Financial Accounting Chapter 2 Investing and Financing Decisions and the Balance Sheet Objective of Financial Reporting Provide useful economic information about a business to help external parties primarily investors and creditors make sound financial decisions The users of accounting information are identified as decision makers Most Users are interested in information to help them project a business s future cash inflows and outflows Qualitative Characteristics of Financial Information Relevant information can influence a decision it is timely and has predictive and or feedback value Reliable information is accurate unbiased and verifiable Accounting Assumptions 3 of the 4 belong to the Balance sheet 1 Separate entity assumption a States that each business s activities must be accounted for separately from the activities of its owners all other persons and other entities 2 Unit of Measure assumption a Each business entity accounts for and reports its financial results primarily in terms of the national monetary unit 3 Continuity assumption a Also called Going concern assumption b A business normally is assumed to continue operating long enough to meet its contractual commitments and plans Elements of the Balance Sheet Assets o Economic resources with probable future benefits owned or controlled by an entity as a result of past transactions o They are the acquired resources an entity can use to operate in the future o Must have a value before being reported o Measured under the Historical Cost Principle Historical Cost Principle requires assets to be recorded at historical cost cash paid plus the current dollar value of all noncash considerations given on the date of the exchange o Most companies list assets in order of liquidity how soon an asset is expected by management to be turned into cash or used o Current Assets Assets that will be used or turned into cash within a year Inventory is always considered a current asset regardless of the time needed to produce and sell it Also consist of o Cash o Accounts receivable o Supplies o Prepaid expenses o Other current assets o All other assets are considered long term Are to be used or turned into cash beyond the coming year Liabilities o Probable debts or obligations claims to a company s resources that result from a company s past transactions and will be paid with assets or services o Listed in order of maturity how soon an obligation is to be paid o Entities that a company owes money to are called creditors o Current Liabilities Obligations that will be settled by providing cash goods or Stockholder s Equity services within the coming year o The financing provided by the owners and by business operations o Contributed Capital Results from owners providing cash and sometimes other Owners invest in the business and receive shares of stock as Owners who invest or buys stock in a company hope to benefit assets to the business evidence of ownership in 2 ways 1 Dividends distribution of a company s earnings 2 Capital gains gains from selling the stock for more than o Retained earnings they paid Earnings that are not distributed to the owners but instead are reinvested in the business by management Nature of Business Transactions Transaction is o An exchange of assets or services for assets services or promises to pay between a business and one or more external parties to a business or o A measurable internal event such as the use of assets in operations o Most transactions with external parties involve an exchange where the business entity gives up something but receives something in return Standardized format that organizations use to accumulate the dollar effect of transactions on each financial statement item Accounts Chart of accounts Transaction Analysis The process of studying a transaction to determine its economic effect on the entity in terms of the accounting equation A L SE The 2 principles underlying the transaction analysis process follow o Every transaction affects at least two accounts correctly identifying those accounts and the direction of the effect whether an increase or a decrease is critical This is called the Dual Effects o The accounting equation must remain in balance after each transaction Balancing the Accounting Equation Step 1 Identify and classify accounts and effects o Identify the accounts by title affected and make sure at least two accounts change o Classify them by type of account Was each account an asset A a liability L or a stockholders equity SE o Determine the direction of the effect Did the account increase or decrease Step 2 Verify account equation is in balance o Verify that the accounting equation A L SE remains in balance How do companies keep track of Account Balances T account is merely a shorthand term for the entire ledger account The T account has a left side called the debit side and a right side called the credit side 1 General Journal 2 General Ledger 3 T accounts Transaction Analysis Model T Account Any account Debit Credit Debits and Credits affect the Balance Sheet model as follows Liabilities Stockholders Equity many accounts two accounts Assets many accounts debit credit debit credit Contributed Capital debit credit Investments by owners Retained Earnings debit Dividends declared credit Net income of business Assets Liabilities Stockholders Equity with Debits Accounts have debit balances with Credits Accounts have credit balances with Credits Accounts have credit balances The Journal Entry An accounting method for expressing the effects of a transaction on accounts in a debit equal credits format c Property and Equipment A 10 000 Cash A Notes Payable L 2 000 8 000 Debit Credit Credits are usually indented Debit always first Credits second The T Account A tool for summarizing transaction effects for each amount determining balances and drawing inferences about a company s activities After journal entries are prepared the accountant posts transfers the dollar amounts to each account affected by the transaction Example 1 Papa John s issues 2 000 of additional common stock to new investors for cash GENERAL JOURNAL Date Account Titles and Explanation Debit Credit Cash A Contributed Capital E 2 000 Posted Ref 2 000 Cash Beg Bal a 6 000 2 000 Contributed Capital 1 000 2 000 Beg Bal a 8 000 3 000 2 The company borrows 6 000 from the local bank signing a three year note b Cash A Cash Beg Bal a b 6 000 2 000 6 000 Notes Payable L 6 000 Debit Credit 6 000 Notes Payable 146 000 6 000
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