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FINANCIAL ACCOUNTINGAN INTRODUCTION TO CONCEPTS,

METHODS, AND USES10th Edition

Clyde P. Stickney and Roman L. Weil

Chapter 2 – Balance Sheet: Presenting the Investments and Financing of a Firm

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Learning Objectives

1. Understand the accounting concepts of (a) assets, (b) liabilities, and (c) shareholders’ equity.

2. Understand the dual-entry recording framework.

3. Develop skills to analyze a balance sheet.

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Chapter Outline

1. The basic accounting equation:Assets = Liabilities + Shareholders’ Equity

2. Assets: recognition, measurement, and classification.3. Liabilities: recognition, measurement, and

classification.4. Shareholders’ Equity5. Dual-entry recording.6. Analysis of the balance sheet.Chapter Summary

2-42. Accounting Concepts of Assets

1. Asset Recognition -- an asset is a resource that has a future economic benefit.

2. Asset Valuation -- the monetary amount assigned to an asset.

3. Asset Classification -- assets are grouped into like categories.

2-52.a. Asset Recognition

Recognize a resource as an asset only if:1. The firm has acquired rights to its use in

the future as a result of a past transaction or exchange, and

2. The firm can measure or quantify the future benefits with a reasonable degree of precision.

All assets are future benefits but not all future benefits are recognized as assets.

2-62.b. Asset Valuation

Valuation is the assignment of a monetary amount to an asset.

Several methods of assignment:1. Acquisition or historical cost,2. Current replacement cost,3. Net realizable value,4. Present value of future net cash flows.

2-72.c. Asset Classification

Similar assets are grouped together in the financial statements into classes.

Examples of common classes of assets: Current assets, Investments, Property, plant and equipment, and Intangible assets.

2-83. Accounting Concepts of Liabilities

1. Liability Recognition -- a liability arises when a firm receives benefits or services and in exchange promises to pay for these at a definite future time.

2. Liability Valuation -- the monetary amount assigned to the liability.

3. Liability Classification -- liabilities are grouped into like categories.

2-93.a. Liability Recognition

Recognize an obligation as a liability:1. The firm has received benefits, and2. In exchange, promised to pay the

provider, and3. The payment will occur at a definite

future time. All liabilities are obligations but not all

obligations are recognized as liabilities.

2-103.b. Liability Valuation

Valuation is the assignment of a monetary amount to a liability.

Two main methods of assignment:1. Liabilities due within a year or less are

generally valued at amount of the cash payment.

2. Liabilities due after one year are generally valued at the net present value of the future cash payments.

2-113.c. Liability Classification

Similar liabilities are grouped together in the financial statements into classes:

Examples of common classes of liabilities: Current Liabilities, Long-Term Debt, and Other Long-Term Liabilities.

2-124. Shareholders’ Equity

Shareholders’ equity is the residual interest in the firm, that is, all assets above those required to satisfy the liabilities.

Shareholders’ equity is equal to total assets less total liabilities.

The valuation of assets and liabilities therefore determines the valuation of shareholders’ equity.

2-13 4.a. Classification of Shareholders’ Equity

Shareholders’ equity is divided into:1. Contributed Capital, which is the original

investment by owners, and2. Retained Earnings, which is the amount of

earnings left in the firm after the payment of dividends to the owners.

2-144.b. Contributed Capital

Contributed Capital is divided into:1. A par or stated value of the shares which

has a legal definition, and2. The remaining amount which is called

Additional Paid-In Capital. This distinction is made for legal reasons and

may have no relationship to any market value of the shares.

2-154.c. Retained Earnings

Retained earnings are the net accumulation of earnings of the firm since its beginning.

Retained Earnings is increased by positive net income, but

Is reduced by losses, and Is reduced by the payment of dividends to the

shareholders or owners.

2-164.d. Retained Earnings

Thus for any accounting period:

Beginning Retained Earnings+ net income (or less net losses)- dividends declared during the period= Ending Retained Earnings.

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5. Dual-Entry Recording Framework

Every economic event has two sides, a give and a take.

Accountants record both sides of some economic events as a transaction.

Furthermore, accountants require that the two sides of a transaction balance so that the basic accounting equation remains in balance.

2-18 5.1. Dual Effect of a Transaction

Recall the basic accounting equationAssets = Liabilities + Owners’ Equity

Any transaction will effect one or more on the three classes of accounts.

Remember that the transaction must balance, and

That the basic equation must balance.

2-19 5.2. Effect on the Equation

There are four general combinations:1. Increase an asset and a liability or owners’ equity

by the same amount,2. Decrease an asset and a liability or owners’ equity

by the same amount,3. Increase an asset and decrease another by the

same amount, and4. Increase a liability or owners’ equity and decrease

another liability or owners’ equity by the same amount.

2-20 5.3. Example, Miller Corp.

transaction assets = liab. + s.h.equity1. Issue 10,000 shares for $10,000 (par = $10).2. Purchase equipment for $60,000 cash.3. Purchase inventory for $15,000 on account.4. Pays supplier $8,000 cash of the $15,000 owned.5. Issues 700 shares of stock to supplier for balance due.6. Pays for one year insurance policy, $600 in cash.7. Customer pays $3,000 for merchandise to be delivered in the future.

2-21 5.3. Example, Miller Corp.

transaction assets = liab. + s.h.equity1. Issue 10,000 shares for $10,000 (par = $10).2. Purchase equipment for $60,000 cash.3. Purchase inventory for $15,000 on account.4. Pays supplier $8,000 cash of the $15,000 owned.5. Issues 700 shares of stock to supplier for balance due.6. Pays for one year insurance policy, $600 in cash.7. Customer pays $3,000 for merchandise to be delivered in the future.

+$100,000 +$100,000

+$60,000 -$60,000+$15,000 +$15,000

-$8,000 -$8,000

-$7,000 +$7,000

+$600 -$600

+$3,000 +$3,000

2-22 5.4. Debits and Credits

There is a pattern in the dual-entry framework, but it is not easy to describe.

Note that increases do not always equal other increases, nor do they always equal decreases.

Accountants use the definitions of debit and credit to describe the requirement to balance the two sides of a transaction and to keep the basic equation in balance.

2-23 5.4. (cont.) Debits and Credits

Debits are defined as increases to asset accounts (the right side of the basic equation) or decreases to liabilities or owners’ equity (the left side).

Credits are defined as increases to to liabilities or owners’ equity (the left side of the basic equation) or decreases to asset accounts (the right side).

Debits = Credits for all transactions and for the basic equation at any time.

2-24 5.5. Journal Entries

Accountants record a transaction by making a journal entry.

A journal entry shows both sides of the transaction with the name of the accounts and their respective debit or credit.

For example, transaction 1 from the Miller Corporation Example would be:

Jan 1 Cash 100,000 Common Stock 100,000

2-25 5.6. The Ledger

The journal entry records both sides to a transaction, but

The Ledger summarizes changes to individual accounts which may be one side of several transactions.

Accountants often use a shorthand notation for the ledger called a T-Account.

2-26 5.7. T-Accounts

A T-Account summarizes debits and credits to a specific account, for example cash.

2-27Figure 2.1 Summary of the Accounting

Process

Journalizingin General

Journal

Periodic Posting to the Appropriate

Accounts in theGeneral Ledger

Preparation ofUnadjusted

Trial Balance

Correction andAdjustments ofthe Unadjusted Trial Balance

Preparation ofFinancial

Statements

Results ofEvents and

Transactions

2-28 6. Analysis of the Balance Sheet

The balance sheet reflects the effects of a firm’s investing and financing decisions.

The asset side gives the resources that are available to the firm. Owners expect management to make efficient use of the assets that are entrusted to them.

The liabilities and shareholders’ equity side gives the sources of those assets. The ratio of liability to shareholders’ equity is called leverage and shareholders expect management to balance liabilities against new shareholders’ equity.

2-29 Chapter Summary

The balance sheet and the basic accounting equation are introduced.

Assets, liabilities and shareholders’ equity are defined.

Recording transactions is a dual-entry format is presented. The initial recording is called journalizing and the summary of the journal into accounts is called posting.

The terms trial balance and ledger are defined. Closing of the temporary accounts to retained

earnings is presented.