Chapter

2
Basic Accounting Concepts: The Balance Sheet

McGraw-Hill/Irwin

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Basic Concepts
Statements of Financial Accounting Concepts
Adopted by FASB Conceptual criteria to help resolve future accounting issues. Not GAAP.

11 concepts in text.
1-5 covered in this chapter. 6-11 in next chapter.

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11 Basic Concepts
1. Money measurement. 2. Entity. 3. Going concern. 4. Cost. 5. Dual aspect. 6. Accounting period. 7. Conservatism. 8. Realization. 9. Matching. 10. Consistency. 11. Materiality.

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Concept #1: Money Measurement

Accounting records are recorded in monetary terms at value at time transaction is recorded. Severe limitation.
Cant be valued, cant be recorded; e.g. presidents health, affect of strike. Price changes ignored.

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Concept #2: Entity

For whom accounts are kept. Distinguish from owner. May or may not be separate legal entity. One entity may be part of a larger entity.
General Electric Company presents one set of financial statements with parent company operations combined with all subsidiaries around the world.

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Concept #3: Going Concern

Assumed to continue in operation for an indefinite period. Alternative assumption:
Liquidation/bankruptcy. Only liquidation values would be meaningful.

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Concept #4: Cost

Assets defined:
= economic resources. = cash or something that helps generate cash.

Assets recorded at cost, that is, price paid. Fair value = amount for which asset could be currently purchased or sold. Book value of asset = recorded value.

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Cost Concept Non-monetary Assets

Land, buildings, machinery and similar. Generally, book value = fair value only at time of acquisition. Depreciation or amortization = systematic allocation of cost over life of asset. B.V. = recorded cost - depreciation to date. Rationale for cost concept:
Relevance sacrificed for objectivity.
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Cost Concept: Monetary Assets

Cash, marketable securities. Initially recorded at cost. Adjusted to fair value (=market value, if available). Rationale: FV is relevant, objective & feasible. Why is FV relevant & objective for monetary assets but not for non-monetary assets?

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Cost Concept: Goodwill

Economic goodwill:
Fair value of business fair value of acquired net asset(s).

Accounting goodwill:
Purchase price - fair value of net assets. Recorded only when purchased. Application of cost concept.

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Concept #5: Dual-Aspect

Assets = economic resources. Equities = claims against assets.
Liabilities = claims of creditors (everyone other than owners). Owners equity (Shareholders or stockholders equity for a corporation).

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Dual Aspect (Continued)

Fundamental accounting equation:
Assets = Equities. Assets = Liabilities + Owners equity.

For a corporation:
Assets = Liabilities + Stockholders equity. Assets = Liabilities + Paid-in-capital + Retained earnings.

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Dual Aspect (Concluded)

Transactions = events that affect accounting records. Every transaction has a dual impact on accounting records. Dual impact:
Results in maintenance of fundamental accounting equation. Double-entry system.
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Balance Sheet
Point in time or status report. More formally, Statement of Financial Position. Contains (and shows equality of amounts of):
Assets. Liabilities and Owners equity.

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Interpretations of Dual Aspect: Resources and Claims View

Assets = Claims on assets. Owners equity is a residual claim. Shortcomings:
Balance Sheet is not at market or liquidating values, Owners equity as a claim is unclear. Claim is a legalistic view.
Better suited to liquidation, not to going concern.

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Interpretations of Dual Aspect: Sources and Uses of Funds View

Left hand side = assets = how funds used or invested. Right hand side = liabilities + owners equity = sources of funds = how assets were financed. Financing supplied by owners:
Paid-in-capital (= contributed capital). Retained earnings.
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Account Categories
Groups of related items. Classifications of:
Assets. Equities (i.e. liabilities, owners equity) Revenues. Expenses.

Discretion of management.

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Assets
Acquired in a transaction. Economic resources (i.e. provide future benefits).
Cash or convertible to cash. Goods to be sold for cash. Items to be used to generate cash.

Controlled by the entity. Objectively measurable cost at time of acquisition.

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Reporting of Assets on Balance Sheet

Grouped into categories. Decreasing order of liquidity. Current assets (almost) always shown separately.

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Current Assets
Cash. Other assets expected to be realized in cash or sold or consumed within longer of one year or normal operating cycle.

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Cash
Funds available for disbursement.

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Marketable Securities
Investments that are:
Readily marketable. Expected to be converted to cash within 1 year.

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Accounts Receivable
Owed by customers. Reported at amount owed less estimated uncollectible. Other receivables:
Owed by other than customers.

Notes receivable:
Evidence by written promises to pay (notes).

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Inventories
Aggregate of those items that are:
Held for sale in ordinary course of business, In process of production for sale, or To be consumed in production of goods or services to be sold.

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Exercise
Is a tractor an inventory item or another type of asset for:
Caterpillar (manufacturer of tractors)? A farm?

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Prepaid Expenses
Intangible. Usefulness will expire in near future. Examples:
Prepaid rent expense. Prepaid insurance expense.

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Property, Plant, and Equipment

Also, called fixed assets. Tangible. Long-lived. Used to produce goods and services to generate cash inflows. Land is not depreciated. Building and equipment shown at:
Cost less accumulated depreciation.
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Other Assets
Investments (not expected to be sold within a year). Intangible assets
Goodwill, patents, trademarks, copyrights. Longer life than prepaid expenses.

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Liabilities
Obligations to transfer assets or provide services to outside parties. Arising from past transactions or events. Claims against entitys assets. Not against specific assets, unless indicated. Reported at amount that would satisfy obligations on BS date.
Principal + interest (through BS date).
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Current Liabilities
Satisfied or extinguished within one year or current operating cycle, whichever is longer.

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Accounts Payable
Suppliers (i.e. vendors) claims for goods or services furnished but not yet paid. Unsecured. Notes payable or short-term loans.
Formal written note. Includes amounts owed to financial institutions.

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Taxes Payable
Owed to government for taxes. Income taxes often shown separately because of size.

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Accrued Expenses
Earned by outside parties but not yet paid. Usually no invoice. Includes interest payable, wages payable.

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Deferred Revenues
Also called unearned revenues or precollected revenues. Advance payment received but company has not yet performed service or delivered product.

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Other Liabilities
Current liability:
Current Portion of Long-Term Debt
Portion due within next year.

Long-term debt or non-current liabilities.

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Owners Equity
Amount owners invested in entity. = Assets Liabilities = Net assets For a corporation: shareholders or stockholders equity .
Shares of stock evidence ownership interest.

Could be invested in any assets on Balance Sheet.

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Two Categories of Shareholders Equity

Paid-in or contributed capital. Retained earnings.

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Paid-in Capital
Capital stock (at stated or par value) + additional paid-in-capital. Amount owners have paid in to purchase shares of stock.

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Retained Earnings
Reinvested earnings from inception to date less dividends to date. If negative, deficit. Residual interest in assets. No necessary relation between RE and Cash.

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Unincorporated Businesses
Proprietorship.
Business owned by one person.

Partnership.
Business owned jointly by two or more persons.

Capital (not SE) account.

Separate for each partner. Drawings.
Withdrawals by owner(s).
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Ratios
One number divided by another. Example: Current ratio.
Current Assets / Current liabilities A measure of liquidity or ability to pay short-term obligations. For some industries, 2 to 1 is believed desirable.

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Balance Sheet Changes Music Mart Start Up

Assets = liabilities + Paid-in capital + Retained earnings Dual effect of transactions. Transactions:
On 1/1 Owner invests $25,000 for stock. On 1/2 borrows $12,500 from bank. On 1/3 purchases $5,000 of mdse for cash. On 1/4 sells mdse for $750 cash that cost $500.
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Chapter

End of Chapter 2

McGraw-Hill/Irwin

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.