Chapter 2 – Balance Sheet: Presenting Investments and Financing of a Firm PDF

2-1 Chapter 2 – Balance Sheet: Presenting the Investments and Financing of a Firm FINANCIAL ACCOUNTING AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 10th Edition Clyde P. Stickney and Roman L. Weil ...

2-1 Chapter 2 – Balance Sheet: Presenting the Investments and Financing of a Firm FINANCIAL ACCOUNTING AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 10th Edition Clyde P. Stickney and Roman L. Weil 2-2 Learning Objectives 1. Understand the accounting concepts of (a) assets, (b) liabilities, and (c) shareholders’ equity. 2. Understand the dual-entry recording framework. 3. Develop skills to analyze a balance sheet. 2-3 Chapter Outline 1. The basic accounting equation: Assets = Liabilities + Shareholders’ Equity 2. Assets: recognition, measurement, and classification. 3. Liabilities: recognition, measurement, and classification. 4. Shareholders’ Equity 5. Dual-entry recording. 6. Analysis of the balance sheet. Chapter Summary 2-4 2. Accounting Concepts of Assets 1. Asset Recognition -- an asset is a resource that has a future economic benefit. 2. Asset Valuation -- the monetary amount assigned to an asset. 3. Asset Classification -- assets are grouped into like categories. 2-5 2.a. Asset Recognition  Recognize a resource as an asset only if: 1. The firm has acquired rights to its use in the future as a result of a past transaction or exchange, and 2. The firm can measure or quantify the future benefits with a reasonable degree of precision.  All assets are future benefits but not all future benefits are recognized as assets. 2-6 2.b. Asset Valuation  Valuation is the assignment of a monetary amount to an asset.  Several methods of assignment: 1. Acquisition or historical cost, 2. Current replacement cost, 3. Net realizable value, 4. Present value of future net cash flows. 2-7 2.c. Asset Classification  Similar assets are grouped together in the financial statements into classes.  Examples of common classes of assets:  Current assets,  Investments,  Property, plant and equipment, and  Intangible assets. 2-8 3. Accounting Concepts of Liabilities 1. Liability Recognition -- a liability arises when a firm receives benefits or services and in exchange promises to pay for these at a definite future time. 2. Liability Valuation -- the monetary amount assigned to the liability. 3. Liability Classification -- liabilities are grouped into like categories. 2-9 3.a. Liability Recognition  Recognize an obligation as a liability: 1. The firm has received benefits, and 2. In exchange, promised to pay the provider, and 3. The payment will occur at a definite future time.  All liabilities are obligations but not all obligations are recognized as liabilities. 2-10 3.b. Liability Valuation  Valuation is the assignment of a monetary amount to a liability.  Two main methods of assignment: 1. Liabilities due within a year or less are generally valued at amount of the cash payment. 2. Liabilities due after one year are generally valued at the net present value of the future cash payments. 2-11 3.c. Liability Classification  Similar liabilities are grouped together in the financial statements into classes:  Examples of common classes of liabilities:  Current Liabilities,  Long-Term Debt, and  Other Long-Term Liabilities. 2-12 4. Shareholders’ Equity  Shareholders’ equity is the residual interest in the firm, that is, all assets above those required to satisfy the liabilities.  Shareholders’ equity is equal to total assets less total liabilities.  The valuation of assets and liabilities therefore determines the valuation of shareholders’ equity. 2-13 4.a. Classification of Shareholders’ Equity  Shareholders’ equity is divided into: 1. Contributed Capital, which is the original investment by owners, and 2. Retained Earnings, which is the amount of earnings left in the firm after the payment of dividends to the owners. 2-14 4.b. Contributed Capital  Contributed Capital is divided into: 1. A par or stated value of the shares which has a legal definition, and 2. The remaining amount which is called Additional Paid-In Capital.  This distinction is made for legal reasons and may have no relationship to any market value of the shares. 2-15 4.c. Retained Earnings  Retained earnings are the net accumulation of earnings of the firm since its beginning.  Retained Earnings is increased by positive net income, but  Is reduced by losses, and  Is reduced by the payment of dividends to the shareholders or owners. 2-16 4.d. Retained Earnings  Thus for any accounting period: Beginning Retained Earnings + net income (or - net losses) - dividends declared during the period = Ending Retained Earnings. 2-17 5. Dual-Entry Recording Framework  Every economic event has two sides, a give and a take.  Accountants record both sides of some economic events as a transaction.  Furthermore, accountants require that the two sides of a transaction balance so that the basic accounting equation remains in balance. 2-18 5.1. Dual Effect of a Transaction  Recall the basic accounting equation Assets = Liabilities + Owners’ Equity  Any transaction will effect one or more on the three classes of accounts.  Remember that the transaction must balance, and  That the basic equation must balance. 2-19 5.2. Effect on the Equation  There are four general combinations: 1. Increase an asset and a liability or owners’ equity by the same amount, 2. Decrease an asset and a liability or owners’ equity by the same amount, 3. Increase an asset and decrease another by the same amount, and 4. Increase a liability or owners’ equity and decrease another liability or owners’ equity by the same amount. 2-20 5.3. Example, Miller Corp. transaction assets = liab. + s.h.equity 1. Issue 1,000 shares for $10,000 (par = $10). 2. Purchase equipment for $60,000 cash. 3. Purchase inventory for $15,000 on account. 4. Pays supplier $8,000 cash of the $15,000 owed. 5. Issues 700 shares of stock to supplier for balance due. 6. Pays for one year insurance policy, $600 in cash. 7. Customer pays $3,000 for merchandise to be delivered in the future. 2-21 5.3. Example, Miller Corp. transaction assets = liab. + s.h.equity 1. Issue 10,000 shares for +$100,000 +$100,000 $10,000 (par = $10). 2. Purchase equipment for +$60,000 $60,000 cash. -$60,000 3. Purchase inventory for +$15,000 +$15,000 $15,000 on account. 4. Pays supplier $8,000 cash -$8,000 -$8,000 of the $15,000 owned. 5. Issues 700 shares of stock -$7,000 +$7,000 to supplier for balance due. 6. Pays for one year insurance +$600 policy, $600 in cash. -$600 7. Customer pays $3,000 for merchandise to be delivered +$3,000 +$3,000 in the future. 2-22 5.4. Debits and Credits  There is a pattern in the dual-entry framework, but it is not always easy to describe.  Accountants use the definitions of debit and credit to describe the requirement to balance the two sides of a transaction and to keep the basic equation in balance. 2-23 5.4. (cont.) Debits and Credits  Debits are defined as increases to asset accounts (the left side of the basic equation) or decreases to liabilities or owners’ equity (the right side).  Credits are defined as increases to liabilities or owners’ equity (the right side of the basic equation) or decreases to asset accounts (the left side).  Debits = Credits for all transactions and for the basic equation at any time. 2-24 5.5. Journal Entries  Accountants record a transaction by making a journal entry.  A journal entry shows both sides of the transaction with the name of the accounts and their respective debit or credit.  For example, transaction 1 from the Miller Corporation Example would be: Jan 1 Cash 100,000 Common Stock 100,000 2-25 5.6. The Ledger  The journal entry records both sides to a transaction, but  The Ledger summarizes changes to individual accounts which may be one side of several transactions.  Accountants often use a shorthand notation for the ledger called a T-Account. 2-26 5.7. T-Accounts A T-Account summarizes debits and credits to a specific account, for example cash. 2-27 Figure 2.1 Summary of the Accounting Process Periodic PeriodicPosting Posting Results of Journalizing Journalizing totothe ininGeneral theAppropriate Appropriate Events and General Accounts Journal Accountsininthe the Transactions Journal General GeneralLedger Ledger Correction Correctionand and Preparation Preparationof of Preparation Preparationofof Adjustments Adjustmentsofof Unadjusted Unadjusted Financial Financial the theUnadjusted Unadjusted Trial TrialBalance Balance Statements Statements Trial TrialBalance Balance 2-28 6. Analysis of the Balance Sheet  The balance sheet reflects the effects of a firm’s investing and financing decisions.  The asset side gives the resources that are available to the firm. Owners expect management to make efficient use of the assets that are entrusted to them.  The liabilities and shareholders’ equity side gives the sources of those assets. The ratio of liability to shareholders’ equity is called leverage and shareholders expect management to balance liabilities against new shareholders’ equity. 2-29 Chapter Summary  The balance sheet and the basic accounting equation are introduced.  Assets, liabilities and shareholders’ equity are defined.  Recording transactions is a dual-entry format is presented. The initial recording is called journalizing and the summary of the journal into accounts is called posting.  The terms trial balance and ledger are defined.  Closing of the temporary accounts to retained earnings is presented.