MODULE 2 LECTURE Bookkeeping, Internal Controls & Assets 1 The Balance Sheet Equation—A Mechanical Key Assets = Liabilities + Stockholders’ Equity The basic accounting equation can be expanded to include the beginning balances of retained earnings, revenues, and expenses. Another principal element of stockholders’ equity is the amount of capital invested by the owners/stockholders—the PIC (paid‐in capital) A = L + PIC + REBEG + R - E LO 4‐1: Illustrate the expansion of the basic accounting equation to include revenues and expenses. The balance sheet equation is written as A (assets) equals L (liabilities) plus SE (stockholders' equity). This basic accounting equation can be expanded to include the beginning balances of retained earnings, revenues, and expenses. There are two major components of stockholders' equity, PIC (paid‐in capital, which represents investments by stockholders) and RE (retained earnings, which represent the accumulated earnings (net income) of the company less dividends paid). NI (net income) equals R (revenue) minus E (expenses). Debits and Credits Debits and credits affect the accounting equation as follows: A = L + SE Debits and credits affect the accounting equation as follows: 1) asset accounts are increased on the left side with a debit and decreased on the right side with a credit; 2) liabilities are increased on the right side with a credit and decreased on the left side with a debit; and 3) equity accounts are increased on the right with a credit and decreased on the left with a debit. An easier way for students to remember this concept is to relate the T‐account increases and decreases (debits vs. credits) to the accounting equation. Assets are on the left‐hand side of the accounting equation; therefore, increases (debits) to asset accounts are recorded on the left‐hand side of the T‐account. Liabilities and equity are on the right‐hand side of the accounting equation; therefore, increases (credits) to these accounts are recorded on the right‐hand side of the T‐account. Increases in Increases with stockholders' credit entries equity Decreases in Increase with stockholders' debit entries equity Revenue represents increases in stockholders' equity, and revenue accounts increase on the right side with a credit. Expenses represent decreases in stockholders' equity, and expense accounts increase on the left side with a debit. A = L + SE The normal balance of an asset and expense account is the debit side because debit entries increase the balances of these accounts. Credit entries in asset and expense accounts decrease the balances of these accounts. The normal balance of liabilities, stockholders' equity, and revenues accounts is the credit side, because credit entries increase these accounts. Debit entries in liabilities, stockholders' equity, and revenue accounts decrease the balances of these accounts. The normal balance of an account is reflected on the same side of the T‐account in relationship to the accounting equation. The normal balance of an asset account appears on the debit side of the T‐account because assets are on the left‐hand side of the accounting equation. What Are Current Assets? Current assets include cash and other assets that are expected to be converted to cash or used up within one year, or an operating cycle, whichever is longer. Cash and Cash Current Inventories Equivalents Assets include… Prepaid Short-Term Marketable Expenses Securities Accounts and Notes Receivable Current assets include cash and other assets that are expected to be converted to cash or used up within one year, or an operating cycle, whichever is longer. Current asset captions usually seen in a balance sheet are the following: cash and cash equivalents, short‐term marketable securities, accounts and notes receivable, inventories, and prepaid expenses or other current assets. Bad Debts/Uncollectible Accounts If a company makes credit sales to customers, some accounts inevitably will turn out to be uncollectible. Credit managers must estimate the probable bad debts expense (or uncollectible accounts expense) of the firm. LO 5‐5: LearningDiscuss how accounts receivable are reported on the balance she Objective 5: Discuss how accounts receivable are reported onet, including the the balance valuation allowances for estimated uncollectible accounts and esheet, including the valuation allowances for estimated uncollestimated cash discounts.ctible accounts and estimated cash discounts. Whenever a firm permits its customers to purchase merchandise or services on credit, it knows that some of the customers will not pay. Based on recent collection experience, tempered by the current state of economic affairs of the industIf a company makes credit sales to customers, some accountsry in which a firm is inevitably will turn out operating, credit managers can estimate with a high degree of ato be uncollectible. ccuracy the probable bad debts expense (or uncollectible accounts expense) of the firm. Balance Sheet Presentation Accounts Receivable Less: Allowance for Bad Debts Net realizable value of accounts receivable The net realizable value is the amount of accounts receivable that the business expects to collect. The balance sheet presentation for accounts receivable is the net realizable value (the amount of accounts receivable that the business expects to collect). It is accounts receivable minus the allowance for bad debts. Writing Off an Uncollectible Account Receivable When an account is determined to be uncollectible, it should be written off against the allowance account. The effect of this entry on the financial statements follows: The write‐off entry is this: When a customer defaults on an accounts receivable and the account is determined to be uncollectible, it no longer qualifies as an asset and should be written off. Inventories For service organizations, inventories consist mainly of office supplies and other items of relatively low value that will be used up within the organization, rather than being offered for sale to customers. For merchandising and manufacturing firms, the sale of inventory in the ordinary course of business provides the major, ongoing source of operating revenue. Inventories represent the most significant current asset for such firms. LO 5‐7: Explain how inventories are reported on the balance sheet. For service organizations, inventories consist mainly of office supplies and other items of relatively low value that will be used up within the organization, rather than being offered for sale to customers. For merchandising and manufacturing firms, the sale of inventory in the ordinary course of business provides the major, ongoing source of operating revenue. Cost of Goods Sold is usually the largest expense that is subtracted from Sales in determining net income, and, not surprisingly, inventories represent the most significant current asset for many such firms. Effects of Purchase and Sale Transactions on the Financial Statements The entries are as follows: The cost of a purchased or manufactured product is recorded as an asset and carried in the asset account until the product is sold (or becomes worthless or is lost or stolen), at which point the cost becomes an expense to be reported in the income statement. The cost of an item purchased for inventory includes not only the invoice price paid to the supplier but also other costs associated with the purchase of the item, such as freight and material handling charges. Cost is reduced by the amount of any cash discount allowed on the purchase. The income statement caption used to report this expense is Cost of Goods Sold. Inventory Cost Flow Assumptions We use one of these inventory valuation methods to determine the cost of goods sold. Specific Weighted identification average FIFO LIFO LO 5‐8: Discuss the alternative inventory cost flow assumptions and generalize about their respective effects on the income statement and balance sheet when price levels are changing. The inventory accounting alternative selected by an entity relates to the assumption about how costs flow from the Inventory account to the Cost of Goods Sold account. We use one of these four inventory valuation methods to determine the cost of inventory sold: specific identification; weighted‐average; first-in, first-out (FIFO); or last-in, first-out (LIFO). Noncurrent Assets Land 1) Classified as assets Buildings because they are owned by the organization 2) Have the ability to Equipment generate revenue for more than one year Intangible Assets Natural Resources Noncurrent assets include land, buildings, and equipment (less accumulated depreciation), intangible assets, and natural resources. Capitalizing versus Expensing • An expenditure involves using an asset (usually cash) or incurring a liability to acquire goods, services, or other economic benefits. Whenever a firm buys something, it has made an expenditure. All expenditures must be accounted for as either assets (capitalizing an expenditure) or expenses (expensing an expenditure). 14 Depreciation Depreciation is the allocation of the cost of an asset to the years in which the benefits of the asset are expected to be received. It is an application of the matching concept. Balance Sheet Income Statement Acquisition Cost Expense Cost Allocation (Unused) (Used) Does not reflect decline in value LO 6‐2: Discuss how the terms capitalize and expense are used with respect to property, plant, and equipment. The original cost of noncurrent assets represents the prepaid cost of economic benefits that will be received in future years. Depreciation is the allocation of the cost of an asset to the years in which the benefits of the asset are expected to be received. It is an application of the matching concept. The acquisition cost of the asset (unused) is presented on the balance sheet and the expense cost (used) is reported on the income statement. Depreciation is not an attempt to recognize a loss in market value or any difference between the original cost and the replacement cost of an asset. In fact, the market value of noncurrent assets may actually increase as they are used but “appreciation” is not presently recorded.