ACC 311H Chapter 2: Constructing Financial Statements
Chapter Organization:
Reporting Financial Condition:
● Assets: resources owned or controlled by a company and expected to
provide the company with future economic benefits that can be
measured in monetary terms; to create shareholder value, assets must
yield resources in excess of the cost of funds required to acquire them;
assets as arranged in order of liquidity on balance sheets
○ Current Assets: assets expected to be converted into cash or used
in operation within the next year or operating cycle; more liquid,
short-term assets
■ Cash and Cash Equivalents: currency, bank deposits,
certificates of deposit, and other cash equivalents
■ Marketable Securities: short-term investments that can be
quickly sold to raise cash
■ Accounts Receivable: amounts due the company arising
from the past sale of products or services on credit
■ Inventory: goods purchased or produced for sale to
customers and supplies used in operating activities
■ Prepaid Expenses: costs paid in advance for insurance or
other services
○ Noncurrent Assets: assets not expected to be converted into cash
within the next year or operating cycle; less liquid, long-term assets
■ Long-Term Financial Investments: investments in debt
securities or shares of other firms that management does not
intend to sell in the near future
■ Property, Plant, and Equipment (PPE): land, factory
buildings, warehouses, office buildings, machinery, office
equipment, and other items used in the operations of the
company
■ Operating Lease Right-Of-Use Assets: representation of a
lessee’s right to use a leased asset over the course of a leased
term
■ Intangible and Other Assets: patents, trademarks, franchise
rights, goodwill, and other items that provide future benefits
but do not possess physical substance
● noncurrent assets as generally generating greater returns than current
assets; but current assets as required to maintain degrees of liquidity;
companies as maintaining just enough current assets to cover liquidity
needs
● some assets, such as marketable securities, are presented at fair value, or
current value; other assets, such as inventory and other physical assets,
are presented at historical cost, or original acquisition cost; some assets,
such as internally-created intangible assets, are excluded from balance
sheets; ultimately, desiring to provide relevance and faithful
representation
● Liabilities and Equity: sources of capital used to finance the acquisition of
assets
● Liabilities: a company’s obligations to repay borrowed funds from lenders
or bond investors and pay suppliers, employees, tax authorities, and other
parties; conditions for a liability as including a probable future obligation,
a reasonable estimate for the amount of the obligation, and the
occurrence of a transaction or event causing the obligation; conditions for
an executory contract as including a probable future obligation and a
reasonable estimate for the amount of the obligation but not the
occurrence of a transaction or event causing the obligation; executory
contracts as not reported as liabilities but disclosed in the notes of
financial statements; liabilities as arranged in order of maturity on balance
sheets
○ Current Liabilities: liabilities due within the next year or operating
cycle
■ Accounts Payable: amounts owed to suppliers for goods or
services purchased on credit
■ Accrued Liabilities: obligations for expenses that have been
recorded but not yet paid, such as accrued compensation
payable, accrued interest payable, and accrued taxes
■ Operating Lease Obligation: an obligation to make payments
arising from a lease, measured on a discounted basis, due to
be paid within a year
■ Deferred or Unearned Revenues: an obligation created when
a company accepts payment in advance for goods and
services, often referred to as contract liabilities, performance
obligations, or customer advances
■ Short-Term Borrowings: short-term debt payable to banks or
other creditors
■ Current Maturities of Long-Term Debt: the current portion of
long-term debt due to be repaid within a year
○ Noncurrent Liabilities: liabilities not due within the next year or
operating cycle
■ Operating Lease Obligation: an obligation to make payments
arising from a lease, measured on a discounted basis, not due
to be paid within a year
■ Long-Term Debt: amounts borrowed from creditors not due
to be repaid within a year
■ Other Long-Term Liabilities: various obligations, such as
warranty and deferred compensation liabilities and
long-term tax liabilities, not due to be satisfied within a year
● Equity: a company’s capital that has been invested by shareholders, either
directly through the purchase of stock or indirectly in the form of earnings
that are reinvested in the company and not paid out as dividends;
shareholders as having a claim on any assets that are not needed to meet
a company’s obligations to creditors; equity as often referred to as
residual interest
○ Contributed Capital: the net funding that a company receives from
issuing and repurchasing its equity shares
■ Common Stock: the capital received from the primary
shareholders of a company
■ Additional Paid-In Capital: amounts received from the
primary shareholders of a company beyond the stated value
of common stock
■ Treasury Stock: the amount that a company paid to reacquire
its own common stock
○ Earned Capital: the cumulative net income or losses retained by a
company rather than paid out to shareholders as dividends
■ Retained Earnings: the accumulated earnings that have not
been distributed to shareholders as dividends
■ Accumulated Other Comprehensive Income or Loss:
accumulated changes in equity that are not reported on
income statements
Analyzing and Reporting Transactions for the Balance Sheet:
● analyzing transactions in financial statement effects templates (FSETs),
journalizing the financial impacts of transactions in journal entries, and
posting the results of transactions to individual accounts to emphasize
the linkage of entries to accounts
● Financial Statement Effects Templates: templates used to analyze the
financial impacts of transactions; recording individual transactions while
linking balance sheets and income statements and reporting resulting
changes in assets, liabilities, and equity; ultimately, used to illustrate the
effects of individual transactions on the accounting equation and financial
statements
● Accounts: mechanisms for accumulating the effects of an organization’s
transactions and events; determining the accounts that are affected by
individual transactions and the directions and magnitudes of those
effects; individual transactions as affecting at least two accounts to
maintain the accounting equation, providing for dual effects in
double-entry accounting systems; accounts titles as divided into assets,
liabilities, equity, revenues, and expenses and recorded in charts of
accounts
● Transaction Analysis Using FSETs: building ending balance sheets from
beginning balance sheets and series of financial statement effects
templates
○ within individual transactions, distinguishing between liabilities that
provide cash assets and liabilities that provide noncash assets;
equity as generally providing cash assets
○ within individual transactions, distinguishing between changes in
assets and liabilities that occur initially and resulting expenses that
occur over time
Reporting Financial Performance:
● Net Assets: the difference between assets and liabilities; revenue as
increasing net assets by increasing retained earnings by transferring
goods and services to customers; expenses as decreasing net assets by
decreasing retained earnings through revenue-generating activities; the
difference between revenue and expenses as providing net income or
loss; net income or loss as reflecting the net change in net assets
provided by revenue and expenses
● Operating Revenue and Expenses: operating revenue and expenses as
pertaining to continuous operating activities; operating revenue and
expenses as recorded during the initiation of transactions, operating cash
flow as recorded during the disbursement of payments
● Nonoperating Revenue and Expenses: nonoperating revenue and
expenses as pertaining to continuous payments in financial and
investment activities; for example, interest revenue and interest expenses
● some income statements as distinguishing between income from
continuing operations and income from nonrecurring items; providing for
more accurate predictions of future financial performance
Accrual Accounting for Revenues and Expenses:
● potential for revenue and expense recognition and corresponding cash
flows (payment transfers) to occur in different periods, given the rising
role of credit in financial transactions; given these discrepancies,
management as often required to estimate future revenues and expenses
● Revenue Recognition: recognizing revenue when goods or services are
transferred to customers, regardless of whether payment has been
received; when value is provided rather than when payment is received
○ Recognizing Revenue During Payment: with revenue recognition,
increase in earned capital and cash assets, providing for an increase
in net assets
○ Recognizing Revenue Before Payment: with revenue recognition,
increase in earned capital and noncash assets (account receivable),
providing for an increase in net assets; with payment, increase in
cash assets and decrease in noncash assets (account receivable),
providing for no change in net assets
○ Recognizing Revenue After Payment (Credit): with payment,
increase in cash assets and liabilities (account payable), providing
for no change in net assets; with revenue recognition, increase in
earned capital and cash assets, providing for an increase in net
assets
● Expense Recognition: recognizing expenses when assets are diminished
or liabilities are increased as a result of earning revenue or supporting
operations, regardless of whether payment has been provided; when
value is received rather than when payment is provided
○ Recognizing Expenses During Payment: with expense recognition,
decrease in earned capital and cash assets, providing for a decrease
in net assets
○ Recognizing Expenses Before Payment (Credit): with expense
recognition, decrease in earned capital and increase in liabilities
(account payable), providing for a decrease in net assets; with
payment, decrease in cash assets and liabilities (account payable),
providing for no change in net assets
○ Recognizing Expenses After Payment: with payment, decrease in
cash assets and increase in noncash assets (account receivable),
providing for no change in net assets; with expense recognition,
decrease in earned capital and noncash assets, providing for a
decrease in net assets
● Accrual Accounting: the practice of recognizing revenue when goods or
services are transferred to customers (when value is provided) and
recognizing expenses when assets are diminished or liabilities are
increased as a result of operations (when value is received), regardless of
the status of corresponding payment transfers
● Asset Transfers: in acquiring inventory, noncash assets increase and cash
assets decrease or liabilities increase, providing for no change in net
assets; in selling inventory, revenue increases, earned capital increases,
cash assets increase or liabilities decrease; moreover, expenses are
accounted for, earned capital decreases, and noncash assets decrease;
increases in cash assets or decreases in liabilities as potentially in excess
of decreases in noncash assets, providing for an increase in net assets
● Transaction Analysis Using FSETs: building ending balance sheets from
beginning balance sheets and series of financial statement effects
templates; building income statements using series of financial statement
effects templates, given the linkage between earned capital and net
income through retained earnings
Reporting on Equity:
● the acquiring and selling of stock as contributing to changes in
contributed capital; the generation of net income and the payment of
dividends as contributing to changes in retained earnings and, by
extension, earned capital
● owner transactions as having no effect on revenue, expenses, or net
income; changes in equity as caused by owner transactions (the acquiring
of stock, the selling of stock, and the payment of dividends) and the
generation of net income
● Transaction Analysis Using FSETs: changes in contributed capital and
earned capital as reflected on financial statement effects templates and
statements of shareholders’ equity; building statements of shareholders’
equity using beginning balance sheets and series of financial statement
effects templates
Journalizing and Posting Transactions:
● representing individual transactions in FSETs in journal entries that are
collected in individual accounts; representing accounts in company
ledgers as T-accounts
● T-accounts: accounts as records of increases and decreases in assets,
liabilities, equity, revenues, or expenses; T-accounts as graphic
representations of accounts, recording debits on the left and credits on
the right
● for assets, increases as recorded on the debit side and decreases as
recorded on the credit side; for liabilities and equity, increases as recorded
on the credit side and decreases and recorded on the debit side; assets as
having normal debit balances, liabilities and equity as having normal
credit balances
● within equity, for common stock and revenues, increases as recorded on
the credit side and decreases as recorded on the debit side; for dividend
payments and expenses, increases as recorded on the debit side and
decreases as recorded on the credit side; common stock and revenues as
having normal credit balances, dividend payments and expenses as
having normal debit balances
● individual transactions as affecting at least two accounts to maintain the
accounting equation, providing for dual effects in double-entry
accounting systems; total debits and total credits as equal for all journal
entries, regardless of simple entries or compound entries
● T-accounts as composed of beginning balances, additions (whether
debits or credits), subtractions (whether credits or debits), and ending
balances; accounts as labeled by name and title, debits and credits as
labeled as additions or subtractions accordingly, and individual
transactions as keyed to corresponding journal entries by numbers or
letters; beginning and ending balances as recorded on the left side if the
corresponding accounts have more debits and on the right side if the
corresponding accounts have more credits
● Journal Entries: journal entries as accounting entries of individual
transactions in company financial ledgers; journal entry reports as
summarizing debits in credits; individual transactions as keyed by
numbers or letters; within individual transactions, debits as included first,
with account names and titles as unindented and debits as in the debit
column (the left column); credits as included second, with account names
and titles as indented and credits as in the credit column (the right
column)
● analyzing transactions in financial statement effects templates (FSETs),
journalizing the financial impacts of transactions in journal entries, and
posting the results of transactions to individual T-accounts to emphasize
the linkage of entries to accounts; the complete general ledger as
capturing the debits and credits of individual accounts following series of
transactions; as reflecting changes in assets, liabilities, and equity and
providing the basis for preparing budget sheets and income statements
Analyzing Financial Statements:
● liquidity as a measure of a company’s ability to pay off its current liabilities
or short-term debts; assessing liquidity using net working capital, current
ratios, and quick ratios
○ Net Working Capital: the difference between current assets and
current liabilities; varying on the basis of company’s cash operating
cycle, the time between paying for raw materials and labor and
receiving cash from sales for cash or on credit; desires to delay
paying for raw materials and labor and advance receiving cash from
sales to maximize cash in possession
○ Current Ratio: the ratio of current assets to current liabilities; desires
to maintain current ratios between one and two
○ Quick Ratio: the ratio of quick assets to current liabilities; excluding
inventories, providing for a more stringent test of liquidity
● different companies and industries as experiencing different operating
cycles, different operating cash flows, and different net working capitals,
current ratios, and quick ratios at optimal levels of activity