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
