Chapter 1-7: Accounting Fundamentals — Key Terms

Chapter 1 Part 2: Financial Statements and Foundations

• General approach and mindset

  • Don’t be overwhelmed if topics feel loosely connected at first; with repetition and practice connections will become clearer.
  • If it’s not clicking, seek help and keep hearing/practicing the material; consistency aids learning.

• The basic accounting equation (recap)

  • Core form: Assets = Liabilities + Stockholders\' Equity
  • Expanded view (how we think about the elements): assets are economic resources; liabilities are obligations; stockholders\' equity represents the owners\' claims (made up of common stock and retained earnings).
  • Specific accounts sit under each element to distinguish what resource or obligation we’re dealing with (e.g., Cash, Land under Assets; Notes Payable under Liabilities; Common Stock and Retained Earnings under Stockholders\' Equity).
  • Retained Earnings (RE) overview within equity:
  • RE is affected by Revenues, Expenses, and Dividends.
  • Net Income contributes to RE: RE{end} = RE{begin} + Net\ Income - Dividends
  • Net Income itself is: Net\ Income = Revenue - Expenses

• Horizontal financial statement model (the practical tool)

  • A visual model used to learn how to record day-to-day transactions.
  • After each transaction, verify that the basic accounting equation remains in balance.
  • Transactions are classified into types based on their effect on the equation (as practiced in exercises such as 01-19a and 01-13a).
  • Practice sets (e.g., Connect) and working papers provide problem outlines to support this practice.

• The four financial statements (purpose and overview)

  • Purpose: summarize all day-to-day transactions into meaningful totals for external users.
  • Order of preparation (typical): Income Statement → Statement of Changes in Stockholders\' Equity → Balance Sheet → Statement of Cash Flows. This order reflects how information flows between statements.
  • Key dating conventions:
  • Income Statement, Statement of Changes in Stockholders\' Equity, and Statement of Cash Flows use the period ended (often written as for the year ended, FYE).
  • Balance Sheet uses an as-of date (a point in time).
  • Why four statements exist: together they tell the story of what happened during the period and show the financial position at a point in time.
  • In short:
  • Income Statement: revenues and expenses over the period → Net Income.
  • Statement of Changes in Stockholders\' Equity: changes in common stock and retained earnings over the period.
  • Balance Sheet: end-of-period snapshot of assets, liabilities, and stockholders\' equity.
  • Statement of Cash Flows: cash movements by operating, investing, and financing activities over the period.

• The four statements in more detail

  • Income Statement (for the year ended, FYE)
  • States income as: Net\ Income = Revenue - Expenses
  • Reflects the matching principle: revenues recognized in a period should be matched with the expenses incurred to generate them.
  • Note: Dividends are not on the income statement; they affect stockholders\' equity on other statements.
  • Statement of Changes in Stockholders\' Equity (for the year ended, FYE)
  • Tracks changes in equity accounts: Common Stock and Retained Earnings.
  • Beginning balances plus transactions during the period yield ending balances.
  • Key flows:
    • Common Stock: affected by issued stock (beginning balance + issuances).
    • Retained Earnings: affected by Net Income and Dividends (RE end = RE begin + Net Income − Dividends).
  • Balance Sheet (as of a date)
  • Presents Assets, Liabilities, and Stockholders\' Equity in a statement-format of the basic accounting equation: Assets = Liabilities + Stockholders\' Equity
  • It balances with a double underline to indicate equality between the two sides.
  • It’s a snapshot: reflects what the company owns and owes at that date.
  • Statement of Cash Flows (for the year ended, FYE)
  • Focuses on cash movements only (not accrual revenues/expenses).
  • Breaks cash flows into three activity types:
    • Operating activities (OA): day-to-day cash inflows/outflows related to running the business (e.g., cash received from customers, cash paid for utilities, operating expenses).
    • Investing activities (IA): cash flows from acquiring or selling long-term assets (e.g., purchase of land).
    • Financing activities (FA): cash flows related to financing the business (e.g., issuing stock, borrowing, dividends paid).
  • Notation: some items like interest may be treated differently (e.g., interest payments often considered operating activities in some chapters, with nuances discussed later).
  • The cash flow statement reconciles beginning cash to ending cash by showing the net cash flow from OA, IA, and FA.

• Dating conventions and the “story” of the period

  • Income Statement uses: for the year ended (FYE).
  • Balance Sheet uses: as of a specific date.
  • The statements together tell the story of how cash, assets, and equity changed over the period and why cash ended where it did.

• Quick definitions and examples from the 01/19a exercise (illustrative data)

  • Asset is an economic resource; examples include Cash and Land.

  • Liability is an obligation; example: Notes Payable.

  • Stockholders\' Equity consists of Common Stock and Retained Earnings.

  • Retained Earnings concept: RE increases with Net Income and decreases with Dividends.

  • Revenue vs. Expenses: Revenue increases retained earnings via Net Income; Expenses decrease retained earnings.

  • Dividends reduce Retained Earnings (not an expense on the Income Statement).

  • Common Stock issued increases Common Stock under Stockholders\' Equity.

  • Example numeric walk-through (01/19a) summarized below with key numbers and how they feed the statements:

  • Given data (example):

  • Revenue: Revenue = 20{,}000

  • Expenses: Expense1 = 1{,}000, Expense2 = 15{,}000

  • Total Expenses: Total\ Expenses = 16{,}000

  • Net Income: Net\ Income = Revenue - Expenses = 4{,}000

  • Beginning Common Stock: CS_{begin} = 6{,}000

  • Beginning Retained Earnings: RE_{begin} = 8{,}000

  • Common Stock Issued during period: Issuance = 30{,}000

  • Dividends paid: Dividends = 2{,}000

  • Beginning Cash: Cash_{begin} = 2{,}000

  • Ending Cash (given after transactions): Cash_{end} = 32{,}000

  • Land: Land = 24{,}000

  • Notes Payable: Notes\ Payable = 10{,}000

  • Derived balances for the year (01/19a example)

  • Ending Common Stock: CS{end} = CS{begin} + Issuance = 6{,}000 + 30{,}000 = 36{,}000

  • Ending Retained Earnings: RE{end} = RE{begin} + Net\ Income - Dividends = 8{,}000 + 4{,}000 - 2{,}000 = 10{,}000

  • Total Stockholders' Equity: Total\ SE = CS{end} + RE{end} = 36{,}000 + 10{,}000 = 46{,}000

  • Beginning to Ending cash flow (operating/investing/financing):

    • Cash collections from customers (operating): Cash_{in, OA} = 20{,}000
    • Cash payments for utilities and other operating expenses: Cash_{out, OA} = 1{,}000 + 15{,}000 = 16{,}000
    • Net Cash OA: Net\ Cash_{OA} = 20{,}000 - 16{,}000 = 4{,}000
    • Land purchase (investing): Cash_{out, IA} = 12{,}000
    • Net Cash IA: Net\ Cash_{IA} = -12{,}000
    • Financing: issuing stock and borrowing bring cash in; dividends pay cash out: Cash{in, FA} = 30{,}000 + 10{,}000 = 40{,}000, Cash{out, FA} = 2{,}000
    • Net Cash FA: Net\ Cash_{FA} = 40{,}000 - 2{,}000 = 38{,}000
    • Net change in cash: Net\ Change\ in\ Cash = Net\ Cash{OA} + Net\ Cash{IA} + Net\ Cash_{FA} = 4{,}000 - 12{,}000 + 38{,}000 = 30{,}000
    • Ending cash check: Cash{end} = Cash{begin} + Net\ Change\ in\ Cash = 2{,}000 + 30{,}000 = 32{,}000

  • Balance sheet snapshot from the example

  • Assets: Cash $32{,}000$, Land $24{,}000$ → Total Assets 56{,}000

  • Liabilities: Notes Payable $10{,}000$ → Total Liabilities 10{,}000

  • Stockholders' Equity: Common Stock $36{,}000$, Retained Earnings $10{,}000$ → Total SE 46{,}000

  • Verify: Assets = Liabilities + Stockholders\' Equity \ 56{,}000 = 10{,}000 + 46{,}000

  • How the numbers flow through the four statements (connectivity from the 01/19a example)

  • Income Statement (for the year ended): Revenue and Expenses → Net Income $4{,}000$.

  • Statement of Changes in Stockholders\' Equity (for the year ended):

    • Beginning CS $6{,}000$; Issuance $30{,}000$ → Ending CS $36{,}000$.
    • Beginning RE $8{,}000$; Net Income $4{,}000$; Dividends $2{,}000$ → Ending RE $10{,}000$.
    • Ending Stockholders\' Equity $46{,}000$ (CS $36{,}000$ + RE $10{,}000$).

  • Balance Sheet (as of the date): matching totals ($56{,}000$ assets; $10{,}000$ liabilities; $46{,}000$ equity).

  • Statement of Cash Flows (for the year ended): operating, investing, and financing activities summarized to yield ending cash $32{,}000$ from beginning cash $2{,}000$, with a net change of $30{,}000$.

• The closing process and practical implications

  • End-of-year financial statements summarize the year’s activity for creditors and investors.
  • The four statements tie together to show how financing, investing, and operating activities affect cash, assets, and equity.
  • Remember general checks and pitfalls:
  • Dividends do not appear on the income statement.
  • Always include beginning cash in the cash flow closing process, even if it is zero.
  • If a line item does not affect cash, it does not appear on the cash flow statement.

• Practical study tips and resources mentioned

  • Practice with exercises (e.g., 01/19a and 01/13a) to determine transaction types and how they affect financial statements.
  • Use Connect practice sets and working papers to reinforce the templates and flow of information.
  • Memorize the dating conventions and the order in which statements are prepared.
  • Be comfortable tracing numbers from one statement to another (e.g., net income affecting RE, ending RE affecting equity totals, etc.).

• Core formulas to remember (LaTeX-ready)

  • Basic accounting equation: Assets = Liabilities + Stockholders\' Equity
  • Expanded equity relation: Stockholders\'\ Equity = Common\ Stock + Retained\ Earnings
  • Retained Earnings update: RE{end} = RE{begin} + Net\ Income - Dividends
  • Net income: Net\ Income = Revenue - Expenses
  • Ending cash reconciliation: Cash{end} = Cash{begin} + Net\ Cash{OA} + Net\ Cash{IA} + Net\ Cash_{FA}
  • Income statement (summary): Net\ Income = \text{Total Revenue} - \text{Total Expenses}
  • Balance sheet balance check: Assets = Liabilities + Stockholders\' Equity
  • Cash flow components: Operating (OA), Investing (IA), Financing (FA) with the corresponding inflows/outflows as described above

• Note on resource structure

  • Chapter two broadly deals with revenue recognition and the matching principle (how revenue relates to the expenses of generating it).
  • Revenue is defined as the sum of prices charged to customers for services provided or goods sold.

• Quick glossary (for quick recall)

  • Asset: economic resource
  • Liability: obligation to pay
  • Revenue: amounts earned from delivering goods or services
  • Expense: costs incurred to earn revenue
  • Dividends: distributions to stockholders
  • Beginning vs ending balances: track changes across periods to reach year-end numbers
  • As-of date vs year-end date: snapshot vs period summary

• Final takeaway

  • Mastery comes from repeatedly mapping transactions to the four statements and understanding how each statement supports the others.