Principles of Accounting.

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Chapt er One: Welcome t o t he World of Account ing

Yo ur go als fo r this “welco ming” chapter are to learn abo ut:

T he nat ure o f f inancial and m anage rial acco unt ing inf o rm at io n.
T he acco unt ing pro f e ssio n and acco unt ing care e rs.
T he acco unt ing e quat io n: Asse t s = Liabilit ie s + Owne rs’ Equit y.
Ho w t ransact io ns im pact t he acco unt ing e quat io n.
T he f o ur co re f inancial st at e m e nt s.

Obt ain a print ed version:

Account ing Inf ormat ion

Yo u likely have a general co ncept o f acco unting. Info rmatio n abo ut the transactio ns and events o f a business is
captured and summarized into repo rts that are used by perso ns interested in the entity. But, yo u likely do no t realize the
co mplexity o f acco mplishing this task. It invo lves a talented blending o f technical kno wledge and measurement artistry
that can o nly be fully appreciated via extensive study o f the subject. The best analo gy is to say that yo u pro bably kno w what a surgeo n do es, but yo u
no do ubt appreciate that co nsiderable kno wledge and skill is needed to successfully treat a patient. If yo u were studying to be a surgeo n, yo u wo uld
likely begin with so me basic anato my class. In this chapter, yo u will begin yo ur study o f acco unting by lo o king at the o verall structure o f acco unting
and the basic anato my o f repo rting.

Be advised that a true understanding o f acco unting do es no t co me easily. It o nly co mes with determinatio n and hard wo rk. If yo u persevere, yo u will
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 Be advised that a true understanding o f acco unting do es no t co me easily. It o nly co mes with determinatio n and hard wo rk. If yo u persevere, yo u will
be surprised at ho w much yo u disco ver abo ut acco unting. This kno wledge is very valuable to business success.

DEFINITIONS

It seems fitting to begin with a mo re fo rmal definitio n o f acco unting: Acco unt ing is a set o f co ncepts and techniques that are used to measure and repo rt financial
info rmatio n abo ut an eco no mic unit. The eco no mic unit is generally co nsidered to be a separate enterprise. The info rmatio n is repo rted to a variety o f different types o f
interested parties. These include business managers, o wners, credito rs, go vernmental units, financial analysts, and even emplo yees. In o ne way o r ano ther, these users
o f acco unting info rmatio n tend to be co ncerned abo ut their o wn interests in the entity.

Business managers need acco unting info rmatio n to make so und leadership decisio ns. Investo rs ho pe fo r pro fits that may eventually lead to distributio ns fro m the
business (e.g., “dividends”). Credito rs are always co ncerned abo ut the entity’s ability to repay its o bligatio ns. Go vernmental units need info rmatio n to tax and regulate.
Analysts use acco unting data to fo rm o pinio ns o n which they base investment reco mmendatio ns. Emplo yees want to wo rk fo r successful co mpanies to further their
individual careers, and they o ften have bo nuses o r o ptio ns tied to enterprise perfo rmance. Acco unting info rmatio n abo ut specific entities helps satisfy the needs o f all
these interested parties.

The diversity o f interested parties leads to a lo gical divisio n in the discipline o f acco unting: financial acco unting and managerial acco unting. Financial acco unt ing is
co ncerned with external repo rting to parties o utside the firm. In co ntrast, m anage rial acco unt ing is primarily co ncerned with pro viding info rmatio n fo r internal
management. One may have tro uble seeing the distinctio n; after all, aren’t financial facts being repo rted? The fo llo wing paragraphs pro vide a clo ser lo o k at the
distinctio ns.

FINANCIAL ACCOUNTING

Co nsider that financial acco unting is targeted to ward a bro ad base o f external users, no ne o f who m co ntro l the actual preparatio n o f repo rts o r have access to
underlying details. Their ability to understand and have co nfidence in repo rts is directly dependent upo n standardizatio n o f the principles and practices that are used to
prepare the repo rts. Witho ut such standardizatio n, repo rts o f different co mpanies co uld be hard to understand and even harder to co mpare.

Standardizatio n derives fro m certain well-o rganized pro cesses and o rganizatio ns. In the United States, a private secto r gro up called the Financial Acco unt ing
St andards Bo ard (FASB) is primarily respo nsible fo r develo ping the rules that fo rm the fo undatio n o f financial repo rting. The FASB’s glo bal co unterpart is the
Int e rnat io nal Acco unt ing St andards Bo ard (IASB). The IASB and FASB are wo rking to ward co nvergence, such that there may so o n be a single harmo nio us set o f
internatio nal financial repo rting standards (IFRS). This effo rt to establish co nsistency in glo bal financial repo rting is driven by the increase in glo bal trade and finance. Just
as standardizatio n is needed to enable co mpariso ns between individual co mpanies o perating within a single eco no my, so to o is standardizatio n needed to facilitate
glo bal business evaluatio ns.

Financial repo rts prepared under the generally accepted acco unting principles (GAAP) pro mulgated by such standard-setting bo dies are intended to be general purpo se
in o rientatio n. This means they are no t prepared especially fo r o wners, o r credito rs, o r any o ther particular user gro up. Instead, they are intended to be equally useful fo r
all user gro ups. As such, attempts are made to keep them free fro m bias (neutral). Standard-setting bo dies are guided by co ncepts that are aimed at pro ductio n o f
relevant and representatio nally faithful repo rts that are useful in investment and credit decisio ns.

MANAGERIAL ACCOUNTING

Managerial acco unting info rmatio n is intended to serve the specific needs o f management. Business managers are charged with business planning, co ntro lling, and
decisio n making. As such, they may desire specialized repo rts, budgets, pro duct co sting data, and o ther details that are generally no t repo rted o n an external basis.
Further, management may dictate the parameters under which such info rmatio n is to be accumulated and presented. Fo r instance, GAAP may require that certain pro duct
develo pment co sts be deducted in co mputing inco me; o n the o ther hand, management may see these co sts as a lo ng-term investment and stipulate that internal
decisio n making be based upo n inco me numbers that exclude such co sts. This is their prero gative. Ho pefully, internal repo rting is being do ne lo gically and ratio nally, but
it need no t fo llo w any particular set o f mandato ry guidelines.

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A QUALITY SYSTEM

Bo th financial acco unting and managerial acco unting depend upo n a stro ng info rmatio n system to reliably capture and summarize
business transactio n data. Info rmatio n techno lo gy has radically reshaped this mundane part o f the practice o f acco unting o ver the
past 50 years. The era o f the “green eye-shaded” acco untant has been relegated to the annals o f histo ry. No w, acco unting is mo re o f
a dynamic, decisio n-making discipline, rather than a bo o kkeeping task.

INHERENT LIMITATIONS

Acco unting data are no t abso lute o r co ncrete. Co nsiderable amo unts o f judgment and estimatio n are necessary to develo p the
specific acco unting measurements that are repo rted during a particular mo nth, quarter, o r year. Fo r example, ho w much pro fit is actually earned when a car is so ld with a
3-year warranty? It will be three years befo re the final co sts o f this warranty agreement are all kno wn. One appro ach wo uld be to wait three years befo re repo rting o n the
pro fit o r lo ss fo r this transactio n. Ho wever, by the time the info rmatio n co uld be repo rted with certainty, it wo uld be so stale as to lo se its usefulness. Thus, in o rder to
timely present info rmatio n, reaso nable estimatio ns are ro utinely embraced in the no rmal preparatio n o f perio dic financial repo rts.

In additio n, acco unting has no t advanced to a state o f being able to value a business. As such, many transactio ns and events are repo rted based o n the hist o rical co st
principle (in co ntrast to fair value). Fo r example, land is typically reco rded and carried in the acco unting reco rds at the price at which it was purchased. The histo rical
co st principle is based o n the co ncept that it is best to repo rt certain financial statement elements at amo unts that are tied to o bjective and verifiable past transactio ns.

The alternative is to value (and perio dically revalue) acco unts based upo n subjective assessments o f current wo rth. Such adjustments are pro blematic and the subject o f
much debate. Nevertheless, the current trend in glo bal standard setting is to ward an increased acceptance o f the circumstances under which fair value acco unting is
deemed acceptable fo r selected financial statement elements.

The o ngo ing debate abo ut fair value versus histo rical co st is o ften cast in the co ntext o f a tradeo ff between the “relevance” o f fair value info rmatio n and the “reliability” o f
histo rical co st info rmatio n. This debate is apt to co ntinue, and the related acco unting standards will likely be in an evo lutio nary state fo r many years to co me.
Nevertheless, it is reaso nable to expect that the acco untant o f the future will be increasingly skilled in valuatio n issues.

The Account ing Prof ession And Careers

To decide to be an acco untant is no mo re descriptive than deciding to be a do cto r. There are many specialty areas. Many acco untants
engage in the practice o f public acco unt ing , which invo lves pro viding audit, tax, and co nsulting services to the general public. To engage
in the practice o f public acco unting usually requires o ne to be licensed. In the United States, individual states issue a license called a CPA
(Ce rt if ie d Public Acco unt ant ). Other co untries o ffer similar designatio ns such as the “Chartered Acco untant.” Audit ing invo lves the examinatio n o f transactio ns
and systems that underlie an o rganizatio n’s financial repo rts, with the ultimate go al o f pro viding an independent repo rt o n the appro priateness o f financial statements.
Tax services relate to the pro viding o f help in the preparatio n and filing o f tax returns and the rendering o f advice o n the tax co nsequences o f alternative actio ns.
Co nsulting services can vary dramatically, and include such diverse activities as info rmatio n systems engineering to evaluating pro ductio n metho ds.

Many acco untants are privately emplo yed by small and large businesses (i.e., “industry acco unting”) and no t-fo r-pro fit agencies (such as ho spitals, universities, and
charitable gro ups). They may wo rk in areas o f pro duct co sting and pricing, budgeting, and the examinatio n o f investment alternatives. They may serve as int e rnal
audit o rs, who lo o k at co ntro ls and pro cedures in use by their emplo yer. Objectives o f these reviews are to safeguard co mpany reso urces and assess the reliability and
accuracy o f acco unting info rmatio n and acco unting systems. They may serve as in-ho use tax acco untants, financial managers, o r co untless o ther o ccupatio ns.

It pro bably go es witho ut saying that many acco untants also wo rk in the go vernmental secto r, whether it be lo cal, state, o r natio nal levels. Many acco untants are
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emplo yed at the Internal Revenue Service, General Acco unting Office, Securities and Exchange Co mmissio n, and even the Federal Bureau o f Investigatio n.

ETHICS

Because investo rs and credito rs place great reliance o n financial statements in making their investment and credit
decisio ns, it is imperative that the financial repo rting pro cess be truthful and dependable. Acco untants are expected to
behave in an entirely ethical fashio n. To help insure integrity in the repo rting pro cess, the pro fessio n has ado pted a co de
o f ethics to which its licensed members must adhere. In additio n, checks and balances via the audit pro cess,
go vernment o versight, and the ever vigilant “plaintiff’s atto rney” all serve a vital ro le in pro viding additio nal safeguards
against the errant acco untant. Tho se who are preparing to enter the acco unting pro fessio n sho uld do so with the
intentio n o f behaving with ho no r and integrity. Others will likely rely upo n acco untants in so me aspect o f their perso nal o r pro fessio nal lives. They have every right to
expect tho se acco untants to behave in a co mpletely trustwo rthy and ethical fashio n. After all, they will be entrusting them with financial reso urces and co nfidential
info rmatio n.

The Account ing Equat ion

The basic features o f the acco unting mo del in use to day trace ro o ts back o ver 50 0 years. Luca Pacio li, a Renaissance era mo nk,
develo ped a metho d fo r tracking the success o r failure o f trading ventures. The fo undatio n o f that system co ntinues to serve the mo dern
business wo rld well, and is the entrenched co rnersto ne o f even the mo st elabo rate co mputerized systems. The nucleus o f that system is
the no tio n that a business entity can be described as a co llectio n o f assets and the co rrespo nding claims against tho se assets. The claims can be divided into the claims
o f credito rs and o wners (i.e., liabilities and o wners’ equity). This gives rise to the fundamental acco unt ing e quat io n:

Assets = Liabilities + Owners’ Equity

ASSETS

Asse t s are the eco no mic reso urces o f the entity, and include such items as cash, acco unts receivable (amo unts o wed to a firm by its custo mers), invento ries, land,
buildings, equipment, and even intangible assets like patents and o ther legal rights and claims. Assets are presumed to entail pro bable future eco no mic benefits to the
o wner.

LIABILITIES

Liabilit ie s are amo unts o wed to o thers relating to lo ans, extensio ns o f credit, and o ther o bligatio ns arising in the co urse o f business. Implicit to the no tio n o f a liability
is the idea o f an “existing” o bligatio n to pay o r perfo rm so me duty.

OWNERS’ EQUITY

Owne rs’ e quit y is the o wner “interest” in the business. It is so metimes called net assets, because it is equivalent to assets minus liabilities fo r a particular business.
Who are the “o wners?” The answer to this questio n depends o n the legal fo rm o f the entity; examples o f entity types include so le pro prieto rships, partnerships, and
co rpo ratio ns. A so le pro prie t o rship is a business o wned by o ne perso n, and its equity wo uld typically co nsist o f a single o wner’s capital acco unt. Co nversely, a
part ne rship is a business o wned by mo re than o ne perso n, with its equity co nsisting o f separate capital acco unts fo r each partner. Finally, a co rpo rat io n is a very

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co mmo n entity fo rm, with its o wnership interest being represented by divisible units o f o wnership called shares o f sto ck. These shares are easily transferable, with the
current ho lder(s) o f the sto ck being the o wners. The to tal o wners’ equity (i.e., “sto ckho lders’ equity”) o f a co rpo ratio n usually co nsists o f several amo unts, generally
co rrespo nding to the o wne r inve st m e nt s in the capital sto ck (by shareho lders) and additio nal amo unts generated thro ugh earnings that have no t been paid o ut to
shareho lders as dividends (divide nds are distributio ns to shareho lders as a return o n their investment). Earnings give rise to increases in re t aine d e arnings, while
dividends (and lo sses) cause decreases.

BALANCE SHEET

The acco unting equatio n is the backbo ne o f the acco unting

and repo rting system. It is central to understanding a key
financial statement kno wn as the balance she e t
(so metimes called the statement o f financial po sitio n). The
fo llo wing illustratio n fo r Edelweiss Co rpo ratio n sho ws a
variety o f assets that are repo rted at a to tal o f $8 9 5,0 0 0 .
Credito rs are o wed $175,0 0 0 , leaving $720 ,0 0 0 o f
sto ckho lders’ equity. The sto ckho lders’ equity sectio n is
divided into the $120 ,0 0 0 that was o riginally invested in
Edelweiss Co rpo ratio n by sto ckho lders (i.e., capital sto ck),
and the o ther $6 0 0 ,0 0 0 that was earned (and retained) by
successful business perfo rmance o ver the life o f the
co mpany.

Do es the sto ckho lders’ equity to tal mean the business is

wo rth $720 ,0 0 0 ? No ! Why no t? Because many assets are
no t repo rted at current value. Fo r example, altho ugh the
land co st $125,0 0 0 , Edelweiss Co rpo ratio n's balance
sheet do es no t repo rt its current wo rth. Similarly, the
business may have unreco rded reso urces, such as a trade
secret o r a brand name that allo ws it to earn extrao rdinary
pro fits . Alternatively, Edelweiss may be facing business
risks o r pending litigatio n that co uld limit its value. If o ne is lo o king to buy sto ck in Edelweiss Co rpo ratio n, they wo uld surely give co nsideratio n to these impo rtant no n-
financial statement valuatio n co nsideratio ns. This o bservatio n tells us that acco unting statements are impo rtant in investment and credit decisio ns, but they are no t the
so le so urce o f info rmatio n fo r making investment and credit decisio ns.

Assets ($895,000) = Liabilities ($175,000) + Stockholders’ equity ($720,000)

How Transact ions Impact The Account ing Equat ion

The preceding balance sheet fo r Edelweiss represented the financial co nditio n at the no ted date. But, each new transactio n brings abo ut a
change in financial co nditio n. Business activity will impact vario us asset, liability, and/o r equity acco unts witho ut disturbing the equality o f
the acco unting equatio n. Ho w do es this happen? To reveal the answer to this questio n, lo o k at fo ur specific cases fo r Edelweiss. See ho w
each impacts the balance sheet witho ut upsetting the basic equality.

CASE A: COLLECT AN ACCOUNT RECEIVABLE

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If Edelweiss Co rpo ratio n co llected $10 ,0 0 0 fro m a custo mer o n an existing acco unt receivable (i.e., no t a new sale, just the co llectio n o f an amo unt that is due fro m
so me previo us transactio n), then the balance sheet wo uld be revised to sho w that cash (an asset) increased fro m $25,0 0 0 to $35,0 0 0 , and acco unts receivable (an
asset) decreased fro m $50 ,0 0 0 to $40 ,0 0 0 . As a result to tal assets did no t change, and liabilities and equity acco unts were unaffected, as sho wn in the fo llo wing
illustratio n.

CASE B: BUY EQUIPMENT VIA LOAN

If Edelweiss Co rpo ratio n purchased $30 ,0 0 0 o f equipment, agreeing to pay fo r it later (i.e. taking o ut a lo an), then the balance sheet wo uld be further revised. The Case
B illustratio n sho ws that equipment (an asset) increased fro m $250 ,0 0 0 to $28 0 ,0 0 0 , and lo ans payable (a liability) increased fro m $125,0 0 0 to $155,0 0 0 . As a result,
bo th to tal assets and to tal liabilities increased by $30 ,0 0 0 .

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CASE C: PROVIDE SERVICES ON ACCOUNT

What wo uld happen if Edelweiss Co rpo ratio n did so me wo rk fo r a custo mer in exchange fo r the custo mer’s pro mise to pay $5,0 0 0 ? This requires further explanatio n;
try to fo llo w this lo gic clo sely! Retained earnings is the inco me o f the business that has no t been distributed to the o wners o f the business. When Edelweiss Co rpo ratio n
pro vided a service to a custo mer, it can be said that it generated revenue o f $5,0 0 0 . Re ve nue is the enhancement resulting fro m pro viding go o ds o r services to
custo mers. Revenue will co ntribute to inco me, and inco me is added to retained earnings. Examine the resulting balance sheet fo r Case C and no tice that acco unts
receivable and retained earnings went up by $5,0 0 0 each, indicating that the business has mo re assets and mo re retained earnings. No te that assets still equal liabilities
plus equity.

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CASE D: PAY EXPENSES

It wo uld be nice if a business co uld be run witho ut incurring any expenses. Ho wever, such is no t the case. Expenses are the o utflo ws and o bligatio ns that arise fro m
pro ducing go o ds and services. Imagine that Edelweiss paid $3,0 0 0 fo r e xpe nse s. This transactio n reduces cash and inco me (i.e., retained earnings), as sho wn in the
Case D illustratio n.

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IN GENERAL

There are co untless transactio ns, and each can be described by its impact o n assets, liabilities, and equity. Impo rtantly, no transactio n will upset the balance o f the
acco unting equatio n.

TERMS

In day-to -day co nversatio n, so me terms are used casually and witho ut precisio n. Wo rds may inco rrectly be regarded as syno nymo us. Such is the case fo r the wo rds
“inco me” and “revenue.” Ho wever, each term has a very precise meaning. Revenues are enhancements resulting fro m pro viding go o ds and services to custo mers.
Co nversely, expenses can generally be regarded as co sts o f do ing business. This gives rise to ano ther acco unting equatio n:

Revenues - Expenses = Income

Revenue is the “to p line” amo unt co rrespo nding to the to tal benefits generated fro m business activity. Inco me is the “bo tto m line” amo unt that results after deducting

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expenses fro m revenue. In so me co untries, revenue is also referred to as “turno ver.”

The Four Core Financial St at ement s

One’s future will undo ubtedly be marked by numero us decisio ns abo ut investing
mo ney in the capital sto ck o f so me co rpo ratio n. Ano ther o ptio n that will present
itself is to lend mo ney to a co mpany, either directly, o r by buying that co mpany’s
debt instruments kno wn as “bo nds.” Sto cks and bo nds are two o f the mo st prevalent financial instruments o f
the mo dern glo bal eco no my. The financial press and televisio n devo te seemingly endless co verage to headline
events pertaining to large public co rpo ratio ns. Public co mpanies are tho se with securities that are readily
available fo r purchase/sale thro ugh o rganized sto ck markets. Many mo re co mpanies are private, meaning their
sto ck and debt is in the hands o f a narro w gro up o f investo rs and banks.

If o ne is co ntemplating an investment in a public o r private entity, there is certain info rmatio n that will lo gically be
so ught to guide the decisio n pro cess. What types o f info rmatio n is desired? What do es o ne want to kno w
abo ut the co mpanies in which o ne is co nsidering an investment? If o ne were to prepare a list o f questio ns fo r
the co mpany’s management, what subjects wo uld be included? Whether this challenge is po sed to a
so phisticated investo r o r to a new business student, the listing almo st always includes the same basic
co mpo nents.

What are the co rpo rate assets? Where do es the co mpany o perate? What are the key pro ducts? Ho w much
inco me is being generated? Do es the co mpany pay dividends? What is the co rpo rate po licy o n ethics and enviro nmental respo nsibility? Many such to pics are no ted
within the illustrated “tho ught clo ud.” So me o f these to pics are financial in nature (no ted in blue). Other to pics are o f mo re general interest and canno t be co mmunicated
in strict mathematical terms (no ted in red).

FINANCIAL STATEMENTS

Financial acco unting seeks to directly repo rt info rmatio n fo r the to pics no ted in blue. Additio nal supplemental disclo sures frequently pro vide insight abo ut subjects such
as tho se no ted in red. One wo uld also need to gain additio nal info rmatio n by reviewing co rpo rate websites (many have separate sectio ns devo ted to their investo rs),
filings with securities regulato rs, financial jo urnals and magazines, and o ther such so urces. Mo st co mpanies will have annual meetings fo r shareho lders and ho st
webcasts every three mo nths (quarterly). These events are very valuable in allo wing investo rs and credito rs to make info rmed decisio ns abo ut the co mpany, as well as
pro viding a fo rum fo r direct questio ning o f management. One might even call a co mpany and seek “special insight” abo ut emerging trends and develo pments. Be aware,
ho wever, that the co mpany will likely no t be able to respo nd in a meaningful way. Securities laws have very strict rules and penalties that are meant to limit selective o r
unique disclo sures to any o ne investo r o r gro up. It is amusing, but rarely helpful, to review “message bo ards” where peo ple ano nymo usly po st their o pinio ns abo ut a
co mpany.

Financial acco unting info rmatio n is co nveyed thro ugh a standardized set o f repo rts. The balance sheet has already been intro duced. The o ther f inancial st at e m e nt s
are the inco me statement, statement o f retained earnings, and statement o f cash flo ws. There are many rules that go vern the fo rm and co ntent o f each financial
statement. At the same time, tho se rules are no t so rigid as to preclude variatio ns in the exact structure o r layo ut. Fo r instance, the earlier illustratio n fo r Edelweiss was
first presented as a “ho rizo ntal” layo ut o f the balance sheet. The subsequent Edelweiss examples were representative o f “vertical” balance sheet arrangements. Each
appro ach, and o thers, is equally acceptable.

INCOME STATEMENT

A summary o f an entity’s results o f o peratio n fo r a specified perio d o f time is revealed in the inco m e st at e m e nt , as it pro vides info rmatio n abo ut revenues generated
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A summary o f an entity’s results o f o peratio n fo r a specified perio d o f time is revealed in the inco m e st at e m e nt , as it pro vides info rmatio n abo ut revenues generated
and expenses incurred. The difference between the revenues and expenses is identified as the ne t inco m e o r ne t lo ss.

The inco me statement can be prepared using a single-step o r a multiple-step appro ach, and might be further mo dified to include a number o f special disclo sures
relating to unique items. These to pics will be amplified in a number o f subsequent chapters. Fo r no w, take careful no te that the inco me statement relates to activities o f a
specified time perio d (e.g., year, quarter, mo nth), as is clearly no ted in its title:

STATEMENT OF RETAINED EARNINGS

Previo us illustratio ns sho wed ho w retained earnings increases and decreases in respo nse to events that impact inco me. Retained earnings is also reduced by
shareho lder dividends.

The st at e m e nt o f re t aine d e arnings pro vides a succinct repo rting o f these changes in retained earnings fro m o ne perio d to the next. In essence, the statement is
no thing mo re than a reco nciliatio n o r “bird’s-eye view” o f the bridge between the retained earnings amo unts appearing o n two successive balance sheets.

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If o ne examines very many sets o f financial statements, o ne will so o n disco ver that many co mpanies pro vide a statement o f sto ckho lders’ equity in lieu o f the statement
o f retained earnings. The statement o f sto ckho lders’ equity po rtrays no t o nly the changes in retained earnings, but also changes in o ther equity acco unts. An expanded
statement o f sto ckho lders’ equity is presented in a future chapter.

BALANCE SHEET

The balance sheet fo cuses o n the acco unting equatio n by revealing the eco no mic reso urces o wned by an entity and the claims against tho se reso urces (liabilities and
o wners’ equity). The balance sheet is prepared as o f a specific date, whereas the inco me statement and statement o f retained earnings co ver a perio d o f time.
Acco rdingly, it is so metimes said that balance sheets po rtray financial po sitio n (o r co nditio n) while o ther statements reflect results o f o peratio ns. Quartz’s balance sheet
is as fo llo ws:

STATEMENT OF CASH FLOWS

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The statement o f cash flo ws details the enterprise’s cash flo ws. This o perating statement reveals ho w cash is generated and expended during a specific perio d o f time. It
co nsists o f three unique sectio ns that iso late the cash inflo ws and o utflo ws attributable to (a) o perating activities, (b) investing activities, and (c) financing activities.

No tice that the cash pro vided by o peratio ns is no t the same thing as net inco me fo und in the inco me statement. This result o ccurs because so me items hit inco me and
cash flo ws in different perio ds. Fo r instance, remember ho w Edelweiss (fro m the earlier illustratio n) generated inco me fro m a service pro vided o n acco unt. That
transactio n increased inco me witho ut a similar effect o n cash. These differences tend to even o ut o ver time. Other cash flo w items may never impact o peratio ns. Fo r
instance, dividends paid are an impo rtant financing cash o utflo w fo r a co rpo ratio n, but they are no t an expense. They are a distributio n o f inco me. The pro ceeds o f a lo an
wo uld be an example o f a no no perating cash inflo w. It wo uld be sho wn as a financing cash flo w item.

The statement cash flo ws require a fairly co mplete kno wledge o f basic acco unting. Do no t be co ncerned by a lack o f co mplete co mprehensio n at this juncture.
Co mprehensio n develo ps as studies pro gress, and a future chapter is devo ted to the statement o f cash flo ws.

SELF-BALANCING

It is impo rtant to no te that the inco me statement, statement o f retained earnings, and balance sheet articulate. This means they mesh to gether in a self-balancing
fashio n. The inco me fo r the perio d ties into the statement o f retained earnings, and the ending retained earnings ties into the balance sheet. This final tie-in causes the
balance sheet to balance. These relatio nships are illustrated in the fo llo wing diagram.

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It seems almo st magical that the final tie-in o f retained earnings will exactly cause the balance sheet to balance. This is reflective o f the brilliance o f Pacio li’s mo del, and
is indicative o f why it has survived fo r centuries. The co mpanio n website includes a series o f web pages that co mprehensively illustrate ho w transactio ns impact the
inco me statement, statement o f retained earnings, and balance sheet. Click thro ugh tho se pages and study the impact o f each transactio n o n the financial statements.

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