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Accounting Fundamentals — Assets, Liabilities, Equity & Reporting Entities (Vocabulary)

Key Accounting Concepts and the Swift Corporation Year 2 Exercise

  • Core idea: accounting tracks what a business owns (assets), owes (liabilities), and is owned by (stockholders’ equity). The recordings ensure the accounting equation stays in balance.

The accounting equation

  • Fundamental equation: \text{Assets} = \text{Liabilities} + \text{Stockholders' Equity}
  • This must always balance; every transaction has a dual effect on the accounting equation.

Assets, liabilities, and stockholders' equity

  • Assets include cash, land, buildings, inventory, etc.
    • Cash is always included as an asset.
    • Example from transcript: Fiesta Brava needs tortilla shells and cheese to operate; these items are part of inventory/assets.
  • Liabilities are what you owe (debt, obligations).
    • Examples include loans payable, accounts payable, notes payable.
  • Stockholders' equity represents the owners' claim after liabilities are paid.
    • Two components:
    • Earned capital (also called retained earnings): profits kept in the business.
    • Contributed capital: capital put in by investors (common stock).

Earned capital vs contributed capital

  • Earned capital = Retained earnings (RE)
    • RE reflects the cumulative earnings retained in the business.
    • RE is affected by revenues, expenses, and dividends:
    • Revenues (earnings) increase RE.
    • Expenses decrease RE.
    • Dividends decrease RE (distribution to shareholders).
    • Net income = Revenues − Expenses.
    • Retained earnings end-of-period can be written as:
      \text{RE}{\text{end}} = \text{RE}{\text{begin}} + \text{Net Income} - \text{Dividends}
  • Contributed capital = Common stock (when investors contribute cash or other assets).
  • Stockholders' equity = Retained earnings + Common stock (i.e., RE + contributed capital).
  • “Sweat equity” is a colloquial way to refer to the effort that builds retained earnings (earned capital) through revenue generation and cost control.

Revenue, expenses, and dividends (in equity terms)

  • Revenues (income) represent inflows from delivering goods/services; they increase retained earnings.
  • Expenses represent costs to operate the business; they decrease retained earnings.
  • Net income is the profit after expenses; it increases retained earnings.
  • Dividends are distributions to shareholders and reduce retained earnings.
  • Example language from transcript:
    • Revenues or income come in, increasing RE (via net income).
    • Expenses reduce RE.
    • Net income is legally incorporated into RE unless distributed as dividends.

Financial accounting vs managerial accounting vs nonprofit accounting

  • Financial accounting: information provided to external users (investors, creditors, brokers).
    • Key reports: balance sheet, income statement, statement of stockholders’ equity, cash flow statement.
    • Purpose: assess overall financial health and future prospects; inform investment and lending decisions.
  • Managerial accounting: information provided for internal decision-making (managers and departments).
    • Focus: detailed, often unit-level data (departments, product lines, budgets).
    • Examples: budgeting, cost behavior, product profitability analysis.
  • Nonprofit accounting: accounting for associations and charitable organizations funded by benefactors.
    • Focus: ensure funds are used as promised; accountability to donors and legislators.
    • Note: revenue comes from donations; expenses go toward beneficiaries.

Why accounting information matters

  • External users (investors, creditors) evaluate financial health, cash flow, and ability to pay debts.
  • Internal users (managers) use managerial accounting for budgeting and operational decisions.
  • The language of accounting helps stakeholders understand dealings, commitments, and ownership.

Two main sources of assets: creditors vs investors

  • Creditors (liabilities): banks, lenders, suppliers who expect repayment.
  • Investors (stockholders): owners who contribute capital and share in profits via retained earnings and dividends.
  • Balance must reflect that resources come from either liabilities or stockholders’ equity; assets are funded by either debt or equity.
  • Sweat equity (earned capital) is the work-derived component of equity; contributed capital is the cash/asset-derived component.

Activity concept: separation of entities and commingling of funds

  • Important rule: keep personal finances separate from business finances.
    • Commingling funds is illegal in fraudulent contexts and creates accounting and legal risk.
  • In scenarios, two or more entities can exist (e.g., John (personal) vs Albert Enterprises (business)); each has its own set of books.
  • When a transaction involves both entities, it must be recorded as affecting both sides separately to maintain the separation.

Activity concept: asset uses, asset sources, and asset exchanges

  • These are the three basic categories of asset-related transactions:
    • Asset source: assets come from somewhere (e.g., issuing stock, borrowing cash).
    • Asset use: assets are consumed or expended (e.g., paying expenses, paying dividends).
    • Asset exchange: trading one asset for another (e.g., paying cash to acquire land; selling land for cash).
  • McGraw Hill’s framing (as described in transcript): classify each transaction as one of these three types to help students understand the impact on the accounting equation.

Example: Swift Corporation year two (opening balances and year-two transactions)

  • Context: Swift Corp starts Year 2 with opening balances in several accounts.
  • Opening balances (beginning of year 2):
    • Cash: $15,000
    • Land: $8,000
    • Notes payable (liability): $5,000
    • Common stock (contributed capital): $10,000
    • Retained earnings (earned capital): $8,000
  • The year-two transactions (and their effects): 1) Purchased land for $10,000 cash.
    • Cash: -$10,000
    • Land: +$10,000
    • Result: Asset exchange; total assets unchanged.
      2) Issued common stock to raise $5,000 cash.
    • Cash: +$5,000
    • Common stock: +$5,000
    • Result: Asset source; liabilities unchanged; equity increases.
      3) Provided services and collected $45,000 cash.
    • Cash: +$45,000
    • Revenues: +$45,000 (increase in retained earnings via net income)
    • Type: asset source and earnings increase (RE).
      4) Paid operating expenses of $32,500 in cash.
    • Cash: -$32,500
    • Expenses reduce retained earnings: -$32,500 in RE (net effect is negative in RE).
      5) Borrowed $10,000 cash from bank.
    • Cash: +$10,000
    • Notes payable: +$10,000
    • Type: asset source (cash) and liability increase.
      6) Paid a dividend of $2,500.
    • Cash: -$2,500
    • Retained earnings: -$2,500 (dividends reduce RE)
      7) Market value change of land: NA for the accounting records (historical cost convention).
  • Ending balances after Year 2 (as shown in the transcript notes):
    • Cash: $30,000
    • Land: $18,000
    • Common stock: $15,000
    • Retained earnings: $18,000
    • Notes payable: $15,000
  • Balance check (assets vs liabilities + equity):
    • Total assets = $30,000 (cash) + $18,000 (land) = $48,000
    • Total liabilities = $15,000 (notes payable)
    • Total stockholders' equity = $15,000 (common stock) + $18,000 (retained earnings) = $33,000
    • Confirm balance: $$48