Accounting Equation & Financial Statements

The accounting equation is the foundation of all bookkeeping. Every transaction must keep it balanced:

Assets = Liabilities + Owners’ Equity

Assets are resources the firm owns. Liabilities are creditors’ claims on those resources. Owners’ equity is what remains for shareholders. If assets exceed liabilities, equity is positive. If liabilities exceed assets, the firm is balance sheet insolvent.

How the Three Statements Connect

graph TD
    IS[Income Statement
Revenue − Expenses = Net Income]
    BS[Balance Sheet
Assets = Liabilities + Equity
Snapshot in time]
    CF[Cash Flow Statement
Operating + Investing + Financing
Period of time]

    IS -->|Net Income flows into| RE[Retained Earnings
in Owners Equity]
    RE -->|Part of Equity on| BS
    CF -->|Ending cash balance appears as| Cash[Cash Asset on Balance Sheet]
    Cash --> BS
    IS -. Accrual basis: Income not equal Cash .-> CF

(diagram saved)

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1. Balance Sheet

What it is: A snapshot of financial position at a single point in time.

Formula: Assets = Liabilities + Owners’ Equity

Assets (listed in order of liquidity — most liquid first)

Current Assets — convertible to cash within 1 year:

• Cash (perfectly liquid)
• Accounts Receivable
• Merchandise Inventory (least liquid current asset)
• Prepaid Expenses

Fixed Assets — long-term use or value:

• Land, buildings, equipment, machinery
• Subject to depreciation = spreading an asset’s cost over its useful life

Intangible Assets — non-physical but economically valuable:

• Patents, trademarks, copyrights, franchise fees
• Goodwill = amount paid for a business beyond the value of its net assets

Liabilities (listed in order they are due)

Current Liabilities — due within 1 year:

• Accounts Payable = unpaid supplier bills
• Wages payable, taxes payable

Long-Term Liabilities — not due for at least 1 year:

• Loans, bonds — borrowed funds on which the company pays interest

Owners’ Equity

• Paid-in Capital = money invested by owners
• Retained Earnings = accumulated net profits not paid out as dividends

Balance Sheet Insolvency: Assets < Liabilities. Even selling all assets will not cover debts. This is an accounting term — Insolvency does not equal Bankruptcy (which is a legal term).

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2. Income Statement (Profit-and-Loss Statement)

What it is: A record of revenues and expenses over a period of time.

Formula: Revenues − Expenses = Net Income (or Loss)

The Income Cascade

flowchart LR
    R[Revenue / Net Sales
Top Line] --> GP[Gross Profit
= Revenue minus COGS]
    GP --> OI[Operating Income
= Gross Profit minus Operating Expenses]
    OI --> NI[Net Income
Bottom Line
= Operating Income minus Taxes]

(diagram saved)

Line	Formula
Revenue (Net Sales)	Top line — all money from selling goods/services
− Cost of Goods Sold (COGS)	Direct costs of producing the product
= Gross Profit	Revenue − COGS
− Operating Expenses	Overhead: salaries, R&D, advertising, admin
= Operating Income	Gross Profit − Operating Expenses
+/− Other income/expense	Interest income, non-operating items
− Income Taxes
= Net Income	The bottom line

EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization — strips out accounting and tax effects to reveal core operating performance.

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3. Statement of Cash Flows

What it is: Tracks actual cash moving in and out of the business over a period of time.

Formula: Starting Cash + Cash Inflows − Cash Outflows = Ending Cash

Three Activities

Activity	What it covers
Operating	Day-to-day: cash from sales, cash paid to employees/suppliers/rent
Investing	Buying/selling long-term assets (equipment, buildings)
Financing	Raising or repaying capital: loans, issuing stock, paying dividends

Dividends are NOT an expense — they are a redistribution of earnings to shareholders.

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Critical Distinction: Cash does not equal Net Income

Accrual Accounting records revenue when a deal is made (product delivered), not when cash changes hands. A company can look profitable and still go bankrupt.

‘A firm with high net income but poor cash flow may have problems financing day-to-day activities. Cash is king.‘

Statement	Metaphor	Time frame
Balance Sheet	Photograph	Point in time
Income Statement	Scoreboard	Period of time
Cash Flow Statement	Checkbook	Period of time

Cash Flow Insolvency (Liquidity Crisis): A company cannot convert assets to cash fast enough to pay its bills — even if it has more assets than liabilities. This is a liquidity problem, distinct from balance sheet insolvency.

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Cross-Course Connections

FinancialRatios — ratios are calculated from balance sheet and income statement data
Accounting — who prepares these statements; IFRS/ASPE standards
FinancialManager — uses these statements for planning and control
LongTermFinancing — debt and equity structures appear on the balance sheet
ShortTermFinancing — current liabilities and working capital management

Key Points for Exam

• Assets = Liabilities + Owners’ Equity — must always balance after every transaction
• Balance sheet = snapshot (point in time); income statement and cash flow = period
• Assets listed in order of liquidity (most liquid first); liabilities in order due (current first)
• Net income feeds into retained earnings which appears as owners’ equity on the balance sheet
• Ending cash from cash flow statement appears as Cash asset on the balance sheet
• Cash does not equal Income — accrual accounting books revenue when deal is made, not when paid
• Balance sheet insolvency = assets < liabilities (accounting term, not bankruptcy)
• Cash flow insolvency = cannot convert assets to cash fast enough (liquidity crisis)
• Gross Profit = Revenue − COGS
• Operating Income = Gross Profit − Operating Expenses
• Net Income = Operating Income − Taxes
• EBITDA = strips out interest, taxes, depreciation, amortization to show core operations

Open Questions

• How does revenue recognition differ under IFRS vs. ASPE?