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Chapter 2

Basic Accounting
Concepts: The
Balance Sheet

McGraw-Hill/Irwin Copyright © 2011. The McGraw-Hill Companies. All Rights Reserved.


Basic Concepts

• Statements of Financial Accounting Concepts.


– Adopted by FASB.
– Conceptual criteria to help resolve future
accounting issues.
– Not GAAP.
• 11 concepts in text.
– 1-5 covered in this chapter.
– 6-11 in next chapter.

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11 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.
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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.

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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.
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Concept #3: Going Concern

• Assumed to continue in operation for an


indefinite period.
• Opposite assumption:
– Liquidation/bankruptcy.
• Only liquidation values would be meaningful.

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Concept #4: 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..
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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.
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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)?

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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.
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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).

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Dual Aspect

• Fundamental accounting equation:


Assets = Liabilities + Owners’ equity

• For a corporation:
Assets = Liabilities + Stockholders’ equity

Assets = Liabilities + Paid-in cap. + Ret. earnings

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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.
– Double-entry accounting system.

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Balance Sheet

• Statement of Financial Position.


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

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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).
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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.

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Account Categories
• Groups of related items.
• Main categories.
– Assets.
– Liabilities.
– Owners’ (shareholders’) equity.
– Revenues.
– Expenses.
• Discretion of management.
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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.
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Reporting of Assets on
Balance Sheet
• Grouped into categories.
• Decreasing order of liquidity (i.e., in US).
• Current assets (almost) always shown
separately.

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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.

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

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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).
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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).

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

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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.
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Other Assets

• Investments (not expected to be sold


within a year).
• Intangible assets.
– Goodwill, patents, trademarks, copyrights.
– Longer life than prepaid expenses.

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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.
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Current Liabilities

• Satisfied or extinguished within one year


– or normal operating cycle, if longer.

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

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

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

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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.

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Current Liabilities:
Current Portion of Long-Term Debt

• Portion due within upcoming year.


• Gives complete picture of entity’s short-
term obligations.

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Long-Term Liabilities

• Also called:
– Long-term debt.
– Non-current liabilities.
• Due beyond upcoming year.

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

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

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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.

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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).
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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.
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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).

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