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Chapter 2 Study Notes - Financial Statements

Chapter 2 Study Notes - Financial Statements - CHAPTER 2...

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CHAPTER 2 STUDYNOTES 1 CHAPTER 2 FINANCIAL STATEMENTS: AN OVERVIEW ACCOUNTING EQUATION A = L + OE ASSETS (what company owns—e.g. cash, buildings, equipment, inventory, patents) = LIABILITIES (what company owes to others—e.g. loans from bank, bonds issued, amounts owned to suppliers) + OWNERS’ EQUITY (what’s left for the owners if assets are applied to pay off liabilities)—If a corporation, composed of two parts: Capital Stock —amounts invested in company by owners (i.e. shareholders) to acquire their ownership interest Retained Earnings —net profits (revenues minus expenses) earned by the company over the years that have not yet been withdrawn (i.e. paid to shareholders as dividends) NOTE: Liabilities and Owners’ Equity show the sources of funds to acquire the assets— amounts invested by owners (paid in capital portion of Owners’ Equity), reinvestment of profits (retained earnings portion of Owners’ Equity) or amounts borrowed (Liabilities) ACCOUNTING FOR BUSINESS TRANSACTIONS GAAP requires use of accrual method of accounting rather than cash basis accounting. Under accrual accounting, events are recorded when they occur rather than when the related cash changes hands. As examples (assuming ABC Co. is your company and has a 12-month operating cycle): ABC Co. provides consulting services to a client. Project is completed and bill is mailed on December 20, 2002. Check from client is received on January 28, 2003. Revenue is recorded in December 2002 and asset “accounts receivable” is recorded—income is recognized when earned, not when cash is later received. Account Receivable is an asset account—it represents amounts owed to you by customers/clients for work performed for them or goods sold to them. It represents the legal right to receive cash in the near future for work already performed—so it is “earned” When cash is received in January 2003, NO income is recorded; instead account receivable is decreased and cash is increased (i.e. transfer between two asset accounts) ABC Co. hires XYZ law firm to perform legal services related to business transactions on its behalf. XYZ performs the services in December 2002 and gives ABC Co. bill for these legal services in December 2002. ABC Co. pays bill on
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