Accounting Is a Language. Financial Accounting: The Balance Sheet BALANCE SHEET. Accounting Information. Assets. Balance Sheet: Layout

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1 Accounting Is a Language Financial Accounting: The Balance Sheet Richard S. Barr Purpose: providing information Financial Statements Summarize accounting information Examples We need to know what the numbers in the statements mean 1 2 Accounting Information BALANCE SHEET Kept for an entity Corporation, partnership, government, proprietorship Any organization or unit for which financial statements are prepared Shows a financial picture of the entity at one point in time A snapshot 3 4 Balance Sheet: Layout Assets Heading Assets shown on left -hand side Liabilities and equity shown on righthand side of sheet Resources owned by the entity Cash, equipment, other resources are needed to operate an entity People, the most important resource, are not represented Total assets as of a particular date are shown Where do assets come from? 5 6 bal-1

2 Liabilities Equity A source of assets Amounts provided by creditors of the entity Accounts payable - credit from suppliers Bank loan payable - funds loaned by bank Creditors have first claim on assets Since assets are used to pay off claims Claims are against all assets, not specific ones A second source of assets Two types of equity funds Paid-in capital Funds provided by equity investors for stock Retained Earnings Accumulated, undistributed earnings, or profits 7 8 Residual Claims of Investors Liabilities & Equity If the entity is dissolved, Creditors can sue the entity if amounts due are unpaid Equity investors have a residual claim: Receive what remains after liabilities are paid So liabilities are a stronger claim against assets Viewed as both Funds supplied by creditors and equity investors to acquire assets Claims against assets The Dual-Aspect Concept Balance Sheet Principles Accounting Principle 1 First of 9 fundamental accounting concepts Rationale Assets not claimed by creditors will be claimed by equity investors Total claims < what is available Hence total assets will always equal total claims (liabilities + equity) bal-2

3 Assets = Liabilities + Equity Applications of A=L+E The Dual-Aspect Concept Always holds in a balance sheet Any deviation is due to a record-keeping error Hence the notion of a balance sheet The residual interest of equity: Equity = Assets - Liabilities Company A has $3,000 in liabilities and $16,000 in equity. Total assets = Company B has $20,000 in assets and $8,000 in liabilities Equity = Balance Sheet Terminology Balance Sheet As a Snapshot Ordinary term Things of value One who lends money to entity Creditors' claim Investors' claims Accounting Term Since assets change daily So do liabilities and equity Balance sheet reports their levels at a point in time Date must be shown Money-Measurement Concept Money Measurement Concept Accounting Principle 2 All amounts in accounting reports are in monetary units All reported facts must be converted to dollars and cents Can use amounts arithmetically 17 Means that accounting: Is an incomplete record of the status of a business May omit important facts A strike is imminent The health of the president A profitable contract is about to be signed The number of cars in inventory is bal-3

4 3. The Entity Concept The Entity Concept: Example Accounting Principle 3 Accounts are kept for entities Not the persons associated with them Sue Smith owns the Green Co. Sue Smith withdraws $100 from the company Is Green Company better off or worse off than before? Is Sue Smith better off or worse off than before? The Going-Concern Concept The Going-Concern Concept Accounting Principle 4 Accounting must assume either Entities are about to cease operations, or They normally will keep on going Accounting assumes the entity: The more realistic assumption Special rules apply in the other case Hence assets market value (if sold) is not shown in the balance sheet The Cost Concept Cost Concept vs. Market Value Accounting Principle 5 When an entity buys an asset, accounting records the amount of the asset as its cost Market value The amount for which an asset can be sold in the marketplace The market value of some assets change over time Some assets deteriorate Inflation can affect asset value Accounting focuses on assets cost bal-4

5 The Cost Concept: Rationale 1 The Cost Concept: Rationale 2 Market value is difficult to estimate Re-valuations for each balance sheet would be difficult Market values are subjective, costs objective Knowing market value is unnecessary The entity will not sell many assets immediately Will keep for use in operations Balance Sheet Does Not Show What the individual assets are worth What the entity is worth What is accounting s answer to this criticism? Balance Sheet Items Balance Sheet Items Assets Current and Noncurrent Liabilities Current and Noncurrent Equity Most items are summaries of more detailed accounts Assets = Things of value bal-5

6 3 Requirements of an Asset 1. Controlled by the Entity 1. Controlled by the entity 2. Valuable to the entity 3. Measurable costs Requirement 1: The item must be controlled (owned) by the entity Rental space? Employees? Contracts for valuable people? Certain special capital leases qualify, and are discussed later Valuable to the Entity 3. Measurable Cost Requirement 2: Valuable to the entity Assets include: Collectable amounts owed by customers Regular stock in inventory Equipment in working condition Do not include: Un-sellable inventory Non-working, irreparable equipment Requirement 3: The item must have been acquired at a measurable cost Purchased trademarks versus selfdeveloped reputation Philip Morris purchased 7-Up name Coca-Cola developed the value of the name Coke over many years Current Assets: Definition Current Assets: Examples Cash and assets expected to become cash or used up soon, usually within one year Reported separately on balance sheet Cash Money on-hand or in bank account that can be withdrawn at any time Theoretically cash is reduced when entity's check is cashed bal-6

7 Current Assets: Examples Current Assets: Examples Securities Stocks and bonds US Treasury bonds are promises to pay amounts to owners Marketable securities Expected to become cash within one year Accounts receivable An amount owed to the business due to normal extension of credit Example: customer's monthly bill from electric company Notes receivable Based on a customer's promissory note to pay what is owed Current Assets: Examples Current Assets: Examples Inventory Goods being held for sale, Supplies, raw materials, work-in-process that will eventually be sold Car on dealer's lot? Car purchased for company use? Prepaid items Prepaid fire insurance Listed as Current Asset even if over a year Non-current Assets Tangible Assets Assets expected to be useful for more than a year Tangible and Intangible Assets 1. Assets with physical substance 2. Property, plant, and equipment Usual name for tangible, noncurrent assets To be used by the entity for over a year bal-7

8 Tangible Assets Intangible Assets 3. Accumulated Depreciation That portion of the tangible assets that have been used up Subtracted from cost to yield a net Other noncurrent assets, without physical substance Investments Securities to be held over one year Otherwise, they would be listed as Intangible Assets: Types Intangible Assets Patents and trademarks The rights to use patents and valuable names Because they are assets we know that they... Goodwill Can be created when one company buys another company The amount paid for the company in excess of the value of its assets Liabilities Current Liabilities: Examples What is a liability? Amount owed a creditor Source of assets Claim on assets What is a current liability? Claims due soon, usually within a year Accounts payable Amounts owed by the entity to its suppliers The opposite of Accounts Receivable Example: 60-day credit Bank loan payable Similar to Notes Receivable Debt is evidenced by promissory note bal-8

9 Current Liabilities: Examples Current Ratio Accrued Liabilities Amounts owed to employees and others for unpaid services rendered Estimated tax liability Amount owed to the government in taxes, within a year Long-term debt (current portion) That portion of long -term debt due within a year of the balance statement Current assets and current liabilities indicate The entity's ability to meet its current obligations One measure: the current ratio Current assets Current liabilities Should be at least 2: Noncurrent Liabilities Long-term debt (noncurrent portion) Long-term, borrowed funds to be repaid after one year Note: single liabilities may be divided into current & noncurrent, but not single assets EQUITY Deferred income taxes Equity Defined Paid-in Capital Capital obtained from sources other than accounts payable, debt, and other liabilities Paid-in capital Retained earnings Supplied by equity investors The owners of the entity If a corporation, the shareholders Amount paid to entity for shares of stock By the original stockholders! bal-9

10 Paid-in Capital Retained Earnings Does not reflect the current value of the shares of ownership Hence transactions between individuals do not directly affect the entity Equity earned by profitable operation of the entity Cumulative profits since the entity began Not cash. Why? In Summary KEY POINTS The equity section of balance sheet reports on capital from Equity investors (paid -in capital) Undistributed profits (retained earnings) Equity section is also labeled Shareholders Equity Owners Equity Assets Sources of assets Claims on assets Dual-aspect concept Money measurement concept Entity concept KEY POINTS Going-concern concept Cost concept Current assets and liabilities Current ratio Marketable security vs. investment Equity 59 bal-10