Accounting For Managers
Professor ZHOU Ning
SCHOOL OF ECONOMICS AND MANAGEMENT
BEIHANG UNIVERSITY
[email protected]
Chapter 2
Basic Accounting Concepts:
The Balance Sheet
The objectives of chapter 2

Basic concepts

The balance sheet

Ratios
2-3
Basic Concepts

Statements of Financial Accounting Concepts




Adopted by FASB
Conceptual criteria to help resolve future
accounting issues.
Not GAAP.
11 concepts in text.


1-5 covered in this chapter.
6-11 in next chapter.
2-4
11 Basic Concepts
Money measurement
2.
Entity
3.
Going concern
4.
Cost
5.
Dual aspect
6.
Accounting period
7.
Conservatism
8.
Realization
9.
Matching
10. Consistency
11. Materiality
1.
2-5
Concept #1: Money Measurement


Accounting records are recorded in monetary
terms at value at time transaction is recorded.
Severe limitation.

Can’t be valued, can’t be recorded;
e.g. president’s health, affect of strike. Not
present full picture of a organization’s condition

Price changes ignored ( purchasing power).
2-6
Concept #2: Entity

An entity is any organization or activity for
which accounting reports are prepared.



For whom accounts are kept.
Distinguish from owner.
May or may not be separate legal entity.
 One entity may be part of a larger entity:
General Electric Company presents one set of
financial statements with parent company
operations combined with all subsidiaries
around the world.
2-7
Concept #3: Going Concern


Assumed to continue in operation for an
indefinite long period.
Alternative assumption:
 Liquidation/bankruptcy.
 Only liquidation values would be
meaningful.
2-8
Concept #4: Cost

Cost definition:



The amount of cash or cash equivalents paid or the
fair value of the other consideration given to acquire
an asset at the time of its acquisition (IAS 16).
Cost may be defined as the sacrifice made, usually
measured by the resources given up, to achieve a
particular purpose (Ronadl W. Hilton).
Fair value definition:

The amount for which an asset would be exchanged,
or a liability settled, between knowledgeable, willing
parties in an arm’s length transaction (IAS 39).
2-9
Concept #4: Cost




Assets defined: A resource controlled by the
enterprise as a result of past events from which future
economic benefits are expected to flow to the
enterprise (IAS)
 = controlled by
 = past events
 = inflow of future economic benefits
Assets recorded at cost, that is, price paid.
Fair value (FV) = amount for which asset could be
currently purchased or sold.
Book value of asset (B.V.) = recorded value.
2-10
Cost Concept: Non-monetary Assets




Land, buildings, machinery and similar.
Generally, book value = fair value only at
time of acquisition.
Depreciation or amortization = systematic
allocation of cost over life of asset.
B.V. = recorded cost - depreciation to date.
2-11
Cost Concept: Monetary Assets





Cash, marketable securities.
Initially recorded at cost.
Adjusted to fair value (=market value, if
available).
Rationale: FV is relevant, objective & feasible.
Class discussion:

Why is FV relevant & objective for monetary assets
but not for non-monetary assets?
2-12
Cost Concept: Goodwill

Economic goodwill:


Fair value of business – fair value of acquired
net asset(s).
Accounting goodwill:



Purchase price - fair value of net assets.
Recorded only when purchased.
Application of cost concept.
2-13
Concept #5: Dual-Aspect

Assets = economic resources.

Equities = claims against assets.


Liabilities = claims of creditors
(everyone other than owners).
Owners’ equity (Shareholders’ or
stockholders’ equity for a corporation).
2-14
Dual Aspect (Continued)

Fundamental accounting equation:



Assets = Equities.
Assets = Liabilities + Owners’ equity.
For a corporation:


Assets = Liabilities + Stockholders’ equity.
Assets = Liabilities + Paid-in-capital +
Retained earnings.
2-15
Dual Aspect (Concluded)



Transactions = events that affect
accounting records.
Every transaction has a dual impact on
accounting records.
Dual impact:


Results in maintenance of fundamental
accounting equation.
Double-entry system.
2-16
Balance Sheet

Balance Sheet is a quantitative summary of a
company’s financial condition at a specific point
in time, including assets, liabilities and owners’
equity.




More formal name: Statement of Financial Position.
It is a snapshot of the financial health of an entity.
Point in time or status report.
Contains and shows equality of amounts of:
 Assets.
 Liabilities and Owners’ equity.
2-17
Balance Sheet – Illustration


I want to purchase a car costing $500,000. To
do so, I have to borrow. A bank agrees to
finance me if I can invest $ 100,000 on my own
Two relevant questions:

What are the things of value you own?

How much do you owe, and to whom?
2-18
Balance Sheet – Illustration
Things of value owned by
me
Savings deposit in bank
Term deposit in bank
Other personal possessions
Total
$
Amounts owed by
me
50,000 Loan from a friend
$
50,000
150,000 Own claim or net worth 200,000
50,000
250,000 Total
250,000
Say, the bank grants me the loan of $ 400,000 and I buy
the car for $ 500,000. After purchase of the car my
financial position statement will change as follows:
2-19
Balance Sheet – Illustration
Things of value owned
by me
$
Claims against things
of value
Savings deposit in bank
50,000 Loan from a friend
Term deposit in bank
50,000 Bank Loan
Car
500,000 Own claim or net worth
Other personal possessions
50,000
Total
650,000


Total
$
50,000
400,000
200,000
650,000
As a result of this transaction my worth is increased
from $ 250,000 to $ 650,000
But, my net worth remains the same. Why?
2-20
Learnings from the example




Things of value possessed by an entity are referred
to as assets
Accountants use the term “assets” to describe
things of value measurable in monetary terms
The amount owed by an entity expressed in
monetary terms, which represents a claim by
outsiders against its assets, is referred to as
“liabilities”
Liabilities are claims of outsiders, against an entity
and are legally enforceable
2-21
Leanings from the example



Net worth of the owner(s) of the entity = The
value of assets owned by the entity less liabilities
(or outsider’s claims)
Also known as “owner(s) equity”

As it represents the claims of owner(s) in case of
an entity
Hence, financial position statement is

a summary of the assets, liabilities and net worth

as of a particular point in time
2-22
Lets compare …
Assets
I
II
Liabilities &
Owner’s equity
Bank Savings Deposit
50,000
50,000
Loan from a friend
Term deposit in bank
150,000
50,000
Own claim / Net worth
Car
-
Personal Possessions
Total


500,000
50,000
50,000
250,000
650,000
Bank Loan
Total
I
II
50,000
50,000
200,000
200,000
-
400,000
250,000
650,000
Outsiders claim has priority over the owner(s) claim on the assets
and hence owner(s) equity is always a residual claim against assets
It follows from this that at any point in time, for all accounting
entities owner(s) equity and liabilities will be equal to assets owned
by that entity.
2-23
Interpretations of Dual Aspect:
Sources and Uses of Funds View



Left hand side = assets = how funds
used or invested.
Right hand side = liabilities + owners’
equity = sources of funds = how assets
were financed.
Financing supplied by owners:


Paid-in-capital (= contributed capital).
Retained earnings.
2-24
Account Categories


Groups of related items.
Classifications of:





Assets.
Equities (i.e. liabilities, owners’ equity)
Revenues.
Expenses.
Discretion of management.
2-25
2-26
Assets


Acquired in a transaction.
Economic resources (i.e. provide future
benefits).





Cash or convertible to cash.
Goods to be sold for cash.
Items to be used to generate cash.
Controlled by the entity.
Objectively measurable cost at time of
acquisition.
2-27
Reporting of Assets on Balance Sheet



Grouped into categories.
Decreasing order of liquidity.
Current assets (almost) always shown
separately.
2-28
Current Assets



Cash.
Other assets expected to be realized in
cash or sold or consumed within longer
of one year or normal operating cycle.
Funds available for disbursement.
2-29
Marketable Securities

Investments that are:


Readily marketable.
Expected to be converted to cash
within 1 year.
2-30
Accounts Receivable



Owed by customer
Reported at amount owed less
estimated uncollectible.
Other receivables:


Owed by other than customer
Notes receivable:

Evidence by written promises to pay (notes).
2-31
Inventories

Aggregate of those items that are:




Held for sale in ordinary course of business,
In process of production for sale, or
To be consumed in production of goods or
services to be sold.
Class discussion:

Is a tractor an inventory item or another type of
asset for:
 Caterpillar (manufacturer of tractors)?
 A farm?
2-32
Prepaid Expenses



Intangible.
Usefulness will expire in near future.
Examples:


Prepaid rent expense.
Prepaid insurance expense.
2-33
Property, Plant, and Equipment






Also, called fixed assets.
Tangible.
Long-lived.
Used to produce goods and services to
generate cash inflows.
Land is not depreciated.
Building and equipment shown at:

Cost less accumulated depreciation.
2-34
Other Assets


Investments (not expected to be sold
within a year).
Intangible assets


Goodwill, patents, trademarks, copyrights.
Longer life than prepaid expenses.
2-35
Liabilities




Obligations to transfer assets or provide
services to outside parties.
Arising from past transactions or events.
Claims against entity’s assets.Not against
specific assets, unless indicated.
Reported at amount that would satisfy
obligations on BS date.
 Principal + interest (through BS date).
2-36
Current Liabilities

Satisfied or extinguished within one
year or current operating cycle,
whichever is longer.
2-37
Accounts Payable



Suppliers (i.e. vendors) claims for goods
or services furnished but not yet paid.
Unsecured.
Notes payable or short-term loans.


Formal written note.
Includes amounts owed to financial
institutions.
2-38
Taxes Payable


Owed to government agencies for
taxes.
Income taxes often shown
separately because of size.
2-39
Accrued Expenses



Earned by outside parties but not yet
paid.
Usually no invoice.
Includes interest payable, wages
payable.
2-40
Deferred Revenues


Also called unearned revenues or precollected revenues.
Advance payment received but
company has not yet performed service
or delivered product.
2-41
Other Liabilities

Current liability:

Current Portion of Long-Term Debt


Portion due within next year.
Long-term debt or non-current liabilities.
2-42
Owners’ Equity



Amount owners’ invested in entity.
= Assets – Liabilities = Net assets
For a corporation: shareholders’ or
stockholders’ equity .


Shares of stock evidence ownership
interest.
Could be invested in any assets on
Balance Sheet.
2-43
Two Categories of
Shareholders’ Equity


Paid-in or contributed capital.
Retained earnings.
2-44
Paid-in Capital


Capital stock (at stated or par value) +
additional paid-in-capital.
Amount owners have paid in to
purchase shares of stock.
2-45
Retained Earnings



Reinvested earnings from inception to
date less dividends to date. If negative,
deficit.
Residual interest in assets.
No necessary relation between RE and
Cash.
2-46
Ratios


One number divided by another.
Example:



Current ratio=Current Assets / Current liabilities
A measure of liquidity or ability to pay short-term
obligations.
For some industries, 2 to 1 is believed desirable.
Discussion problem 2-6, p45
2-47
Balance Sheet in business – Illustration


First step in accounting is “creation” of the entity
Ram starts “Ramstore” on January 1, 20X5 with an
investment of $ 20,000 brought from his personal
savings.
Assets
Cash
$
Liabilities And
Owners Equity
20,000 Owners equity
$
20,000
2-48
Balance Sheet in business – Illustration

Transactions during January

On January 2 the store purchases a shop for $
50,000 paying $ 10,000 cash and signing a
mortgage for $ 40,000.
A new asset, shop premises, is acquired worth
$ 50,000.
 A new liability, mortgage on the shop is
contracted in the amount of $ 40,000.
Owners equity = Total assets – Liabilities, that is,
 $ 20,000 = $ 60,000 – $ 40,000.


2-49
Balance Sheet in business – Illustration
Modified Trial Balance: this shows that there is no
change in the owner(s) equity. Thus, the new Balance
sheet will be as follows:
RAMSTORE
Balance Sheet As Of January 2, 20X5
Assets
Liabilities
Equity
And
Owners
Cash
10,000 Mortgage on shop
40,000
Shop premises
50,000 Owners equity
20,000
60,000
60,000
Total
Total
2-50
Balance Sheet in business – Illustration

Further transaction
 On January 3, the store purchased merchandise for
$ 5,000 in cash
 The store also purchased merchandise for $ 15,000
on credit from Vanik
RAMSTORE
Balance Sheet As Of January 3, 20X5
Assets
Cash
$
Liabilities
Equity
And
Owners
$
5,000 Mortgage on shop
40,000
Merchandise inventory
20,000 Accounts payable
15,000
Shop premises
50,000 Owners equity
20,000
Total
75,000
75,0002-51
Total
Balance Sheet in business – Illustration

And more… On January 4, the store sells the
entire merchandise inventory for $ 25,000 cash
RAMSTORE
Balance Sheet As Of January 4, 20X5
Assets
Liabilities
And
Owners $
$
Equity
Cash
30,000 Mortgage on shop
40,000
Merchandise
Accounts payable
15,000
inventory
Shop premises
50,000 Owners equity
25,000
Total
80,000 Total
80,000
Business profit is earned in this process of exchange of
‘utility differential’ for a ‘monetary differential’
2-52
Summary of Chapter 2



Basic concepts
The balance sheet
Ratios
2-53
Balance Sheet Changes (HW)
Possibility Changes in Balance sheet
Example
An increase in assets followed by an
increase in liabilities and vice versa
Purchase of a tractor using a bank
loan
A decrease in assets followed by a
decrease in liabilities and vice versa
Using the savings deposit in bank to
return the loan from a friend
An increase in assets followed by an
increase in equity and vice versa
Interest earned on the savings
deposit increasing the net worth
A decrease in assets followed by a
decrease in equity and vice versa
using cash
owners.
An increase in an asset followed by a
decrease in another asset and vice
Using my savings balance in bank to
purchase a computer
An increase in a liability followed by a
decrease in another liability and vice
Taking a new bank loan to return the
loan from a friend
versa
versa
to
pay
dividends
to
2-54
Assignments of Chapter 2




Problem 2-4, p44
Problem 2-5, p45
Case 2-1, p46
Case 2-2, p47
2-55
Thank you
2-56
Answer for discussion problem 2-6
BRIAN COMPANY
CURRENT ASSETS AND LIABILITIES AS OF DECEMBER 31.
Current Assets
Cash
Current Liabilities
$ 2,000
Accounts payable
$5,000
Marketable securities
3,500
Wages payable
1,500
Accounts receivable
7,000
Bonds due – current
portion
2,000
Current assets
Current ratio =
$12,500
Current liabilities
$8,500
$12,500 $8,500 = 1.47
The current ratio is an indication of an entity’s ability to meet its
current obligations.
2-57
Answer for discussion problem 2-3










Cash + $100,000; Capital stock + $100,000.
Bonds payable - $25,000; Capital stock + $25,000.
Retained earnings (Depreciation expense) - $8,500;
Accumulated depreciation on plant and equipment + $8,500.
Cash - $15,900; Inventory + $15,900.
Inventory + $9,400; Accounts payable + $9,400.
Inventory - $4,500; Accounts receivable + $7,200;
Retained earnings + $2,700
Cash + $3,500; Accounts receivable - $3,500.
Dividends payable + $3,000; Retained earnings - $3,000.
Cash - $3,000; Dividends payable - $3,000.
No effect
Objective: familiar with the balance sheet account names.
2-58