Define the objective of financial reporting, the elements of the balance sheet, and the related key accounting assumptions and principles.
The primary objective of external financial reporting is to provide useful economic information about a business to help external parties, primarily investors and creditors, make sound financial decisions.
Elements of the balance sheet:
Assets—probable future economic benefits owned by the entity as a result of past transactions.
Liabilities—probable debts or obligations acquired by the entity as a result of past transactions, to be paid with assets or services.
Stockholders' equity-the financing provided by the owners and by business operations.
Key accounting assumptions and principles:
Separate-entity assumption—transactions of the business are accounted for separately from transactions of the owner.
Unit-of-measure assumption—financial information is reported in the national monetary unit.
Continuity (going-concern) assumption—a business is expected to continue to operate into the foreseeable future.
Historical cost principle—financial statement elements should be recorded at the cashequivalent cost on the date of the transaction.
Identify what constitutes a business transaction and common balance sheet account titles used in business. A transaction includes:
An exchange between a business and one or more external parties to a business. or
A measurable internal event, such as adjustments for the use of assets in operations.
An account is a standardized format that organizations use to accumulate the dollar effects of transactions related to each financial statement item. Typical balance sheet account titles include the following:
Assets: Cash, Accounts Receivable, Inventory, Prepaid Expenses, and Buildings and Equipment.
Stockholders' equity: Contributed Capital and Retained Earnings.
Apply transaction analysis to simple business transactions in terms of the accounting model: Assets = Liabilities + Stockholders' Equity.
To determine the economic effect of a transaction on an entity in terms of the accounting equation, each transaction must be analyzed to determine the accounts (at least two) that are affected. In an exchange, the company receives something and gives up something. If the accounts, direction of the effects, and amounts are correctly analyzed, the accounting equation must stay in balance.
Determine the impact of business transactions on the balance sheet using two basic tools, journal entries and T-accounts.
Journal entries express the effects of a transaction on accounts in a debits-equal-credits format. The accounts and amounts to be debited are listed first. Then the accounts and amounts to be credited are listed below the debits and indented, resulting in debits on the left and credits on the right.
T-accounts summarize the transaction effects for each account. These tools can be used to determine balances and draw inferences about a company's activities.
Prepare and analyze a simple balance sheet using the financial leverage ratio. Classified balance sheets are structured with
Assets categorized as "current assets" (those to be used or turned into cash within the year, with inventory always considered a current asset) and noncurrent assets, such as long-term investments, property and equipment, and intangible assets.
Liabilities categorized as "current liabilities" (those that will be paid with current assets) and long-term liabilities.
Stockholders' equity accounts are listed as Contributed Capital first followed by Retained Earnings.
The financial leverage ratio (Average Total Assets _ Average Stockholders' Equity) measures the relationship between total assets and the stockholders' capital that finances the assets. The higher the ratio, the more debt is used to finance the assets. As the ratio (and thus debt) increases, risk increases.
Identify investing and financing transactions and demonstrate how they are reported on the statement of cash flows. A statement of cash flows reports the sources and uses of cash for the period by the type of activity that generated the cash flow: operating, investing, and financing. Investing activities are purchasing and selling long-term assets and making loans and receiving principal repayments from others. Financing activities are borrowing and repaying to banks the principal on loans, issuing and repurchasing stock, and paying dividends.
In this chapter, we discussed the fundamental accounting model and transaction analysis. Journal entries and T-accounts were used to record the results of transaction analysis for investing and financing decisions that affect balance sheet accounts. In Chapter 3, we continue our detailed look at the financial statements, in particular the income statement. The purpose of Chapter 3 is to build on your knowledge by discussing the measurement of revenues and expenses and illustrating the transaction analysis of operating decisions.
