Accounting Basics: Financial Information, Business Structures, and the Accounting Equation
Key purpose of accounting
Accounting provides financial information to help people make decisions.
It records inputs, processes, and outputs in a business context to assess performance and financial position.
What is a business? (General model)
A business takes inputs, applies a process, and sells the output to customers.
Inputs include resources such as materials, labor, equipment, and overhead.
The process transforms inputs into a product or service, which is then sold to generate revenue.
The ultimate goal is to earn profit (net income).
Bakery example: identifying inputs, outputs, and profit
Inputs for cupcakes and desserts:
Materials: flour, sugar, butter, icing, sprinkles, etc.
Transportation to deliver products to events.
Equipment: ovens and other machinery.
Labor: bakers and staff.
Other inputs: electricity, rent, supplies.
Output: finished desserts sold to customers.
Revenue: income from selling cupcakes, cookies, wedding cakes, etc.
Costs (inputs): salaries, electricity, sugar/flour, rent, materials, utilities, etc.
Net income (profit) = Revenue − Total inputs/costs.
If Costs > Revenue, you have a deficit or loss; if Costs < Revenue, you earn a profit.
Profit vs. net income
Profit is commonly used informally to mean net income.
Net income is the formal accounting term for profit after subtracting expenses from revenue.
Profit/Net Income = Revenue − Expenses.
Business structures
Sole proprietorship (sole ownership): one person owns and runs the business; owner is personally responsible for debts.
Partnership: two or more owners share ownership and liabilities.
Corporation: separate legal entity; ownership through stockholders; profits distributed as dividends; limited liability for shareholders.
Limited Liability Company (LLC): blends features of partnerships and corporations; limited liability for owners; flexible management.
In class: focus on corporations as a major engine of economic activity; ownership via stock market and dividends.
Corporations: how they work (dividends and ownership)
Investors can buy into a bakery idea and become part-owners without working in the business.
Profits are distributed to owners as dividends when earned.
A corporation protects shareholders with limited liability; if the company fails, shareholders are not personally liable for the loans.
Three main business activities (regardless of type)
Operations (or operating activities): day-to-day activities that generate revenue and profits (selling goods/services).
Investing: acquiring long-term assets used to run the business (e.g., ovens, delivery vans).
Financing: obtaining funds to start or grow the business (creditors/loans or investors/equity).
Types of business activities in the bakery example
Long-term assets (investing): ovens, delivery van, and other equipment used repeatedly to generate revenue.
Financing: obtaining funds from banks (loans) or investors (new ownership stakes).
Users of financial information
Managerial users (internal): managers and employees who need information to run the business efficiently and profitably.
Financial users (external): creditors, lenders, investors, government agencies, journalists, and other outside parties interested in the firm's financial health.
In this course, the focus is on financial accounting for external users.
External vs internal users (examples)
External: creditors, banks, investors, potential investors, government agencies, regulators, suppliers, customers, journalists.
Internal: managers, employees.
Governing bodies and accounting standards
FASB (Financial Accounting Standards Board): sets Generally Accepted Accounting Principles (GAAP).
GAAP (Generally Accepted Accounting Principles): the rules used to prepare financial statements in the United States.
SEC (Securities and Exchange Commission): government agency that oversees publicly traded companies and enforces correct financial reporting.
IFRS (International Financial Reporting Standards): international accounting standards used by many countries; US companies primarily follow US GAAP.
In the US: the primary framework is GAAP; in many other countries, IFRS is used or country-specific GAAP.
Key qualitative characteristics and assumptions (high-level)
Relevance: information that can influence decisions (timely and capable of making a difference).
Faithful representation (verifiability): information should faithfully represent economic phenomena and be verifiable by independent sources.
Timeliness: information should be available when it matters for decision making.
Understandability: information should be clear and easy to understand.
Verifiability: information can be checked by an independent party (e.g., third-party sources).
Comparability: information should allow users to compare across entities and time periods.
Monetary unit assumption: financial information is measured in a stable currency (e.g., dollars).
Time period assumption: financial reports cover consistent periods (e.g., monthly, quarterly, yearly).
Business entity concept: the business is separate from owners personally.
Going concern: assume the business will continue operating into the future unless there is evidence otherwise.
Historical cost principle: assets are recorded at their original acquisition cost and reported at that cost until disposed of.
In practice: use verifiable, objective measurements; e.g., inventory is reported based on counts or estimates verified by records.
Historical cost principle and an example
Principle: record assets at their original cost when acquired and keep that amount on the books until sale or depreciation.
Example: If land is purchased for $500 in 1980 but is worth $5,000,000 today, the financial statements report the land at $500 until a sale or impairment triggers adjustment.
If the land is later sold for $5,000,000, the gain is realized on the sale, not in periodic revaluation (under historical cost rules).
Note: taxes are not discussed here; focus is on accounting measurement and reporting principles.
The accounting equation
Foundational relation: Assets = Liabilities + Stockholders' Equity.
Intuition:
Assets: what the company owns that will bring future benefits (cash, inventory, equipment, land).
Liabilities: debts/obligations to outsiders (loans, payables).
Stockholders' Equity: owner claims after debts are settled (contributed capital + retained earnings).
Example problem: If a bakery has Assets = 100 and Liabilities = 25, then Equity = 75.
Calculation:
Profit and equity: Profit (net income) increases equity (retained earnings); distributions to owners (dividends) decrease equity.
Short exercise (practice question from class)
Given Assets = 100, Liabilities = 25, Equity = ?
Answer:
Types of businesses: services, retail, manufacturing
Services: provide a service or intellectual work rather than a physical good.
Examples: accounting firm, law firm, movie production company, hair/nail salons, restaurant service.
Service example in class: Delta Airlines (strictly a service business — no physical product sold to customers in a store setting).
Retail: sells finished goods to consumers; inventory is a key asset.
Examples: Costco, Walmart, Trader Joe’s, Target.
Manufacturing: transforms raw inputs into finished goods; products then sold to retailers or directly to customers.
Examples: Nestlé (converts raw ingredients into food products), General Motors (builds cars), copper refinery (produces copper).
Checkpoint concepts (class mechanics)
Three main business activities (operating, investing, financing) apply to any business type.
External users rely on GAAP-compliant financial statements; internal users rely on managerial accounting for decision-making.
The monetary unit, time period, business entity, and going concern assumptions underlie the reporting framework.
Ethical considerations: integrity and accuracy in financial reporting are essential for trust and decision making.
Quick recap of the main ideas
The purpose of accounting is to provide relevant, timely, understandable, and verifiable information to help people make decisions.
There are several business structures with different liability and ownership implications; corporations offer limited liability and potential dividends.
Businesses perform three activities: operating, investing, and financing.
Financial accounting reports are primarily for external users (investors, creditors, regulators); managerial accounting serves internal users.
GAAP (US) and IFRS (international) provide the framework for reporting; standards are set by FASB (US) and overseen by the SEC for public companies.
Qualitative characteristics and fundamental assumptions guide what gets measured and reported, including the historical cost principle and the accounting equation: .
Profit (net income) increases equity; losses decrease equity; in a corporation, profits can be distributed as dividends to shareholders.
In practice, information should be verifiable, timely, comparable, and easy to understand; third-party sources (e.g., Carfax for cars) can help verify information; taxes are not the focus of this course.
End-of-lesson thought: why this matters
Understanding the accounting equation and the flow of activities helps explain how business decisions impact financial position and profitability.
Recognizing the differences between business structures clarifies risks, rewards, and reporting requirements.
Knowing who uses financial information and what information is most relevant helps tailor financial reporting to decision makers.