“FINANCIAL ACCOUNTING”
Phillips, Libby, Libby, 6e
Chapter 2 – Reporting Investing and Financing Results on the Balance Sheet
Primary Objective of Financial Reporting:
To provide useful economic information about a business to help external parties
make sound financial decisions.
Nature of Business Transactions:
business transaction: an economic event that affects the financial position of a business.
- can involve either: 1) an exchange of value with an external party
(e.g., sale, borrowing, purchase)
or
2) a measurable internal event
[(which may not be an exchange of value (e.g., wear and tear of
equipment or physical loss)]
- be aware that some business activities are not recorded as business transactions if
they do not affect the financial position of the business (i.e., they do not impact the
accounting equation).
(e.g., the hiring of an employee or the ordering of supplies do not affect the
financial position of a business)
Cost Principle (Historical Cost Principle):
Requires assets to be recorded at the historical cash-equivalent cost
- the exchange price associated with a business transaction
Order of reporting assets and liabilities on the balance sheet:
- assets are reported based on liquidity which means there ability to turn in to cash
- liabilities are reported in much the same way, in the order in which you need to
pay them (these are obligations that you must pay to creditors)
- Stockholders’ Equity is always reported as Contributed Capital followed by
Retained Earnings
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EXHIBIT 2.13 ON PAGE 67 ( below) IS A GOOD EXAMPLE OF A CLASSIFIED
BALANCE SHEET (meaning assets and liabilities are classified between short term and
long term).
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TRANSACTION ANALYSIS:
The process of studying a transaction to determine its economic effect in terms of the
accounting equation (i.e., identifying the impact of transactions on various financial
statement accounts).
Account
- a standardized format used to accumulated the dollar effects of transactions on each
financial statement item
(e.g., cash, inventory, accounts payable, sales revenue, wages expense, etc.)
Chart of Accounts
- the list of account titles and numbers that a company uses in recording business
transactions.
- each company has its own chart of accounts based on their needed complexity
Two basic rules exist with respect to transaction analysis:
1) Every transaction affects at least two accounts
2) The accounting equation must remain in balance
after each transaction
Steps in Transaction Analysis
1) Identify the specific accounts affected by the transaction and the related dollar amount.
(e.g., a company borrowed $6,000 from a bank and signed a note; this transaction affected both
the company’s cash account and its notes payable account by $6,000.)
2) Identify whether the accounts increased or decreased.
(e.g., since cash was received, the cash account increased; borrowing from the bank increased
the company’s obligations; thus the notes payable account increased)
3) Identify the types of accounts affected.
(e.g., cash is an ASSET; notes payable is a LIABILITY)
4) Verify that the accounting equation (A = L + SE) remains in balance after the
transaction. For example:
ASSETS
Cash
A/R
Land
=
Equip.
=
LIABILITIES
A/P
Notes Pay.
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+
STOCKHOLDERS EQUITY
Contributed Capital
(or Common Stock)
R.E.
HOW COMPANIES RECORD BUSINESS TRANSACTIONS
Accountants use a double-entry system to record business transactions:
- relates to the fact that business transactions have at least two effects on the financial
position (i.e., the accounting equation of A = L + SE) of an entity.
Often, it is easy to use the T-Account to analyze the effects of business transactions:
Title of the Account
--------------------------------------Debit
| Credit
(left side) | (right side)
|
Analyzing and Recording Transactions:
There exist two general rules for the double-entry system:
1) Every transaction affects at least two accounts.
2) Total Debits must equal Total Credits.
Rules of Debits and Credits:
We know the following from the basic accounting equation:
Assets
Debit to increase, credit to decrease
=
Liabilities +
Stockholders’ Equity
Credit to increase, debit to decrease
ASSETS
-----------------------------Debit
| Credit
+
|
(increase) | (decrease)
LIABILITIES
--------------------------------Debit | Credit
|
+
(decrease) | (increase)
STOCKHOLDERS’ EQUITY
-----------------------------------------Debit | Credit
|
+
(decrease) | (increase)
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RECORDING TRANSACTIONS
Steps for recording business transactions (effects on the accounting equation):
1) ANALYZE the transaction, what happened???
a. Identify the specific accounts affected and the related dollar amount
(e.g., a company issued $10,000 of stock for cash; this transaction
affects the company’s cash account and its contributed capital account.)
b. Identify whether the accounts increased or decreased
(e.g., since cash was received, the cash account increased; receiving money from
stockholders increases the Contributed Capital account)
c. Identify the types of accounts affected
(e.g., cash is an Asset, Contributed Captital is a Stockholders Equity account.)
A (assets)
=
L (Liabilities)
+
SE (Stockholders equity)
2) RECORD transaction
Apply the debit (DR) and credit (CR) rules to increase or decrease the particular
accounts and record the journal entry making sure that DR = CR
3) SUMMARIZE in a T-account format for preparation of the balance sheet
4) REPARE a classified balance sheet.
Beginning to analyze financial statements – the Current Ratio.
The current ratio is used to see if the current assets of a company are great enough to pay
their current liabilities. This is an example of a Liquidity Ratio. A Liquidity ratio measures the
ability of the company to pay their short term liabilities existing assets.
Example: Current Assets = $10,000 Current Liabilities = $2500
Current Ratio = 4 ($10,000/$2500)
Do we want this ratio to be higher or lower?
Does this company seem to have a high enough ratio?
What ratio do investors like to see? This amount is also in most debt covenants.
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Let’s try an example. This should help you with significantly with your chapter
2 homework.
The following transactions are for the first month of operations for XYZ, Inc.
Show the effect on the Balance Sheet Equation from each of the following. Then total each column.
Left side: Increase with DEBIT (DR)
Right Side: Increase with a CREDIT (CR)
Decrease with a CREDIT (CR)
Decrease with a DEBIT (DR)
ASSETS
= LIABILITIES
Cash
Supplies
Land
Accouts
Payable
+
Notes
Payable
STOCKHOLDERS’ EQUITY
Common Stock
Retained
Earnings
1
2
3
4
Total
B/S totals
1.
2.
3.
4.
Assets =
Liabilities =
Stockholders Equity =
1/1/19 Stockholders contribute $50,000 to start the company.
1/1/19 Company borrows $30,000 from a bank to be repaid in two years.
1/5/19 The company buys land for $25,000 cash.
1/17/19 The company buys a supplies of $10,000. They pay $5,000 cash and will pay
the supplier the remaining $5,000 in 30 days.
A. Record the journal entry for each transaction above in the correct debit/credit format
1. DR
CR
2.
3.
.
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B. SUMMARIZE: Prepare T-Accounts for each account impacted in transactions 1-4
above. There should be six T-Accounts since six accounts were impacted by the
transactions.
Supplies
Cash
Accounts Payable
Land
Common Stock
Notes Payable
C. Prepare a classified balance sheet from your t-account balances
Assets
Current Assets:
Cash
Supplies
XYZ, Inc.
Balance Sheet
At January 31, 2019
Liabilities & Stockholders Equity
Current Liabilities:
Accounts Payable
$
_______
Total Current Liabilities
Total Current Assets
Total Assets:
______
________
Notes Payable
Land
$ ______
______
________
$ ________
Total Liabilities
______
Stockholders’ Equity
Common Stock
Retained Earnings
Total Stockholders’ Equity
_______
_______
_______
Total Liabilities and
Stockholders’ Equity
$_______
Compute the company’s current ratio.
Remember, the formula is Current Assets
Current Liabilities
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