Chapter 2 Establishing a Business and the Balance Sheet © 2009 The McGraw-Hill Companies, Inc

Chapter 2

Establishing a Business and Establishing a Business and the Balance Sheetthe Balance Sheet

© 2009 The McGraw-Hill Companies, Inc.

Slide 2Slide 2

The Nature of Business Transactions

External Events

Exchanges between the business and others involving

the exchange of assets and services from one company for other assets or promises

to pay from another company.

Internal Events

Certain events that are not exchanges between the

business and others, but which have a direct and measurable effect on the

entity.

Slide 3Slide 3

Account Number Account Name Description

101 Cash amount of coins, paper money, and funds in the bank

104 Investments amount of excess cash invested in stocks, bonds, certificates of deposit, etc.

106 Accounts Receivable

amounts owed by customers buying goods or services on account

107 Notes Reveivable signed promises to pay by customers, employees, and others

110 Inventories goods to be sold

115 Supplies pencils, boxes, paper, etc. to be used in future periods

120 Prepaid Rent amount paid to rent buildings and equipment in future periods

121 Prepaid Insurance amount paid to receive insurance coverage in future periods

122 Prepaid Advertising

amount paid to advertise in future periods

140 Equipment trucks, machinery, computers, etc. to be used in future periods

145 Buildings structures acquired to use in future periods

160 Land real estate property acquired to use in future periods

180 Intangible Assets long-term rights such as patents and trademarks

201 Accounts Payable amounts owed to suppliers due to buying goods or services on account

205 Wages (or Salaries) Payable

amounts owed to employees for work in past periods

210 Notes Payable signed promise by the company from borrowing money

217 Interest Payable amount due on notes payable as the cost of borrowing

230 Unearned Revenue

amount received from customers in advance of delivering goods or services to them

300 "Owner's Name," Capital

amount of equity owner has in the business

Chart of Accounts (partial - balance sheet accounts only)

Each company

establishes a chart of

accounts—a list of all the

account titles and

their numbers that are

unique to each

company.

Slide 4Slide 4

Transaction Analysis

Two simple ideas are used when analyzing transactions:

Duality of Effects

Every transaction affects at least two accounts.

Balancing the Equation

Assets = liabilities + owner’s equity must remain in balance.

Slide 5Slide 5

Dual Effects

Pay cash for supplies.

Duality of Effects

1. Pizza Aroma receives Supplies.

2. Pizza Aroma gives Cash.


Supplies (an asset) increases.

Cash (an asset) decreases.

Supplies (an asset) increases

Cash (an asset) decreases

Slide 6Slide 6

Balancing the Accounting Equation

Pay cash for supplies.

Assets = Liabilities + Owner's Equity+ Supplies No change No change

- Cash

Duality of Effects

1. Pizza Aroma receives Supplies.

2. Pizza Aroma gives Cash.


Supplies (an asset) increases.

Cash (an asset) decreases.

Slide 7

Identify the

accounts affected.

Classify them by

the type of account.

Determine the

direction of the effect.

Step 1

Verify that the accounting equation remains in balance.

Step2

Transaction Analysis Steps

Slide 8

Analysis of Pizza Aroma’s Transactions

(a) Investment by Owner. The business receives $30,000 cash as an initial investment from owner-manager, Mauricio Rosa.

Step 1: Identify and classify accounts and effects:

Received: Cash (+A) $30,000.

Given: Recognition of owner’s investment in the business.

M. Rosa, Capital (+OE) $30,000.

Step 2: Is the accounting equation in balance?

Yes. The left side increased by $30,000 and the right side

increased by $30,000.

= +Owner's Equity

Cash Investments SuppliesPrepaid

Rent EquipmentAccounts Payable

Notes Payable

M. Rosa, Capital

(a) 30,000 30,000

Assets Liabilities

Slide 9


(b) Borrow from Bank. Pizza Aroma obtains a $20,000 loan from a local bank.


Received: Cash (+A) $20,000.

Given: A written promise by the business to pay the bank.

Notes Payable (+L) $20,000.


Yes. The left side increased by $20,000 and the right side

increased by $20,000.

= +Owner's Equity



Notes Payable

M. Rosa, Capital

(b) 20,000 20,000

Assets Liabilities

Slide 10


(c) Prepaid Rent. Pizza Aroma pays $4,800 in advance to the building owner to cover rent for the store for May through October (six months).


Received: Prepaid Rent (+A) $4,800.

Given: Cash (-A) $4,800.


Yes. The left side increased and decreased by the same amount

($4,800).

= +Owner's Equity



Notes Payable

M. Rosa, Capital

(c) (4,800) 4,800

Assets Liabilities

Slide 11


(d) Purchase Equipment. A construction company renovates the store and installs equipment at a cost of $36,000; $33,000 in cash is paid and Pizza Aroma promises to pay the balance next month.


Received: Equipment (+A) $36,000.

Given: Cash (-A) $33,000, anda promise to pay,

Accounts Payable (+L) $3,000.


Yes. The left side increased by $3,000 ($36,000 - $33,000) and the

right side increased by $3,000.

= +Owner's Equity



Notes Payable

M. Rosa, Capital

(d) (33,000) 36,000 3,000

Assets Liabilities

Slide 12


(e) Purchase Supplies. Pizza Aroma orders and receives $2,000 in supplies on account from local fresh food suppliers.


Received: Supplies(+A) $2,000.

Given: A promise to pay.Accounts Payable (+L) $2,000.


Yes. The left side increased by $2,000 and the right side increased

by $2,000.

= +Owner's Equity



Notes Payable

M. Rosa, Capital

(e) 2,000 2,000

Assets Liabilities

Slide 13


(f) Pay Account Owed to Supplier. Pizza Aroma pays $1,000 cash on account to a supplier.


Received: A reduction in the amount owed to the supplier.Accounts Payable (-L) $1,000.



Yes. The left side decreased by $1,000 and the right side

decreased by $1,000.

= +Owner's Equity



Notes Payable

M. Rosa, Capital

(f) (1,000) (1,000)

Assets Liabilities

Slide 14


(g) Acquire Investments. Pizza Aroma puts $6,000 in a savings account at a bank.


Received: Investments(+A) $6,000.



Yes. The left side increased and decreased by the same amount

($6,000).

= +Owner's Equity



Notes Payable

M. Rosa, Capital

(g) (6,000) 6,000

Assets Liabilities

Slide 15


= +Owner's Equity



Notes Payable

M. Rosa, Capital

(a) 30,000 30,000 (b) 20,000 20,000 (c) (4,800) 4,800 (d) (33,000) 36,000 3,000 (e) 2,000 2,000 (f) (1,000) (1,000) (g) (6,000) 6,000

Totals 5,200 6,000 2,000 4,800 36,000 4,000 20,000 30,000

Assets Liabilities

$54,000 $54,000

Slide 16

The Accounting Cycle

During the Period(Chapters 2 and 3)

1.Analyze transactions2.Record journal entries in the general journal3.Post amounts to the general ledger

At the End of the Period(Chapter 4)

4.Adjust revenues and expenses and related balance sheet accounts5.Prepare a complete set of financial statements and disseminate it to users6.Close revenues, gains, expenses, and losses to owner’s equity

Start of New Period

Slide 17

Analyzing Business Transactions

= ++ - - + - +

debit credit debit credit debit credit

Assets Liabilities Owner's Equity

Withdrawals by owners decrease owner’s equity.

Investments by owners

and net income of business increase owner’s equity.

Slide 18

Analyzing Business Transactions

= ++ - - + - +

debit credit debit credit debit credit

Assets Liabilities Owner's Equity

Debit = Left Credit = Right

Withdrawals by owners decrease owner’s equity.

Investments by owners

and net income of business increase owner’s equity.

Slide 19

Recording Transaction Effects

Date Account Titles and Explanation Ref. Debit Credit

May 1 30,000

30,000

May 2 20,000

20,000

May 5 36,000

Cash 33,000

3,000

Notes Payable

(Borrowed from bank.)

Equipment

Accounts Payable(Purchased equipment paying part cash and the rest on credit.)

Cash

M. Rosa, Capital

(Investment by owner.)

Cash

General Journal Page G1

Slide 20

Recording Transaction Effects

Event Debit Credit

(d) 36,000

Cash (-A) 33,000

3,000

Account Titles

Equipment (+A)

Accounts Payable (+L)

Slide 21

Posting Transaction EffectsAfter journal entries have

been recorded, the bookkeeper

posts (transfers) the dollar amounts to each ledger

page that is affected by the transaction, so

that the account

balances can be computed.

Ledger101

Date Explanation Ref. Debit Credit Balance

May 1 G1 30,000 30,000

May 2 G1 20,000 50,000

May 3 G1 4,800 45,200

May 5 G1 33,000 12,200

Cash

Event Debit Credit

May 5 36,000

Cash (-A) 33,000

3,000

Equipment (+A)


Account Titles

Slide 22

Posting Transaction Effects

The T-account is a simplified version of a

ledger page.

Ledger

Beg. -

(a) 30,000 4,800 (c)

(b) 20,000 33,000 (d)

End. 12,200

Debit (+) Credit (-)

Cash

Slide 23

Pizza Aroma’s Accounting Records

Using T-Accounts

Ledger Pages

General Journal

Journal Entries

Identify and classify

accounts

Transactions

(1) Analyze (2) Record (3) Post

Slide 24


Assets = Liabilities + Owner's EquityCash + $30,000 No change M. Rosa, Capital +$30,000

(a) Investment by Owner. The business receives $30,000 cash as an initial investment from owner-manager, Mauricio Rosa.

Event Debit Credit

(a) 30,000

M. Rosa, Capital (+OE) 30,000

Cash (+A)

Account Titles

- Beg. 30,000 (a)30,000 Bal.

M. Rosa, CapitalBeg. -

(a) 30,000 Bal. 30,000

Cash

Slide 25


Assets = Liabilities + Owner's EquityCash + $20,000 Notes Payable + $20,000 No change

Event Debit Credit

(b) 20,000

Notes Payable (+L) 20,000

Cash (+A)

Account Titles

Beg. - (a) 30,000 (b) 20,000

Bal. 50,000

Cash

- Beg. 20,000 (b)20,000 Bal.

Notes Payable

(b) Borrow from Bank. Pizza Aroma obtains a $20,000 loan from a local bank.

Slide 26


Debit Credit

(a) 30,000

30,000

(b) 20,000

20,000

(c) Prepaid Rent (+A) 4,800

Cash (-A) 4,800

(d) 36,000

Cash (-A) 33,000

3,000

(e) Supplies (+A) 2,000

2,000

(f) 1,000

1,000

(g) Investments (+A) 6,000

6,000

Account Titles

Cash (+A)

M. Rosa, Capital (+OE)

Cash (+A)

Notes Payable (+L)

Equipment (+A)


Accounts Payable (-L)

Cash (-A)

Cash (-A)


Slide 27

Beg. - (a) 30,000 4,800 (c) (b) 20,000 33,000 (d)

1,000 (f)6,000 (g)

Bal. 5,200

Cash

Beg. - (e) 2,000

Bal. 2,000

Supplies

- Beg.(f) 1,000 3,000 (d)

2,000 (e)4,000 Bal.

Accounts Payable

- Beg.20,000 (b)20,000 Bal.

Notes Payable- Beg.

30,000 (a)30,000 Bal.

M. Rosa, Capital

Beg. - (d) 36,000

Bal. 36,000

Equipment

Beg. - (g) 6,000

Bal. 6,000

Investments

Beg. - (g) 4,800

Bal. 4,800

Prepaid Rent

Slide 28

Preparing a Trial Balance

Debit CreditCash 5,200$ Investments 6,000 Supplies 2,000 Prepaid Rent 4,800 Equipment 36,000 Accounts Payable 4,000$ Notes Payable 20,000 Mauricio Rosa, Capital 30,000 Total 54,000$ 54,000$

Pizza AromaTrial Balance

On May 7

Slide 29

Locating and Correcting Errors

Possible Errors 1.Totaling the debit and credit columns in the trial balance.2.Copying the ending balances from the T-accounts to the trial balance.3.Computing the ending balances in the T-accounts.4.Incorrectly posting the dollar effects of a transaction from the journal entry to the T-accounts.5.Preparing journal entries in which the debits do not equal the credits.

Slide 30

Classified Balance Sheet

Current AssetsCash 5,200$ Investments 6,000 Supplies 2,000 Prepaid Rent 4,800 Total current assets 18,000 Equipment 36,000 Total Assets 54,000$

Current LiabilitiesAccounts payable 4,000$ Total current liabilities 4,000 Notes Payable 20,000 Total Liabilities 24,000

M. Rosa, Capital 30,000 Total Liabilities and Owner's Equity 54,000$

Pizza Aroma

Balance Sheet

May 7, 2009

Assets

Liabilities

Owner's Equity

Current assets will be used or turned into cash within one

year.

Noncurrent assets are expected to last for several

years.

Current liabilities will need to be paid or settled within the

coming year.

Noncurrent liabilities are owed beyond one year.

Slide 31

Limitations of the Balance Sheet

What is (and is not) recorded?

What amounts are assigned to recorded

items?

Cost Principle Conservatism

Slide 32

Summary of the Accounting Cycle

During the Period(Chapters 2 and 3)

1.Analyze transactions2.Record journal entries in the general journal3.Post amounts to the general ledger

At the End of the Period(Chapter 4)

4.Adjust revenues and expenses and related balance sheet accounts5.Prepare a complete set of financial statements and disseminate it to users6.Close revenues, gains, expenses, and losses to owner’s equity

Start of New Period

Slide 33Slide 33

Supplement 2-A: Accounting Concepts Revisited

Qualitative Characteristics

Relevancy

Reliability

Comparability

Consistency

Qualitative Characteristics

Relevancy

Reliability

Comparability

Consistency

Elements of Statements

Asset

Liability

Owner’s Equity

Revenue

Expense

Elements of Statements

Asset

Liability

Owner’s Equity

Revenue

Expense

Objective of Financial Reporting

To provide useful economic information to external users for decision making.

Objective of Financial Reporting

To provide useful economic information to external users for decision making.

Primary Characteristics• Relevancy: predictive value, feedback value, and timeliness.• Reliability: verifiability, representational faithfulness, and neutrality.

Secondary Characteristics• Comparability: across companies.• Consistency: over time.

Slide 34Slide 34

Supplement 2-A: Accounting Concepts Revisited

AssumptionsSeparate entityUnit-of-measure

ContinuityTime Period

AssumptionsSeparate entityUnit-of-measure

ContinuityTime Period

PrinciplesHistorical cost

Revenue RecognitionMatching

Full Disclosure

PrinciplesHistorical cost

Revenue RecognitionMatching

Full Disclosure

ConstraintConservatism

Slide 35

End of Chapter 2

Documents

Chapter 2 Establishing a Business and the Balance Sheet © 2009 The McGraw-Hill Companies, Inc