Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Investing and Financing Decisions and the Balance Sheet Chapter 2

2-2 Understanding the Business To understand amounts appearing on a company’s balance sheet we need to answer these questions: What business activities cause changes in the balance sheet? How do specific activities affect each balance? How do companies keep track of balance sheet amounts?

2-3 Learning Objectives Define the objective of financial reporting, the elements of the balance sheet, and the related key accounting assumptions and principles.

2-4 The Conceptual Framework Qualitative Characteristics Relevancy Reliability Comparability Consistency Qualitative Characteristics Relevancy Reliability Comparability Consistency Elements of Statements Asset Liability Stockholders’ Equity Revenue Expense Gain Loss Elements of Statements Asset Liability Stockholders’ Equity Revenue Expense Gain Loss Objective of Financial Reporting To provide useful economic information to external users for decision making and for assessing future cash flows. Objective of Financial Reporting To provide useful economic information to external users for decision making and for assessing future cash flows.

2-5 Elements of Statements Asset Liability Stockholders’ Equity Revenue Expense Gain Loss Elements of Statements Asset Liability Stockholders’ Equity Revenue Expense Gain Loss The Conceptual Framework Qualitative Characteristics Relevancy Reliability Comparability Consistency Qualitative Characteristics Relevancy Reliability Comparability Consistency Objective of Financial Reporting To provide useful economic information to external users for decision making and for assessing future cash flows. Objective of Financial Reporting To provide useful economic information to external users for decision making and for assessing future cash flows. Primary Characteristics Relevancy: predictive value, feedback value, and timeliness. Reliability: verifiability, representational faithfulness, and neutrality. Secondary Characteristics Comparability: across companies. Consistency: over time.

2-6 Qualitative Characteristics Relevancy Reliability Comparable Consistent Qualitative Characteristics Relevancy Reliability Comparable Consistent The Conceptual Framework Elements of Statements Asset Liability Stockholders’ Equity Revenue Expense Gain Loss Elements of Statements Asset Liability Stockholders’ Equity Revenue Expense Gain Loss Objective of Financial Reporting To provide useful economic information to external users for decision making and for assessing future cash flows. Objective of Financial Reporting To provide useful economic information to external users for decision making and for assessing future cash flows. Asset: economic resource with probable future benefit. Liability: probable future sacrifices of economic resources. Stockholders’ Equity: financing provided by owners and operations. Revenue: increase in assets or settlement of liabilities from ongoing operations. Expense: decrease in assets or increase in liabilities from ongoing operations. Gain: increase in assets or settlement of liabilities from peripheral activities. Loss: decrease in assets or increase in liabilities from peripheral activities.

2-7 The Conceptual Framework Assumptions Separate entity: Activities of the business are separate from activities of owners. Continuity: The entity will not go out of business in the near future. Unit-of-measure: Accounting measurements will be in the national monetary unit ($). Assumptions Separate entity: Activities of the business are separate from activities of owners. Continuity: The entity will not go out of business in the near future. Unit-of-measure: Accounting measurements will be in the national monetary unit ($). Principle Historical cost: Cash equivalent cost given up is the basis for initial recording of elements. Principle Historical cost: Cash equivalent cost given up is the basis for initial recording of elements.

2-8 Learning Objectives Identify what constitutes a business transaction and recognize common balance sheet account titles used in business.

2-9 Nature of Business Transactions External events External events: exchanges of assets and liabilities between the business and one or more other parties. Borrow cash from the bank

2-10 Nature of Business Transactions Internal events Internal events: not an exchange between the business and other parties, but have a direct effect on the accounting entity. Loss due to fire damage.

2-11 Accounts CashEquipmentInventory Notes Payable An organized format used by companies to accumulate the dollar effects of transactions.

2-12 Typical Account Titles Assets Cash Short-Term Investment Accounts Receivable Notes Receivable Inventory (to be sold) Supplies Prepaid Expenses Long-Term Investments Equipment Buildings Land Intangibles Liabilities Accounts Payable Accrued Expenses Notes Payable Taxes Payable Unearned Revenue Bonds Payable Stockholders’ Equity Contributed Capital Retained Earnings The Balance Sheet

2-13 Typical Account Titles Revenues Sales Revenue Fee Revenue Interest Revenue Rent Revenue Expenses Cost of Goods Sold Wages Expense Rent Expense Interest Expense Depreciation Expense Advertising Expense Insurance Expense Repair Expense Income Tax Expense The Income Statement

2-14 International Perspective While U.S. companies follow GAAP to prepare their financial statements, other countries have significant variations from the accounting and reporting rules of GAAP. Some countries use different account titles than those used by U.S. companies.

2-15 Learning Objectives Apply transaction analysis to simple business transactions in terms of the accounting model: Assets = Liabilities + Stockholders’ Equity

2-16 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)

2-17 Duality of Effects exchange gives up receives Most transactions with external parties involve an exchange where the business entity gives up something but receives something in return.

2-18 Balancing the Accounting Equation Accounts and effects  Identify the accounts affected and classify them by type of account (A, L, SE).  Determine the direction of the effect (increase or decrease) on each account. Balancing  Verify that the accounting equation (A = L + SE) remains in balance.

2-19 Balancing the Accounting Equation Let’s see how we keep the accounting equation in balance for Papa John’s. All amounts we use are expressed in thousands of dollars.

2-20 Identify & Classify the Accounts Determine the Direction of the Effect Papa John’s issues $2,000 of additional common stock to new investors for cash. Identify & Classify the Accounts 1. Cash (asset). 2. Contributed Capital (equity). Identify & Classify the Accounts 1. Cash (asset). 2. Contributed Capital (equity). Determine the Direction of the Effect 1. Cash increases. 2. Contributed Capital increases. Determine the Direction of the Effect 1. Cash increases. 2. Contributed Capital increases.

2-21 Papa John’s issues $2,000 of additional common stock to new investors for cash. A = L + SE

2-22 Identify & Classify the Accounts Determine the Direction of the Effect The company borrows $6,000 from the local bank, signing a three-year note. Identify & Classify the Accounts 1. Cash (asset). 2. Notes Payable (liability). Identify & Classify the Accounts 1. Cash (asset). 2. Notes Payable (liability). Determine the Direction of the Effect 1. Cash increases. 2. Notes Payable increases. Determine the Direction of the Effect 1. Cash increases. 2. Notes Payable increases.

2-23 A = L + SE The company borrows $6,000 from the local bank, signing a three-year note.

2-24 Determine the Direction of the Effect Identify & Classify the Accounts 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 & Classify the Accounts 1. Equipment (asset). 2. Cash (asset). 3. Notes Payable (liability). Identify & Classify the Accounts 1. Equipment (asset). 2. Cash (asset). 3. Notes Payable (liability). Determine the Direction of the Effect 1. Equipment increases. 2. Cash decreases. 3. Notes Payable increases. Determine the Direction of the Effect 1. Equipment increases. 2. Cash decreases. 3. Notes Payable increases.

2-25 A = L + SE Papa John’s purchases $10,000 of new equipment, paying $2,000 in cash and signing a two-year note payable for the rest.

2-26 Identify & Classify the Accounts Determine the Direction of the Effect Papa John’s lends $3,000 to new franchisees who sign five-year notes agreeing to repay the loan. Identify & Classify the Accounts 1. Cash (asset). 2. Notes Receivable (asset). Identify & Classify the Accounts 1. Cash (asset). 2. Notes Receivable (asset). Determine the Direction of the Effect 1. Cash decreases. 2. Notes Receivable increases. Determine the Direction of the Effect 1. Cash decreases. 2. Notes Receivable increases.

2-27 A = L + SE Papa John’s lends $3,000 to new franchisees who sign five-year notes agreeing to repay the loan.

2-28 Identify & Classify the Accounts Determine the Direction of the Effect Papa John’s purchases $1,000 of stock in other companies as an investment. Identify & Classify the Accounts 1. Cash (asset). 2. Investments (asset). Identify & Classify the Accounts 1. Cash (asset). 2. Investments (asset). Determine the Direction of the Effect 1. Cash decreases. 2. Investments increase. Determine the Direction of the Effect 1. Cash decreases. 2. Investments increase.

2-29 A = L + SE Papa John’s purchases $1,000 of stock in other companies as an investment.

2-30 Identify & Classify the Accounts Determine the Direction of the Effect Papa John’s board of directors declares and pays $3,000 in dividends to shareholders. Identify & Classify the Accounts 1. Cash (asset). 2. Retained Earnings (equity). Identify & Classify the Accounts 1. Cash (asset). 2. Retained Earnings (equity). Determine the Direction of the Effect 1. Cash decreases. 2. Retained Earnings decreases. Determine the Direction of the Effect 1. Cash decreases. 2. Retained Earnings decreases.

2-31 A = L + SE Papa John’s board of directors declares and pays $3,000 in dividends to shareholders.

2-32 Learning Objectives Determine the impact of using two basic tools, journal entries and T-accounts.

2-33 The Accounting Cycle During the period: Analyze Record Post During the period: Analyze transactions. Record journal entries in the general journal. Post amounts to the general ledger. End of the period: Adjust End of the period: Adjust revenues and expenses and related balance sheet accounts. Prepare Disseminate Prepare a complete set of financial statements. Disseminate statements to users. Close Close revenues, gains, expenses and losses to retained earnings.

2-34 How Do Companies Keep Track of Account Balances? Journal entries T-accounts

2-35 A T-account is a tool used to represent an account. Account Name LeftRight Direction of Transaction Effects

2-36 Direction of Transaction Effects The left side of the T-account is always the debit side. The right side of the T-account is always the credit side. Account Name Left Right DebitCredit

2-37 A = L + SE The Debit-Credit Framework ASSETS Debit for Increase Credit for Decrease EQUITIES Debit for Decrease Credit for Increase LIABILITIES Debit for Decrease Credit for Increase Debits and credits affect the Balance Sheet Model as follows:

2-38 A = L + SE The Debit-Credit Framework ASSETS Debit for Increase Credit for Decrease EQUITIES Debit for Decrease Credit for Increase LIABILITIES Debit for Decrease Credit for Increase Remember that Stockholders’ Equity includes Contributed Capital and Retained Earnings.

2-39 A typical journal looks like this: Analytical Tool: The Journal Entry

2-40 Analytical Tool: The Journal Entry A journal entry might look like this:

2-41 Analytical Tool: The Journal Entry Provide a reference date for each transaction. Debits are written first. Credits are indented and written after debits. Total debits must equal total credits.

2-42 Post Ledger Analytical Tool: The T-Account After journal entries are prepared, the accountant posts (transfers) the dollar amounts to each account affected by the transaction.

2-43 Transaction Analysis Illustrated Let’s prepare some journal entries for Papa John’s and post them to the ledger.

2-44 Papa John’s issues $2,000 of additional common stock to new investors for cash. (a)

2-45 The company borrows $6,000 from the local bank, signing a one-year note. (b)

2-46 Let’s see how to post this entry... Papa John’s purchases $10,000 of new equipment, paying $2,000 in cash and signing a two-year note payable for the rest. (c)

2-47 Papa John’s purchases $10,000 of new equipment, paying $2,000 in cash and signing a two-year note payable for the rest.

2-48 Balance Sheet Preparation It is possible to prepare a balance sheet at any point in time from the balances in the accounts.

2-49 This is the asset section of Papa John’s balance sheet.

2-50 This is the liability and stockholders’ equity section of Papa John’s balance sheet.

2-51 Learning Objectives Prepare and analyze a simple balance sheet using the financial leverage ratio.

2-52 Change in Balance Sheet Amounts

2-53 Key Ratio Analysis Financial Leverage Ratio Average Total Assets Average Stockholders’ Equity = (Beginning Balance + Ending Balance) ÷ 2 The 2004 financial leverage ratio for Papa John’s was: ($363,000 + $347,000) ÷ 2 ($158,000 + $159,000) ÷ 2 =2.24 The ratio tells us how well management is using debt to increase assets the company employs to earn income.

2-54 Learning Objectives Identify investing and financing transactions and demonstrate how they are reported on the statement of cash flows.

2-55 Statement of Cash Flows

2-56 Statement of Cash Flows

2-57 End of Chapter 2