1 Foundations of Financial Accounting

Purpose of financial accounting

Financial accounting identifies, records, and summarizes an organization’s financial activities in reports. Investors, lenders, and other users rely on these reports to make decisions about the organization.

Because users need information they can interpret and compare, financial accounting follows established reporting rules and conventions.

The accounting equation

The Accounting equation expresses the fundamental relationship between a business’s resources and the claims against those resources:

The equation must remain balanced. A business’s resources are financed either by creditors’ claims, represented by liabilities, or owners’ claims, represented by equity. Equity is the owners’ residual claim after liabilities are subtracted from assets.

How transactions affect the equation

A Business transaction is an economic event that can be measured and changes the business’s financial position. Each transaction affects at least two parts of the accounting equation, keeping it in balance.

A transaction can change amounts within one side of the equation without changing that side’s total. For example, buying equipment with cash increases equipment and decreases cash by the same amount.

When an owner contributes $\$10{,}000$ in cash, cash (an asset) increases by $\$10{,}000$, and owner’s equity increases by $\$10{,}000$. If the business then buys $\$3{,}000$ of equipment with cash, equipment increases and cash decreases by $\$3{,}000$; total assets and equity do not change. Transactions provide the underlying information summarized in financial statements.

How financial statements relate

Financial statements present connected views of a business. The Income statement and Statement of cash flows report activity over a period, while the Balance sheet reports financial position on a particular date. The Statement of changes in equity explains how owners’ claims changed during the period.

Together, these statements show performance, resources and obligations, changes in equity, and cash movement. Their amounts connect, but profit and cash are not the same.

Following one example through the statements

Consider a business during one period. The owner contributes $\$10{,}000$ in cash, the business buys $\$3{,}000$ of equipment with cash, earns $\$3{,}000$ in service revenue (collecting $\$2{,}000$ in cash and leaving $\$1{,}000$ receivable), and pays $\$500$ in rent.

• Income statement: Revenue of $\$3{,}000$ minus rent expense of $\$500$ gives net income of $\$2{,}500$.

• Statement of changes in equity: The owner’s $\$10{,}000$ contribution plus $\$2{,}500$ of net income gives ending equity of $\$12{,}500$, assuming there are no owner withdrawals or dividends.

• Balance sheet: Cash is $\$8{,}500$, receivables are $\$1{,}000$, and equipment is $\$3{,}000$, giving total assets of $\$12{,}500$. With no liabilities, assets of $\$12{,}500$ equal equity of $\$12{,}500$.

• Statement of cash flows: Operating activities provide net cash of $\$1{,}500$ ($\$2{,}000$ collected less $\$500$ rent). Investing activities use $\$3{,}000$ to buy equipment, and financing activities provide $\$10{,}000$ from the owner. Net cash increases by $\$8{,}500$, matching ending cash on the balance sheet.

The $\$1{,}000$ service receivable contributes to revenue and net income even though it has not yet brought in cash. The statements are complementary: their linked amounts help readers understand the same business from different perspectives.