Chapter 2 Classified Balance Sheet & Chapter 3 Accounting Cycle Notes

Balance Sheet and the Accounting Cycle: Key Concepts and Examples

  • Four primary financial statements (Chapter 1 recap):

    • Income statement computes net income: extNetIncome=extRevenues−extExpensesext{Net Income} = ext{Revenues} - ext{Expenses}
    • Net income is reflected on the retained earnings statement:
    • Beginning retained earnings + net income − dividends = ending retained earnings
    • Ending retained earnings flows into the balance sheet as part of stockholders’ equity
    • The balance sheet shows assets, liabilities, and stockholders’ equity, following the accounting equation:
    • extAssets=extLiabilities+extStockholders′Equityext{Assets} = ext{Liabilities} + ext{Stockholders' Equity}
    • The balance sheet order in this chapter uses classified categories for assets and liabilities
    • The statement of cash flows requires the cash balance from the balance sheet to begin with

  • Chapter 2: The balance sheet in detail

    • Core idea: assets are resources used in operations; liabilities are creditors’ claims; stockholders’ equity are owners’ claims
    • Classified balance sheet versus a standard balance sheet: assets and liabilities are grouped into categories

Classified Balance Sheet: Asset categories

  • Current assets: will be used up or turned into cash within the next year
    • Examples: cash; debt investments (investments in securities) with maturity or management’s intention to convert within a year; accounts receivable; notes receivable; inventory; supplies; prepaid expenses (prepaid insurance, prepaid rent, prepaid advertising)
    • Debt investments: two ways to be current
    • If there is a maturity date within one year, it’s current
    • If no maturity date, management’s intention to cash in within the next year makes it current
    • Notes receivable vs accounts receivable:
    • Accounts receivable: amounts due from customers, typically due in about 30 days
    • Notes receivable: formal promise to pay, often with interest; usually more legally binding; also due within 12 months to be current
    • Prepaid assets: arise when we pay for expenses before we receive the benefit (e.g., prepaid insurance, prepaid rent); until the service is received, it remains an asset
    • Inventory and supplies: assets expected to be consumed or sold within a short period (within one year)
  • Long-term investments: investments expected to be held longer than one year or without a stated maturity within the next year
    • Examples: debt investments with maturity > 1 year or no stated maturity but intended to hold > 1 year; investments in real estate; other long-term investments
    • For stock investments: absence of maturity means management’s plan to hold > 1 year
  • Property, plant, and equipment (PP&E): assets used in operations and not intended for sale
    • Order typically shown: Land (property), Buildings (plants), Equipment (movable assets)
    • Depreciation: a contra-asset account (accumulated depreciation) is used to allocate the cost of PP&E over its use in operations
    • Example: cost of equipment is shown as an asset, with a line for accumulated depreciation subtracted to reflect book value
  • Intangible assets: lack physical substance
    • Examples: Patent (cost amortized over its legal life, often 20 years), trademarks, goodwill
    • Amortization is the cost allocation technique for intangible assets

Classified Balance Sheet: Liability and Equity categories

  • Liabilities: obligations of the company; divided into current and long-term
    • Current liabilities: due within the next 12 months
    • Examples: notes payable (short-term note), accounts payable, unearned revenue (also called deferred revenue), salaries and wages payable, interest payable
    • Long-term liabilities: due beyond 12 months
    • Examples: mortgage payable (classic example; long-term unless the current portion is due within a year)
    • The concept of mortgage foreclosures is discussed to illustrate risk of long-term debt when payments lapse
  • Stockholders’ equity: ownership claims, made up of two main components
    • Paid-in capital (often referred to as common stock when discussing specific stock): the amount investors paid to the company for stock
    • Retained earnings: accumulated profits not distributed as dividends; net income increases retained earnings, net losses or dividends reduce it
    • Dividends reduce retained earnings; net income increases retained earnings through higher retained earnings on the balance sheet

Recap of classifications and examples (from in-class exercises)

  • Example exercise: classify each item on a classified balance sheet
    • Accounts payable → current liability
    • Cash → current asset
    • Accumulated depreciation, equipment → PP&E
    • Buildings → PP&E
    • Goodwill → intangible asset
    • Income taxes payable → current liability
    • Inventory → current asset
    • Stock investments → current or long-term asset depending on intent/maturity
    • Land held for use → PP&E (in use) or held for sale otherwise; if held for future use, may be long-term investment
    • Mortgage payable → long-term liability (unless current portion is due within 12 months)
    • Prepaid rent → current asset
    • Prepaid advertising → current asset
    • Trademarks → intangible asset
    • Salaries and wages payable → current liability
    • Retained earnings → stockholders’ equity
    • Patents → intangible asset

The accounting cycle: from analysis to journalizing

  • Visual: page with a sequence of steps (arrows indicating steps from analysis to journalizing, etc.)
  • The five major types of accounts (the accounting equation) emphasized:
    • Assets
    • Liabilities
    • Stockholders’ equity
    • Revenues
    • Expenses
  • How revenues and expenses affect the accounting equation
    • Revenues increase earnings directly and therefore increase retained earnings (and thus stockholders’ equity)
    • Expenses decrease earnings and hence reduce retained earnings (and stockholders’ equity)
  • Revenues and expenses are income statement accounts; their effect is ultimately reflected in retained earnings on the balance sheet
  • The example illustration (Illustration 3.2) shows the accounting equation and how revenues, expenses, and dividends affect it; basic idea: revenues increase assets/stockholders’ equity via retained earnings; expenses reduce retained earnings

Transaction analysis examples (treated as “events” in the accounting cycle)

  • Event 1: Investment of cash by stockholders
    • On October 1, cash increases by 10,00010{,}000 (Asset: Dr Cash +10,000+10{,}000)
    • In exchange, common stock increases stockholders’ equity (Paid-in capital: Cr Common Stock +10,000+10{,}000)
  • Event 2: Sierra borrows 5,0005{,}000 from the bank
    • Cash increases (Asset: Dr Cash +5,000+5{,}000)
    • Note payable increases (Liability: Cr Notes Payable +5,000+5{,}000)
  • Event 3: Purchase of equipment for cash
    • Equipment increases (Asset: Dr Equipment +5,000+5{,}000)
    • Cash decreases (Asset: Cr Cash −5,000-5{,}000)
    • Note: this is an asset-for-asset exchange; total assets remain the same, but composition changes
  • Event 4: October 2, cash received in advance from a client (unearned revenue)
    • Cash increases (Asset: Dr Cash +1,200+1{,}200)
    • Unearned service revenue increases (Liability: Cr Unearned Service Revenue +1,200+1{,}200)
  • Event 5: October 3, cash received for services not yet performed (service revenue earned later)
    • Cash increases (Asset: Dr Cash +10,000+10{,}000)
    • Service revenue increases (Stockholders’ equity via retained earnings; Revenue is recognized, so Cr Service Revenue +10,000+10{,}000)
    • Concept to highlight: revenue recognition timing; revenue is earned when service is performed, not just when cash is received
  • The instructor notes: the numerical example in the lecture may include corrections (e.g., correcting a misstatement like $1,200 vs $10,000) and emphasizes the process of analyzing transactions first, then journalizing later in the course

The accounting assumptions, principles, and the six terms (Exercise 2.17 section)

  • Going concern assumption: belief that a company will continue operations for the foreseeable future
  • Economic entity assumption: personal and business records are separate; economic activities of the business are accounted for separately from the owner(s)
  • Monetary unit assumption: financial statements are recorded in a stable monetary unit; quantities can be expressed in money terms
  • Periodicity (or periodicity assumption): financial statements are prepared for specific time periods
  • Historical cost principle: assets are recorded at their original cost, not current market value
  • Full disclosure principle: financial statements should disclose all information necessary for users to make informed decisions

Practical reminders and takeaways

  • The balance sheet provides a snapshot of financial position at a point in time, while the income statement and statement of retained earnings show performance over a period

  • The classification of assets and liabilities into current vs long-term affects liquidity and financial analysis

  • Depreciation and amortization are cost allocation techniques used to match costs with the periods benefiting from the use of assets or intangible rights

  • The accounting cycle starts with analyzing transactions, then journalizing and posting, and continues through adjusting, closing, and preparing financial statements (the course will cover these steps in chapters 3 and 4)

  • If you’re preparing for exams, be prepared to:

    • Classify items into the correct asset, liability, or equity category (current vs long-term as applicable)
    • Demonstrate how a simple sequence of events affects the accounting equation and the related accounts
    • Explain the relationship between the income statement, retained earnings, and the balance sheet
    • Apply the going concern and monetary unit assumptions, periodicity, historical cost, and full disclosure concepts to problem sets

  • Key formulas to remember:

    • extNetIncome=extRevenues−extExpensesext{Net Income} = ext{Revenues} - ext{Expenses}
    • extEndingRetainedEarnings=extBeginningRetainedEarnings+extNetIncome−extDividendsext{Ending Retained Earnings} = ext{Beginning Retained Earnings} + ext{Net Income} - ext{Dividends}
    • extAssets=extLiabilities+extStockholders′Equityext{Assets} = ext{Liabilities} + ext{Stockholders' Equity}

  • Final note: the instructor emphasizes practicing the accounting cycle steps until they become second nature, with a focus on analysis first and journalizing second as you work through subsequent chapters.