BUAD 203- Chapter 2 Notes
BUAD 203- Chapter 2 Notes BUAD 203
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This 10 page Class Notes was uploaded by Danielle Palmucci on Sunday February 7, 2016. The Class Notes belongs to BUAD 203 at College of William and Mary taught by Michael Stump in Spring 2016. Since its upload, it has received 52 views. For similar materials see Principles of Accounting in Accounting at College of William and Mary.
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Date Created: 02/07/16
Chapter 2- Investing and financing decisions and the Accounting System To understand amounts appearing on a company’s balance sheet we need to answer these questions: o What business activities cause changes in the balance sheet? o How do specific activates affect each balance? o How do companies keep track of balance sheet amounts? Qualitative Characteristics of Useful Information For accounting information to be useful, it must be relevant and be a faithful representation o Relevant information is capable of influencing decisions by allowing users to assess past activities and/or predict future activities o Faithful representation requires that the information be complete, neutral, and free from error o Comparability, verifiability, timeliness, and understandability are qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented Recognition and Measurement Concepts We should consider three assumptions and a measurement concept that underlie much of our application of these definitions o First we make the separate-entity assumption, which states that each business’s activities must be accounted for separately from the activities of its owners, all other persons, and other entities For example, when an owner purchases property for personal use, the property is not an asset of the business o Second, under the continuity assumption (sometimes called the going-concern assumption), unless there is evidence to the contrary, we assume that the business will continue operating into the foreseeable future, long enough to meet its contractual commitments and plans For example, if there was a high likelihood of bankruptcy, then its assets should be valued and reported on the balance sheet as if the company were to be liquidated (that is, discontinued, with all of its assets sold and all debts paid) o Under the stable monetary unit assumption, each business entity accounts for and reports its financial results primarily in terms of the national monetary unit (e.g., dollars in the United States, yen in Japan, and euros in Germany), without any adjustment for changes in purchasing power (e.g., inflation) Elements of the balance sheet (A = L + SE) Assets = economic resources with probable future benefits owned or controlled by an entity as a result of past transactions. In other words, they are the acquired resources the entity can use to operate in the future. To be reported, assets must have a measurable, verifiable value, usually based on the purchase price Liabilities = 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. Entities that a company owes money to are called creditors Stockholders’ equity (also called owners’ equity or shareholders’ equity) = is the financing provided by the owners and by business operations. Owner-provided cash (and sometimes other assets) is referred to as contributed capital. Owners invest in the business and receive shares of stock as evidence of ownership Balance sheet = “snap shot” at any given point in time of the company’s assets, liabilities, and stockholders’ equity o May be prepared monthly, quarterly, or annually List assets in order of liquidity, or how soon an asset is expected by management to be turned into cash or used. Current assets are those resources that Chipotles will use or turn into cash within one year (the next twelve months). Note that inventory is always considered a current asset, regardless of how long it takes to produce and sell the inventory o Chipotles current assets include Cash, Short-term Investments, Accounts Receivable, Supplies, Prepaid Expenses—typical titles utilized by most entities Long term assets (or noncurrent assets) include all other assets that are to be used or turned into cash beyond the coming year o Chipotle’s noncurrent assets include Long-Term Investments, Property and Equipment (net of amounts used in the past) Liabilities are usually listed on the balance sheet in order of maturity (how soon an obligation is to be paid) Current liabilities are obligations that will be settled by providing cash, goods, or services within the coming year o Chipotle’s balance sheet includes current liabilities; Accounts Payable, Accrued Expenses Payable, and Unearned Revenue o Noncurrent liabilities, including Notes Payable Contributed capital is owner-provided cash (and sometimes other assets) which is usually composed of Common Stock and Additional Paid-in Capital o Owners who invest (or buy stock) in a company hope to benefit from their investment in two ways Receipts of dividends, which are a distribution of a company’s earnings (a return on the shareholders’ investment) Gains from selling the stock for more than they paid (known as capital gains) Retained earnings are earnings that are not distributed to the owners but instead are reinvested in the business by management What business activities cause changes in the financial Statement amounts? Transactions are events that are recorded as part of the accounting process o Accounting focuses on certain events that have an economic impact on the entity o Transactions with external parties involve exchanges where the business entity gives up something and receives something in return As the definitions of assets and liabilities indicate, only economic resources and debts resulting from past transactions are recorded on the balance sheet Transactions include two types of events: o External events: exchanges of assets, goods, or services by one party for assets, services, or promises to pay (liabilities) by one or more other parties Examples include the purchase of a machine from a supplier, sale of merchandise to customers, borrowing cash from a bank, and investment of cash in the business by the owners o Internal events: certain events that are not exchanges between the business and other parties but nevertheless have a direct and measurable effect on the entity Examples include using up insurance paid in advance and using buildings and equipment over several years Accounts- an organized format used by companies to accumulate the dollar effects of transactions Common Account Titles: To facilitate the recording of transactions, each company establishes a chart of accounts, a list of all account titles and their unique numbers Accounts are usually organized by financial statement element, with (1) asset accounts, (2) liability, (3) stockholders’ equity, (4) revenue, and (5) expense accounts in that order Principles of Transaction Analysis 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 the fundamental accounting model) Every transaction affects at least two accounts (duality of effects) The accounting equation must remain in balance after each transaction Balancing the Accounting Equation Step 1: Ask--What was received and what was given? 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--Is the accounting equation in balance? o Verify that the accounting equation (A = L + SE) The Accounting Cycle 1. Start of new period 2. During the Period (Chapters 2 and 3) a. Analyze transactions b. Record journal entries in the general journal c. Post amounts to the general ledger 3. At the End of the Period (Chapter 4) a. Prepare a trial balance to determine if debits equal credits b. Adjust revenues and expenses and related balance sheet accounts (record in journal and post to ledger) c. Prepare a complete set of financial statements and disseminate it to users d. Close revenues, gains, expenses, and losses to Retained Earnings (record in journal and post to ledger) How Do Companies Keep Track of Account Balances? Transactions that result in exchanges between the company and other external parties are analyzed and recorded in the general journal in chronological order Related accounts are updated in the general ledger These formal records are based on two very important tools used by accountants: journal entries and T-accounts. From the standpoint of accounting systems design, these analytical tools are a more efficient way to reflect the effects of transactions, determine account balances, and prepare financial statements. As future business managers, you should develop your understanding and use of these tools in financial analysis. Transaction Analysis Model: T-account- a tool to represent a ledger account; a shorthand term for the entire ledger account o Left side= debit o Right side= credit Transaction effects increase and decrease assets, liabilities, and stockholders’ equity To reflect the direction of these effects, the critical structural factor is the following: o The increase symbol + is located on the left side of the T for accounts on the left side of the accounting equation (assets) and on the right side of the T for accounts on the right side of the equation (liabilities and stockholders’ equity) From this transaction analysis model, we can observe the following: 1. Asset accounts increase on the left (debit) side; they have debit balances. It would be highly unusual for an asset account, such as Inventory, to have a negative (credit) balance 2. Liability and stockholders’ equity accounts increase on the right (credit) side, creating credit balances Posting Transaction Effects 1. We issue 10,000 of additional common stock to new investors for cash 2. We first record this transaction in the general journal 3. We debit, or increase, the cash account for $62,300 and credit, additional paid-capital for $100 (10,000 shares times $0.01 par value per share) 4. Finally, we credit Additional-paid in capital for $62,200 Next we must make sure the accounting equation is in balance. Look at step (2) to see that we are in balance Moving the accounting information from the journal to the ledger is called posting Posting involves the moving of the accounting information from the general journal to the general ledger. Remember that the general ledger shows the balance for each account in the chart of accounts. In the manual accounting system used by some small organizations, the ledger is often a three-ring binder with a separate page for each account. In a computerized system, accounts are stored on a disk. The posting process was tedious when done by hand, but is very quickly completed when done with the aid of a computer. After journal entries are prepared, the accountant posts (transfers) the dollar amounts to each account affected by the transaction. Trial Balance A listing of all accounts in the general ledger The purpose of the trial balance is to make sure the debits and credits are equal before we prepare the balance sheet Classified Balance Sheet In a classified balance sheet, assets and liabilities are classified into two categories – current and noncurrent o Current assets are those to be used or turned into cash within the upcoming year o Noncurrent assets are those that will last longer than one year o Current liabilities are those obligations to be paid or settled within the next 12 months with current assets Key Ratio Analysis Current Ratio= Current Assets / Current Liabilities How ratios change over time and how they compare to the ratios of the company’s competitors or industry averages provide valuable information about a company’s strategies for its operating, investing, and financing activities Creditors and security analysts use the current ratio to measure the ability of the company to pay its short-term obligations with short-term assets o Generally, the higher the ratio, the more cushion a company has to pay its current obligations if future economic conditions take a downturn o However, a company with a high current ratio might still have liquidity problems if the majority of its current assets consist of slow-moving inventory Cash Flows Statement that categorizes all transactions that affect cash into three categories: operating, investing, and financing activities. 1. Operating activities are covered in Chapter 3 2. Investing activities include buying and selling noncurrent assets and investments 3. Financing activities include borrowing and repaying debt including short-term bank loans, issuing and repurchasing stock, and paying dividends. When cash is involved, these activities are reported on the Statement of Cash Flows. (When cash is not included in the transaction, such as when a building is acquired with a long-term mortgage note payable, there is no cash effect to include on the statement of cash flows. You must see cash in the transaction for it to affect the Statement of Cash Flows.) In general, the effects (new cash inflows and outflows) of such activities are as shown on this slide.
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