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 =$2{,}000$</p></li></ul></li><li><p>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).</p></li></ul><h3 collapsed="false" seolevelmigrated="true">Dividends and Retained Earnings</h3><ul><li><p>Dividends are distributions of earnings to shareholders and are not an expense.</p></li><li><p>Dividends reduce Retained Earnings on the statement of Retained Earnings.</p></li><li><p>If a company keeps all profits, it can increase Retained Earnings; if it distributes profits as dividends, Retained Earnings decreases accordingly.</p></li><li><p>Prairie Proud notes on dividends:</p><ul><li><p>Dividends reduce Retained Earnings; they do not appear as an expense on the income statement.</p></li><li><p>Example in Prairie Proud: Net Income of$2{,}000$minus Dividends of$1{,}000$leads to a Retained Earnings outcome (illustrated below).</p></li></ul></li></ul><h3 collapsed="false" seolevelmigrated="true">Financial Statements: Purpose and Order</h3><ul><li><p>Financial statements are four reporting reports that collectively present a company’s financial position and performance:<br>1) Income Statement (also called the statement of operations)<br>2) Statement of Retained Earnings<br>3) Balance Sheet (also called the statement of financial position)<br>4) Statement of Cash Flows</p></li><li><p>Reports are typically prepared monthly, quarterly, or annually depending on the company.</p></li><li><p>Unit of measure and currency considerations:</p><ul><li><p>Many reports include a note about rounding (e.g., nearest thousand or million).</p></li><li><p>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).</p></li><li><p>Some large international firms report in a currency like USD or EUR.</p></li></ul></li><li><p>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.</p></li></ul><h3 collapsed="false" seolevelmigrated="true">The Income Statement (for Prairie Proud example)</h3><ul><li><p>Heading identifies: Who (Prairie Proud), What (Income Statement), When (For the Month Ended September 30, 2023).</p></li><li><p>Format: the body is built around three major captions: Revenues, Expenses, Net Income, with underlined subtotals and a double-underlined bottom line.</p></li><li><p>Revenues are listed on top; Expenses are listed below (typically from largest to smallest, with Income Tax Expense last).</p></li><li><p>Net Income is the difference between total revenues and total expenses.</p></li><li><p>The income statement is a measure of profitability, not cash flow;</p><ul><li><p>This helps explain why a company can have positive net income but still not have as much cash as Net Income might imply.</p></li></ul></li><li><p>Prairie Proud’s Income Statement (single-step format):</p><ul><li><p>Revenues:</p></li><li><p>Sales Revenue =$11{,}000$</p></li><li><p>Total Revenues =$11{,}000$</p></li><li><p>Expenses:</p></li><li><p>Supplies Expense =$4{,}000$</p></li><li><p>Salaries and Wages Expense =$2{,}000$</p></li><li><p>Rent Expense =$1{,}500$</p></li><li><p>Utilities Expense =$600$</p></li><li><p>Insurance Expense =$300$</p></li><li><p>Advertising Expense =$100$</p></li><li><p>Income Tax Expense =$500$</p></li><li><p>Total Expenses =$9{,}000$</p></li><li><p>Net Income =$2{,}000$</p></li></ul></li><li><p>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).</p></li></ul><h3 collapsed="false" seolevelmigrated="true">The Statement of Retained Earnings</h3><ul><li><p>Purpose: shows how Retained Earnings change over the accounting period.</p></li><li><p>Structure (Exhibit 1.4):</p><ul><li><p>Retained Earnings, beginning of period (Sept 1, 2023) =$0$(new business)</p></li><li><p>Add: Net Income =$2{,}000$</p></li><li><p>Subtract: Dividends =$1{,}000$</p></li><li><p>Retained Earnings, end of period (Sept 30, 2023) =$1{,}000$</p></li></ul></li><li><p>Explanation of components:</p><ul><li><p>Net Income increases Retained Earnings; Dividends reduce Retained Earnings.</p></li><li><p>Beginning Retained Earnings for a new business is often$0$.</p></li></ul></li></ul><h3 collapsed="false" seolevelmigrated="true">The Balance Sheet (Statement of Financial Position)</h3><ul><li><p>Purpose: reports the company’s assets, liabilities, and shareholders’ equity at a specific point in time.</p></li><li><p>The balance sheet is a snapshot (as of a date, e.g., Sept 30, 2023).</p></li><li><p>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).</p></li><li><p>Prairie Proud Balance Sheet (Projected, Sept 30, 2023):</p><ul><li><p>Assets:</p></li><li><p>Cash =$14{,}000$</p></li><li><p>Accounts Receivable =$1{,}000$</p></li><li><p>Supplies =$3{,}000$</p></li><li><p>Equipment =$40{,}000$</p></li><li><p>Total Assets =$58{,}000$</p></li><li><p>Liabilities:</p></li><li><p>Accounts Payable =$7{,}000$</p></li><li><p>Notes Payable =$20{,}000$</p></li><li><p>Total Liabilities =$27{,}000$</p></li><li><p>Shareholders' Equity:</p></li><li><p>Contributed Capital =$30{,}000$</p></li><li><p>Retained Earnings =$1{,}000$</p></li><li><p>Total Shareholders' Equity =$31{,}000$</p></li><li><p>Total Liabilities and Shareholders' Equity =$58{,}000$</p></li></ul></li><li><p>Key concepts illustrated:</p><ul><li><p>Assets are listed in order of liquidity (how soon they become cash).</p></li><li><p>Liabilities are listed in order of due date.</p></li><li><p>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.