Accounting Principles and Concepts (Chapter 1)

Risk and Uncertainty in Business

• Risk is uncertainty; you could be making a profit and then the economy changes and profits can evaporate. Risk is widespread and part of business and personal life.
• Whether in business or personal life, we are exposed to risk. The core idea: risk = uncertainty about future outcomes, including profit.
• Profit intuition: profit = revenues − expenses; even a well-known company can face profit swings due to volume, price, or cost changes.
• Examples of risk in business context: big tech firms (Google, Microsoft, Netflix, Amazon) and consumer brands (Domino’s, Papa John’s) all face risk from demand, competition, and input costs.
• The key idea: owners and managers are uncertain about profit because volume (sales), price per unit, and costs can all change.

Information as a Tool to Mitigate Risk

• Businesses want to mitigate or reduce risk, typically through better information.
• The quality of information matters: there is good information and bad information; credibility varies.
• Before buying a stock, for example, investors seek information about the company to reduce risk.
• Types of information: broadly qualitative and quantitative.
  • Qualitative information: qualitative, subjective, can involve physical inspection or qualitative assessment (e.g., checking a tire by eye).
  • Quantitative information: numeric measurements (e.g., tire PSI reading) that provide precise data.
• In a business, accounting information comes from everyday transactions and is transformed into useful reports.
• Everyday transactions example: Publix milk purchase → inventory (milk) → cash register records sale → receipt issued and recorded in the system.
• A bookkeeper aggregates transactions into information that leaders can use to assess performance and risk.

The Four Basic Accounting Reports

• Accounting information is transformed into four basic reports that support decision-making:
  • Income Statement: reports on the operations of a business, including revenues and expenses.
  • Balance Sheet: reports the financial position of a company (assets, liabilities, and stockholders' equity).
  • Retained Earnings Statement: discusses retained earnings (profits kept in the business) and their changes over time.
  • Cash Flow Statement: explains where cash comes from and where it goes (operating, investing, and financing activities).
• These reports provide information to both internal and external decision makers and help keep score against goals and competitors (e.g., Disney vs Time Warner, Amazon vs Walmart).
• The concept of “keeping score” is similar to grades or benchmarking in exams; there needs to be a consistent framework to compare performance.
• An anecdote: a professor might reveal a class-wide high score that changes the interpretation of a single exam score, illustrating how scoring rules affect perceived performance.

GAAP, Principles, Assumptions, and Constraints

• GAAP = Generally Accepted Accounting Principles; these are the principles that guide scorekeeping in business accounting.
• Not strictly rigid rules; they are principles that serve as guides for consistent reporting across diverse types of businesses.
• Key principles highlighted in Chapter 1 include:
  • Historical Cost Principle: assets are recorded at their original purchase cost.
  • Fair Value Principle: (mentioned as a contrast to historical cost) emphasizes measuring assets at estimated current market value in some contexts.
• Assumptions that underlie GAAP reporting:
  • Monetary Unit Assumption: report in a single currency; for global companies, currencies are converted to the reporting currency (e.g., dollars).
  • Economic Entity Assumption: the business is treated as a separate economic entity from its owners; transactions are not commingled with personal finances.
• Constraint (Cost Constraint): information has a cost to produce, so companies weigh the benefits of providing information against the costs to produce it (e.g., staff time, systems).
• These pieces (GAAP, assumptions, and constraints) guide how financial information is prepared and reported.

The Accounting Equation and Its Components

• Core equation: \text{Assets} = \text{Liabilities} + \text{Stockholders' Equity}.
• Assets: resources owned by a business that provide future benefits or services.
  • Examples: cash, supplies (paper, pens), equipment (cars, computers).
  • Classification: often split into short-term (current) and long-term (noncurrent) assets.
• Liabilities: creditors’ claims against the company; what the company owes.
  • Examples: accounts payable (money owed to vendors like Walmart’s suppliers), notes payable (loans, typically from banks) with interest.
• Stockholders' Equity: owners' claim on the assets after liabilities are paid; the residual interest.
  • Two major components:
  • Common stock (contributed capital): investment by owners in exchange for ownership; increases equity.
  • Retained earnings (RE): profits kept in the business after distributions; part of equity.
• Residual nature of equity: \text{Assets} - \text{Liabilities} = \text{Stockholders' Equity}.

Assets in Detail

• Assets are the stuff a business owns that provides future benefits.
• Categories typically include:
  • Cash
  • Supplies (short-term items like paper, pens)
  • Equipment (long-term assets like vehicles, computers)
• Remember the two-part concept: ownership and benefit to the business.
• Examples in personal terms: a mobile phone and a car are assets because you own them and they provide benefits.

Liabilities in Detail

• Liabilities represent what the company owes to others.
• Examples include:
  • Accounts payable: amounts owed to vendors (e.g., Walmart owes Pepsi for soda).
  • Notes payable: loans from banks or other lenders, typically with interest.
• Liabilities are claims by creditors against the company’s assets.

Stockholders’ Equity in Detail

• Stockholders' Equity represents the owners' claims after liabilities are settled.
• Two big components:
  • Common stock (contributed capital): the investment by owners in exchange for ownership; increases equity.
  • Retained earnings (RE): profits retained in the business after dividends.
• Retained earnings is essentially profits held back for reinvestment; if profits are distributed to owners, that distribution is called dividends.

Common Stock and Contributed Capital

• Common stock (or contributed capital) = investment by owners into the corporation.
• In corporate contexts, this is the typical form of owner investment; it increases stockholders' equity.
• In other business forms (sole proprietorship, partnerships), the term contributed capital may be used differently, but the concept is the same: infusion of resources by owners.

Retained Earnings: Definition and Significance

• Retained earnings = profits that are held back in the business rather than distributed to owners.
• How they arise:
  • Profit (or net income) = Revenue − Expense.
  • Profits can be reinvested in the business (retained) or distributed as dividends.
• Relationship to equity:
  • Retained earnings are part of stockholders' equity.
• Synonyms and related terms:
  • Net income, net earnings, earnings are other terms for profit.
  • Retained earnings = profits kept in the business for growth.

Revenues: What Counts as Revenue and What Does Not

• Revenues are the results of business activities entered into for the purpose of earning income.
• Different names for revenue depending on the activity:
  • Sales (goods sold to customers)
  • Fees (services rendered)
  • Commissions (agents earning fees for services)
  • Interest, dividends, royalties
  • Rent
• Distinguishing revenue from non-revenue activities:
  • Example 1: Starbucks selling a Verismo espresso machine to consumers is revenue because it is in the ordinary course of business (retail goods).
  • Example 2: Selling a commercial-grade espresso machine used in stores (not sold to consumers) at a loss or as surplus is typically not revenue because the activity is not part of the primary operation for earning income.
• Summary: revenues arise from ongoing business activities intended to earn income; not all sales of assets are revenues.

Expenses and How They Relate to Profit

• Expenses are the costs of assets consumed or services used in the process of earning revenue.
• Examples: salaries, rent, utilities, taxes, advertising.
• Effect on profit: expenses reduce profit (profit = revenues − expenses).
• Important distinction: expenses are not the same as dividends; dividends are distributions to owners and reduce retained earnings, not operating expenses.

Dividends: Distributions to Owners

• Dividends are distributions of profit to stockholders and are not considered an expense.
• Effect on equity:
  • Dividends reduce retained earnings and thus reduce total stockholders' equity.
• Why this matters: if you treated dividends as expenses, they would be included in the income statement and reduce reported profit, which is not how GAAP-based reporting works.

How Profit Affects Equity and the Flow of Funds

• Increases to stockholders' equity come from:
  • Investment by owners (common stock / contributed capital)
  • Revenues (increases in equity due to earnings)
• Decreases to stockholders' equity come from:
  • Dividends (distributions to owners)
  • Expenses (through reducing net income and retained earnings)
• Note on the interaction: expenses reduce profit, which reduces retained earnings, a component of equity.

Practical Takeaways: Memorization and Application

• Memorize the key vocabulary and how to apply it in context:
  • Assets, Liabilities, Stockholders' Equity
  • Common Stock, Retained Earnings
  • Revenues, Expenses, Dividends
  • The four reports: Income Statement, Balance Sheet, Retained Earnings Statement, Cash Flow Statement
• Understand what each report measures and how it supports decision making and risk mitigation.
• Remember the formulas and their implications for decision making:
  • Profit: \text{Profit} = \text{Revenue} - \text{Expenses}
  • Accounting Equation: \text{Assets} = \text{Liabilities} + \text{Stockholders' Equity}

Quick Reference: Numerical Examples from the Transcript

• Cost example: A bottle of Mountain Dew sold for 1.50 and bought for 1.00; Profit = 1.50 - 1.00 = 0.50 dollars.
• Pricing example: A sandwich priced at 5.00 per unit.
• Tire example: Tire PSI example cited as 45\, \text{PSI}.
• Inventory example: 50{,}000 pounds of coffee inventory.

Chapter Connections and Real-World Relevance

• GAAP and scorekeeping connect to real-world reporting standards used by public companies and regulators (e.g., SEC, FASB).
• The four reports provide a framework for evaluating performance and comparing against peers (e.g., Disney vs Time Warner, Amazon vs Walmart).
• The historical cost vs fair value principles illustrate how assets can be measured differently depending on context and report type.
• The economic entity assumption reminds us not to mix personal and business finances in reporting.
• The cost constraint emphasizes that producing information has a cost, so companies must balance informativeness with cost.

Ethical, Philosophical, and Practical Implications

• Ethical implication: accurate and honest reporting is essential for stakeholders to make informed decisions.
• Practical implication: misclassifying expenses vs dividends or revenue can mislead investors and misstate a company’s financial performance.
• Philosophical implication: reporting standards attempt to create a common language for diverse businesses to communicate value and risk consistently.

Study Tips and Final Reminders

• Focus on understanding the definitions and relationships (assets, liabilities, equity; revenues vs expenses; retained earnings vs dividends).

• Practice with the four reports and what information each provides for decision making.

• Memorize key terms and their interrelationships, then practice applying them to simple scenarios (industry examples, personal finance analogies, etc.).

• Use the four principles and assumptions as a framework when evaluating new information or case studies.

• End of summary: review each section, ensure you can explain each concept in your own words, and be able to identify whether a transaction would affect revenues, expenses, dividends, or different components of stockholders’ equity.