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McGraw-Hill/I rwin

Chapter 2
Basic Accounting
Concepts: The
Balance Sheet
Copyright 2011. The McGraw-Hill Companies. All Rights Reserved.
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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 cant be easily valued.
E.g., presidents 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 entitys 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 entitys 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).