chapter 1-5

INTERPRETING INFORMATION SHOWN IN THE ACCOUNTING EQUATION

Learning Objective (LO) 1-5: Understand how to interpret information displayed in an accounting equation.

Introduction

• Before delving into how financial information is reported to stakeholders, there are significant features of the accounting equation to explore.

Accounting Equation Overview

Basic Structure of the Accounting Equation

• The accounting equation is expressed as:
  $ext{Assets} = ext{Liabilities} + ext{Common Stock} + ext{Retained Earnings}$

Example for Educate Inc.

• Initial Accounting Equation for Educate Inc.:
  • Assets:
  • Cash: $2,000$
  • Land: $0$
  • Liabilities: $1,200$
  • Common Stock: $500$
  • Retained Earnings: $300$
  • Thus, the equation appears as:
    $2,000 = 1,200 + 500 + 300$

Transaction of Land Purchase

• Educate Inc. uses all cash to acquire land.
• Accounting Equation after Purchase:
  • Assets:
  • Cash: $0$
  • Land: $2,000$
  • Liabilities: $1,200$
  • Common Stock: $500$
  • Retained Earnings: $300$
  • Thus, it looks like:
    $0 + 2,000 = 1,200 + 500 + 300$
• Key Insight: The liabilities, common stock, and retained earnings are not cash; they represent the sources of assets.

Expressing the Equation in Percentages

• The composition of the sources of assets can be represented as percentages:
  • ext{Liabilities: } 60 ext{%}
  • ext{Common Stock: } 25 ext{%}
  • ext{Retained Earnings: } 15 ext{%}
• This indicates how each component contributes to the total assets.

Cash and Retained Earnings

• Retained Earnings Definition: The amount of retained earnings does not directly represent cash availability. It restricts the cash available for dividends.
• Example with Creative Associates:
  • Initial Accounting Equation:
    • Assets:
    • Cash: $400$
    • Land: $1,900$
  • Thus:
    $400 + 1,900 = 700 + 1,000 + 600$
  • Dividend Limitation Example:
    • Can the company pay a $500$ cash dividend? No, as cash available is only $400$.
  • If sold land for $1,900$ cash, accounting equation:
    • $2,300 = 700 + 1,000 + 600$
  • Maximum dividend distribution would still be limited to $600$ as per retained earnings available.

Business Liquidations Resulting from Net Losses

• Liquidation Overview: When a business ceases operation, it liquidates by selling remaining assets, prioritizing creditors first, followed by investors.

Example with Cruz Company

• Initial Financial Position:
  • Assets: $300$
  • $ext{Cash from Creditors: } 200$
  • $ext{Cash from Investors: } 100$
• After Net Operating Loss of $75$:
  • Accounting Equation:
    $225 = 200 + 100 + (-75)$
  • Liquidation Outcome: Creditors receive $200$; investors receive $25$.

Scenario with Increased Loss

• If increased to a net loss of $120$:
  • Adjusted Accounting Equation:
    $180 = 200 + 100 + (-120)$
  • Liquidation Outcome: Investors receive $0$ and creditors receive $180$.
• Implication: Creditors are somewhat safeguarded due to their priority in repayment but still face risk of loss.

Mismanagement Leading to Liquidations

• Example with Bandera Company:
• Company acquires:
  • Cash from Creditors: $300$
  • Cash from Investors: $500$
  • Net Income: $200$
• Total expenses paid for land: $950$, leading to:
  • Accounting Equation:
    $50 + 950 = 300 + 500 + 200$
• Bankruptcy Risk: Even profitable, may face bankruptcy due to insufficient cash to cover debts.

Going Concern Doctrine

• The assumption that a business will continue its operations into the future. If uncertain, accountants must alert creditors/investors.

Two Views of the Right Side of the Accounting Equation

• View 1: Right side indicated as sources of assets (e.g., loans create cash, which is an asset).
• View 2: Right side as obligations to return assets (i.e., liabilities are seen as debts owed to creditors).
• Common stock and retained earnings can also be seen as sources of assets, and the duty to manage these assets serves investors' interests.
• It is crucial to recognize that the right side of the accounting equation may serve dual purposes, encompassing both the sources of assets as well as the obligations of the business.