McGraw-Hill/Irwin Chapter 2 Basic Accounting Concepts: The Balance Sheet Copyright © The McGraw-Hill Companies. All Rights Reserved.

2-2 Basic Concepts Accounting principles are built on a foundation of a few basic concepts. The concepts are more general than GAAP. They are intended to provide FASB with explicit conceptual criteria to help resolve future accounting issues. We will consider 11 concepts. – 1-5 covered in this chapter. –6-11 in next chapter.

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.

2-4 Concept #1: Money Measurement Accounting records are recorded in monetary terms at value at time transaction is recorded. Severe limitation. –Some items can’t be easily valued. E.g., president’s health, effect of strike. –Price changes ignored.

2-5 Concept #2: Entity Organization or activity for which accounting records are prepared. Need distinction between entities. –Entity vs. owner. –Entity vs. other entities. Difficulties. –May or may not be separate legal entity. E.g., family owned business. –One entity may be part of a larger entity. E.g., multiple entities in a consolidated corporation.

2-6 Concept #3: Going Concern Assumed to continue in operation for an indefinite period. ‒Resources available to the entity will be used in its future operations. Opposite assumption: –Liquidation/bankruptcy. Only liquidation values would be meaningful.

2-7 Concept #4: Cost Concept Cost Terminology Assets. –economic resources of an entity. –recorded at cost (i.e., price paid). Book value of assets. –recorded value. Fair value of assets. –amount for which asset could be currently purchased or sold..

2-8 Cost Concept Non-monetary Assets E.g., land, buildings, machinery and similar. –Maintain in accounting records at book value. –Generally, book value = fair value only at time of acquisition. Depreciation (or amortization). –Systematic allocation of cost over life of asset. Book value: Recorded cost minus depreciation to date. Rationale: Relevance sacrificed for objectivity.

2-9 Cost Concept: Monetary Assets E.g., cash, marketable securities. Initially recorded at cost and then adjusted to fair value. Rationale: Fair value is relevant, objective, and feasible. Question: Why is fair value relevant and objective for monetary assets (e.g., marketable securities) but not for non-monetary assets (e.g., building)?

2-10 Cost Concept: Goodwill E.g., intellectual capital, market power, reputation, clientele. Only recorded when paying more than fair value of net assets acquired. –E.g., purchasing another company. –Purchase price minus fair value of net assets equals amount of goodwill. Rationale: If no cost is paid, no asset is recorded.

2-11 Concept #5: Dual-Aspect Assets = economic resources. Equities = claims against assets. –Liabilities = claims of creditors (everyone other than owners). –Owners’ equity = claims of investors (Shareholders’ or stockholders’ equity for a corporation).

2-12 Dual Aspect Fundamental accounting equation: Assets = Liabilities + Owners’ equity For a corporation: Assets = Liabilities + Stockholders’ equity Assets = Liabilities + Paid-in cap. + Ret. earnings

2-13 Dual Aspect Transactions are events that affect accounting records. Every transaction has a dual impact on accounting records. Dual impact: –Results in maintaining equality of accounting equation. –Accounting systems are designed to record both of the impacts of a transaction: Double-entry accounting system.

2-14 Balance Sheet More formally, Statement of Financial Position. Point in time or status report. Contains (and shows equality of amounts of): –Assets = Liabilities + Owners’ equity. –Assets = Liabilities + Shareholders’ equity.

2-15 Balance Sheet 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 (i.e., residual claim). –Claim is a legalistic view (i.e., better suited to liquidation, not to going concern).

2-16 Balance Sheet Sources and Uses of Funds View Assets. –how funds were used or invested. Liabilities + owners’ equity. –sources of funds. –how assets were financed.

2-17 Account Categories Groups of related items. Main categories. –Assets. –Liabilities. –Owners’ (shareholders’) equity. –Revenues. –Expenses.

2-18 Assets An asset must be: 1.Acquired in a transaction. 2.An economic resource (i.e. provide future benefits). Cash or convertible to cash. Goods to be sold for cash. Items to be used to generate cash. 3.Controlled by the entity. 4.An objectively measurable cost at time of acquisition.

2-19 Reporting of Assets on Balance Sheet Grouped into categories. Decreasing order of liquidity. Current assets (almost) always shown separately.

2-20 Current Assets Cash. –Funds available for disbursement. Other assets expected to be realized in cash, or sold, or consumed, within one year. –Or normal operating cycle, if longer.

2-21 Current Assets: Marketable Securities Investments that are: –Readily marketable, AND, –Expected to be converted to cash within one year.

2-22 Current Assets: Accounts (and Notes) Receivable Accounts Receivable: –Owed by customers. –Reported at amount owed less an estimated uncollectible amount. Notes (Other) receivables: –Owed by other than customers. –Evidence by written promises to pay (notes).

2-23 Current Assets: Inventories 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. Question: Is a truck inventory? –To Ford Motor Company = Inventory. –To Home Builder = Equipment (Noncurrent Asset).

2-24 Current Assets: Prepaid Expenses Intangible. Usefulness will expire in near future. Examples: –Prepaid rent expense. –Prepaid insurance expense.

2-25 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.

2-26 Other Assets Investments (not expected to be sold within a year). Intangible assets. –Goodwill, patents, trademarks, copyrights. –Longer life than prepaid expenses.

2-27 Liabilities Obligations to transfer assets or provide services to outside parties. Arising from past transactions or events. Claims against entity’s assets. –But not against specific assets, unless indicated. Reported at amount that would satisfy obligations on Balance Sheet date. –Principal + unpaid interest.

2-28 Current Liabilities Satisfied or extinguished within one year –or normal operating cycle, if longer.

2-29 Current Liabilities: Accounts (and Notes) Payable Accounts Payable: –Suppliers (i.e. vendors) claims for goods or services furnished, but not yet paid. Notes payable: –Short-term loans. –Formal written note. –Includes amounts owed to financial institutions.

2-30 Current Liabilities: Taxes Payable Owed to government agencies for taxes. Income taxes often shown separately because of size.

2-31 Current Liabilities: Accrued Expenses Earned by outside parties but not yet paid (i.e., unpaid expenses). Usually no invoice. Includes interest payable, wages payable.

2-32 Current Liabilities: Deferred Revenues Also called unearned revenues or pre- collected revenues. Advance payment received, but company has not yet performed service or delivered product.

2-33 Current Liabilities: Current Portion of Long-Term Debt Portion due within upcoming year. Gives complete picture of entity’s short- term obligations.

2-34 Long-Term Liabilities Also called: –Long-term debt. –Non-current liabilities. Due beyond upcoming year.

2-35 Owners’ Equity Amount owners have invested in entity. Also know as “Net assets” (i.e., Assets minus Liabilities). For a corporation: –Shareholders’ or stockholders’ equity. –Shares of stock evidence ownership interest.

2-36 Two Categories of Shareholders’ Equity Paid-in or contributed capital. Retained earnings.

2-37 Shareholders’ Equity: Paid-in Capital Amount owners have paid in to purchase shares of stock. Classified as: –Par value. –Additional paid-in capital.

2-38 Shareholders’ Equity: Retained Earnings Reinvested earnings from inception to date less dividends to date. If negative, amount labeled as deficit. Question: Is Retained Earnings the same as Cash? –No, does not indicate the form of reinvestment.

2-39 Unincorporated Businesses Proprietorship. –Business owned by one person. Partnership. –Business owned jointly by two or more persons. –Utilize a Capital account for each partner. –Capital account decreased by withdrawals by each owner (i.e., drawings).

2-40 Financial Statement Ratios One number expressed in relation to 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.

2-41 Balance Sheet Changes Music Mart Start Up Assets = Liabilities + Paid-in cap. + Ret. Earnings Dual effect of transactions. Transactions: –1/1: Owner invests $25,000 for stock. –1/2: Borrows $12,500 from bank. –1/3: Purchases $5,000 of merchandise for cash. –1/4: Sells merchandise for $750 cash (cost $500).