accounting - chapter 2 outline

ACCT1201 FALL 2014

Chapter 2: Investing and Financing Decisions and the Balance Sheet

A. Financial Accounting Conceptual Framework

Underlying assumptions of accounting help the decision maker to understand what accounting information reports as well as the inherent limitations.

1. Qualities that make accounting information useful:

• Relevancy –

Timeliness

Predictive ValueAble to be used to help predict some future event

Feedback ValueAllows me to evaluate my decisions after they have been made

• Reliability – Accurate

Representational faithfulnessTruthful

VerifiabilityVerifiable, when 2 or more independent look at the same method and come out with the same outcome

NeutralityUnbiased

• Comparability – Comparable across firms and across time within the firm (usually 2 or more years of

information presented) (within same industry such as Google and Yahoo)

• Consistency –

2. Basic Assumptions – Relate to the Balance Sheet

• Separate Entity (Economic Entity) – Business is distinct and separate from its owners

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• Unit of Measure (Monetary Measure) - The financial statement are represented in the monetary unit of the country in which it is

operating• Time Period (Accounting Period) - Indefinite life, allows a business to break that indefinite life down into measurable

periods• Continuity (Going Concern) -

3. Principles:

• Historical Cost Principle (Measurement Principle) – Assets are reported on the financial statement at the cost of what was paid to acquire that

asset

• Revenue Recognition Principle – Report revenue on our income statement when we have earned the revenue

• Expense Recognition (Matching Principle) – Recognize or record an expense in the period in which it was used to generate revenue

• Full Disclosure Principle –Company’s financial statement should report enough information for users to make

knowledgeable decisions about the company

4. Constraints

• Cost benefit – The cost of producing information should not outweigh the benefit

• Materiality – A company must report information that is important enough to the users that if it was omitted, it would make a difference in the users decision

• Conservatism – A company must report all items on the financial statement and the amount that leaves to

the most cautious, immediate result

Exercise: Indicate the basic principle or principles of accounting that underlie each of the following independent situations.

1. Dr. Kline is a practicing pediatrician. Over the years, she has accumulated a personal investment portfolio of securities, virtually all of which have been purchased from her

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earnings as a pediatrician. The investment portfolio is not reflected in the accounting records of her medical practice.Separate entity

2. A company purchases a desk tape dispenser for use by the office secretary. The tape dispenser cost $10 and has an estimated useful life of 15 years. The purchase is immediately expensed on the company’s income statement.Materiality

3. A company sells a product that has a two-year warranty covering parts and labor. In the same period that revenues from product sales are recorded, an estimate of future warranty costs is recorded on the company’s income statement.Expense recognition/matching principle

4. A company is sued for $1 million by a customer claiming that a defective product caused accident. The company believes that the lawsuit is without merit. Although the case will not be tried for a year, the company adds a note describing the lawsuit to its current financial statements.Full disclosure principle

B. Accounts and Chart of Accounts

1. Account: a standardized format to accumulate the dollar effects of transactions on a specific financial statement item.

2. Chart of Accounts: A listing of the account titles and their unique numbers that a company uses to record the transactions of its business operations. (such as 101, 102, 103, 201, 202, 301, 302, etc.)

Balance Sheet Accounts –

a. Assets Cash, accounts receivable, inventory, land, equipmentb. Liabilities Accounts payable, unearned revenues, bank loans payablec. Stockholders’ equity

Common stock, retained earningsIncome Statement Accounts-

d. RevenuesSales,

e. ExpensesRent expense, salaries expense, utilities expense

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C. The Classified Balance Sheet

Company Name Balance Sheet

Specific date of statement Unit of measure

AssetsAssets listed in order of liquidityCurrent Assets Cash

Accounts receivableShort term investmentsInventoryPrepaid expenses

Total current assets

Non-Current Assets:Long-term investmentsProperty, plant and equipmentIntangibles

Total non-current assets

TOTAL ASSETS

Liabilities and Stockholders’ EquityLiabilities are listed in order of maturityCurrent liabilities

Accounts payableDividends payableSalary payable

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Total current liabilities

Non-current LiabilitiesLong-term notes payableBonds payableOther long-term liabilities

Total non-current liabilities

Stockholders’ EquityCommon stockPreferred stockAdditional paid in capital – common stock when you sell stock for more than par value (arbitrary # that is set) (an equity kept in the

company to protect our creditors)Additional paid in capital – preferred stock when you sell stock for more than the par valueRetained earnings

Total stockholders’ equity

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

Exercise: The following is a list of accounts from American Eagle Outfitters financial statements. Categorize each of the following as a current asset, non-current asset, current liability, non-current liability, or stockholders’ equity account

Cash and cash equivalents CURRENT ASSETMarketable securities CURRENT ASSETProperty and equipment, net NON-CURRENT ASSET Accounts payable CURRENT LIABILITYAccounts and note receivables CURRENT ASSETCommon stock STOCKHOLDER’S EQUITYDeferred rent CURRENT ASSETRetained earnings SEInventories CURRENT ASSETS

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D. Transaction Analyses

Transaction Analyses

o Each transaction affects at least two accountso The accounting equation always remains in balance after each transaction (the duality of effects)ASSETS = LIABILITES + OWNER’S EQUITY (STOCKHOLDER’S EQUITY)

Exercise: Steve Gates first established Web Action on January 1, 2014. The company’s transactions for December, the first month of operations, are given below. For each of these events, indicate the account, amount and direction of the effect on the accounting equation. If an event does not affect the accounting equation, explain why.

1. On January 1, the company received $30,000 cash from the Steve Gates who organized Web Action Corporation. Steve Gates received Capital Stock from the company in exchange

Assets = Liabilities + Stockholders’ Equity30,000 = 0 + 30,000

2. On January 3, the company borrowed $75,000 cash and signed a note agreeing to pay back the money in two years.

Assets = Liabilities + Stockholders’ Equity75,000 = 75,000

3. On January 4, purchased $15,000 worth of supplies on credit.

Assets = Liabilities + Stockholders’ Equity15,000 = 15,000

4. On January 9, purchased land for $25,000 cash

Assets = Liabilities + Stockholders’ Equity25,000-25,000

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E. Summarizing the Transactions using the T-account

1. T-Account Consists of:

The title of the accountLeft side (debit, DR)Right side (credit, CR)

2. Debit, Credit and the Normal BalanceA=Liabilites + Contributed Capital + Retained Earnings + revenues – Expenses – Dividends

Debit, put on left side of T chart. Credit, put on right side of T chartIncrease Assets, dividends + expenses with debit; decrease them with creditIncrease everything else (liabilities, contributed capital, retained earnings, revenues) with credit; decrease with debit

The results of the accounting processes do not reflect "exact" information.

Exercise: Identify each of the following accounts as Asset, Liability, Revenue, Expense, orStockholders’ Equity and state the normal balance for the account.

Accounts payable LIABILITY, CREDIT Capital stock SE, CREDIT Fees earned REVENUE, CREDIT Accounts receivable ASSET, DEBITRetained Earnings SE, CREDITRent expense EXPENSE, CREDIT Cash ASSET, DEBIT Equipment Supplies ASSET, DEBIT F. Recording the transactions in a journal (Journal Entry) o Provides a chronological record of transactions o Written in a debits-equal-credits format (the double entry system)

1. Individuals invest $50,000 to start the business. They receive Capital Stock from the company in exchange.

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2. The company borrows $75,000 and signs a note agreeing to pay back the money.

3. Purchased $15,000 worth of supplies on credit.

4. Land is purchased for $25,000 cash.

Required: Show how each transaction affects the accounting equation.

Assets = Liabilities +StockholdersEquity

Cash Supplies LandNotesPayable

AcctsPayable

CommonStock

50,000

Journalize the transactions and post the transactions to T-accounts.

ASSETS

Cash Supplies Land

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LIABILITIES STOCKHOLDERS’ EQUITY

Notes Payable Accounts Payable Capital Stock

G. Financial leverage ratio:

Financial leverage ratio

o average total assets ÷ average stockholders’ equityo measures the relationship between total assets and the stockholders’ equity that finances the assets.

The higher the portion of assets financed with stockholders’ equity, the lower the ratio. The higher the ratio, the more debt financing. Debt financing is riskier.

Prepare a simple classified Balance Sheet and analyze the company using the financialleverage ratio.

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EXERCISE 2 – 1

ANALYZING TRANSACTIONSAnalyze each of the following transactions of World Wide Webster by performing each of the following. Then, use the chart on the following page to keep track of the amount in each account:

(a) Stockholder invests $10,000 into the business.

1. Decide if a transaction took place.

2. Identify the accounts affected.

3. Classify each account affected.

4. Identify direction and amount.

5. Ensure the accounting equation is in balance.

(b) Borrow $15,000, using a note payable to the bank.






(c) Acquire a $15,000 truck and $5,000 worth of equipment.






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EXERCISE 2 – 1, continued(d) Purchase $300 worth of supplies on credit. “On credit” means that you receive the supplies now, and pay for them later.






(e) Sign contract for first website design for $10,000.






ChartAssets = Liabilities + SE

Ref. Cash + Supplies +Property, Plant &

Equipment=

Accounts Payable

+Notes

Payable+

Contributed Capital

(a) 10,000 10,000

(b) -15,000 15,000

(c) 20,000 20,000

(d) 300 300

(e)

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EXERCISE 2 – 2THE DEBIT/CREDIT FRAMEWORK

Analyze each of the following transactions of World Wide Webster and prepare the journal entry required to record the related transaction. (a) Stockholder invests $10,000 into the business.Debit and credit the accounts affected

Ensure the equation still balances and debits = creditsAssets = Liabilities + Stockholders’ Equity

(b) Borrow $15,000 signing a note payable to the bank that is due in three months.Debit and credit the accounts affected


(c) Acquire a $15,000 truck and $5,000 worth of equipment.Debit and credit the accounts affected


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EXERCISE 2 – 3, continued (d) Purchase $300 worth of supplies on credit.Debit and credit the accounts affected


(e) Sign contract for first website design for $10,000.Debit and credit the accounts affected


(f) Company pays off $300 Accounts Payable. Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets = Liabilities + Stockholders’ Equity

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(g) Company pays for and receives $600 worth of supplies.Debit and credit the accounts affected



(h) Company acquires and receives $1,000 worth of equipment.Debit and credit the accounts affected



(i) Order a $900 computer, to be delivered in 90 days.Debit and credit the accounts affected



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EXERCISE 2 – 5POSTING TO T-ACCOUNTS

Post the transactions from EXERCISEs 2-3 and 2-4 and determine the ending balances of each of the following T-accounts.

Assets Liabilities Stockholders’ Equity

+ Cash – - Accounts Payable + - Contributed Capital +

+ Supplies – - Notes Payable + - Retained Earnings +

+ Equipment –

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EXERCISE 2 – 6PREPARING A BALANCE SHEETUse the ending balances from the T-accounts on EXERCISE 2-5 to prepare a classified balance sheet for World Wide Webster as of December 31, 2014.

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EXERCISE 2 – 7CURRENT RATIORefer to the classified balance sheet from EXERCISE 2-6 and calculate the current ratio of World Wide Webster as of December 31, 2014. Then, interpret the current ratio.

Calculation:

Interpretation:

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accounting - chapter 2 outline

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