• Understand what the accounting equation is
• Understand what an income statement is
• Understand what a statement of owner’s equity is
• Understand what a balance sheet is
• Understand what a statement of cash flows is

Financial Statements

Financial statements are reports that summarize and communicate information obtained from day-to-day bookkeeping activities. After all of the income and expenses of the business have been recorded, financial accountants prepare financial statements in the following order:

1. Income Statement
2. Statement of Retained Earnings—also called Statement of Owner’s Equity
3. The Balance Sheet
4. The Statement of Cash Flows

The Accounting Equation

the accounting equation

Assets = Liabilities + Owner’s Equity

 

• Assets: Things of value owned by the organization
• Liabilities: The organization’s debts
• Owner’s equity: The total amount of investment in the organization minus the liabilities

The accounting equation represents the relationship between assets, liabilities, and the owner’s equity of a business. It can be calculated at any point in time using information from the balance sheet, which we will discuss later. It’s the foundation for the double-entry accounting system, accepted to be the most reliable and accurate method of recording the financial transactions of a business.

• Assets may be anything tangible or intangible that can be owned or controlled to produce value. Tangible assets are things like cash, equipment, and buildings. Intangible assets are things like patents and trademarks.
• Liabilities are debts, or what the organization owes to its creditors. Liabilities include things like loans and monies owed to suppliers.
• Owner’s equity is the difference between the value of the assets and the amount of the liabilities. It is also sometimes called net worth. When the owners are shareholders, the interest can be called shareholders’ equity; the accounting remains the same, and it is ownership equity spread out among shareholders.

Double-Entry Bookkeeping

The accounting equation must always be in balance (that is, the total of the elements on one side of the equals sign must equal the total on the other side). Suppose you start a coffee shop and put $10,000 in cash into the business. At that point, the business has assets of $10,000 and no liabilities. This would be the accounting equation:

$$\begin{array}{llllll}\text{Assets}\hfill & =\hfill & \text{Liabilities}\hfill & +\hfill & \text{Owners’ equity}\hfill & \hfill \\ \text{\$10,000}\hfill & \text{=}\hfill & \text{\$0}\hfill & +\hfill & \text{\$10,000}\hfill & \hfill \end{array}$$

The liabilities are zero and owners’ equity (the amount of your investment in the business) is $10,000. The equation balances.

To keep the accounting equation in balance, every transaction must be recorded as two entries. As each transaction is recorded, there is an equal and opposite event so that two accounts or records are changed. This method is called double-entry bookkeeping.

Suppose that after starting your business with $10,000 cash, you borrow another $10,000 from the bank. The accounting equation will change as follows:

$$\begin{array}{llllll}\text{Assets}\hfill & =\hfill & \text{Liabilities}\hfill & +\hfill & \text{Owners’ equity}\hfill & \hfill \\ \text{\$10,000}\hfill & \text{=}\hfill & \text{\$0}\hfill & +\hfill & \text{\$10,000}\hfill & \text{Initial equation}\hfill \\ \text{\$10,000}\hfill & \text{=}\hfill & \text{\$10,000}\hfill & +\hfill & \text{\$0}\hfill & \text{Borrowing transaction}\hfill \\ \text{\$20,000}\hfill & \text{=}\hfill & \text{\$10,000}\hfill & +\hfill & \text{\$10,000}\hfill & \text{Equation after borrowing}\hfill \end{array}$$

 

Now you have $20,000 in assets—your $10,000 in cash and the $10,000 loan proceeds from the bank. The bank loan is also recorded as a liability of $10,000 because it’s a debt you must repay. Making two entries keeps the equation in balance.