CHAPTER 2 – Investing and Financing Decisions and the Balance Sheet
I. THE OBJECTIVE OF FINANCIAL REPORTING, THE ELEMENTS OF THE BALANCE SHEET, AND THE RELATED KEY ACCOUNTING ASSUMPTIONS AND PRINCIPLES. A.
Primary objective of financial reporting
1. To provide useful economic information about a business to help investors and creditors make good financial decisions. a. Decision makers are expected to have a reasonable understanding of accounting concepts and procedures. b. Decision makers need to be able to use financial information to help them predict future cash flows related to investing and financing.
B. Elements of the Balance Sheet
1. Balance sheet elements present the basic accounting equation (A = L + SE).
a. Assets: economic resources with probable future benefits owned by the entity as a result of past transactions.
1. Listed on the balance sheet in the order of liquidity.
2. Current assets are assets that will be used or turned into cash within one year.
b. Liabilities: probable debts or obligations of the company that result from past transactions, which will be paid with assets or services.
1. Listed on balance sheet in the order of maturity dates.
2. Current liabilities are obligations that will be paid in cash or other current assets or satisfied by providing cash, goods, or services within one year.
c. Stockholders equity: the owners’ residual interest in net assets (assets minus liabilities).
1. Contributed capital (Stock)
Assets (usually cash) provided by the owners in exchange for ownership 2. Retained earnings
a) The cumulative earnings that are not distributed to the owners and are
reinvested in the business. b) Increased by net income and reduced by declared dividends. Classified Balance Sheet accounts:
2. Marketable securities
6. Prepaid expenses
Property, Plant, and Equipment
d. Long-term investments
a. Current liabilities:
b. Long-term liabilities
3. STOCKHOLDERS’ EQUITY
a. Common Stock, Preferred Stock
b. Retained Earnings
C. Key Accounting Assumptions and Principles
Underlying assumptions of accounting help the decision maker to understand what accounting information reports as well as the inherent limitations.
a. Separate-entity assumption – “business” transactions are separate from “owner” transactions.
b. Unit-of-measure assumption – accounting information will be measured and reported in the national monetary unit of that company.
c. Continuity (going-concern) assumption – a business is expected to continue operations in the foreseeable future without forced liquidation.
d. Time period assumption
2. There are four basic accounting principles. The first directly relates to the balance sheet:
a. Historical Cost Principle: The historical cost principle states that the cash (or cash-equivalent cost) should be used to initially record financial statement elements. This historical cost amount is measured on the initial transaction date and does not typically reflect market value changes.
b. Revenue Recognition Principle
c. Matching Principle
d. Full Disclosure Principle
D. Guiding Principles for Communicating Useful Information
1. Information must be reliable to be useful: it must be accurate, unbiased, and verifiable.
2. Information should be consistent within a company so that it can be viewed over time. This requires similar accounting methods to be applied over time.
3. Information should be comparable: comparable information allows comparisons across business because similar accounting methods have been applied.
4. All material amounts must be disclosed. Material...
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