Financial Accounting Chapter 2. Investing and Financing Decisions and the Balance Sheet

Objectives Balance Sheet Accounting Equation Double-Entry Accounting and Transaction Major Assumptions of Accounting

The Conceptual Framework Objective of Financial Reporting To provide useful economic information to external users for decision making and for assessing future cash flows. Fundamental Characteristics Relevance Faithful Representation Enhancing Characteristics Comparability Verifiability Timeliness Understandability

Balance Sheet Balance sheet shows the company’s financial status at a particular time. Especially, the B/S reports assets, liabilities, and owners’ equity (shareholders’ equity). Assets = Liabilities + Owners’ Equity

Assets Assets are economic resources with probable future benefits owned or controlled by an entity as a result of past transaction. The balance sheet of an entity records the monetary value of the assets owned by the entity The assets include cash, accounts receivable, inventory, land, buildings, equipment, and intangible items.

Liabilities Liabilities are economic obligations to pay cash or other assets, or provide services to someone else. Liabilities are probable debt or obligations that result from an entity’s past transactions and will be paid for with assets or services The liabilities include accounts payable, notes payable, and interest payable.

Types of Assets and Liabilities Current assets ◦ cash and other assets that are expected to be converted to cash within a year. ◦ Current assets generally are listed in order of liquidity. Long-term assets (or non-current assets) ◦ Assets that a company needs in order to operate its business over an extended period of time. ◦ The examples are land, buildings, and equipments. Liabilities are also classified as either current liabilities or long-term (or non-current) liabilities.

Owners’ equity The owner’s equity is the residual claim against the assets of a business, after deducting liabilities (= residual amount, net assets). The owner of a business can be one person (sole proprietorship), a small group (a partnership), or a diffuse group of owners (a corporation).

Owners’ equity (Cont.) The portion of a corporation’s owners’ equity contributed by owners in exchange for shares of stock is contributed capital (=paid-in capital). ◦ Par value is the face value (nominal value) of stocks. Usually, the sales price (total Paid-in capital = contributed capital) of stocks is higher than par value. ◦ The difference is called as Additional Paid-in Capital (APIC), Paid-in Capital in excess of par, or Contributed capital in excess of par. The portion of the profit which is not distributed to shareholders as dividends is called as retained earnings (=retained income).

Transaction Transaction is an event that should be recorded in the accounting book. Only the event that influences the economic value of the company is the transaction. In summary, the event that does not change assets, liabilities, or SHE is not a transaction.

Double-Entry Accounting Double-entry accounting is a system of recording transactions in a way that maintains the equality of the accounting equation. Every transaction has at least two effects (=duality of effects) on the accounting equation. ◦ Step 1: Identify and classify accounts and effects ◦ Step 2: Verify account equation is in balance.

Historical Cost Principle The transaction is basically recorded as historical cost. Historical cost is the price when the item is acquired by the company. Other measures ◦ Current cost: resale price or repurchase price ◦ Net present value: present value of future cash flows

Three major assumptions in accounting Separate-entity assumptions states that business transactions are separate from the transactions of owners. Unit-of-measure assumption states that accounting information should be measured and reported in the monetary unit. Going-concern (continuity) assumption states that business are assumed to continue to operate in the foreseeable future.