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Items To Memorize
🔹 The Accounting Equation
Assets = Liabilities + Equity
This fundamental equation represents the connection between a company's assets, liabilities, and the equity (“value”) of the owners' ownership in the business. Luca Pacioli, known as the 'father of accounting,' is often attributed with introducing this formula in the 1600s, after witnessing Italian merchants utilizing it. In his book "Summa de Arithmetica, Geometria, Proportioni et Proportionalita," Pacioli described the double-entry bookkeeping system, which revolutionized accounting by providing a systematic way to record financial transactions.
🔹 The Effects of Transactions on the Accounting Equation
Investment by Owner
A = L + E ↑ ↑
- When an owner invests, it means they're putting their own money or other assets (e.g. equipment, building, land, etc) into the business.
- This has two effects: the business's assets increase (because it now has more resources), and the owner's equity also increases (because the owner has a stronger claim on these new resources).
- Think of equity as the business's "worth" that belongs to the owner. When the owner invests, they're adding to the business's worth, and their claim to this worth goes up too.
- Example: If the owner invests $10,000 in cash in the business, the business now has $10,000 more in assets (cash) and $10,000 more in owner's equity (because the owner has a stronger claim on the business's assets).
Purchase Supplies for Cash
A = L + E ↑↓
- This doesn't affect the total assets because while the business's cash decreases, its supplies increase equivalently. The business has simply traded one asset (cash) for another (supplies).
- Example: If the business buys $500 of office supplies for cash, cash decreases by $500 but supplies (another asset) increase by $500.
Purchase Equipment for Cash
A = L + E ↑↓
- Similar to purchasing supplies for cash, the business is exchanging one asset (cash) for another (equipment), so total assets remain the same. Example: If the business purchases a $2,000 machine with cash, cash decreases by $2,000 but equipment increases by $2,000.
Purchase Supplies on Credit
A = L + E ↑ ↑
- When the business purchases supplies on credit, it receives supplies now (increasing assets) but has an obligation to pay later (increasing liabilities). Example: If the business buys $700 of inventory on credit, supplies increase by $700 and accounts payable (a liability) increase by $700.
Provide Services for Cash
A = L + E ↑ ↑
- When a business sells services for cash, this activity increases the business's cash assets and also its revenue.
- As a result, equity also increases. This is because equity is like the owner's claim on the business's worth or value. When the business earns more (from selling services), it's worth more, and the owner's claim (equity) on this increased value goes up too.
- In short, more revenue means a higher business value (equity).
- Example: If the business sells services worth $1,000 for cash, its cash (an asset) increases by $1,000, and its equity also increases by $1,000 (because the business is now worth $1,000 more).
Provide Services on Credit
A = L + E ↑ ↑
- When a business sells services on credit, this activity increases the business's Accounts Receivable (an asset) and also its revenue.
- As a result, equity also increases. This is because equity is like the owner's claim on the business's worth or value. When the business earns more (from selling services), it's worth more, and the owner's claim (equity) on this increased value goes up too.
- In short, more revenue means a higher business value (equity).
- Example: If the business sells services worth $1,000 for cash, its cash (an asset) increases by $1,000, and its equity also increases by $1,000 (because the business is now worth $1,000 more).
Payment of Expenses in Cash
A = L + E ↓ ↓
- Paying expenses decreases the business's cash assets and also decreases equity. This is because expenses reduce the owner's claim on the business's resources. Example: If the business pays $800 rent expense in cash, cash decreases by $800 and equity decreases by $800 (because the business is now worth $800 less).
🔹 The Financial Statement Formulas
Income Statement Formula
The income statement shows a company's revenues, expenses, gains, and losses over a specific period. Its formula is: Company Name Income Statement For Period Ended [date]
Revenue - Expenses = Net Income (or Net Loss)
The income statement summarizes the company's financial performance during the reporting period.
Statement of Retained Earnings Formula
The statement of retained earnings outlines changes in a company's retained earnings balance over a specific period. If a company has Net Income, its formula is:
Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings If a company has Net Loss, its formula is: Beginning Retained Earnings - Net Loss - Dividends = Ending Retained Earnings
This statement helps track the accumulated profits or losses that have been retained in the business.
Balance Sheet Formula
The balance sheet presents a company's financial position at a specific point in time. Its formula is:
Assets = Liabilities + Equity
The balance sheet provides an overview of what a company owns (assets), what it owes (liabilities), and the residual value for owners (equity).
“Flow” of Financial Statements
#1 Income Statement
Revenues - Expenses = Net Income
Always start with the Income Statement!
#2 Statement of R/E
Beginning R/E + Net Income - Dividends = Ending R/E
Net Income flows into the Statement of Retained Earnings!
#3 Balance Sheet
Assets = Liabilites + Equity
Ending R/E flows into the Equity section of the Balance Sheet!
Cash Flows Statement Formula
The cash flow statement reports the cash inflows and outflows from a company's operating, investing, and financing activities over a specific period. Its formula generally consists of three sections:
Cash Flows from Operating Activities + Cash Flows from Investing Activities + Cash Flows from Financing Activities = Net Increase/Decrease in Cash
