2Reporting Investing. and Financing Results on the Balance Sheet YOUR LEARNING OBJECTIVES. Understand the business. Study the accounting methods

Transcription

1 2Reporting Investing and Financing Results on the Balance Sheet YOUR LEARNING OBJECTIVES Understand the business LO1 Explain and select common balance sheet account titles. THAT WAS THEN In the previous chapter, you were introduced to the four main financial statements: the balance sheet, income statement, statement of retained earnings, and statement of cash flows. Study the accounting methods LO2 Apply transaction analysis to business transactions. LO3 Use journal entries and T-accounts to show how business transactions affect the balance sheet. LO4 Prepare a classified balance sheet. Evaluate the results LO5 Explain the concepts that determine whether an item is reported on the balance sheet and at what amount. Review the chapter LP2

2 Do you spend hours looking for messages that you received just a couple of weeks ago? Do your file names contain meaningless labels like final paper? If so, you probably could use an organizing system that neatly sorts every and file into categories. With such a system, you might be able to quickly find that joke about the magician and the parrot, or the marketing assignment due tomorrow. Businesses also need systems for organizing information. Just think what could happen if FedEx didn t have a system to track the 5 million packages and $88 million in sales revenues that the company handles every day, or to evaluate its use of $10.8 billion to buy airplanes and other equipment. Clearly, big companies need well-organized systems for tracking their business activities and financial results. The same is true for small businesses, like your local Supercuts store. In this chapter, we ll focus on the decisions that business managers make when starting up a single Supercuts salon and how their accounting systems track the financial results of the salon s investing and financing activities. In later chapters, you ll see how things are basically the same, only bigger, at Regis Corporation a public company that is involved with over 2,000 Supercuts stores and 9,000 other hair salons. With that many stores, Regis is the main player in the U.S. hair business, which generates $53 billion of revenue and 365,000 tons of hair clippings every year. THIS IS NOW This chapter focuses on just the balance sheet and the accounting system used to produce it.

3 44 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet You may remember our earlier promise that, in Chapters 2 through 4, you d have time to learn the details about specific financial statement accounts. That time has come. We begin this chapter with a look at how business activities map into the balance sheet and its asset, liability, and stockholders equity accounts. After you become reacquainted with these topics, you ll learn about the accounting cycle that is used to produce accounting reports. We conclude the chapter by looking carefully at what the balance sheet tells you and what it doesn t, and giving lots of review and practice material. The main tasks and chapter topics are summarized below. Notice that the focus of this chapter is on the balance sheet. Income statement reporting is discussed in Chapters 3 and 4. ORGANIZATION OF THE CHAPTER Understand the business Study the accounting methods Evaluate the results Review the chapter Business activities and balance sheet accounts The accounting cycle The debit/credit frame work Preparing a balance sheet Balance sheet concepts and values Demonstration case Chapter summary Key terms Practice material Understand the Business Learning Objective 1 Explain and select common balance sheet account titles. BUSINESS ACTIVITIES AND BALANCE SHEET ACCOUNTS Let s begin by going over what s needed to get a business, like a Supercuts hair salon, up and running. First, you will need some financing, which is money the business obtains through loans or owners contributions. Most small businesses start with personal funds contributed to the business by the owner and close friends. After lining that up, you will need to decide on a location. Because the idea behind Supercuts is to make hair care convenient for customers, you ll try to fi nd space for your salon in a neighborhood shopping mall, anchored by either a major grocery chain or mass merchandiser. This will ensure your salon attracts what are known as destination shoppers. These are customers who want to go to the grocery store, video store, and hair salon without driving all over the place. Your mall location makes this possible. Now that you ve selected a location, you ll need to start investing in some assets that your business will use for many years to come. First, you ll need to install equipment like salon chairs and shampoo stations in your salon space, consistent with the standard Supercuts design. Typically, this takes four to six weeks to complete and costs about $42,000. You ll also need to spend $18,000 on additional equipment for the salon. This might seem like a lot of money, but the next time you get your hair cut, just take a look around at all the different things in a hair salon. You ll need a reception desk, lighting fixtures, styling chairs, shampoo stations, computers, mirrors, scissors, trimmers, razors, and dryers. But wait! You have been able to scrounge up only $50,000, all of which you will contribute to starting up a company. To fi nance the cost of all the assets needed for the

4 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet 45 EXHIBIT 2.1 Balance Sheet SUPERCUTS Balance Sheet At August 31, 2008 Who: Company name What: Financial statement name When: Date of report Assets Cash $10,000 Supplies 630 Equipment 60,000 Total assets $70,630 Liabilities and Stockholders Equity Liabilities Accounts payable $ 630 Note payable 20,000 Stockholders equity Contributed capital 50,000 Retained earnings 0 Total liabilities and stockholders equity $70,630 Cash in company s bank account Shampoo and other supplies for use Cost of equipment purchased for use $10, ,000 Owed to supplier on account Owed to bank for loan (formal note) Contributed by stockholders No operations yet, so no earnings $630 20,000 50,000 0 business, your company will need to get a loan from a bank. A $20,000 loan would give the company enough cash to pay for equipment and still leave some money to pay for operating supplies like shampoo and fuzzy pink rollers. From this description and what you remember from Chapter 1, try to imagine what the balance sheet of your Supercuts store will look like. Really, cover up Exhibit 2.1 and take 10 seconds to picture what should be on the balance sheet of your business. When you re done, compare it to the balance sheet in Exhibit 2.1. So, how did you do? The most important thing at this stage is that you knew to think about assets, liabilities, and stockholders equity accounts. One thing to know about balance sheets is that assets are listed in order of how fast they will be used up or can be turned into cash. Another thing to notice is that all assets have three features: (1) it is probable that they will generate future economic benefi ts for the company, (2) the company can obtain these benefi ts and control others access to them, and (3) these benefi ts arise from having acquired the assets in the past. These features obviously exist for the cash in Exhibit 2.1, but they also apply to the other assets shown because (1) both supplies and equipment will allow Supercuts to provide hair care services and charge customers for them, (2) these assets will be used by Supercuts and no one else, and (3) these assets arise from Supercuts having purchased them in the past. There are three things for you to notice in the bottom half of the balance sheet in Exhibit 2.1. First, liabilities are listed in order of how soon they will be paid, satisfi ed, or fulfi lled. Second, all liabilities share the common features that they are unavoidable obligations, requiring a future sacrifi ce of resources, arising from a past transaction or event. Third, the stockholders equity section contains two accounts. Contributed capital shows the amount of fi nancing contributed to the company by stockholders, and Retained earnings indicates the total earnings of the business that have been retained in the company as of the balance sheet date. In our Supercuts example, this account has a zero balance because the business isn t open to customers yet, so there are no earnings to report as having been retained. Don t be surprised if you thought of account names that differ from what we used in Exhibit 2.1. It s okay to use different account names as long as they have the same meaning as ours and are properly classified as assets, liabilities, or stockholders equity. In the real world of fi nancial reporting, even commonly used accounts are given different labels by YOU SHOULD KNOW Assets are resources owned by a business that generate future economic benefits. Liabilities are amounts owed by a business. Stockholders equity is the amount invested and reinvested in a company by its stockholders.

5 46 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet EXHIBIT 2.2 Sample Chart of Accounts (Balance Sheet Accounts Only) Account Name Assets Cash Accounts receivable Interest receivable Inventories Supplies Prepaid expenses Notes receivable Land Buildings Equipment Intangible assets Liabilities Accounts payable Wages payable Accrued liabilities Unearned revenues Notes payable Bonds payable Other liabilities Stockholders Equity Contributed capital Retained earnings Description Includes cash in the bank and in the cash register Amounts owed to your business by customers for sales on credit Interest owed to your business by others Goods on hand that are being held for resale Read this chart of accounts but don t memorize it. Also, don t try Items on hand that will be used to make goods or provide services to force this chart of accounts on Rent, insurance, and other expenses paid for future services all problems. Account names Amounts loaned to others under a formal agreement ( note ) vary from company to company. Cost of land to be used by the business Cost of buildings the business will use for operations Cost of equipment used to produce goods or provide services Trademarks, brand names, goodwill, and other assets that lack a physical presence Amounts owed to suppliers for goods or services bought on credit Amounts owed to employees for salaries, wages, and bonuses Amounts owed to others for advertising, utilities, interest, etc. Amounts (customer deposits) received in advance of providing goods or services to customers Amounts borrowed from lenders, involves signing a promissory note Amounts borrowed from lenders, involves issuance of bonds A variety of liabilities with smaller balances Amount of cash (or other property) received for stock issued Amount of accumulated earnings not distributed as dividends COACH S TIP YOU SHOULD KNOW The chart of accounts is a summary of all account names (and corresponding account numbers) used to record financial results in the accounting system. different companies. Depending on the company, you may see a liability for a bank loan called a note payable, loan payable, or simply long-term debt. The names you see in the financial statements of most large businesses are actually aggregations (or combinations) of several specific accounts. For example, Regis Corporation the company that owns most of the Supercuts stores keeps separate accounts for land, buildings, and equipment, but combines them into one title on the balance sheet called Property and equipment. When choosing account names, companies will attempt to use names that already exist, if appropriate, or come up with one that describes the underlying business activity. Once an account name is selected, it is given a reference number, and this exact name and number are used for all business activities affecting that account. Although companies tend to use similar account names, designated account numbers vary greatly depending on each company s particular accounting system. To ensure consistency in reporting financial results, each company keeps a summary of account names and account numbers called the chart of accounts. A simple example from one company (with account numbers removed) is given in Exhibit 2.2. The accounts in blue are used in this chapter and other accounts are used in later chapters. Now that you reviewed some key parts of the balance sheet, it s time to learn about the systematic accounting process that produces it. Study the Accounting Methods Learning Objective 2 Apply transaction analysis to business transactions. THE ACCOUNTING CYCLE To be sure that fi nancial statements, such as the balance sheet, report all of the fi nancial results of a company s business activities, a systematic process of accounting is used. This process, called the accounting cycle, includes three main steps: 1. Analyze 2. Record 3. Summarize

6 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet 47 Before we look at each of these steps, we should warn you that learning how the accounting cycle works is a key part of this chapter and is crucial to understanding the rest of this course. So, take your time as you read the following sections. Step 1: Analyze Accounting Transactions The goal of this fi rst step is to determine the fi nancial effects of your company s business activities on assets, liabilities, or stockholders equity. If a business activity affects any of these types of accounts and if its effects can be measured in dollars and cents, it is called a transaction. Transactions are of special importance because they are the only activities to be recorded (in step 2) and summarized (in step 3). Business activities that do not have direct or measurable fi nancial effects on the company are not recorded in the accounting system. For example, if someone at Supercuts answers the phone or faxes a document to the bank, there is no immediate fi nancial impact so these activities will not be recorded. Activities like cutting hair and buying hair dryers have a direct fi nancial impact, so they are considered transactions and will be recorded. How do you know if a business activity is considered an accounting transaction? Look for two types of events, both of which are considered accounting transactions: 1. External exchanges: These are exchanges involving assets, liabilities, and/or stockholders equity that you can see between the company and someone else. When Starbucks sells you a Frappucino, it is exchanging an icy taste of heaven for your cash, so Starbucks would record this in its accounting system. 2. Internal events: These events do not involve exchanges with others outside the business, but rather occur within the company itself. For example, when the company Red Bull combines sugar, water, taurine, and caffeine, something magical happens: these ingredients turn into Red Bull Energy Drink. This internal event is a transaction because it has a direct fi nancial effect whereby some assets (supplies of sugar, etc.) are used up to create a different asset (an inventory of Red Bull drinks). One word of warning: not all external exchanges and internal events are considered transactions. If an exchange or event does not have a direct fi nancial impact on the basic accounting equation (A L SE) when it occurs, it is not considered a transaction. So, for example, when Supercuts orders supplies to be received in the future, no exchange of assets or services has occurred yet. There has been only the supplier s promise to deliver and Supercuts promise to pay after the supplies are delivered an exchange of promises does not qualify as an accounting transaction. Similarly, when Supercuts moves bottles of shampoo from the back of the store to the display case at the front, this internal event has not yet created a fi nancial impact, so it is not considered an accounting transaction. Video2.1 YOU SHOULD KNOW A transaction has a direct and measurable financial effect on the assets, liabilities, or stockholders equity of a business. Transaction Analysis Once a transaction is identified, you have to analyze it carefully to determine its financial effects. Two simple ideas are used when analyzing transactions: 1. Duality of effects. It s a fancy name, but the idea is simple. Every transaction has at least two effects on the basic accounting equation. To remember this, just think of expressions like give and receive or push and pull or, if you re a closet scientist, Newton s Third Law of Motion. 2. A L SE. You know this already, right? Well, just remember that the dollar amount for assets must always equal the total of liabilities plus stockholders equity for every accounting transaction. If it doesn t, then you are missing something and you should go back to the fi rst (duality of effects) idea. Let s do a few examples to show how these ideas are used when analyzing transactions. Suppose Supercuts paid cash to buy a salon chair from a salon supply company called

7 48 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet Etopa. This is a transaction because an exchange exists between Supercuts and Etopa. To apply the duality of effects idea, look for what Supercuts gives and receives in this transaction: Transaction: Pay cash for salon chair. Give: Cash Receive: Equipment The next thing to do is check the effects of this give and receive on the accounting equation. In the box below, notice that this transaction involves a decrease in one asset (cash), which is offset by an increase in another asset (equipment). There are no changes in liabilities or stockholders equity, so the accounting equation remains in balance, as it should. Accounting Equation Cash Equipment No change No change In the example just given, Supercuts paid cash to Etopa immediately upon receiving the chair. Typically, when a company buys goods or services from another company, it will do so on credit with the promise to pay for it later. For the next example, let s assume that Supercuts receives another salon chair from Etopa but promises to pay for this purchase at the end of the month. In this example, Supercuts has entered into two transactions: (1) the purchase of an asset on credit and (2) the eventual payment. The fi rst part of this is considered a transaction because, although Supercuts has given a promise, the exchange involves more than just a promise. Supercuts actually receives equipment (an increase in an asset). The promise to pay that Supercuts has given is called accounts payable (an increase in a liability). COACH S TIP Accounts payable is a promise to pay for items received from a supplier. Transaction 1: Buy salon chair on credit. Give: Accounts payable Receive: Equipment Notice that A L SE for this transaction, as shown below. Accounting Equation (1) Equipment Accounts payable No change

8 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet 49 Let s move on to apply the duality of effects idea to part (2), where Supercuts pays for the purchase in (1). At this point, Supercuts gives up cash (a decrease in an asset) to fulfi ll its promise to pay Etopa and, as a result, eliminates or receives back its promise (a decrease in the liability called accounts payable). Again, two effects exist: Transaction 2: Pay cash for amount owed. Give: Cash Receive: Elimination of Accounts payable Now, let s make sure that the basic accounting equation is still in balance after we enter these effects: Accounting Equation (2) Cash Accounts payable No change Notice that the accounting equation remained in balance after each of the two transactions. In the fi rst, the increase in an asset was accompanied by a corresponding increase in a liability and, in the second, the decrease in an asset was accompanied by a corresponding decrease in a liability. Although you haven t seen it yet in this chapter, you also will run into transactions where a stockholders equity account changes and is accompanied by a corresponding change in either an asset or liability account. We ve almost covered everything you need to know about analyzing transactions. The only piece that s missing is the amount of the fi nancial effects. Because transactions are based on the idea of an exchange, their fi nancial effects are based on the company s cost of that exchange. This cost principle, as it is called, is one of the main principles of accounting: record transactions at the dollar value of the assets or liabilities involved in the exchange. If Supercuts pays $600 for a salon chair that sells elsewhere for $650, the chair is recorded at what it actually cost Supercuts ($600). Decide: An Approach to Analyzing Transactions You ve now seen the thought process used in the Analyze step of the accounting cycle. At fi rst, you may need some help in remembering this process, so we have created a little memory device to help you DECIDE on the accounting effects of business activities. Train yourself to follow this systematic approach and soon you ll be able to complete the entire analysis step with ease and accuracy: D etect transactions. Go to the next step only if a transaction exists. E xamine the accounts affected. Put account names on what is given and received. C lassify each account as asset (A), liability (L), or stockholders equity (SE). ID entify the fi nancial effects. Do asset, liability, and stockholders equity accounts increase or decrease, and by how much? E nd with the effects on the basic accounting equation. Ensure A L SE. The best way to learn how to account for business activities is to work through examples, so let s use this DECIDE approach to analyze some typical transactions that occur when a business is started. Assume the following events took place in August. YOU SHOULD KNOW The cost principle states that, at the time of a transaction, assets and liabilities should be recorded at their original cost to the company. LP2

9 50 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet (a) Financing from Stockholders You incorporate your Supercuts salon on August 1. The company issues stock certifi cates to you and your parents as co-owners in exchange for $50,000, which is deposited in the company s bank account. COACH S TIP Analyze transactions from the standpoint of the business, not its owners. Detect transactions. Examine accounts. Classify accounts. IDentify $ effects. End with A L SE. Supercuts receives cash and gives ownership interests (stock certifi cates). Cash is cash. Contributions by owners to a company are called Contributed Capital. Cash is an asset (A) and Contributed Capital is a stockholders equity (SE) account. Cash (A) $50,000 and Contributed Capital (SE) $50,000. (a) Cash 50,000 Contributed Capital 50,000 Notice that in the table above, we included a transaction reference (a) so that we can refer back to the original transaction description if needed. You too should use transaction letters (or numbers or dates) as references in your homework problems. (b) Investing in Equipment Your salon pays $42,000 cash for equipment. COACH S TIP Although we use the same format for all of our examples, the content in each differs. Don t skip this section with the plan of coming back to it later, because the next part of this chapter builds on this part. Most students say that, of all the topics in this course, transaction analysis is the one they wished they had spent more time on when first learning it. Detect transactions. Examine accounts. Classify accounts. IDentify $ effects. End with A L SE. Supercuts receives equipment and gives cash. Equipment typically is called just that: equipment. Cash is cash. Equipment is an asset (A) and Cash is an asset (A). Equipment (A) $42,000 and Cash (A) $42,000. (b) Cash 42,000 Equipment 42,000 No Change Notice that even though transaction (b) did not affect liabilities or stockholders equity, the accounting equation remained in balance because the decrease in one asset (Cash) was offset by the increase in another asset (Equipment).

10 (c) Financing from Lender CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet 51 Your company borrows $20,000 from a bank, depositing those funds in its bank account and signing a formal agreement to repay the loan in two years. Detect transactions. Examine accounts. Classify accounts. IDentify $ effects. End with A L SE. Supercuts receives cash and gives a formal promise to pay (called a note ). Cash is cash, and the formal promise to pay is called a note payable. Cash is an asset (A), and the Note Payable is a liability (L). Cash (A) $20,000, and Note Payable (L) 20,000. COACH S TIP Notes payable are like accounts payable except that they (a) charge interest, (b) can be outstanding for periods longer than one year, and (c) are documented using formal documents called notes. (c) Cash 20,000 Note Payable 20,000 (d) Investing in Equipment Your salon installs $18,000 of additional equipment, paying $16,000 in cash and giving an informal promise to pay $2,000 at the end of the month. Detect transactions. Examine accounts. Classify accounts. IDentify $ effects. Supercuts receives equipment and gives both cash and a promise to pay. Equipment is equipment, cash is cash, and the promise to pay is accounts payable. Equipment and Cash are assets (A), and Accounts Payable is a liability (L). Equipment (A) $18,000, Cash (A) $16,000, and Accounts Payable (L) 2,000. End with A L SE. (d) Cash 16,000 Equipment 18,000 Accounts Payable 2,000 If you ever run into a transaction that you have no idea how to analyze, just break it down. Rather than trying to solve it all at once, begin by looking just for what is received. This step is crucial, and you may find that the reason you were having trouble is that there was more than one item received. After you fi nd what is received, look just for what is given. Again, you may fi nd that, as in transaction (d), more than one item is involved. Also, take the time to E nd with ensuring the accounting equation is in balance, because this may give you a clue about whether you ve detected all the accounts affected.

11 52 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet (e) Ordering Supplies Your salon orders $800 of shampoo and other operating supplies. None have been received yet. Detect transactions. This is not a transaction. Supercuts has received nothing and given only a promise. (f) Paying a Supplier Your company pays $2,000 to the equipment supplier in (d). Detect transactions. Examine accounts. Classify accounts. IDentify $ effects. Supercuts fulfi lls its informal promise to pay by giving cash. The informal promise to pay is called accounts payable and cash is cash. Accounts Payable is a liability (L) and Cash is an asset (A). Accounts Payable (L) 2,000 and Cash (A) 2,000. End with A L SE. (f) Cash 2,000 Accounts Payable 2,000 (g) Receiving Supplies Your company receives $630 of the supplies ordered in (e) and promises to pay for them next month. Detect transactions. Examine accounts. Classify accounts. IDentify $ effects. Supercuts receives supplies and gives a promise to pay. Supplies are called just that: supplies. The promise to pay is accounts payable. Supplies is an asset account (A), and Accounts Payable is a liability (L). Supplies (A) $630 and Accounts Payable (L) 630. End with A L SE. (g) Supplies 630 Accounts Payable 630

12 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet 53 As we said, the best way to learn accounting is to do examples, so try the following quiz. (Cover the answers in the margin with your thumb until you re done.) HOW S IT GOING? Self-Study Quiz For the following event, complete the transaction analysis steps by fi lling in the empty boxes. Then check your answers with the solutions in the margin. May 1: NIKE, Inc. purchased equipment costing $500,000, paying $200,000 cash and signing a formal promissory note to pay the balance in three years. Detect transactions. Examine accounts. Classify accounts. IDentify $ effects. End with A L SE. May 1 Cash Equipment Nike receives and a promise to pay. Note Payable and gives both Equipment is equipment, cash is cash, and the formal promise to pay is a payable. Equipment and Cash are, and Payable is a liability (L). Equipment (A) $500,000, Cash (A) $200,000, and. Cash 200,000 Equipment 500,000 Note payable 300,000 End: IDentify: Note Payable (L) 300,000 Classify: assets (A), Note Examine: note Detect: equipment, cash Quiz Answers Steps 2 and 3: Record and Summarize In the previous section, you saw the thought processes that accountants follow when analyzing a company s business activities. This fi rst step of the accounting cycle ended with an understanding of the fi nancial effects of each transaction on assets, liabilities, or stockholders equity. The next two steps of the accounting cycle will involve recording and summarizing these financial effects so that accounting reports, like the balance sheet, can be prepared and evaluated. 1. Analyze 2. Record 3. Summarize One method for recording and summarizing the fi nancial effects of accounting transactions is to prepare a spreadsheet like the one in Exhibit 2.3 on page 54. The spreadsheet takes the financial effects of each transaction that you determined in the last step of the DECIDE transaction analysis and adds or subtracts these amounts from the balance in each account at the beginning of the month. By summing each spreadsheet column, you could compute new balances at the end of the month and report them on a balance sheet. Although this method would work, you can just imagine how impractical it would be in a company like Regis Corporation, which has to account for transactions with about 8 million customers and 55,000 employees every month. Rather than create a spreadsheet as big as three football fields, a more manageable system is used to record and summarize transactions.

13 54 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet EXHIBIT 2.3 Using a Spreadsheet to Record and Summarize Transactions YOU SHOULD KNOW Journals are organized by date, and are used to record the effects of each day s transactions. A ledger is organized by account, and is used to summarize the effects of journal entries on each account. Learning Objective 3 Use journal entries and T-accounts to show how business transactions affect the balance sheet. The system of recording and summarizing used in business is a lot like what you do as a student when taking notes and preparing for exams. Day after day, you go to class, take notes, go to class, take notes, rinse, repeat. The reason you take notes is to create a record of what happened each day, kind of like an academic diary or journal. Later, when preparing for exams, you copy your notes to summary sheets to study from. The same ideas are used in the accounting cycle. The financial effects of transactions are entered into journals each day they occur. Later, these journal entries are summarized in ledger accounts that keep track of the financial effects of the transactions on each account (e.g., cash, supplies, and accounts payable). To make this process as efficient as possible, journals and ledger accounts share the same underlying framework discussed in the following section. THE DEBIT/CREDIT FRAMEWORK The framework used for journals and ledger accounts was created more than 500 years ago, yet it continues to exist in accounting systems today. Although computers now perform many routine accounting tasks involving journals and ledger accounts, most computerized systems still require you to know how these accounting records work. To understand this framework, think of the accounting equation (A L SE) as an oldfashioned weight scale that tips at the equals sign. Assets like cash and supplies are put on the left side of the scale and liabilities and stockholders equity accounts are put on the right. Likewise, each individual account has two sides, with one side used for increases and the other for decreases, similar to what is shown in Exhibit 2.4. EXHIBIT 2.4 The Debit/Credit Framework Assets Liabilities Stockholders Equity Increase using Debit Decrease using Credit Decrease using Debit Increase using Credit Decrease using Debit Increase using Credit

14 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet 55 Take special note of two important rules illustrated in Exhibit 2.4 : 1. Accounts increase on the same side as they appear in A L SE. Accounts on the left side of the accounting equation increase on the left side of the account and accounts on the right side of the equation increase on the right. So Assets increase on the left side of the account. Liabilities increase on the right side of the account. Stockholders equity accounts increase on the right. Decreases are the opposite, as shown in Exhibit Left is debit ( dr ), right is credit ( cr ). The terms (and abbreviations) debit ( dr ) and credit ( cr ) come from Latin words that had meaning back in the day, but today they just mean left and right. When combined with how increases and decreases are entered into accounts, the following rules emerge: Use debits for increases in assets (and for decreases in liabilities and stockholders equity accounts). Use credits for increases in liabilities and stockholders equity accounts (and for decreases in assets). Accountants didn t dream up this debit/credit framework just to confuse you. The purpose of this double-entry system is to introduce another check on the accuracy of accounting numbers. In addition to requiring that A L SE, the double-entry system also requires that debits credits. If either of these relationships is not equal, then you know for sure that you ve made an error that will need to be corrected. Step 1: Analyzing Transactions The debit/credit framework does not change this step. Continue to use the DECIDE approach to determine the fi nancial effects of transactions, which you will enter into the accounting system in step 2. Step 2: Recording Journal Entries The financial effects of transactions are entered into a journal using a debits-equal-credits format, as shown in Exhibit 2.5. When looking at these journal entries, as they are called, notice the following: A date is included for each transaction. Debits appear first (on top). Credits are written below the debits and are indented to the right (both the words and the amounts). The order of the debited accounts YOU SHOULD KNOW Debit refers to the left side of an account, or the act of entering an amount into the left side of an account. Credit refers to the right side of an account, or the act of entering an amount into the right side of an account. YOU SHOULD KNOW Journal entries indicate the effects of each day s transactions in a debits-equal-credits format. EXHIBIT 2.5 Formal Journal Page General Journal Page G1 Credit Date 2008 Aug. 1 Account Titles and Explanation Cash Contributed capital (Financing from stockholders.) Ref. Debit 50,000 50,000 Aug. 2 Equipment Cash (Bought equipment using cash.) 42,000 42,000 Aug. 5 Equipment Cash Accounts payable (Bought equipment using cash and credit.) 18,000 16,000 2,000

15 56 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet Topic Tackler PLUS Check out for audio, visual, and PowerPoint presentations on this topic. or credited accounts doesn t matter, as long as for each journal entry debits are on top and credits are on the bottom and indented. Total debits equal total credits for each transaction (for example, see the entry on August 5 where $18,000 $16,000 $2,000). Dollar signs are not used because the journal is understood to be a record of fi nancial effects. The reference column (Ref.) will be used later (in step 3) to indicate when the journal entry has been summarized in the ledger accounts. A brief explanation of the transaction is written below the debits and credits. The line after the explanation is left blank before writing the next journal entry. When writing journal entries in this course, we ll make a few minor changes to the formal entries, which should make it easier for you to learn the most important aspects of recording journal entries. The way we would show the journal entry for August 5 is: (d) dr Equipment ( A) ,000 cr Cash ( A) ,000 cr Accounts Payable ( L) ,000 The main differences between our simplifi ed format and a formal journal entry are: When a date is not given, use some form of reference for each transaction, such as ( d ), to identify the event. Omit the reference column and transaction explanation to simplify the entry. Indicate whether you are debiting ( dr ) or crediting ( cr ) each account. This will help to reinforce the debit/credit framework from Exhibit 2.4. Plus, it will make it easier to interpret journal entries when indents aren t clear (sometimes an issue in handwritten homework). Include the appropriate account type (A, L, or SE) along with the direction of the effect ( or ) next to each account title to clarify the effects of the transaction on each account. Again, this will reinforce the debit/credit framework and help you to determine whether the accounting equation has remained in balance. YOU SHOULD KNOW A T-account is a simplified version of a ledger account used for summarizing the effects of journal entries. Step 3: Summarizing in Ledger Accounts By themselves, journal entries show the effects of transactions, but do not indicate the balance in each account. That s why ledger accounts are needed. After journal entries have been recorded (in step 2), their dollar amounts are copied ( posted ) to each ledger account affected by the transaction so that account balances can be computed. In most computerized accounting systems, this happens automatically. In homework assignments, you ll have to do it yourself, so Exhibit 2.6 shows you how this is done using the journal entry for August 5. If account numbers are provided, keep track of the posting of journal entries to general ledger accounts by writing the account number in the Ref. column of the journal and the journal page number in the Ref. column of the ledger. As we did earlier for journal entries, we will use a simplifi ed format for ledger accounts to make it easier to focus on their main features. The simplifi ed version of a ledger account is called a T-account. Compare the T-accounts in Exhibit 2.7 to the Cash and Accounts Payable ledger accounts in Exhibit 2.6. Notice that the T-accounts contain only the debit and credit columns of the ledger account. To remind you of the effects of debits and credits, the title bar for the Cash T-account shows that increases in cash (an asset) appear on the left side and decreases appear on the right side. For Accounts Payable, increases are shown on the right and decreases on the left because it is a liability

16 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet 57 EXHIBIT 2.6 Posting from the Journal to the Ledger General Ledger Acct. 101 Date 2008 Aug. 5 Account Titles and Explanation General Journal Equipment Cash Accounts payable (Bought equipment using cash and credit.) Ref Debit 18,000 Page G1 Credit 16,000 2,000 Date 2008 Aug. 1 Aug. 2 Aug. 3 Aug. 5 Date 2008 Aug. 2 Aug. 5 Explanation Explanation Ref. G1 G1 G1 G1 Cash Debit Credit 50,000 20,000 General Ledger Ref. G1 G1 42,000 16,000 Equipment Debit Credit 42,000 18,000 Balance 50,000 8,000 28,000 12,000 Acct. 205 Balance 42,000 60,000 General Ledger Acct. 301 Accounts Payable Date Explanation Ref. Debit Credit Balance 2008 Aug. 5 G1 2,000 2,000 account. (If you ve forgotten why they work this way, take a quick look back at Exhibit 2.4 on page 54.) In Exhibit 2.7 below, notice the following: Every account starts with a beginning balance, usually on the side where increases are summarized. For balance sheet accounts, the ending balance from the prior period is the beginning balance for the current period. Because our Supercuts salon is a new business, the beginning balance in each account is zero in this example. Dollar signs are not needed. Each amount is accompanied by a reference to the related journal entry, which makes it easy to trace back to the original transaction should errors occur. EXHIBIT 2.7 T-Accounts: Simplified Format for Ledger Accounts dr Cash (A) cr Beg. 0 (a) 50,000 42,000 (b) (c) 20,000 16,000 (d) 2,000 (f) End. 10,000 dr Accounts Payable (L) cr 0 Beg. 2,000 (d) (f) 2, (g) 630 End.

17 58 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet To fi nd ending account balances, express the T-accounts as equations: Cash Accounts Payable Beginning balance $ 0 $ 0 Add: side 50,000 2,000 20, Subtract: side 42,000 2,000 16,000 2,000 Ending balance $ 10,000 $ 630 Knowing how to use T-accounts in this way will help you answer homework questions that involve solving for missing values in accounts. The ending balance is double underlined to distinguish it from transactions and symbolize the fi nal result of a computation. The ending balance is shown on the side that has the greater total dollar amount. Assets normally end with a debit balance (because debits to assets normally exceed credits) and liabilities and stockholders equity accounts normally end with credit balances (credits exceed debits). A Review of the Accounting Cycle Exhibit 2.8 summarizes and illustrates the main tools used in the accounting cycle to analyze, record, and summarize the financial effects of business activities. In the remainder of this section, we will work with you to account for the transactions that were presented earlier in this chapter for the Supercuts salon. Because we show the analyze step in detail on pages 47 53, we do not show it in detail here. Instead, we pick up where step 1 left off with the effects of each transaction on the accounting equation. By reviewing steps 2 and 3 of the accounting cycle in detail, you will get to practice using the new concepts of debits, credits, journal entries, and T-accounts. Study the following examples carefully. The biggest mistake people make when fi rst learning accounting is they think they understand how it all works without actually going through enough examples. To understand accounting, you have to practice, practice, practice, as if you re learning to play a new sport or musical instrument. EXHIBIT 2.8 Tools Used in the Accounting Cycle 1. Analyze Transactions 2. Record in Journals 3. Summarize in Ledgers Tools: DECIDE Journal Entries T-Accounts (a) Cash 50,000 Contributed Capital 50,000 dr Cash ( A) ,000 cr Contributed Capital ( SE).. 50,000 (a) 50,000 Cash (A) Contributed Capital (SE) 50,000 (a) (a) Financing from Stockholders You incorporate your Supercuts salon on August 1. The company issues stock certifi cates to you and your parents as co-owners in exchange for $50,000, which is deposited in the company s bank account.

18 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet Analyze (a) Cash 50,000 Contributed Capital 50, Record (a) dr Cash ( A) ,000 cr Contributed Capital ( SE) , Summarize dr Cash (A) cr Beg. Bal. 0 (a) 50,000 dr Contributed Capital (SE) cr 0 Beg. Bal. 50,000 (a) (b) Investing in Equipment Your salon pays $42,000 cash for equipment. 1. Analyze (b) Cash 42,000 Equipment 42, Record (b) dr Equipment ( A) ,000 cr Cash ( A) , Summarize dr Cash (A) cr Beg. Bal. 0 (a) 50,000 42,000 (b) dr Equipment (A) cr Beg. Bal. 0 (b) 42,000 (c) Financing from Lender Your company borrows $20,000 from a bank, depositing those funds in its bank account and signing a formal agreement to repay the loan in two years. 1. Analyze (c) Cash 20,000 Note Payable 20, Record (c) dr Cash ( A) ,000 cr Note Payable ( L) , Summarize dr Cash (A) cr Beg. Bal. 0 (a) 50,000 42,000 (b) (c) 20,000 dr Note Payable (L) cr 0 Beg. Bal. 20,000 (c)

19 60 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet (d) Investing in Equipment Your salon installs $18,000 of additional equipment, paying $16,000 in cash and giving an informal promise to pay $2,000 at the end of the month. 1. Analyze (d) Cash 16,000 Accounts Payable 2,000 Equipment 18, Record (d) dr Equipment ( A) ,000 cr Cash ( A) ,000 cr Accounts payable ( L) , Summarize dr Cash (A) cr Beg. Bal. 0 (a) 50,000 42,000 (b) (c) 20,000 16,000 (d) dr Equipment (A) cr Beg. Bal. 0 (b) 42,000 (d) 18,000 dr Accounts Payable (L) cr 0 Beg. Bal. 2,000 (d) (e) Ordering Supplies Your salon orders $800 of shampoo and other operating supplies. None have been received yet. Because this event involves the exchange of only promises, it is not considered a transaction. No journal entry is needed. (f) Paying a Supplier Your company pays $2,000 to the equipment supplier in (d). 1. Analyze (f) Cash 2,000 Accounts Payable 2, Record (f) dr Accounts payable ( L) ,000 cr Cash ( A) , Summarize dr Cash (A) cr Beg. Bal. 0 (a) 50,000 42,000 42,000 (b) (c) 20,000 16,000 16,000 (d) 2,000 2,000 (f) (f) dr Accounts Payable (L) cr 0 0 Beg. Bal. (f) 2,000 2,000 (d)

20 (g) Receiving Supplies CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet 61 Your company receives $630 of the supplies ordered in (e) and promises to pay for them next month. 1. Analyze (g) Supplies 630 Accounts Payable Record (g) dr Supplies ( A) cr Accounts payable ( L) Summarize dr Supplies (A) cr Beg. Bal. 0 (g) 630 dr Accounts Payable (L) cr 0 Beg. Bal. (f) 2,000 2,000 (d) 630 (g) Exhibit 2.9 summarizes the journal entries and T-accounts affected by events (a) through (g) for Supercuts. It also reports the ending balances for each account. EXHIBIT 2.9 Journal Entries and T-Accounts for Supercuts Journal Entries (a) dr Cash ( A) ,000 cr Contributed Capital ( SE)... 50,000 (b) dr Equipment ( A) ,000 cr Cash ( A) ,000 (c) dr Cash ( A) ,000 cr Note Payable ( L) ,000 (d) dr Equipment ( A) ,000 cr Cash ( A) ,000 cr Accounts Payable ( L) ,000 (e) not a transaction (f) dr Accounts Payable ( L) ,000 cr Cash ( A) ,000 (g) dr Supplies ( A) cr Accounts Payable ( L) Cash (A) Beg. Bal. 0 (a) 50,000 42,000 (b) (c) 20,000 16,000 (d) 2,000 (f) End. 10,000 Beg. Bal. 0 (g) 630 End. 630 Beg. Bal. 0 (b) 42,000 (d) 18,000 Supplies (A) Equipment (A) Accounts Payable (L) 0 Beg. Bal. (f) 2,000 2,000 (d) 630 (g) 630 End. Note Payable (L) 0 Beg. Bal. 20,000 (c) 20,000 End. Contributed Capital (SE) 0 Beg. Bal. 50,000 (a) 50,000 End. End. 60,000 PREPARING A BALANCE SHEET Using the ending amount from each T-account, you could now prepare a balance sheet. Before you do this, however, it s a good idea to check that the accounting records are in balance by determining whether debits credits. With just six accounts so far, this is easy enough to do ($10, ,000 $70,630 $630 20,000 50,000). In Chapter 3, after more accounts have been introduced, we ll show you how to prepare an internal accounting report called the trial balance to check whether debits credits. Learning Objective 4 Prepare a classified balance sheet.

21 62 CHAPTER 2 Reporting Investing and Financing Results on the Balance Sheet EXHIBIT 2.10 Classified Balance Sheet SUPERCUTS Balance Sheet At August 31, 2008 Explanation of Classification Assets Current assets Cash $10,000 Supplies 630 Total current assets 10,630 Equipment 60,000 Total assets $70,630 Liabilities and Stockholders Equity Current liabilities Accounts payable $ 630 Total current liabilities 630 Note payable 20,000 Stockholders equity Contributed capital 50,000 Retained earnings 0 Total liabilities and stockholders equity $70,630 This cash will be used (and replenished) before August 31, These supplies will be used before August 31, This equipment will be used for many years. These amounts will be paid before August 31, Repayment of this note is not required until Stockholders equity accounts are not classified. YOU SHOULD KNOW A classified balance sheet is one that shows a subtotal for current assets and current liabilities. Current assets will be used up or converted into cash within 12 months of the balance sheet date. Current liabilities are debts and obligations that will be paid, settled, or fulfilled within 12 months of the balance sheet date. Noncurrent (or long-term) assets and liabilities are those that do not meet the definition of current. To prepare a balance sheet for your Supercuts salon after recording transactions (a) (g), just take the ending balances from each T-account in Exhibit 2.9 and group them as assets, liabilities, and stockholders equity in balance sheet format. If you do this, you should end up with a balance sheet like the one presented way back in Exhibit 2.1. We realize that the odds of you flipping all the way back to page 45 right now are slim, so we ve taken this opportunity to show you a slightly different balance sheet format in Exhibit 2.10 called the classified balance sheet. A classifi ed balance sheet contains subcategories for assets and liabilities labeled current. Current assets are assets your business will use up or turn into cash within 12 months of the balance sheet date. For example, your salon will spend the cash and use the supplies during the next 12 months, so these assets are classified as current. Current assets are listed in order of how fast they will be used up or turned into cash. Current liabilities are debts and other obligations that will be paid or fulfilled within 12 months of the balance sheet date. In our example, accounts payable is the only current liability. The other liability note payable is expected to be paid in two years, so it is considered noncurrent. Like Supercuts equipment and note payable accounts, its stockholders equity accounts are understood to be long-term in nature, although they are not labeled as such. Exhibit 2.10 includes the retained earnings account in stockholders equity despite its zero balance because we don t want you to forget about this account. It will become a key link to the income statement, when introduced in Chapter 3. Evaluate the Results Learning Objective 5 Explain the concepts that determine whether an item is reported on the balance sheet and at what amount. BALANCE SHEET CONCEPTS AND VALUES Some people mistakenly believe that the balance sheet reports what a business is actually worth. To them, this is not a crazy idea because the balance sheet lists the company s assets and liabilities, so the net difference between the two must be the company s worth.