Accounting Basics: Basic Equation and Financial Statements
Basic Accounting Equation and the Separate Entity Assumption
The basic idea: what a company owns must be financed either by creditors or by shareholders. In accounting terms, this is captured by the basic accounting equation:
A = L + SE
where A = Assets, L = Liabilities, SE = Shareholders' Equity.The business is treated as a separate entity from its owners (separate entity assumption). Financial reports include only the business’s activities, not those of its shareholders.
Assets
An asset is an economic resource presently controlled by the company with measurable value.
Expected to benefit the company by generating cash inflows or reducing outflows in the future.
Prairie Proud example: assets include cash, supplies, inventory, and equipment such as a printing press and a dryer.
Some valuable assets may not appear on financial statements because they lack measurable monetary value (e.g., skilled employees).
Asset examples from Prairie Proud (cost principle applies):
Cash: 14{,}000
Accounts Receivable: 1{,}000
Supplies: 3{,}000
Equipment: 40{,}000
Total Assets: 58{,}000
Liabilities
Liabilities are measurable obligations the company owes to others (creditors).
Examples: if Prairie Proud borrows 20{,}000 from a bank, this is a liability called Notes Payable.
Purchases on credit create Accounts Payable (on account).
Other possible liabilities include Salaries and Wages Payable and Taxes Payable.
Prairie Proud liabilities (from the example):
Accounts Payable: 7{,}000
Notes Payable: 20{,}000
Total Liabilities: 27{,}000
Shareholders' Equity (SE)
Represents owners’ claims on assets after creditors’ claims are fulfilled. Creditors have priority; liabilities are paid before shareholders.Wh
SE arises from two sources:
1) Contributed Capital: equity contributed by shareholders (Paid-In Capital).
2) Retained Earnings: equity earned by the company through its operations.Relationships and formulas:
SE = Contributed\ Capital + Retained\ Earnings
Retained Earnings increase with profits and decrease with losses or dividends.
Retained Earnings is important because profits are the resource that can be kept in the business or distributed to owners.
Prairie Proud SE components (from the example):
Contributed Capital: 30{,}000
Retained Earnings: 1{,}000
Total Shareholders' Equity: 31{,}000
Revenues, Expenses, and Net Income
Revenues: amounts earned from selling goods or services. Prairie Proud’s revenue is measured by the price charged to customers for apparel.
Expenses: costs incurred to earn revenues (advertising, utilities, rent, wages, insurance, supplies used, etc.).
In accounting, expenses are said to be incurred when the activities that give rise to the cost occur in the period revenues are generated.
Net Income: the difference between total revenues and total expenses.
Formula: Net\ Income = Revenues - Expenses
Net income increases shareholders’ equity (via Retained Earnings) when profits are kept in the business; profits can also be distributed as dividends to shareholders.
Prairie Proud example (from the income statement):
Revenues: Sales Revenue = 11{,}000; Total Revenues = 11{,}000
Expenses:
Supplies Expense = 4{,}000
Salaries and Wages Expense = 2{,}000
Rent Expense = 1{,}500
Utilities Expense = 600
Insurance Expense = 300
Advertising Expense = 100
Income Tax Expense = 500
Total Expenses = 9{,}000
Net Income = 11{,}000 - 9{,}000 = 2{,}000
Important nuance: Net Income is a measure of profitability, not cash. Revenues and expenses in a period do not necessarily correspond to cash inflows and outflows in the same period (accrual accounting concept).
Dividends and Retained Earnings
Dividends are distributions of earnings to shareholders and are not an expense.
Dividends reduce Retained Earnings on the statement of Retained Earnings.
If a company keeps all profits, it can increase Retained Earnings; if it distributes profits as dividends, Retained Earnings decreases accordingly.
Prairie Proud notes on dividends:
Dividends reduce Retained Earnings; they do not appear as an expense on the income statement.
Example in Prairie Proud: Net Income of 2{,}000 minus Dividends of 1{,}000 leads to a Retained Earnings outcome (illustrated below).
Financial Statements: Purpose and Order
Financial statements are four reporting reports that collectively present a company’s financial position and performance:
1) Income Statement (also called the statement of operations)
2) Statement of Retained Earnings
3) Balance Sheet (also called the statement of financial position)
4) Statement of Cash FlowsReports are typically prepared monthly, quarterly, or annually depending on the company.
Unit of measure and currency considerations:
Many reports include a note about rounding (e.g., nearest thousand or million).
Reports may be prepared in a currency other than the home currency; international firms may translate foreign currency to domestic currency (unit of measure assumption).
Some large international firms report in a currency like USD or EUR.
International differences: Some companies report a statement of comprehensive income to include net income plus other comprehensive gains/losses (pensions, foreign currency translations, etc.). For basic operations, a simpler income statement is common.
The Income Statement (for Prairie Proud example)
Heading identifies: Who (Prairie Proud), What (Income Statement), When (For the Month Ended September 30, 2023).
Format: the body is built around three major captions: Revenues, Expenses, Net Income, with underlined subtotals and a double-underlined bottom line.
Revenues are listed on top; Expenses are listed below (typically from largest to smallest, with Income Tax Expense last).
Net Income is the difference between total revenues and total expenses.
The income statement is a measure of profitability, not cash flow;
This helps explain why a company can have positive net income but still not have as much cash as Net Income might imply.
Prairie Proud’s Income Statement (single-step format):
Revenues:
Sales Revenue = 11{,}000
Total Revenues = 11{,}000
Expenses:
Supplies Expense = 4{,}000
Salaries and Wages Expense = 2{,}000
Rent Expense = 1{,}500
Utilities Expense = 600
Insurance Expense = 300
Advertising Expense = 100
Income Tax Expense = 500
Total Expenses = 9{,}000
Net Income = 2{,}000
Note on format: this is a single-step income statement; other formats exist and will be discussed later (e.g., multi-step formats in Chapter 6).
The Statement of Retained Earnings
Purpose: shows how Retained Earnings change over the accounting period.
Structure (Exhibit 1.4):
Retained Earnings, beginning of period (Sept 1, 2023) = 0 (new business)
Add: Net Income = 2{,}000
Subtract: Dividends = 1{,}000
Retained Earnings, end of period (Sept 30, 2023) = 1{,}000
Explanation of components:
Net Income increases Retained Earnings; Dividends reduce Retained Earnings.
Beginning Retained Earnings for a new business is often 0.
The Balance Sheet (Statement of Financial Position)
Purpose: reports the company’s assets, liabilities, and shareholders’ equity at a specific point in time.
The balance sheet is a snapshot (as of a date, e.g., Sept 30, 2023).
Structure: Assets on the left (or top) and Liabilities + Shareholders' Equity on the right (or bottom), with the total assets equal to total claims on resources (A = L + SE).
Prairie Proud Balance Sheet (Projected, Sept 30, 2023):
Assets:
Cash = 14{,}000
Accounts Receivable = 1{,}000
Supplies = 3{,}000
Equipment = 40{,}000
Total Assets = 58{,}000
Liabilities:
Accounts Payable = 7{,}000
Notes Payable = 20{,}000
Total Liabilities = 27{,}000
Shareholders' Equity:
Contributed Capital = 30{,}000
Retained Earnings = 1{,}000
Total Shareholders' Equity = 31{,}000
Total Liabilities and Shareholders' Equity = 58{,}000
Key concepts illustrated:
Assets are listed in order of liquidity (how soon they become cash).
Liabilities are listed in order of due date.
The balance sheet “balances” because A = L + SE$$, i.e., total assets equal total claims by creditors and shareholders.
Explanations of components included in Prairie Proud example:
Cash reflects cash on hand and in the bank.
Accounts Receivable reflects the right to collect from customers for sales on credit.
Supplies reflect the cost of office supplies on hand.
Equipment reflects the cost of major assets (printing press, dryer).
Accounts Payable reflects amounts owed to suppliers for purchases on credit.
Notes Payable reflects the bank loan (promissory note).
Contributed Capital reflects the cash put in by owners for shares.
Retained Earnings reflect accumulated profits retained in the business (as of the date).
Cost principle reminder: assets are initially reported at their cost to the company.
Legal priority: creditors have priority over shareholders in claims on assets.
Connecting the Statements: How items relate across reports
Net income from the Income Statement increases Retained Earnings on the Balance Sheet via the Statement of Retained Earnings.
Dividends reduce Retained Earnings, thereby reducing Shareholders’ Equity.
The Balance Sheet shows the ending balances that feed into the next period’s opening balances for Retained Earnings and other equity accounts.
The four-statement cycle links results (income statement) to retained earnings (statement of retained earnings) to the financial position (balance sheet).
The statements provide a complete view of profitability, distribution decisions, and financial position at a point in time and over an interval.
Unit of Measure, Currency Translation, and Comprehensive Income
Unit of measure assumption: financial reports use a standard unit of measure (e.g., a currency) and may indicate rounding or translation specifics.
Translated reporting: international companies may translate foreign-currency transactions into the reporting currency.
Comprehensive income (for some firms): in addition to net income, gains and losses from pensions, foreign currency translations, and other items may be shown in a statement of comprehensive income. However, basic operations may use a simpler income statement.
Key Takeaways and Practical Implications
The basic accounting equation (A = L + SE) must always balance; assets must equal the combined claims of creditors and owners.
The separate entity assumption keeps owners’ personal activities out of the business financials.
Retained Earnings captures the accumulated profits that have not been distributed as dividends.
Net Income is a measure of profitability, not cash, due to accrual accounting.
Dividends are distributions to owners and reduce Retained Earnings, not an expense.
The four primary financial statements provide complementary views: profitability (income statement), changes in retained earnings (statement of retained earnings), financial position at a date (balance sheet), and cash movements (statement of cash flows).
Prairie Proud’s example illustrates how transactions translate into financial statement items and how the interconnections between statements reflect the company’s financial story.