyzing and Recording Transactions

Chapters 3–5 follow one running example, Mark Summers's dry-cleaning business Supreme Cleaners, through a complete accounting cycle. Chapter 3 describes FASB, the SEC and the conceptual framework, and sets out principles and assumptions: revenue and expense recognition, cost, full disclosure, separate entity, conservatism, monetary measurement, going concern and time period. It introduces the expanded accounting equation and the chart of accounts, and covers the first four steps of the cycle: analysing transactions, journalising, posting to T-accounts in the general ledger, and preparing an unadjusted trial balance, including how to trace trial balance errors.

Chapter 4: The Adjustment Process

The chapter explains accrual versus cash basis accounting, calendar and fiscal years, and interim periods. It covers the four common adjustments (prepaid expenses, unearned revenues, accrued revenues and accrued expenses) and gives rules for them: each adjusting entry touches one income statement account and one balance sheet account, and never cash. It then builds the adjusted trial balance, the financial statements and a 10-column worksheet.

Chapter 5: Completing the Accounting Cycle

The chapter covers the four closing entries through the Income Summary account, the difference between permanent and temporary accounts, and the post-closing trial balance. It introduces the classified balance sheet and returns to liquidity, working capital and the current ratio. An appendix walks a service business through a complete cycle from formation to financial statements.

Chapter 6: Merchandising Transactions

Using J&J Games, a video game retailer, the chapter contrasts service and merchandising operating cycles and perpetual versus periodic inventory systems. It records purchases and sales under the perpetual system, including discounts, returns and allowances, and the separate cost-of-sale entry, and explains FOB shipping point and FOB destination for ownership of goods in transit and freight costs. It compares multi-step and simple income statements, introduces the gross profit margin ratio, and in an appendix repeats the entries for the periodic system.

Chapter 7: Accounting Information Systems

This chapter describes an accounting information system as input, processing, output and storage, whether on paper or computerised. Most of it is about special journals (sales, purchases, cash receipts and cash disbursements) and subsidiary ledgers for accounts receivable and payable, with rules for which journal records which transaction and when to post to the general ledger. It ends with career areas where accounting meets information systems, such as data analytics, data security, blockchain and forensic accounting.

Chapter 8: Fraud, Internal Controls, and Cash

The chapter introduces the fraud triangle (perceived opportunity, incentive and rationalisation) and the purpose of internal controls, with principles such as clear responsibilities, documentation, insurance and separation of duties. It covers petty cash as an imprest fund, management's responsibility for controls and the "tone at the top", bank reconciliations and their journal entries, and financial statement fraud, using HealthSouth and Enron as examples and outlining the Sarbanes-Oxley Act, which applies to public companies.

Chapter 9: Accounting for Receivables

The chapter links receivables to revenue recognition and the matching principle and records sales on in-house credit and third-party credit cards. It compares the direct write-off method with the allowance method, using three estimation approaches: the income statement (percentage of sales) method, the balance sheet percentage of receivables method, and aging of receivables. It also covers the accounts receivable turnover and days' sales in receivables ratios, earnings management versus earnings manipulation through bad debt estimates, revenue recognition for long-term projects (percentage of completion, completed contract and installment methods), and notes receivable, including interest, honoured and dishonoured notes. An appendix gives a comprehensive bad debt example.

Chapter 10: Inventory

This chapter explains how the cost of goods available for sale is split between ending inventory and cost of goods sold, and works through four cost flow methods (specific identification, FIFO, LIFO and weighted average) under both the periodic and perpetual systems. It notes that cost flow assumptions need not match how goods physically move, and that the perpetual system now dominates in practice. It then shows how errors in beginning and ending inventory affect the income statement and balance sheet, and closes with the inventory turnover and days' sales in inventory ratios.

Chapter 11: Long-Term Assets

Following Liam, a new business owner deciding whether to buy a silk-screening machine, the chapter separates tangible from intangible assets and capitalised costs from expenses. It covers straight-line, units-of-production and double-declining-balance depreciation, depletion of natural resources, and amortisation of intangible assets such as patents, copyrights and trademarks; intangibles with indefinite lives, such as goodwill, are tested for impairment instead. It ends with revising estimates of useful life and salvage value and recording gains and losses on disposal.

Chapter 12: Current Liabilities

The chapter covers accounts payable, unearned revenue, the current portion of long-term notes, taxes payable and short-term notes payable, with journal entries for each. It explains contingent liabilities such as litigation and warranties under the FASB categories (probable and estimable, probable and not estimable, reasonably possible, and remote) and how each is recognised or disclosed. A long final section records payroll: gross and net pay, withholdings for income taxes, Social Security and Medicare, and the employer's own payroll taxes, including FUTA and SUTA.

Chapter 13: Long-Term Liabilities

The chapter explains how businesses raise money through notes and bonds, what a bond indenture contains, and why bonds sell at face value, a premium or a discount depending on the market interest rate compared with the stated rate. It covers the effective-interest method of amortising premiums and discounts and journal entries across a bond's life, from issue through interest payments to retirement. An appendix compares debt and equity financing.

Chapter 14: Corporation Accounting

The chapter describes how corporations are formed, their advantages and disadvantages (including double taxation), and the choice between debt and equity financing. It covers common and preferred stock, authorised, issued and outstanding shares, par, no-par and stated value, issuing stock for cash or property, and treasury stock. It then records cash, property and stock dividends (with the 25% line between small and large stock dividends) and stock splits, and explains retained earnings, restricted and appropriated retained earnings, the statement of stockholders' equity, prior period adjustments and earnings per share.

Chapter 15: Partnership Accounting

Using a landscaping partnership, the chapter weighs the tax advantages of partnerships against mutual agency and unlimited liability, and mentions related forms that limit liability. It records the formation of a partnership at current market values, the allocation of income and loss by fixed ratios, capital balances or a combination, the admission and withdrawal of partners, and the four steps of liquidation.

Chapter 16: Statement of Cash Flows

The final chapter explains why cash flow matters alongside accrual-based income, classifies cash flows into operating, investing and financing activities, and prepares the statement by the indirect method, starting from net income and adjusting for non-cash items and changes in current accounts, with separate reporting of noncash investing and financing activities. It introduces free cash flow, cash flows to sales and cash flows to assets, and an appendix prepares the same statement for the running example, Propensity Company, by the direct method.

Key Concepts

• Accounting equation: Assets = Liabilities + Owner's (or Stockholders') Equity; the expanded form breaks equity into stock, dividends, revenues and expenses.
• Accounting cycle: analysing, journalising and posting transactions, preparing trial balances, adjusting, preparing statements and closing.
• Accrual versus cash basis: recording revenues and expenses when earned or incurred, not when cash moves.
• Adjusting entries: end-of-period entries for prepaid expenses, unearned revenues, accrued revenues and accrued expenses.
• Closing entries and temporary accounts: transferring revenue, expense and dividend balances to retained earnings through Income Summary.
• Perpetual and periodic inventory: continuous versus end-of-period updating of inventory and cost of goods sold.
• FOB shipping point and FOB destination: terms that decide when ownership and shipping costs pass to the buyer.
• Special journals and subsidiary ledgers: tools for recording repeated kinds of transactions and individual customer and supplier balances.
• Fraud triangle and internal control: why fraud occurs, and the policies and procedures that protect assets.
• Bank reconciliation: matching the bank's record of an account with the company's own record.
• Allowance method and aging of receivables: estimating bad debts so that the expense matches the revenue it relates to.
• Inventory cost flow methods: specific identification, FIFO, LIFO and weighted average.
• Depreciation, depletion and amortisation: allocating the cost of long-term tangible assets, natural resources and intangibles over their useful lives.
• Contingent liabilities: possible obligations recognised or disclosed according to probability and how well they can be estimated.
• Bond premium and discount; effective-interest method: how market rates set bond prices and how interest expense is measured.
• Treasury stock, dividends and stock splits: equity transactions of corporations.
• Statement of cash flows (indirect and direct methods): reporting operating, investing and financing cash flows.
• Liquidity, efficiency and solvency ratios: working capital, current ratio, receivable and inventory turnover, gross profit margin, earnings per share and free cash flow.

Critical Analysis

Strengths

• Full coverage of the accounting cycle with one running example. Chapters 3–5 follow Supreme Cleaners from the first transaction to the post-closing trial balance, so students see how each step uses the output of the one before, and an appendix repeats the whole cycle with a new business.
• Explicit rules for journal entries. Summaries spell out which accounts are debited and credited in common situations (purchase discounts, returns, sales tax, payroll, treasury stock reissues), which suits students who learn well from clear procedures.
• Breadth for an introductory text. Beyond the core cycle, it covers accounting information systems and special journals, fraud and internal control, earnings management, contingent liabilities, payroll, partnerships and both methods of preparing the cash flow statement.
• Plentiful practice at several levels. Each chapter offers Multiple Choice, Questions, two exercise sets, two problem sets and Thought Provokers, and features such as IFRS Connection boxes and a recurring retailer, Gearhead Outfitters, in Continuing Application at Work link the mechanics to practice.
• Attention to analysis, not only bookkeeping. Ratios appear throughout (current ratio, gross margin, receivable and inventory turnover, EPS, free cash flow), and Appendix A brings them together in horizontal and vertical analysis.

Limitations

• Centred on United States GAAP and US rules. The standards discussed are those of FASB and the SEC, and payroll covers US taxes such as FICA, FUTA and SUTA. IFRS appears only in feature boxes, so courses that teach IFRS need another source.
• Procedure-heavy. Much of the text and many summaries are lists of debits and credits; the reasons behind standards, measurement debates and the theory of financial reporting get little space, which matters for courses that go beyond bookkeeping.
• Uneven depth and some repetition. The summaries for the two indirect-method sections of Chapter 16 are almost word for word the same, and some topics found in other financial accounting courses, such as lease accounting, are mentioned only in passing.
• Answers for students are limited. Students get answers only to odd-numbered Multiple Choice and Questions; answers to exercises, problems and Thought Provokers are for instructors only.
• Dated details. The book was published in 2019, so references to SOX compliance, technology and careers reflect that time.

Where It Fits in the Course

For a Financial Accounting course, this book works as a free introductory text alongside Financial Accounting: An Introduction by Weetman and Jubb, with which it shares an entry-level aim; because this book follows US GAAP, students should check how far the course's main text uses the same standards and terms. It also prepares students for the fuller textbooks on the list, Libby and colleagues' Financial Accounting and Atrill and McLaney's Financial Accounting for Decision Makers, by giving them the mechanics of the accounting cycle and the basic ratios.

It is not a substitute for the more specialised titles. Kieso and colleagues' Intermediate Accounting takes topics this book introduces, such as revenue recognition, bonds, equity and cash flows, to the level of detailed standards, and Scott and O'Brien's Financial Accounting Theory deals with the theory and economics of financial reporting, which this book barely touches. Students heading for those books can use Chapters 3–5 and 9–16 here as a refresher on the underlying entries.

How to Use This Book

No accounting background is needed; basic arithmetic and percentages are enough. Chapters 1–5 should be read in order, because each relies on the accounts and steps introduced before it, and working the Supreme Cleaners example by hand is a practical way to learn the cycle. After that, the asset and liability chapters (9–13) can be taken in the order a syllabus needs, though Chapter 6 on merchandising should come before Chapter 10 on inventory. Chapters 14 and 15 can be chosen according to whether the course focuses on corporations or small businesses, and Chapter 16 belongs at the end because it draws on the balance sheet changes from all earlier chapters.

For self-study, read each section's learning objective, then the section, then check the chapter summary; do Exercise Set A and compare reasoning with a classmate or an instructor, and keep Set B and the problem sets for review before exams. Use Appendix A whenever ratios appear, and continue with Volume 2 (managerial accounting) if the programme covers both.

Edition and Sources

This guide is based on Principles of Accounting, Volume 1: Financial Accounting by senior contributing authors Mitchell Franklin, Patty Graybeal and Dixon Cooper (OpenStax, 2019; hardcover ISBN 978-1-947172-68-5), read in the official PDF from https://openstax.org/details/books/principles-financial-accounting. It draws on the preface, the full table of contents, every chapter's "Why It Matters" opening and full end-of-chapter summary (section by section), and selected passages including the Chapter 13 appendix and Appendix A.