2:
The Accounting Balance Sheet
Professor Ted Chadwick
Based on a lecture by
Professor Eng Wu June 5, 2007
Quiz 1
Stockholders' equity is
A. The fair market value of a company
B. Liabilities minus assets C. Contributed capital plus retained earnings D. Revenue minus expenses
Recap
Operating Activities SMG Corporation Balance Sheet
22 January 2007
Financing Activities
Current Assets
Long term assets
Current Liabilities
Long term Liabilities
Owners Equity
Investing Activities A
=
L + OE
Balance Sheet
Some items commonly found in the balance sheet: Current Assets Cash Current Liabilities Accounts payable
Accounts receivable Inventories Prepaid expenses
PPE
Wages Payable Accrued liabilities
Unearned revenues Notes Payable
Intangibles Others
Bonds Payable
Contributed capital Retained Earnings
Transaction Analysis
Once a company is formed and starts to do business, there will be many accountable activities. Some are: Explicit: Activities that are observable. Example: You buy a book from Barnes and Noble B&N gives you the book and in return you pay for it with cash (or credit card).
Some observable activities are not recorded because they have no immediate impact on Assets, Liabilities, or Owners Equity. Also, we cannot reasonably assign a $ amount to such event.
***Daisuke Matsuzaka signs with Red Sox ***
Implicit: These are unobservable activities that must be recorded. These will be covered in lecture next Tuesday.
The Balance Sheet Equation
Accountable transactions usually have impact on two or more accounts. We need to examine each transaction and determine: 1. The accounts that are affected
2. Whether the impact is positive (increasing the value of the account) or negative (decreasing the value of the account).
With the BS equation A=L+OE we can see the impact of the transaction on the balance sheet.
Example of transaction
The company borrowed $50,000 from a bank, signing a note agreeing to repay the amount in two years. The two accounts affected are: Cash Cash is increased because Co. received $50,000 from a bank. Note Payable A Cash = N/P, a liability is increased because the company has committed to repay the loan. L N/P + OE
Example 2
The Company bought $5,000 worth of inventories (goods for resale) paying the supplier 20% cash and the rest to be paid in 60 days. Here, 3 accounts are involved:
Inventories Cash Accounts Payable A Inventories
5,000
Co. has more goods - asset increases Cash is paid out asset decreases Commitment to repay liability increases = Cash
- 1,000
L A/P
4,000
+ OE
Example 3
The Company signed a contract with Mr. Smart to employ him as the Company's CFO from January 2007. The annual salary is agreed at $200,000 a year. This is not an accountable transaction no impact on asset, liability, or OE.
Once Mr. Smart starts working, company will have to pay him the accounting starts then.
Note also, when analyzing a transaction always take it from the Company's point of view unless otherwise stated.
Quiz 2
American Corp installed $25,000 of equipment, paying $5,000 in cash and promising to pay $20,000 in 90 days. As a result of this transaction A. Total assets will increase by $5,000
B. Total assets will increase by $20,000 C. Total assets will increase by $25,000 D. Total assets will increase by $30,000
Recording of Transactions
We are now familiar with how transactions can affect the balance sheet. Do companies analyze each event and adjust the BS as necessary? No. Events are first recorded in books (journals), summarized, adjusted, and checked for accuracy before the balance sheet is prepared. Accounting attempts to record the transactions in a precise and concise manner using a system known as "double-entry" bookkeeping.
The Language of Business
Accounting is commonly known as the language of business because it adopts a common method to communicate with stakeholders. Double-entry because companies not only record what they have, but also, how they are financed. Transactions are first recorded in "Journals" and subsequently posted to "Ledgers". To keep the recording simple and yet meaningful, accounting employs a system of "Debits" and "Credits". The terms Debits and Credits must not be confused with the meaning of the words in English. They are simply words employed in accounting. You may think of:
Debit as left hand side and Credit as right hand side.
Debits and Credits
The balance sheet is organized in the debit/credit format: Balance Sheet
Liabilities
Assets
Owners Equity
Credit side All liabilities and OE accounts are "credit" items
Debit side All asset accounts are "debit" or items
Increase Decrease
Assets are debit items so, when we "debit" an asset we increase its value
Conversely, when we "credit" an asset, we decrease its value.
Liabilities and OE items are on the "credit" side, so they work in the reverse way. When we "credit" a liability or OE item, we increase its value and if we "debit" one, we decrease its value.
It's not good English, but it's kind of logical:
The value of the account will increase when you "Debit" a debit item or "Credit" a credit item
Journal Entries
Transactions are recorded in Journals in a concise manner. The recordings are called "Journal Entries" and they are written in a specific form. Example: A company paid $25,000 cash for a car. Using the balance sheet equation, we would say cash decreased by $25,000 and another asset (equipment) increased by $25,000. Both items involved in this transaction are assets or "debit" items. The rule: "debit" a debit item - increase "credit" a debit item - decrease
J.E. - continues
We need to "debit" equipment and "credit" cash to recognize that the company is using cash to purchase new equipment.
The journal entry for this is: Equipment (car)
Cash
25,000
25,000
NB: Eqpt 25,000 Cash 25,000 is not a JE
By convention: the "debit" entry is written first. The "credit" entry follows and is indented right.
Each entry has an account name and the relevant $ amount. Sometimes there are multiple debit and/or credit items. In such cases, total $ of debits must equal total $ credits.
Examples of J.E.'s
Using the same examples that were used when we examined the balance sheet equation:
1. Co. borrowed $50,000 from a bank, signing note. 2. Co. purchased inventories for $5,000 paying 20% cash and the rest in 60 days.
Journal entries: 1. Cash 50,000 Notes Payable
50,000 Note: Debit = sum of credits
2. Inventories 5,000 Cash Accounts Payable
1,000 4,000
T-Accounts
All accountable transactions are first recorded in "Journals" using the journal entry format and subsequently posted (or transferred) to "Ledgers" or T-Accounts. Every account in the balance sheet has its summary in a T-account. BS accounts are permanent in that the reported balances for each account are carried over to the next accounting period.
If a company reported, say, $10,000 cash in its year end BS, then this amount is the beginning balance for the cash T-account in the following accounting period. Cash
Using the above and the previous examples, the Cash T-account would look like:
BB: 10,000
(1) 50,000 EB: 59,000
1,000 (2)
T-Accounts
Note that the same Debit/Credit convention is used here:
Debits
Credits
1. Cash
50,000 Notes Payable
50,000
2. Inventories 5,000 Cash Accounts Payable
1,000 4,000
Postings
Except for the Cash a/c other T-accounts are affected by very few types of activities.
Accounts Receivable: 1. Debited (increased) by credit sales 2. Credited (decreased) by collections 3. Credited (decreased) by write-offs Accounts Payable: 1. Credited (increased) by purchases 2. Debited (decreased) by payments
Equipment: 1. Debited by purchases new equipment 2. Credited by sales of old equipment What about depreciation?
Preparation of BS
Once all T-accounts are completed, the ending balance of each T-account forms the final value on the new BS.
T-a/cs
Old BS Beginning balances
(assets) EB EB (Liab. OE)
Journal entries
New BS
Complete example
Consider a Co. reported in last year BS: $30,000 cash, $15,000 accounts receivable, $40,000 inventories, and $12,000 accounts payable. Current year transactions are: 1. Purchased $30,000 inventories, paying 20% cash, the rest to be paid in 60 days. 2. Sold $60,000 worth of inventories for $100,000 collecting 20% cash and the rest on credit. 3. Paid $25,000 to suppliers for the purchase of inventories. 4. Collected $70,000 from clients
JE1: Inventories 30,000 Cash 6,000 A/P 24,000
JE3: A/P 25,000 Cash 25,000
JE2: Cash A/R
20,000 80,000 Revenue 100,000 Costs of Goods sold 60,000 Inventory 60,000 70,000
JE4: Cash 70,000 A/P
T-a/c's for Example
Cash
BB: 30,000 6,000 (1) (2): 20,000 (4): 70,000 25,000 (3) EB: 89,000 BB: 15,000 (2): 80,000 EB: 25,000 Inventories BB: 40,000 A/P (3): 25,000 BB: 12,000 A/R 70,000 (4)
(1): 30,000
EB: 10,000 Revenues
(2): 60,000
(1): 24,000
EB: 11,000
COGS
(2): 100,000
(2): 60,000
Quiz 3
Which of the following requires a credit?
A. Decreases in liabilities B. Decreases in stockholders' equity
C. Increases to assets D. Increases to liabilities
Have a Nice Day!