Accounting 101: Financial Statements and Key Concepts
Context and course logistics
Quiz due tonight at 11:30; SmartBook assignments due today as well (parts a and b); expect ~10 minutes to complete.
No class on Monday due to USC holiday; suggested to read Chapter 2 before Wednesday to ease pace.
Class moves quickly; staying current with readings makes later material easier.
Instructor encourages questions and participation.
Key accounting concepts (definitions and tests)
Assets
Definition: things or legal rights measured at a point in time that provide future benefits and are legally owned.
Test for asset status: does it have value, can it be legally owned, can you control it, and could it provide future benefits via a transaction?
Typical focus: assets are evaluated at a point in time (end of period/year), not throughout the period.
Example analogy: a well-organized closet inventory (T-shirts, shoes, wallets) represents assets you own.
Example: a twelve-month lease example shows an asset with future value for the lease period; after month 13 its value is exhausted, so it’s no longer an asset.
Liabilities
Definition: obligations owed to others (to pay or to perform services).
Example: the balance on a credit card at a point in time is a liability.
Stockholders’ equity (Owner’s claim on assets)
Two components (as introduced today): contributed capital and retained earnings.
Contributed capital = money contributed by shareholders in exchange for ownership (common stock evidence).
Retained earnings = earnings kept in the business after paying dividends.
In the company’s perspective (the issuer): shares issued to investors create contributed capital; the owners’ equity claim grows when retained earnings accumulate.
Common stock and contributed capital
Common stock is the legal document evidencing ownership in a corporation; it represents the ownership stake given to shareholders in exchange for cash or other assets.
Transaction example: a company (the issuer) issues common stock to an investor (the buyer) in exchange for cash. If Ivan pays $100, the company issues $100 of common stock and gains $100 in cash as an asset.
Two-sided nature of transactions: every transaction has a this side (company) and a that side (investor); accounting records both sides.
Dilution: if new shares are issued to others, existing shareholders’ ownership percentage can decrease even though total equity rises.
Retained earnings
Definition: cumulative net income kept in the business, not paid out as dividends.
Formula: ending retained earnings depend on beginning retained earnings, net income, and dividends paid:
RE{end} = RE{begin} + NI - Dividends
Analogy: beginning retained earnings behave like a fixed gold bar that remains in the closet; ending RE of one year equals beginning RE of the next year.
Revenue
Definition: an action resulting from a transaction with a customer; revenue is earned only when the company delivers a product or performs a service for the customer (ownership transfers at that moment).
Key points:
Must involve a customer; revenue is an action that increases assets (usually cash) or decreases liabilities.
Revenue is not recognized from cash received from lenders or shareholders (that cash is contributed capital or financing, not revenue).
Revenue is recognized only when the product or service is delivered; mere promises or agreements do not count until ownership passes.
Examples:
Jewelry store sells a ring for $1,000; cost to produce is $700. Revenue = $1,000; expense (cost of goods sold) = $700; net effect increases assets by $1,000 and reduces assets by $700 in the form of cost.
Car rental example: $50/day for 4 days = $200 revenue recognized after the 4th day when the car is delivered to the customer, not when the contract is signed.
Coffee shop sells an $8 drink; cost to make is $6; revenue = $8 when delivered.
Important nuance: revenue is not the same as income (net income); revenue is the top-line activity of delivering goods/services; net income is revenue minus expenses.
Expenses
Definition: actions that consume assets or create a liability with no future value, aimed at generating revenue.
Key features:
Expenses result from the use or consumption of assets in the pursuit of revenue.
Advertising, research and development (R&D), and travel/entertainment are examples; in the U.S., R&D is always expensed (not capitalized as an asset here), unlike some other countries where R&D can be capitalized.
Interest expense arises when borrowing; principal repayment is not an expense but a reduction of liability; interest is the lender’s profit for lending money.
Common examples:
Electricity consumed (no future value after use) = expense.
Rent for office space during a period; as time passes, the pre-paid asset is consumed and recognized as expense (depreciation-like concept for prepaid assets).
Salaries and wages, utilities, taxes, advertising, travel, and entertainment.
Depreciation (see below) is the systematic allocation of the cost of a tangible asset over its useful life; depreciation is considered an expense for the portion consumed each period.
Dividends
Definition: distributions of assets to stockholders; often cash, but can be other assets.
Dividends are never expense; they are payments to owners from earnings and reduce retained earnings (part of stockholders’ equity).
Why pay dividends? To keep shareholders happy; not tied to generating revenue in that period (no return in exchange for goods/services).
Dividends affect the stockholders’ equity section, typically reducing retained earnings.
Four basic outcomes when you spend money (how transactions drive changes)
You can buy an asset (increase assets).
You can repay a liability (decrease liabilities).
You can pay a dividend to owners (decrease cash and reduce retained earnings in equity).
You can incur an expense (use assets or create a liability with no future value).
Core concept: transactions are the unit of accounting; every transaction has a this and a that (two sides).
The time dimension of RE: beginning RE carries into the next year; end of year RE equals beginning of next year RE (example with the solid gold bar analogy).
The purpose and interconnection of financial statements
Four financial statements (and notes) provide owners with a complete view of the company’s financial position and performance:
Income Statement (period): shows revenue and expenses to derive net income (or net loss).
Balance Sheet (point in time): shows assets, liabilities, and stockholders’ equity at a specific date; fundamental equation: A = L + SE
Statement of Stockholders’ Equity (period): shows changes in components of equity (common stock and retained earnings) over a period; includes new stock issuances, net income (increases RE), and dividends (decrease RE).
Statement of Cash Flows (period): shows cash flows from operating activities, investing activities, and financing activities; notes the existence of direct vs indirect methods; most organizations use the indirect method because it aligns with the income statement and is easier to model for analysts.
Notes to the financial statements: accompany the primary statements and provide additional detail and context.
Why these concepts matter in practice
Revenue growth is highly valued by investors because it signals customer demand and future asset generation.
Net income and retained earnings indicate profitability and the ability to reinvest in the business.
Dividends reflect shareholder satisfaction but reduce retained earnings and equity.
The linkage between statements shows how actions in one area (e.g., issuing stock, recognizing revenue, incurring expenses) flow through the financials: assets, liabilities, equity, and cash.
Financial statements in detail (structure, purpose, and formulas)
Income Statement (period)
Purpose: present profitability over a period (e.g., month, quarter, year).
Core components: Revenue and Expenses; Net Income (or Net Loss).
Key relationships:
Net Income = Revenue − Expenses; NI = Revenue - Expenses
Terminology:
Revenue = top line.
Net Income = bottom line (also called net profit or net earnings).
Example layout (conceptual):
Revenue (top line)
Expenses (sum of costs)
Net Income = Revenue − Expenses (bottom line)
In public companies (U.S.), common practice is to present quarterly income statements and year-to-date totals.
FORMAT:
Heading- The heading includes a companies name, the title of the financial statment, and the time period covered.
Revenues- This section details the total income generated from the sale of goods and services before any expenses are deducted.
Expenses - This section lists all costs incurred in generating the revenues, including operating expenses, cost of goods sold, and any other necessary expenditures. Rent and salaries and so on (operating expenses)
Net Income: Revenues - Expenses
Balance Sheet (point in time)
Purpose: show what the company owns and owes at a specific date; includes assets, liabilities, and stockholders’ equity.
Fundamental equation: A = L + SE
Presentation formats: left-right (assets on left, liabilities and equity on right) or top-down (assets on top; liabilities and equity below). Either format is acceptable; the right-hand side reflects the financing of assets.
Liquidity ordering for assets: list by ease of conversion to cash (cash first, then inventory, receivables, PP&E, etc.).
Maturity ordering for liabilities: list obligations by when they are due.
Reports Assets, Liabilities, and Stockholders equity, at a spesific point in time
FORMAT:
Heading: Company name, (financial statment) state that its a balance sheet, and date.
Assets: Top Left
Current Assets: Cash, Accounts Receivable, Inventory
Harder to liquidate Assets: Property, Plant, and Equipment, Intangible Assets
Liabilities: Top right
Current Liabilities: Accounts Payable, Short-term Debt
Long-term Liabilities: Bonds Payable, Long-term Debt
Stockholders' Equity: Bottom Right
Common Stock, Retained Earnings,
Bottom: Shows that: total assets = Stockholders equity +Liability
Statement of Stockholders’ Equity (period)
Purpose: show changes in owners’ accounts during the period.
Components introduced: common stock (contributed capital) and retained earnings.
Key relationships:
Net income increases retained earnings (via the RE account) and may be distributed as dividends (which decrease retained earnings).
Issuance of common stock increases contributed capital.
Example connection: If net income for the period is $1,200 and dividends paid are $200, ending retained earnings increase by $1,000 relative to the beginning of the period.
The statement tells owners what happened to their accounts over the period (issuances, earnings retained, and dividends paid).
FORMAT:
Heading- The statement reports the activity for common stock and retained earnings over an interval of time: Company name, financial statment (in this case stockholders equity), and time period
Common stock- Begining of common stock: balance reflects the initial investment made by shareholders (during time period). And then the evaluation of stocks at the end of the time period. For example, if the company issued 10 shares for 10$ each, the balance of common stock increases by 100$
Retained earnings: This section shows how much money (from the net income) generated by the business goes back into the business. Reflects company’s profits after paying out dividends.
Total stock holders equity: Represents the 2 components and adds them together
Statement of Cash Flows (period)
Purpose: show changes in cash balances and explain where cash came from and how it was used.
Three sections:
Operating Activities (day-to-day business operations, generating revenue and incurring expenses).
Investing Activities (purchases and sales of long-term assets and investments).
Financing Activities (transactions with lenders and shareholders; debt and equity financing, dividends).
Methods:
Direct method: lists cash receipts and payments; preferred by textbooks but rarely used in practice because it’s complex and not aligned with the other statements.
Indirect method: starts with net income and reconciles to cash flow from operations by adjusting for non-cash items and changes in working capital; this is the method most analysts use and most companies employ.
Net change in cash: ext{Net Increase in Cash} = ext{CFO} + ext{CFI} + ext{CFF}
Example components:
CFO adjustments typically include non-cash expenses (e.g., depreciation), changes in working capital, and interest/taxes paid.
CFI includes purchases/sales of PPE and investments.
CFF includes issuance of stock, payment of dividends, and repayment of debt.
Linking the statements (how they fit together)
Net income from the Income Statement flows into the Statement of Stockholders’ Equity as an increase to Retained Earnings (RE).
Dividends decrease Retained Earnings in the Stockholders’ Equity statement and reduce cash in the Cash Flows from Financing activities.
Issuance of common stock increases both Common Stock (in Stockholders’ Equity) and cash (in the Balance Sheet via assets) and appears in Financing activities.
Beginning and ending Retained Earnings: Ending RE for the year equals Beginning RE for the next year (the gold bar analogy).
The Balance Sheet at year-end reflects the aggregate results of the period; the Income Statement summarizes performance over the period; the Cash Flows Statement explains cash movement across the same period.
Worked examples and references from today’s transcript
Summary linking:
The four financial statements—the Income Statement, Statement of Stockholders' Equity, Balance Sheet, and Statement of Cash Flows—are intrinsically linked to provide a comprehensive financial picture of a company. The process begins with the Income Statement, which summarizes a business's revenues and expenses over a period to determine its net income (or loss). This net income is then transferred to the Statement of Stockholders' Equity, where it increases retained earnings—the cumulative profits kept in the business. The Statement of Stockholders' Equity also tracks other changes in equity, such as the issuance of common stock (which increases contributed capital) and dividends paid (which reduce retained earnings). The ending balance of total stockholders' equity from this statement then directly feeds into the Balance Sheet, ensuring that the fundamental accounting equation (Assets = Liabilities + Stockholders’ Equity) holds true at a specific point in time. Finally, the Statement of Cash Flows explains the changes in the cash balance shown on the Balance Sheet over a period, categorizing cash inflows and outflows into operating, investing, and financing activities. This statement directly reflects cash movements related to operations (which produce net income), investments in assets (like buying a warehouse, an investing activity, not an operating cost, as discussed previously), and financing (such as issuing stock or paying dividends, which impact stockholders' equity). The net change in cash calculated on the Statement of Cash Flows reconciles precisely with the difference between the beginning and ending cash balances on the Balance Sheet, thus completing the interwoven financial narrative.
Asset vs liability and revenue recognition
Asset example: a 12-month lease valued at $24,000 is an asset for the lease term (twelve months) and is expensed as the time passes; after month 12 it is exhausted.
Revenue example: sale of a car for $1,000 with a cost of goods sold (COGS) $700 results in revenue $1,000 and expense $700; net income contributions are $300 for that transaction.
Common stock and contributed capital example (transaction model)
Scenario: Investor Ivan pays $100 in cash to company XY&Z in exchange for common stock.
Company records: Asset (Cash) increases by $100; Common Stock increases by $100; this shows contributed capital of $100.
If there were multiple investors (e.g., Mary contributed $300), contributed capital increases to $400, with assets increasing correspondingly.
Concept of dilution: new issuances bring in new owners, diluting existing owners’ percentage ownership even if total equity increases.
Revenue and expense mechanics
Revenue is recognized only when the company delivers goods/services to the customer (e.g., the ski lesson example where a customer pays for four lessons at $400; revenue is recognized as services are delivered, i.e., as lessons are performed).
If a customer pays before delivery, the amount is a liability (unearned revenue) until the service is performed.
Revenue is never recognized from cash received from lenders or shareholders; such cash is financing or contributed capital, not revenue.
Expense examples and rationale
Examples: employee compensation, rent, utilities, advertising, R&D, travel, interest expense, taxes.
Advertising is always expensed due to uncertainty of future benefits; R&D in the U.S. is expensed rather than capitalized; long-run capitalization practices vary across countries.
Interest expense reflects the lender’s compensation for providing funds; principal repayment is a reduction of the liability, not an expense.
Taxes (income taxes) are expenses because they are obligatory payments with no future value realized by the company beyond avoiding penalties; they are not revenue.
Depreciation (and asset life)
Assets have finite useful lives; depreciation allocates cost over that life, reducing the asset’s book value each period.
Example: Car purchased for $50,000 with a 5-year life; annual depreciation = rac{50{,}000}{5} = 10{,}000; after one year, book value = 50{,}000 - 10{,}000 = 40{,}000.
Depreciation is a non-cash expense that reflects the consumption of an asset over time; effect is to reduce net income and accumulate accumulated depreciation on the balance sheet.
Dividends and their accounting treatment
Dividends are distributions of assets to owners and are not expenses.
They reduce retained earnings and cash (in the financing section), reflecting return of capital to owners.
Quick reference to a few interrelated points
Net Income vs. Net Cash Flow: net income is not the same as cash flow; the Cash Flows Statement reconciles the two.
The top-line focus: revenue is referred to as the top line on the income statement; the bottom line is net income.
Note on measurement timing: assets, liabilities, and stockholders’ equity are measured at a point in time (balance sheet), while revenue and expenses are measured over a period of time (income statement).
The four financial statements work together to tell the company’s complete story: performance, position, changes in equity, and cash movements.
Notes on exam readiness and upcoming coverage
Expect questions on identifying whether a given item is an asset, liability, revenue, expense, or dividend.
Be comfortable with the basic equations:
A = L + SE
NI = Revenue - Expenses
RE{end} = RE{begin} + NI - Dividends
Net change in cash: CFO + CFI + CFF
Be able to classify cash flows into operating, investing, and financing activities and distinguish the indirect vs direct method for the statement of cash flows.
Be prepared to walk through sample balance sheets, income statements, and statements of stockholders’ equity, and explain how changes in one statement drive changes in others.
Understand the rationale for why R&D, advertising, and many other costs are expensed rather than capitalized in the U.S., and how that contrasts with some other jurisdictions.
Appreciate the historical lineage of accounting concepts (e.g., the idea that notes accompany the main statements) and the practical purpose of financial statements for owners and analysts.
Next steps and study tips
Practice with simple numerical examples: create a hypothetical company, record a few transactions (issuance of stock, revenue recognition, expenses, dividends), and prepare the four financial statements to see the interconnections.
Review the four statements’ formats (left-right vs top-down balance sheet) and the logic that underpins each statement.
Prepare to discuss how depreciation, interest, and taxes affect net income and cash flow in different scenarios.
Be ready to explain the meaning and implications of “top line” (revenue) versus the “bottom line” (net income) in investment analyses.
Business activities:
Cash Flows from Operating Activities
Cash flows from operating activities arise from the activities a business uses to produce net income. For example, operating cash flows include cash sources from sales and cash used to purchase inventory and to pay for operating expenses such as salaries and utilities. Operating cash flows also include cash flows from interest and dividend revenue interest expense, and income tax.
Cash Flows from Investing Activities
Cash flows from investing activities are cash business transactions related to a business’ investments in long-term assets. They can usually be identified from changes in the Fixed Assets section of the long-term assets section of the balance sheet. Some examples of investing cash flows are payments for the purchase of land, buildings, equipment, and other investment assets and cash receipts from the sale of land, buildings, equipment, and other investment assets.
Cash Flows from Financing Activities
Cash flows from financing activities are cash transactions related to the business raising money from debt or stock, or repaying that debt. They can be identified from changes in long-term liabilities and equity. Examples of financing cash flows include cash proceeds from issuance of debt instruments such as notes or bonds payable, cash proceeds from issuance of capital stock, cash payments for dividend distributions, principal repayment or redemption of notes or bonds payable, or purchase of treasury stock. Cash flows related to changes in equity can be identified on the Statement of Stockholder’s Equity, and cash flows related to long-term liabilities can be identified by changes in long-term liabilities on the balance sheet. Also dividends fr
ON QUIZ:
Sole proprietorships:
-Something owned by 1 person
-Typically Private
-The owner carries all the liability (unlimited)
Partnership:
When 2 or more people decide to work together
Public or private
Pros:
-Easy to form
-Tax advantage
Cons:
-Unlimited liability
- Difficult to transfer ownership and raise capitol
-Unlimited liability
Corporation:
A separate legal entity
Basically a citizen that simply cant vote
Get taxed separately
Owner and cooperation have their own separate liabilities
Board members are hired by shareholders
Pros:
-easiest to raise capitol
-easy to transfer ownership
-Protection to stockholders against personal liability
Cons:
-Both business and owner are taxed
-Reporting requirements can be complex and may vary based on the location and type of business entity chosen.