3.1. Measuring and Reporting Financial Position

Three Assumptions and Measurement Concept of Financial Statements

1. Separate Entity Assumption

2. Going Concern Assumption

3. Monetary Unit Assumption

+Historical Cost Measurement Concept

Separate Entity Assumption

each business’s activities must be accounted for separately from the personal activities of the owners, all other persons, and other entities.

Going Concern Assumption (Continuity Assumption)

it is assumed that the business will continue operating into the foreseeable future, long enough to meet its contractual commitments and plans. This means, for example, that if there was a high likelihood of bankruptcy, then its assets should be valued and reported on the balance sheet as if the company were to be liquidated.

Monetary Unit Assumption

the financial statements are reported using the national monetary unit (e.g. dollars in the US) without any adjustment for changes in purchasing power (e.g., inflation)

Historical Cost Measurement Concept

the balance sheet elements are initially recorded at their cost

Assets

• economic resources owned or controlled by the company that have a measurable value and benefit the company by producing cash flows or reducing cash outflows in the future

• in the balance sheet, assets are in order of liquidity

Two Types of Assets

Current Assets: resources the company will use or turn into cash within a year

Long-Term (Non-Current) Assets: to be use or turned into cash after a year

Current Assets

• held for less than a year

• generally used for daily purposes and provide information about operating activities

• Common CA include: cash, inventories, accounts receivable, prepaid expense

Cash

money or any instrument that banks will accept for deposit and immediate credit to a company’s account, such as a check, money order, or bank draft. most liquid asset, a good indicator of a company’s health

Inventory

tangible property held for sale in the normal course of business or used in producing goods or services for sale. a significant asset on the balance sheet as merchandising and manufacturing companies generate revenue and profit via the sale of inventories

Circulating Nature of Current Assets

Inventories could be sold cash or credit. Sales made on credit are considered accounts receivable, which will be converted into cash once payment is made. That cash can then be used to by more inventory, beginning a new cycle

Accounts Receivable (Trade Receivables)

represents amounts owed to a company by its customers for products/services sold on credit

large amount of receivables relative to revenue may indicate a problem with collecting cash from customers

Concentration of Credit Risk (Accounts Receivable)

whether the receivables are diverse in terms of customer base or concentrated on limited number of customers: high concentration usually indicates high risk

Non-Current Assets

• held for more than a year

• represent infrastructure from which the entity operates and used from a strategic and long-term perspective

• Common NCA: PPE, Intangible Assets, Goodwill

Tangible and Intangible Assets

Tangible Assets: with physical form (can be touched) usually referred to as PP&E or fixed assets

Intangible Assets: lack physical form and confer specific rights on their owner (e.g., patents, licenses, trademarks)

The footnotes will disclose how much of the account receivables are owed by customers

Goodwill

• for accounting purposes, the excess of the purchase of the purchase price of an acquired business over the fair value of the acquired business’s assets and liabilities

• It accounts for non-quantifiable items like reputation, employee skill level, relationship with clients

• Only recognized on the balance sheet during an acquisition

• good way to overstate assets

Requirements for Asset Inclusion on the Balance Sheet

1. It is probable that the future economic benefits will flow to the entity

2. The economic resources must be under the control of the business (e.g., legal ownership, contractual agreement)

3. The asset has a cost or value that can be measured reliably in monetary terms

Not all assets will included in the balance sheet: e.g., management skills

Liabilities

• measurable obligations resulting from a past transaction, they are expected to be settled in the future by transferring assets or providing services

• listed in order of maturity (how soon an obligation is to be paid) and group by term

Current Liabilities

• to be settled within a year

• Common CL accounts: trade payables, short-term loans, bank overdraft, accrued expense

Non-Current Liabilities

• to be settled within more than a year

• Common CL accounts: long-term borrowings, notes payable

Trade Payables (Accounts Payable):

• amounts a company owes its vendors for purchase of goods/services in case of credit purchase

• Trends: significant changes in accounts payable relative to purchases could signal changes in a company’s credit relationship with suppliers

Trade Credit

• allows a company to pay the supplier at a later schedule date

• could be seen as interest-free financing, as it allows firms to pay the trade payable at a later date without interest

Accrued Expense (Accrued Liabilities)

liabilities created when expenses are incurred, but cash will be paid in the future: created at the end of period during the adjustment process to reflect the amount of expense incurred that the company will pay in the future. they are recognized on the income statement but not yet been paid as of the balance sheet date.

Types of Accrued Liabilities

Wage Expense: wages owed to employees who worked during the period will be paid in next period

Interest Expense: interest are always paid in the future

Utilities Expense: organization receive utility bills after using utility services, the services will be paid next period

Stockholders’ Equity

represents the residual interest in the assets of the entity after subtracting liabilities. it is a combination of the financing provided by the owners and business operations

Contributed Capital

• financing provided by the owners

• owners invest in the business by providing cash and sometimes other assets, receiving in exchange shared of stock as evidence of ownership

• use the accounts Common Stock and Additional Paid-In Capital to represent the amount investors paid when they purchased the stock from the company

Retained Earnings

• financing provided by operations

• the portion of profits reinvested in the business

• losses and dividends decrease the Retained Earnings Accounts

Unrecorded but Valuable Assets

Intangible assets not recorded:

• assets developed inside a company (not purchased)

• assets developed over time though research, development and advertising (not purchased)

many valuable intangible assets, such as trademarks and patents are not reported on the balance sheet

Accounts

organizations use account, a standardized format, to accumulate the dollar effect of transactions

each company established a chart of accounts a list of all accounts to facilitate transaction recordings

Typical Assets Account Titles

• Cash

• Short-Term Investments

• Accounts Receivable

• Notes Receivable

• Inventory (to be sold)

• Supplies

• Prepaid Expenses

• Long-term Investments

• Equipment

• Buildings

• Land

• Intangibles

Typical Liabilities Account Titles

• Accounts Payable

• Accrued Expenses

• Notes Payable

• Taxes Payable

• Unearned Revenue

• Bonds Payable

Typical Stockholder’s Equity Account Titles

• Common Stock

• Additional Paid-In Capital

• Retained Earnings

Typical Revenues Account Titles

• Sales Revenue

• Fee Revenue

• Interest Revenue

• Rent Revenue

• Service Revenue

Typical Expenses Account Titles

• Cost of Goods Sold

• Wages Expense

• Rent Expense

• Interest Expense

• Depreciation Expense

• Advertising Expense

• Insurance Expense

• Repair Expense

• Income Tax Expense

Transaction

1. An exchange between a business and one or more external parties to a business

2. A measurable internal event such as the use of assets in operations

2 Principles of Transaction Analysis

1. Dual-Aspect Convention: every transaction affects at least two accounts. Correctly identifying those accounts and the direction of the effect (increase or decrease)

2. Accounting equation will ALWAYS hold balance after each transaction

Steps to Analyze Transactions

1. What was received?

   1. Identify the account affected

   2. Classify the account by the type of element

      1. Asset (A), Liability (L), Equity (SE)

   3. Determine the direction and amount of the effect

      1. The account increased or decrease (±)

2. What was given?

3. Is the accounting equation in balance?