Chapter 1-8: Basic Accounting Concepts (Video Notes)

What is Accounting?

Accounting as the language of business: the way a business tells its story in numbers.
Simple example (single transaction): selling a phone for 200 that cost 100 to make gives profit 200 - 100 = 100.
Not all accounting is the same: depending on the audience, the report may have different names and goals:
- Financial accounting: for banks and investors (external users) to assess profitability and solvency.
- Tax accounting: information presented to government to determine taxes due (might reflect lower profits).
- Managerial accounting: for internal managers to make decisions; should be accurate and useful, not exaggerated.
The video emphasizes three types of accounting and their audiences.

Types of Accounting and Key Roles

Private accounting (internal): for internal decision-making (controller, accounts receivable, etc.).
Public accounting (external): third-party CPAs who may provide audits or tax services.
- CPA = Certified Public Accountant; licensed in a state; requires exam and work experience.
Not-for-profit: another type of organization; not focused on profit; discussed but not a major focus in this course.
Profit concept: selling price minus cost; used to define profit on a single transaction, but the course focuses on aggregated results (revenue, expenses, net income).

The Big Picture: Fundamental Definitions

Accounting information system: reports on economic activities and the financial condition of a business.
Revenue and expenses: components that, when netted, determine net income.
Profit vs. loss: profit = when revenue > expenses; loss = when expenses > revenue.
Financial accounting vs managerial accounting (audience focus):
- Financial accounting serves external users (banks, investors).
- Managerial accounting serves internal users (managers).
GAAP (Generally Accepted Accounting Principles): the rule system for public financial reporting in the U.S., established by the FASB (Financial Accounting Standards Board).
- IFRS (International Financial Reporting Standards) is used by many other countries.
The acronym GAAP stands for Generally Accepted Accounting Principles.

Key Concepts: Assets, Liabilities, and Equity

Asset: an economic resource that will provide a future benefit or generate revenue. Examples: ext{cash}, ext{land}, ext{inventory}, ext{buildings}, ext{equipment}.
Liability: an obligation to repay money or other resources; typically evidenced by a debt that must be paid back (e.g., notes payable).
Stockholders’ equity (owner’s equity): the residual interest in the assets after deducting liabilities. It includes common stock and retained earnings; also referred to as S/E or O/E.
Common stock (CS): ownership in a company; represents contributed capital from investors.
Retained earnings (RE): cumulative earnings retained in the business after dividends are paid; part of stockholders’ equity.
Resource providers: the sources of assets include creditors (lenders) and investors (owners).
The basic accounting equation ties assets to claims against them:
- ext{Assets} = ext{Liabilities} + ext{Stockholders' Equity}
- Expanded: ext{Assets} = ext{Liabilities} + ext{Common Stock} + ext{Retained Earnings}
Convenience of the equation: it must balance after every transaction; this is the core of financial accounting.

Basic Accounting Equation: Worked Examples

Start-up example: a business borrows 500{,}000 and sells 500{,}000 worth of stock. Result:
- Assets = 1{,}000{,}000, Liabilities = 500{,}000, Stockholders’ equity = 500{,}000.
- This demonstrates assets = liabilities + equity, with sources from creditors and investors.
Liquidation (order of payout): if the business liquidates, creditors are paid first; any remaining assets go to stockholders.
- Example 1: end state with assets 1{,}000{,}000; pay creditors 500{,}000; stockholders receive the remaining 500{,}000 (everyone gets back what was put in in this simplified scenario).
- Example 2: if the business performs well and ends with 1{,}100{,}000, creditors receive 500{,}000, stockholders receive 600{,}000.
- Example 3: if the business performs poorly and ends with 900{,}000, creditors still receive 500{,}000; stockholders receive the remaining 400{,}000 (they may receive less than their original investment).

Retained Earnings, Net Income, and Dividends

Retained earnings (RE): the earnings kept in the business to reinvest or reward investors; part of stockholders’ equity.
Net income: ext{Net Income} = ext{Revenue} - ext{Expenses}.
Dividends: distributions to stockholders; decrease retained earnings.
Expanded relation:
- RE{ ext{end}} = RE{ ext{begin}} + ext{Net Income} - ext{Dividends}
- Equivalently: RE{ ext{end}} = RE{ ext{begin}} + ext{Revenue} - ext{Expenses} - ext{Dividends}
In practice, many items affect RE via the equation in a straightforward way: revenue increases RE, while expenses and dividends decrease RE.
Mnemonic: RED = Revenue, Expenses, Dividends. These components feed into retained earnings.
- - RED 2 Re means Revenue increases Retained Earnings; expenses and dividends decrease it.

The Expanded and Collapsed Forms of the Equation

Expanded form:
- ext{Assets} = ext{Liabilities} + ext{Common Stock} + ext{Retained Earnings}
- with ext{Retained Earnings} = ext{Revenue} - ext{Expenses} - ext{Dividends}
Net income and dividends connect to RE:
- Net income = ext{Revenue} - ext{Expenses};
- RE contributes to total equity alongside common stock.
Collapsing back to a compact form:
- Assets = Liabilities + Common Stock + Retained Earnings
- Retained Earnings = Net Income − Dividends
- Net Income = Revenue − Expenses
- Therefore: Assets = Liabilities + Common Stock + Net Income − Dividends
The key takeaway: the accounting equation can be expanded to show exactly what components of equity are driving changes in assets.

The Horizontal Financial Statement Model

A transaction is recorded on its own line with two (or more) affected accounts to keep the equation in balance.
Recording rules:
- An increase in an asset or a decrease in a liability/equity is shown as a positive amount.
- A decrease in an asset or an increase in a liability/equity is shown in parentheses (negative impact).
- The total on both sides of the equation must balance after every transaction.
Not every column will be used in every transaction; some accounts may not be affected in a given event.
This model is used to track how each event affects the basic accounting equation over time.

Patterns of Transactions (Three Types)

Asset Source (increase in assets): also increases claims on those assets (liabilities or equity). Examples:
- Borrowing money from the bank → cash increases; notes payable (liability) increases.
- Issuing common stock → cash increases; common stock (equity) increases.
- Providing services for cash → cash increases; revenue increases retained earnings (via NI).
Asset Use (decrease in assets): reduces assets and reduces claims on those assets. Examples:
- Paying expenses in cash → cash decreases; expenses decrease retained earnings via net income impact.
- Paying a cash dividend → cash decreases; dividends decrease retained earnings.
Asset Exchange (swap one asset for another): total assets remain unchanged, but composition changes. Example:
- Paying cash to acquire land → cash decreases; land increases; total assets unchanged.
Each event affects the left side (assets) and right side (claims) in at least two places to keep the equation balanced.

Worked Examples: Dakota Company Year Two

Event 1: Acquire $30{,}000 cash by issuing common stock.
- Affects: Cash (+$30{,}000), Common Stock (+$30{,}000).
- Pattern: Asset Source (increase in assets and increase in equity).
Event 2: Pay $12{,}000 cash to purchase land.
- Affects: Cash (−$12{,}000), Land (+$12{,}000).
- Pattern: Asset Exchange (one asset for another).
Event 3: Borrow $10{,}000 cash.
- Affects: Cash (+$10{,}000), Notes Payable (+$10{,}000).
- Pattern: Asset Source (cash increases; liability increases).
Event 4: Provided services for $20{,}000 cash.
- Affects: Cash (+$20{,}000); Revenue (+$20{,}000) which increases Retained Earnings.
Event 5: Pay $1{,}000 cash for utilities expense.
- Affects: Cash (−$1{,}000); Expenses (−$1{,}000) which decrease Retained Earnings.
Event 6: Pay $15{,}000 cash for other operating expenses.
- Affects: Cash (−$15{,}000); Expenses (−$15{,}000) which decrease Retained Earnings.
Event 7: Pay a $2{,}000 cash dividend.
- Affects: Cash (−$2{,}000); Dividends (−$2{,}000) which decrease Retained Earnings.
Event 8: Market value of land purchased in Event 2 is now $12{,}700.
- No entry recorded due to Historical Cost Concept; value is not updated to reflect market fluctuations.
Totals (as given in the transcript):
- Cash: 32{,}000;
- Notes payable: 10{,}000;
- Common stock: 36{,}000;
- Retained earnings: 10{,}000.
Conceptual takeaway from the Dakota sequence:
- The accounting equation remains in balance after each transaction using the horizontal model.
- Some entries are made in cash and corresponding asset accounts; RE is affected by revenue, expenses, and dividends (Red 2 Re).
- The market value adjustment for land is not recorded due to the historical cost concept.

Historical Cost Concept vs. Market Value

Historical cost concept: assets are recorded at their original purchase cost and are not adjusted for market value fluctuations.
Market value concept: would reflect current fair value; not used in this class for asset valuation.
Real-world implication: even if land’s market value increases, the accounting entry keeps the asset at its historical cost until disposal, unless an impairment or sale occurs.

The “Red 2 Re” Rule and Expanded Retained Earnings

RED stands for Revenue, Expenses, Dividends.
In the expanded equation, revenue increases retained earnings; expenses and dividends decrease retained earnings.
Net income (NI) = Revenue − Expenses; REend = REbegin + NI − Dividends.
This helps trace how operating results flow into equity over time.

Quick Reference: Abbreviations and Terminology

CS = Common Stock (ownership shares).
RE = Retained Earnings.
S/E or O/E = Stockholders’ Equity or Owner’s Equity.
NP = Notes Payable (liability).
N/P = Notes Payable (alternative abbreviation).
A = Assets; L = Liabilities; CS = Common Stock; RE = Retained Earnings.
NI = Net Income = Revenue − Expenses.
RO/Investors vs Creditors:
- Creditors (lenders) are creditors to be repaid (liabilities).
- Investors (owners) provide equity in exchange for ownership (common stock).
Not-for-profit: a business type focused not on profit; not the primary focus of this chapter.

Summary of Key Formulas and Concepts

Basic accounting equation:
- ext{Assets} = ext{Liabilities} + ext{Stockholders' Equity}
Expanded equity:
- ext{Assets} = ext{Liabilities} + ext{Common Stock} + ext{Retained Earnings}
Net income:
- ext{Net Income} = ext{Revenue} - ext{Expenses}
Retained earnings ending balance:
- RE{ ext{end}} = RE{ ext{begin}} + ext{Net Income} - ext{Dividends}
Alternative RE form using revenues and expenses:
- RE{ ext{end}} = RE{ ext{begin}} + ext{Revenue} - ext{Expenses} - ext{Dividends}
Relationship among terminology:
- ext{Common Stock} + ext{Retained Earnings} = ext{Stockholders' Equity}
- ext{Net Income} = ext{Revenue} - ext{Expenses}
  ightarrow ext{Net Income} ext{ contributes to } RE
Transaction patterns in the horizontal model:
- Asset Source: increases assets and increases claims (liability or equity).
- Asset Use: decreases assets and decreases claims.
- Asset Exchange: increases one asset and decreases another; total assets unchanged.

Practical Takeaways for Exam Preparation

Be able to state and use the basic accounting equation and its expanded form.
Distinguish between external (financial) vs internal (managerial) users and GAAP’s role in the U.S. context.
Recognize and classify common entries as asset sources, asset uses, or asset exchanges.
Understand how revenues, expenses, and dividends affect retained earnings and how net income links to RE.
Remember the historical cost concept and the market value caveat introduced in the chapter.
Memorize standard abbreviations (CS, RE, NP, S/E) and how they appear on balance sheets and statements.
Practice with the idea of balancing after every transaction using the horizontal model and checks for balance.