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

22-2 Understanding the Business To understand amounts appearing on a company’s balance sheet we need to answer these questions: 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?

32-3 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.

42-4 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. Primary Characteristics Relevancy: predictive value, feedback value, and timeliness. Reliability: verifiability, representational faithfulness, and neutrality. Secondary Characteristics Comparability: across companies. Consistency: over time.

52-5 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 benefits. 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.

62-6 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.

72-7 Nature of Business Transactions External events External events: exchanges of assets and liabilities between the business and one or more other parties. External events External events: exchanges of assets and liabilities between the business and one or more other parties. Borrow cash from the bank

82-8 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. 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.

92-9 Accounts CashEquipmentInventory Notes Payable An organized format used by companies to accumulate the dollar effects of transactions.

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

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

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)

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.

2-14 Balancing the Accounting Equation Step 1: 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. Step 2: Balancing  Verify that the accounting equation (A = L + SE) remains in balance. Step 1: 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. Step 2: Balancing  Verify that the accounting equation (A = L + SE) remains in balance.

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. Analyzing Transactions

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

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

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

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

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

2-21 Papa John’s board of directors declares and pays $3,000 in dividends to shareholders. Analyzing Transactions Identify & Classify the Accounts Determine the Direction of the Effect 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.

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

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.

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

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

A = L + SE Transaction Analysis Model 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:

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

Analytical Tool: 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. Account Titles: Debited accounts on top. Credited accounts on bottom. Amounts: Debited amounts on left. Credited amounts on right. Amounts: Debited amounts on left. Credited amounts on right.

2-29 Post Ledger The T-Account After journal entries are prepared, the accountant posts (transfers) the dollar amounts to each account affected by the transaction.

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

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

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

The Asset Section of a Classified Balance Sheet

Liabilities and Stockholders’ Equity Section of the Balance Sheet

Key Ratio Analysis Financial Leverage Ratio Average Total Assets Average Stockholders’ Equity = (Beginning Balance + Ending Balance) ÷ 2 The 2006 financial leverage ratio for Papa John’s was: ($351,000 + $380,000) ÷ 2 ($161,000 + $148,000) ÷ 2 =2.37 The ratio tells us how well management is using debt to increase assets the company employs to earn income.

Focus on Cash Flows

Investing and Financing Activities

© 2009 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin End of Chapter 2