ACCOUNTING NOTES CHAPTER 2 INVESTING AND FINANCING DECISIONS AND THE BALANCE SHEET UNDERSTANDING THE BUSINESS While the business pizza depends heavily on human capital companies can compete through product quality marketing OVERVIEW OF ACCOUNTING CONCEPTS Primary objective of external financial reporting provide useful economic information about a business to help external parties make sound financial decisions o The users of accounting info are identified as decision makers These decision makers include average investors creditors and experts who provide financial advice Information should be relevant provide feedback and predictive value on a timely basis and reliable accurate unbiased verifiable Three of the four basic assumptions that underlie accounting measurement and reporting relate to the balance sheet The Separate entity assumption states that business transactions are accounted for separately from the transactions of owners The Unit of measure assumption each business entity accounts for and reports its financial results primarily in terms of the national monetary unit The continuity assumption businesses are usually assumed to continue operating long enough to meet its contractual commitments and plans The elements of the financial statements are defined as part of the conceptual framework Assets economic resources with probable future benefits owned or controlled by an entity as a result of past transactions Assets are measured initially by historical cost principle on the acquisition date cash paid pus dollar value of all noncash considerations given in exchange become the historical cost of a new asset Current assets assets that will be used or turned into cash within one year Inventory is always considered a current asset regardless of the time needed to produce and sell it o All other assets are considered long term noncurrent Liabilities are probable debts or obligations that result from a company s past transactions and will be paid with assets or services o Entities that a company owes money to are called creditors o Liabilities on the balance sheet are usually listed in order of maturity Current liabilities obligations that will be settled by providing cash goods or services within the coming year Stockholders equity the financing provided by the owners and by business operations Contributed capital owners providing cash to the business o Dividends stock for more than they paid capital gain distribution of a company s earnings and gains from selling the Retained Earnings earnings that are not distributed to the owners but instead are reinvested in the business by management Exceptions to the Measurement Reporting Principles Materiality suggests that when relatively small dollar amounts are not likely to influence a user s decision the item can be accounted for in the most cost beneficial manner Conservatism suggests that when options in measurement exist and no option is better than any other accountants should apply the methods that do not overstate assets and revenues or understate liabilities and expenses that is they should choose conservative methods WHAT BUSINESS ACTIVITIES CAUSE CHANGES IN FINANCIAL STATEMENT AMOUNTS Transactions 1 an exchange of assets or services for assets services or promises that pay between a business and one or more external parties to a business External Events 2 a measurable internal event such as the use of assets in operations Internal Events Account a standardized format that organizations use to accumulate the dollar effect of transactions on each financial statement item o To facilitate the recording of transactions each company establishes a chart of accounts a list of all account titles and their unique numbers o The accounts are usually organized by financial statement element with asset accounts listed first followed by liability stockholders equity revenue and expense accounts in that order o The accounts you see in the financial statements of most large corporations are actually summations of a number of specific accounts in the recordkeeping system HOW DO TRANSACTIONS AFFECT ACCOUNTS The decision to purchase additional inventory for cash in anticipation of a major sales initiative for example will increase inventory and decrease cash Transaction Analysis the process of studying a transaction to determine its economic effect on the entity in terms of the accounting equation also known as fundamental accounting model The idea that every transaction has at least two effects on the basic accounting equation is knows as the dual effects concept Most transactions with external parties involve an exchange by which the business entity both receives something and gives up something in return The accounting equation must remain in balance after each transaction That is total assets much equal total liabilities and stockholders equity Step 1 Identify and classify accounts and effects Identify accounts by title affected making sure that at least two accounts change Ask yourself what was received and what was given Classify them by type of account Was each account an Asset Liability or a Determine the direction of the effect Did the account increase or stockholders equity decrease Verify accounting equation is in balance Verify that the accounting equation A L SE remains in balance Retained earnings represent the profits available to shareholders When a company s board of directors declares a cash dividend Retained Earnings is reduced HOW DO COMPANIES KEEP TRACK OF ACCOUNT BALANCES To handle the multitude of daily transactions that a business generates companies establish accounting systems usually computerized that follow a cycle During the accounting period transactions that result in exchanges between the company and other external parties are analyzed and recorded in the general journal in chronological order and the related accounts are updated in the general ledger The Direction of Transaction Effects We saw earlier transaction effects increase and decrease assets liabilities and stockholders equity The increase symbol is located on the left side of the T accounts on the left side of the accounting equation assets The increase symbol is located on the right side of the T accounts on the right side of the equation liabilities stockholders equity The term debit is always written on the left side of the account The term credit is always written on the right side of the account Debit is on the left credit on the right The
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