Investing and Financing Decisions

and the Balance Sheet

Chapter 2

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

Understanding the Business

To understand amounts appearing

on a company’s balance sheet we
need to answer these questions:

What
How do How do
business
specific companies
activities cause
activities keep track of
changes in
affect each balance sheet
the balance
balance? amounts?
sheet?

2-2
2
The Conceptual Framework
Objective of Financial Reporting
To provide useful economic information to external users
for decision making and for assessing future cash flows.

Qualitative
QualitativeCharacteristics
Characteristics Elements
Elementsof
ofStatements
Statements
Relevancy
Relevancy Asset
Asset
Reliability
Reliability Liability
Liability
Comparability
Comparability Stockholders’
Stockholders’Equity
Equity
Consistency
Consistency Revenue
Revenue
Expense
Expense
Gain
Gain
Loss
Loss 2-3
3
The Conceptual Framework
Objective of Financial Reporting
To provide useful economic information to external users
for decision making and for assessing future cash flows.
Primary Characteristics
Qualitative •Relevancy: predictive value,
QualitativeCharacteristics
Characteristics Elements
Elementsof ofStatements
Statements
feedback value, and
Relevancy
Relevancy Asset
timeliness. Asset
Reliability
Reliability •Reliability: verifiability,
Liability
Liability
Comparability representational
Stockholders’
faithfulness,
Comparability Stockholders’Equity
Equity
and neutrality.
Consistency
Consistency Revenue
Revenue
SecondaryExpense
Characteristics
Expense
•Comparability: across
Gain
companies. Gain
•Consistency: Loss
over
Loss time. 2-4
4
 The Conceptual Framework
Asset: economic resource with
probable future benefits. Objective
ObjectiveofofFinancial
FinancialReporting
Reporting
To
Toprovide
provide
Liability: probableuseful
future economic
useful economic
sacrifices of information
informationto toexternal
externalusers
users
for
fordecision
economic making
makingand
resources.
decision andfor forassessing
assessingfuture
futurecash
cashflows.
flows.
Stockholders’ Equity: financing
provided by owners and operations.
Revenue: increase in assets or Elements
Qualitative Characteristics
Qualitative Characteristics Elementsof ofStatements
Statements
settlement of liabilities from ongoing
operations. Relevancy
Relevancy Asset
Asset
Expense: decrease in assets or
Reliability Liability
Reliability Liability
increase in liabilities from ongoing
operations.Comparable
Comparable Stockholders’
Stockholders’Equity
Equity
Gain: increase in assets or settlement
Consistent Revenue
Consistent Revenue
of liabilities from peripheral
activities. Expense
Expense
Loss: decrease in assets or Gain
increase in liabilities from peripheral Gain
activities. Loss
Loss 2-5
5
The Conceptual Framework

Assumptions
Assumptions
Separate
Separateentity:
entity:Activities
Activitiesof ofthe
thebusiness
businessare
are separate
separatefromfrom
activities
activitiesof
ofowners.
owners.
Continuity:
Continuity:The Theentity
entitywill
willnot
notgo
goout
outof
of business
businessininthe
thenear
near
future.
future.
Unit-of-measure:
Unit-of-measure:Accounting
Accountingmeasurements
measurementswillwillbe
beininthe
thenational
national
monetary
monetaryunitunit(i.e.,
(i.e.,$$ininthe
theU.S.).
U.S.).

Principle
Principle
Historical
Historicalcost:
cost: Cash
Cashequivalent
equivalentcost
cost given
givenup up
isisthe
thebasis
basisfor
forthe
theinitial
initialrecording
recordingofof elements.
elements.

2-6
6
Nature of Business Transactions

External
External events:
events exchanges of assets
and liabilities between the business
and one or more other parties.

Borrow cash

from the bank

2-7
7
Nature of Business Transactions

Internal
Internal events:
events not an exchange between
the business and other parties, but have
a direct effect on the accounting entity.

Loss due to
fire damage.

2-8
8
Accounts
An
An organized
organized format
format used
used by
by
companies
companies toto accumulate
accumulate thethe dollar
dollar
effects
effects of
of transactions.
transactions.

Cash Inventory

Notes
Equipment Payable

2-9
9
Typical Account Titles
The Balance Sheet

Assets
Assets Liabilities
Cash Accounts Payable
Short-Term Investment Accrued Expenses
Accounts Receivable Notes Payable
Notes Receivable Taxes Payable
Inventory (to be sold) Unearned Revenue
Supplies Bonds Payable
Prepaid Expenses
Long-Term Investments Stockholders’
Stockholders’ Equity
Equipment Contributed Capital
Buildings Retained Earnings
Land
Intangibles
2-10
10
Typical Account Titles
The Income Statement

Revenues
Revenues Expenses
Sales Revenue Cost of Goods Sold
Fee Revenue Wages Expense
Interest Revenue Rent Expense
Rent Revenue Interest Expense
Depreciation Expense
Advertising Expense
Insurance Expense
Repair Expense
Income Tax Expense

2-11
11
Principles of Transaction Analysis

 Every transaction affects at least two accounts

(duality of effects).
 The accounting equation must remain in
balance after each transaction.

A = L + SE
(Assets) (Liabilities) (Stockholders’
Equity)

2-12
12
Duality of Effects

Most transactions with

external parties involve
an exchange where the
business entity gives up
something but receives
something in return.

2-13
13
Balancing the Accounting Equation
Step
Step 1:
1: Accounts
Accounts and
and effects
effects
 Identify
Identify the
the accounts
accounts affected
affected and
and classify
classify them
them by
by
type
type of
of account
account (A,
(A, L,
L, SE).
SE).
 Determine
Determine the
the direction
direction of
of the
the effect
effect (increase
(increase or
or
decrease)
decrease) on
on each
each account.
account.
Step
Step 2:
2: Balancing
Balancing
 Verify
Verify that
that the
the accounting
accounting equation
equation (A
(A == LL ++ SE)
SE)
remains
remains in
in balance.
balance.

2-14
 Analyzing Transactions
Papa John’s issues $2,000 of additional common
stock to new investors for cash.

Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset).
(asset).
2.
2. Contributed
ContributedCapital
Capital (equity).
(equity).

Determine
Determine the
the Direction
Direction of
of the
the Effect
Effect
1.
1. Cash
Cashincreases.
increases.
2.
2. Contributed
Contributed Capital
Capitalincreases.
increases.

2-15
15
 Analyzing Transactions
Papa John’s issues $2,000 of additional common
stock to new investors for cash.
Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000

Effect 2,000 = 2,000

A = L + SE
2-16
16
 Analyzing Transactions
The company borrows $6,000 from the
local bank, signing a three-year note.

Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash (asset).
(asset).
2.
2. Notes
NotesPayable
Payable(liability).
(liability).

Determine
Determinethe
theDirection
Directionof
ofthe
theEffect
Effect
1.
1. Cash
Cashincreases.
increases.
2.
2. Notes
NotesPayable
Payableincreases.
increases.

2-17
17
 Analyzing Transactions
The company borrows $6,000 from the
local bank, signing a three-year note.
Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000

Effect 8,000 = 8,000

A = L + SE
2-18
18
 Analyzing Transactions
Papa John’s purchases $10,000 of new equipment, paying
$2,000 in cash and signing a two-year note payable for the rest.

Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Equipment
Equipment(asset).
(asset).
2.
2. Cash
Cash(asset).
(asset).
3.
3. Notes
NotesPayable
Payable(liability).
(liability).

Determine
Determine the
the Direction
Direction of
of the
the Effect
Effect
1.
1. Equipment
Equipmentincreases.
increases.
2.
2. Cash
Cashdecreases.
decreases.
3.
3. Notes
NotesPayable
Payableincreases.
increases.

2-19
19
 Analyzing Transactions
Papa John’s purchases $10,000 of new equipment, paying
$2,000 in cash and signing a two-year note payable for the rest.
Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000
(c) (2,000) 10,000 8,000

Effect 16,000 = 16,000

A = L + SE
2-20
20
Papa John’s lends $3,000 to new franchisees
who sign five-year notes agreeing to repay
the loan.

Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset)
(asset)
2.
2. Notes
NotesReceivable
Receivable(asset)
(asset)

Determine
Determine the
the Direction
Direction of
of the
the Effect
Effect
1.
1. Cash
Cashdecreases.
decreases.
2.
2. Notes
NotesReceivable
Receivableincreases.
increases.

2-21
21
 Papa John’s lends $3,000 to new franchisees
who sign five-year notes agreeing to repay
the loan.
Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000
(c) (2,000) 10,000 8,000
(d) (3,000) 3,000

Effect 16,000 = 16,000

A = L + SE
2-22
22
 Papa John’s purchases $1,000 of stock in
other companies as an investment.

Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset)
(asset)
2.
2. Investments
Investments(asset)
(asset)

Determine
Determine the
the Direction
Direction of
of the
the Effect
Effect
1.
1. Cash
Cashdecreases.
decreases.
2.
2. Investments
Investmentsincrease.
increase.

2-23
23
 Papa John’s purchases $1,000 of stock in
other companies as an investment.

Notes Notes Contributed Retained

Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000
(c) (2,000) 10,000 8,000
(d) (3,000) 3,000
(e) (1,000) 1,000

Effect 16,000 = 16,000

A = L + SE
2-24
24
 Analyzing Transactions
Papa John’s board of directors declares and
pays $3,000 in dividends to shareholders.

Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset).
(asset).
2.
2. Retained
RetainedEarnings
Earnings(equity).
(equity).

Determine
Determinethe
theDirection
Direction of
of the
theEffect
Effect
1.
1. Cash
Cashdecreases.
decreases.
2.
2. Retained
RetainedEarnings
Earningsdecreases.
decreases.

2-25
 Analyzing Transactions
Papa John’s board of directors declares and
pays $3,000 in dividends to shareholders.
Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000
(c) (2,000) 10,000 8,000
(d) (3,000) 3,000
(e) (1,000) 1,000
(f) (3,000) (3,000)
Effect 13,000 = 13,000

A = L + SE
2-26
26
The Accounting Cycle

During the period: Close revenues, gains,

Analyze transactions. expenses and losses
Record journal entries in the general journal. to retained earnings.
Post amounts to the general ledger.

Prepare a complete
End of the period: set of financial statements.
Adjust revenues and expenses Disseminate statements
and related balance sheet accounts. to users.

2-27
27
How Do Companies Keep Track of Account
Balances?

T-accounts

Journal entries

2-28
28
 Direction of Transaction Effects

The left side of the The right side of the

T-account is always the debit T-account is always the credit
side. side.

Account Name

Left Right
Debit Credit

2-29
29
 Transaction Analysis Model

Debits
Debits and
and credits
credits affect
affect the
the Balance
Balance Sheet
Sheet
Model
Model as
as follows:
follows:

A = L + SE
ASSETS LIABILITIES EQUITIES
Debit Credit Debit Credit Debit Credit
for for for for for for
Increase Decrease Decrease Increase Decrease Increase

2-30
30
 The Debit-Credit Framework

A = L + SE
ASSETS LIABILITIES EQUITIES
Debit Credit Debit Credit Debit Credit
for for for for for for
Increase Decrease Decrease Increase Decrease Increase

Remember that Stockholders’ Equity includes

Contributed Capital and Retained Earnings.
2-31
31
 Analytical Tool: The Journal Entry

A journal entry might look like this:

Account
Account Titles:
Titles:
Debited
Debited accounts
accounts on
on top.
top.
Reference:
Reference: Credited
Credited accounts
accounts on
on bottom.
bottom.
Letter,
Letter,
number,
number, or
or Amounts:
Amounts:
date.
date. Debited
Debited amounts
amounts on
on left.
left.
Credited
Credited amounts
amounts on
on right.
right.

2-32
32
The T-Account

After journal entries are prepared, the

accountant posts (transfers) the dollar
amounts to each account affected by the
transaction.

Ledger
Post

2-33
Papa John’s issues $2,000 of additional common
stock to new investors for cash.

(a)

Cash Contributed Capital

Beg. Bal. 6,000 1,000 Beg. Bal.
(a) 2,000 2,000 (a)

8,000 3,000

2-34
34
The company borrows $6,000 from the local
bank, signing a three-year note.

Cash Notes Payable

Beg. Bal. 6,000 146,000 Beg. Bal.
(a) 2,000 6,000 (b)
(b) 6,000

14,000 152,000

2-35
35
Balance Sheet Preparation

It is possible to prepare Balance

BalanceSheet
a balance sheet at any Sheet

point in time from the

balances in the
accounts.

2-36
36
The Asset Section of a Classified Balance Sheet

2-37
37
Liabilities and Stockholders’ Equity Section of
the Balance Sheet

2-38
38
Key Ratio Analysis
Financial
Average Total Assets
Leverage = Average Stockholders’ Equity
Ratio

(Beginning Balance + Ending Balance) ÷ 2

The 2006 financial leverage ratio for Papa John’s was:

($351,000 + $380,000) ÷ 2
= 2.37
($161,000 + $148,000) ÷ 2

The ratio tells us how well management is using debt to

increase assets the company employs to earn income.

2-39
39
Focus on Cash Flows

2-40
40
Investing and Financing Activities

2-41
41
 End of Chapter 2

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.