Investing and Financing Decisions and the Balance Sheet Chapter 2 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

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. 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 Primary Characteristics Relevancy: predictive value, feedback value, and timeliness. Reliability: verifiability, representational faithfulness, and neutrality. Secondary Characteristics Comparability: across companies. Consistency: over time.

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 (i.e., $ in the U.S.). 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 (i.e., $ in the U.S.). Principle Historical cost: Cash equivalent cost given up is the basis for the initial recording of elements. Principle Historical cost: Cash equivalent cost given up is the basis for the initial recording of elements.

The Conceptual Framework Exceptions Materiality: Account for small amounts in the most cost effective way, even if not technically correct. Conservatism: Do not overstate assets or revenue and do not understate liabilities or expenses.

Nature of Business Transactions exchange gives up receives Most transactions with external parties involve an exchange where the business entity gives up something but receives something in return.

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)

Double-Entry Accounting Double-entry bookkeeping means to record the dual effects of each business transaction.

Accounting for Business Transactions The Lyons invest $50,000 to begin the business, and Air & Sea Travel issues common stock. Stockholders’ Assets =Liabilities+Equity (1) Cash+ 50,000= +50,000* *Common stock

Accounting for Business Transactions Air & Sea purchases land for an office location, paying $40,000 in cash. Balance+ 50,000= +50,000* *Common stock (2) Cash– 40,000 Land+ 40,000 50,000= +50,000* Stockholders’ Assets =Liabilities+Equity

Analytical Tool: The T-Account Account Title Debit LEFT SIDE RIGHT SIDE Credit

Rules of Debit and Credit Accounting Equation:Assets=Liabilities+ Stockholders’ Equity Rules of Debit and Credit: Debit + Debit – Debit – Credit – Credit + Credit +

Rules of Debit and Credit Air & Sea received $50,000 and issued stock. Assets=Liabilities+ Stockholders’ Equity Debit for Increase, 50,000 Credit for Increase, 50,000 Cash Common Stock

Rules of Debit and Credit Air & Sea purchased land for $40,000 cash. Common Stock Bal. 50,000 Cash Credit for Decrease, 40,000 Bal. 50,000 Land Debit for Increase, 40,000 Assets=Liabilities+ Stockholders’ Equity

The Journal Entry A journal entry might look like this: Reference: Letter, number, or date. Reference: Account Titles: Debited accounts on top. Credited accounts on bottom usually indented. Account Titles: Debited accounts on top. Credited accounts on bottom usually indented. Amounts: Debited amounts on left. Credited amounts on right. Amounts: Debited amounts on left. Credited amounts on right.

Recording Transactions in the Journal Identify the transaction and specify each account affected. Determine whether each account is increased or decreased by the transaction. Use the rules of debits and credits. Enter the transaction in the journal, including a brief explanation for the entry.

How Do Companies Keep Track of Account Balances? General Journal General Ledger

Post Ledger Posting from GJ to GL After journal entries are prepared, the accountant posts (transfers) the dollar amounts to each account affected by the transaction.

Classified Balance Sheet In a classified balance sheet assets and liabilities are classified into two categories – current and noncurrent. Current assets are those to be used or turned into cash within the upcoming year, whereas noncurrent assets are those that will last longer than one year. Current liabilities are those obligations to be paid or settled within the next 12 months with current assets.

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Key Ratio Analysis Current Ratio Current Assets Current Liabilities = Current ratio for Papa John’s: The current ratio for Papa John’s shows a low level of liquidity, below 1. The current ratio for Papa John’s shows a low level of liquidity, below = = 0.75

The Accounting Cycle During the Period (Chapters 2 and 3) Analyze transactions Record journal entries in the general journal Post amounts to the general ledger During the Period (Chapters 2 and 3) Analyze transactions Record journal entries in the general journal Post amounts to the general ledger Start of new period At the End of the Period (Chapter 4) Prepare a trial balance to determine if debits equal credits Adjust revenues and expenses and related balance sheet accounts (record in journal and post to ledger) Prepare a complete set of financial statements and disseminate it to users Close revenues, gains, expenses, and losses to Retained Earnings (record in journal and post to ledger) At the End of the Period (Chapter 4) Prepare a trial balance to determine if debits equal credits Adjust revenues and expenses and related balance sheet accounts (record in journal and post to ledger) Prepare a complete set of financial statements and disseminate it to users Close revenues, gains, expenses, and losses to Retained Earnings (record in journal and post to ledger)

Focus on Cash Flows Companies report cash inflows and outflows over a period in their statement of cash flows.

End of Chapter 2