Accounting - Finanatial Statements

CHAPTER 2 STUDYNOTES

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CHAPTER 2 FINANCIAL STATEMENTS: AN OVERVIEW

ACCOUNTING EQUATION A = L + OE

ASSETS (what company ownsÐ'--e.g. cash, buildings, equipment, inventory, patents)

=

LIABILITIES (what company owes to othersÐ'--e.g. loans from bank, bonds issued,

amounts owned to suppliers)

+

OWNERS' EQUITY (what's left for the owners if assets are applied to pay off

liabilities)Ð'--If a corporation, composed of two parts:

Ð'* Capital StockÐ'--amounts invested in company by owners (i.e. shareholders) to

acquire their ownership interest

Ð'* Retained EarningsÐ'--net profits (revenues minus expenses) earned by the company

over the years that have not yet been withdrawn (i.e. paid to shareholders as

dividends)

NOTE: Liabilities and Owners' Equity show the sources of funds to acquire the assetsÐ'--

amounts invested by owners (paid in capital portion of Owners' Equity), reinvestment of

profits (retained earnings portion of Owners' Equity) or amounts borrowed (Liabilities)

ACCOUNTING FOR BUSINESS TRANSACTIONS

GAAP requires use of accrual method of accounting rather than cash basis accounting.

Under accrual accounting, events are recorded when they occur rather than when the

related cash changes hands. As examples (assuming ABC Co. is your company and has a

12-month operating cycle):

Ð'* ABC Co. provides consulting services to a client. Project is completed and bill is

mailed on December 20, 2002. Check from client is received on January 28, 2003.

Ð'* Revenue is recorded in December 2002 and asset "accounts receivable" is

recordedÐ'--income is recognized when earned, not when cash is later received.

Ð'* Account Receivable is an asset accountÐ'--it represents amounts owed to you

by customers/clients for work performed for them or goods sold to them. It

represents the legal right to receive cash in the near future for work already

performedÐ'--so it is "earned"

Ð'* When cash is received in January 2003, NO income is recorded; instead account

receivable is decreased and cash is increased (i.e. transfer between two asset

accounts)

Ð'* ABC Co. hires XYZ law firm to perform legal services related to business

transactions on its behalf. XYZ performs the services in December 2002 and gives

ABC Co. bill for these legal services in December 2002. ABC Co. pays bill on

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January 29, 2003. ABC records expenses when the underlying good or service is

provided to the company, not when the company pays for the good or service.

Ð'* Legal expense is recorded by ABC in December 2002 and a liability "accounts

payable" is recorded.

Ð'* Accounts payable is a liability account (short-term)Ð'--it represents amounts

the company owes to its suppliers for goods purchased or to its service

providers.

Ð'* When bill is paid in January 2003, expense is NOT recognized; instead, cash

(asset) and accounts payable (liability) are both decreased.

Ð'* Computer is acquired on December 26, 2002. ABC Co. receives a bill from Computer

Company which it pays on January 6, 2003. Assets are recorded when legal

possession is taken, not when the cash actually changes hands.

Ð'* Asset (computer) is recorded in December 2002 on ABC's books because ABC

takes legal title to it, along with a liability (accounts payable).

Ð'* When bill is paid in January 2003, liability and cash accounts are both decreased.

KEY FINANCIAL STATEMENTS

BALANCE SHEET

Ð'* Key statement of accounting equationÐ'--Assets = Liabilities + Owners' Equity

Ð'* Picture of company as of a particular day (e.g. last day of year, month or quarter) as

to what it owns (assets), what it owes (liabilities) and what's left for owners (owners'

equity)

Ð'* Should be presented in classified format

Ð'* Current assets are presented first & sub-totaled

Ð'* Current assets are cash & other assets that will be turned into cash or used up

within a year

Ð'* Typically accounts receivable, inventory, notes receivable (if short-term--1 year.

Ð'* Liabilities are also classified into current & non-current (often called long-term

for liabilities) based on when they are due to be paid

Ð'* Common current liabilitiesÐ'--accounts payable, wages payable, taxes payable,

notes