Difficulty: Introductory. Read Part 1 of these notes first (accounting fundamentals, the two pillars, business activities and assumptions).
This is the second half of Chapter 1. Now that you know what accounting is and who uses it, this section introduces the four financial statements that every company produces. These statements are the outputs of the entire accounting system. Every chapter that follows will teach you how to build, adjust or analyse one of them. The accounting equation (A = L + SE) is the single most important formula in the course.
Four statements tell a company's financial story. The balance sheet shows what the company owns and owes at a point in time. The income statement shows profit or loss over a period. The statement of stockholders' equity tracks changes in owners' claims. The statement of cash flows shows actual cash movements. They are linked: net income from the income statement feeds into retained earnings, which feeds into the balance sheet.
Assets
Resources a company owns that provide future economic benefit. Examples: cash, accounts receivable, inventory, investments, supplies, equipment. Think of it as everything the company has that is worth something.
Liabilities
Obligations a company owes to outside parties, representing future sacrifices of economic benefit. In simple terms, the company's debts.
Accounts payable
An informal, short-term liability with no written contract. Arises from routine purchases on credit. Think of it as the tab you run at a supplier: no formal agreement, just an understanding you will pay.
Notes payable
A formal liability backed by a written agreement or signed contract, almost always carrying interest. Think of it as a proper loan with paperwork, like a mortgage or a bank note.
Stockholders' equity (owners' equity)
The owners' residual claim on the company's assets after all liabilities have been paid. Equals common stock plus retained earnings. In simple terms, what is left for the owners after the company pays everyone it owes.
Common stock
The amount of capital stockholders have invested directly in the company by purchasing shares.
Retained earnings
The cumulative net income the company has earned over its life minus all dividends paid to stockholders. Think of it as the profits the company kept instead of distributing.
Revenue
Cash received and promises (receivables) earned from selling goods or services to customers. In simple terms, the money coming in from the core business.
Expenses
Resources consumed or used up in the process of generating revenue. Think of it as the cost of doing business: wages, rent, supplies used, utilities.
Net income (profit)
Revenues minus expenses. The bottom line of the income statement. In simple terms, what is left after you subtract the costs from the earnings.
Dividends
Distributions of a company's earnings to its stockholders. Dividends reduce retained earnings. Think of it as the company sharing its profits with its owners.
Accounts
Standardised categories companies use to accumulate and track the monetary effect of transactions. Examples: Cash, Inventory, Equipment, Notes Payable.
Assets = Liabilities + Stockholders' Equity
This is the foundation of the entire course. Every transaction a company records must keep this equation in balance.
Assets (left side): what the company owns
Cash, accounts receivable, inventory, investments, supplies, equipment
Liabilities (right side, part 1): what the company owes
Accounts payable (informal, no contract)
Notes payable (formal, signed contract, usually carries interest)
Stockholders' equity (right side, part 2): the owners' residual claim
Common stock (what stockholders invested)
Retained earnings (cumulative profits kept in the business)
Formula: Retained Earnings + Common Stock = Stockholders' Equity
Net Income = Revenues - Expenses
The income statement covers a period of time (a quarter or a year) and tells you whether the company made money.
Revenue: cash and promises from selling goods or services
Expenses: resources used to generate that revenue
Net income: the bottom line, also called profit
Critical rule: always prepare the income statement first, because net income flows into the other statements.
This statement shows how the owners' claims changed during the period. It has two main components:
Common stock
Beginning common stock + stock issuance = ending common stock
Retained earnings
Beginning retained earnings + net income - dividends = ending retained earnings
Notice the link: net income from the income statement feeds directly into retained earnings here.
One of the four required financial statements. It reports the actual cash moving in and out of the business, organised into:
Operating cash flows: cash from the core business
Investing cash flows: cash from buying or selling long-term assets
Financing cash flows: cash from borrowing, repaying debt, issuing stock or paying dividends
The four statements are not independent. They form a chain:
Prepare the income statement first (revenues - expenses = net income)
Net income feeds into the statement of stockholders' equity (beginning retained earnings + net income - dividends = ending retained earnings)
Ending stockholders' equity feeds into the balance sheet (A = L + SE)
The statement of cash flows reconciles the cash figure on the balance sheet
The notes to the financial statements are considered an integral part of all four statements.
The accounting equation: A = L + SE
Net income: NI = Revenue - Expenses
Stockholders' equity: SE = Common Stock + Retained Earnings
Ending retained earnings: Beginning RE + Net Income - Dividends = Ending RE
When Apple releases its quarterly 10-Q filing, every number in that report maps to one of these four statements. Investors compare net income across quarters using the income statement. Banks check the balance sheet before approving a loan. The statement of cash flows tells analysts whether a profitable company is actually generating cash, or just booking revenue on paper.
Students confuse accounts payable and notes payable. Accounts payable is informal (no contract). Notes payable is formal (signed agreement, usually with interest). Think: groceries tab vs. mortgage.
Students think retained earnings is a pile of cash sitting in a vault. It is not. Retained earnings is a claim, an accounting number. The actual cash may have been spent on equipment or inventory long ago.
Students forget the preparation order. The income statement must be prepared first, because net income flows into the statement of stockholders' equity, which flows into the balance sheet.
Students mix up "stock issuance" and "stock insurance." The source notes mention "stock insurance," but the correct term is stock issuance (the company selling new shares).
⚠️ The accounting equation (A = L + SE) will appear in some form on nearly every exam in this course. Know it cold.
⚠️ Be able to write the retained earnings formula from memory: Beginning RE + NI - Dividends = Ending RE.
⚠️ Know the preparation order: income statement first, then statement of stockholders' equity, then balance sheet, then statement of cash flows.
⚠️ Understand the difference between accounts payable (informal) and notes payable (formal, with interest).
⚠️ Distinguish between the two components of stockholders' equity: common stock (invested capital) and retained earnings (accumulated profits).
Fill in the blank: Assets = Liabilities + ______
True or False: Retained earnings is a bank account full of cash.
Fill in the blank: Net Income = Revenue - ______
True or False: The balance sheet should be prepared before the income statement.
Fill in the blank: Accounts payable is ______ (formal/informal), while notes payable is ______ (formal/informal).
Answers: 1. Stockholders' Equity. 2. False (it is an accounting figure, not a cash balance). 3. Expenses. 4. False (the income statement is prepared first). 5. Informal; formal.
Q: State the accounting equation and name what each component represents.
A: Assets = Liabilities + Stockholders' Equity. Assets are what the company owns, liabilities are what it owes, and stockholders' equity is the owners' residual claim.
Q: What is the formula for ending retained earnings?
A: Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings.
Q: Why must the income statement be prepared before the other statements?
A: Because net income from the income statement is needed to calculate retained earnings in the statement of stockholders' equity, and retained earnings is needed for the balance sheet.
Q: Explain the difference between accounts payable and notes payable.
A: Accounts payable is an informal obligation with no written contract (e.g. buying supplies on credit). Notes payable is a formal obligation backed by a signed agreement and almost always carries interest (e.g. a bank loan).
Q: A company earns $100,000 in revenue and incurs $75,000 in expenses. It pays $10,000 in dividends. If beginning retained earnings were $50,000, what is ending retained earnings?
A: Net income = $100,000 - $75,000 = $25,000. Ending RE = $50,000 + $25,000 - $10,000 = $65,000.
Q: Name the three sections of the statement of cash flows.
A: Operating activities, investing activities and financing activities.
The accounting equation introduced here is the backbone of double-entry bookkeeping, which you will learn in Chapter 2. Every journal entry you record must keep A = L + SE in balance. The income statement concepts (revenue, expenses, net income) reappear throughout the course as you learn accrual accounting, adjusting entries and closing entries. The statement of cash flows links directly to the three activity categories (operating, investing, financing) from Part 1 of these notes.
accounting equation, balance sheet, income statement, statement of stockholders' equity, statement of cash flows, assets, liabilities, stockholders' equity, owners' equity, common stock, retained earnings, net income, profit, revenue, expenses, dividends, accounts payable, notes payable, accounts, GAAP, A = L + SE, ACCT 100, Chapter 1, financial statements, business decisions, preparation order, four financial statements