Category: Accounting 101 Topics

In the book we use at my school, chapter 2 continues the discussion of financial statements by showing you the classified balance sheet. The classified balance sheet still contains assets, liabilities, and stockholders equity as we discussed in the previous post. The difference is that the assets and liabilities are grouped in to categories (classifications). Stockholders equity remains the same as it was in chapter 1 (common stock + retained earnings). I will explain the various classifications below. Look at the illustrations in your textbook. In some textbooks this topic is contained in chapter 2. In others the classified balance sheet usually appears in the chapter on inventory and merchandising transactions, probably chapter 4 or 5.

Asset Classifications

The assets can be grouped in to the following classifications:

1. Current Assets
2. Long-term Investments
3. Property, Plant, and Equipment
4. Intangible Assets

Current assets are those assets that have a life of one-year or less. These assets include (but are not limited to) cash, short-term investments, accounts receivable, inventory, supplies, and prepaid insurance.

Long-term investments can arise under three circumstances. One, where the business takes its own cash and uses it to buy the stock or bonds of another corporation. Second, where the business buys an asset that it does not intend to use currently. For example, a business buys a piece of land that one day it hopes to build a factory on. Until then, this land cannot be classified as property, plant, and equipment since it is not in use. Third, the business has an asset that was in use but has been taken out of service. For example, a business owns two factories, one in New York and the other in New Jersey. Due to a decline in the economy it decides to temporarily close the factory in New Jersey until the economy improves. That factory can no longer be classified as property, plant, and equipment since it is no longer in use. It must be re-classified as a long-term investment.

Property, Plant, and Equipment are assets that have a service life of more than one year. Property means land. Plant means building. Buildings would include office buildings, factories, stores, and air plane hangers. Equipment means equipment. Equipment is a very broad category and can include such things as factory machinery, office equipment, computers, furniture, and vehicles. The buildings and equipment depreciate while land does not.

Now is probably a good time for a brief discussion on depreciation. Depreciation, as an accounting concept, has nothing to do with market or resale value. Depreciation is a method of allocating the cost of an asset over the period of time in which we expect to use it. In accounting depreciation represents the deterioration or wearing out of an asset over time.

In this section of the balance sheet, we subtract the amount of depreciation that has accumulated on that asset from the day we first acquired it up to the date of that balance sheet. This is why we call it “accumulated depreciation.”

Land does not depreciate because it doesn’t have a finite life. Buildings and equipment will eventually wear out but land does not.

The assets that fall in to this category are currently in use. By use I mean they are helping the company to earn revenue. It is because they are in use that they depreciate.

Intangible assets do not have physical substance but yet they exist. Examples of intangible assets include patents, trademarks, copyrights, franchises, and goodwill. Intangibles usually give their owner the exclusive right to use something. These assets do not depreciate like property, plant, and equipment but they do eventually expire. These assets amortize, rather than depreciate.

Liability Classifications

As was explained in an earlier post, liabilities are debts or obligations that eventually have to be repaid (satisfied). Liabilities are broken down in to two classifications:

1. Current liabilities
2. Long-term liabilities

Currently liabilities have to be satisfied within one year. Generally, they are satisfied from current assets (i. e. cash).

Long-term liabilities are satisfied more than one year hence.

Some liabilities can be both current and long-term. For example, if you were to take a five year loan to buy a car, the bank would require you to make 60 monthly payments. The first twelve payments would be classified as a current liability while the remaining forty eight months would be classified as long-term.

I think that’s enough for now. The next chapter is one of the most important in the course. Be ready.

I thought the first post should have something to do with helping you understand accounting. I have always felt that if you can get off to a good start you have a much better chance of succeeding in your accounting classes.

You have probably been back at school for two or three weeks now and are probably two to three chapters in to your course. Let me try to help summarize what you have probably learned so far.

The first chapter in most accounting textbooks is devoted to providing you with background information about the accounting profession and the various forms of business organization (sole proprietorship, partnership, corporation). In addition, the books often describe the various financial statements and show you illustrations of each. There are four financial statements:

1. Income statement
2. Retained earnings statement
3. Balance sheet
4. Statement of cash flows

I’ll describe each statement here. You can refer to your textbook to see what they look like.

Income statement

The income statement measures profitability for a given period of time. It contains three sections:

1. Revenue
2. Expenses
3. Net income

Revenues are the amount of goods and services a business provides to its customers. Revenue is “earned,” that is the business has to do something to get it (sell goods or provide services). Revenue is not the same as cash. Another word for revenues is sales.

Expenses are the costs of doing business. Expenses are “incurred,” that is the business uses expenses to help it earn revenues.

Net income results when revenues exceed expenses. In other words:

Revenues – Expenses = Net income

Retained earnings statement

The word retained means to “keep.”

The word earnings refers to net income.

Therefore the retained earnings statement shows you how much “net income” the business “keeps.”

Some businesses keep all of their net income while others share some with the owners (stockholders) of the business. The distribution of net income to the stockholders of the business is call “dividends.”

The retained earnings statement is very brief. It usually only contains four or so lines:

Beginning balance of retained earnings

Add: Net income

Less: Dividends

Equals Ending balance of retained earnings

Balance sheet

The balance sheet is probably the most difficult statement to understand. It contains three sections. The three sections can be expressed as an equation:

Assets = Liabiliites + Stockholders equity

Assets are the resources of the business. They are things the business needs to have in order to do the thing it went in business to do. Many textbooks often refer to assets as a “store of wealth.” I’m not really sure what that means but I think they are trying to say that assets are things that the business will have for a while.

Liabilities are often called debts or obligations. Obligations to pay money back that was borrowed or to pay for something you purchased on credit. I like to refer to liabilities as promises. If you borrow money from the bank you promise to pay it back. If you buy something on credit you agreee to pay for it on or before a designated date.

Stockholders equity represents how much has been invested in the business. It is composed of two parts:

1. Common stock
2. Retained earnings

Common stock represents the amount that stockholders paid us when they bought shares of our stock. We discussed retained earnings earlier.

To summarize the balance sheet, the assets represent the resources of the business and the liabilities and stockholders equity represent how the business acquired them. How much did they borrow to buy them? How much did the stockholders contribute so the business could buy them?

Statement of cash flows

The statement of cash flows shows where cash came from and where it went.

The life of a business can be divided up in to three activities:

1. Financing
2. Investing
3. Operating

Financing activities – when a business starts it needs cash. It has two primary sources. It can borrow money (liabilities) or it can sell shares of stock (stockholders equity).

Investing activities – now that the business has cash it can go out and purchase the resources (assets) it needs to carry out its mission.

Operating activities – next, the business can open its doors, welcome its customers, and provide them with goods and services (revenues). At the same time, the business has to pay its bills (expenses) in order to stay in business.

I hope you found this useful. I’ll be back in a few days to talk about what happens next.

Be well.