2 The Conceptual Framework Objective of Financial ReportingTo provide useful economic information to external users for decision making and for assessing future cash flows.Qualitative CharacteristicsRelevancyReliabilityComparabilityConsistencyElements of StatementsAssetLiabilityStockholders’ EquityRevenueExpenseGainLossPart IThe objective of financial reporting is to provide useful economic information to external users for decision-making, and for assessing future cash flows of the company.Part IIFor economic information to be useful, it must be relevant, reliable, comparable and consistent.Part IIIThe elements of our four basic financial statements include assets, liabilities, stockholders’ equity, revenues, expenses, gains and losses.
3 The Conceptual Framework AssumptionsSeparate 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.).There are four basic assumptions that are central to the accounting process.The first is the separate entity assumption. This assumption states that activities of the business can be separated from activities of the owners of that business.The second assumption is the continuity assumption. In the absence of information to the contrary, we assume that the business will operate into the foreseeable future.The third assumption is the unit of measure assumption. This assumption states that accounting information measures only those transactions that are capable of being measured in monetary terms.In addition to our accounting assumptions, the historical cost principle requires us to record transactions at their cash equivalent cost from the date of the transaction between two parties in an arms-length exchange.PrincipleHistorical cost: Cash equivalent cost given up is the basis for the initial recording of elements.
4 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 + SEAs accountants, every transaction we deal with affects at least two accounts. As we record the transactions we must make sure that the accounting equation remains in balance.(Assets)(Liabilities)(Stockholders’ Equity)
5 Balancing the Accounting Equation Step 1: Accounts and effectsIdentify 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: BalancingVerify that the accounting equation (A = L + SE) remains in balance.The accounting process involves the identification of the accounts affected by a transaction. We must determine whether the accounts are assets, liabilities or stockholders’ equity. After we determine the accounts affected, we determine the direction of the effect, such as whether the account increased or decreased. Finally, we must make sure the accounting equation remains in balance.
6 Analyzing Transactions Papa John’s issues $2,000 of additional common stock to new investors for cash.Identify & Classify the Accounts1. Cash (asset).2. Contributed Capital (equity).Determine the Direction of the Effect1. Cash increases.2. Contributed Capital increases.Papa John’s first transaction is to issue $2,000 of additional common stock to new investors for cash.The two accounts affected were the cash account, an asset, and contributed capital, an equity account. The cash account was increased as was the contributed capital account.
7 Analyzing Transactions Papa John’s issues $2,000 of additional common stock to new investors for cash.A = L + SENotice the total assets of $2,000 is equal to total liabilities plus stockholders’ equity of $2,000.
8 Analyzing Transactions The company borrows $6,000 from the local bank, signing a three-year note.Identify & Classify the Accounts1. Cash (asset).2. Notes Payable (liability).Determine the Direction of the Effect1. Cash increases.2. Notes Payable increases.In the second transaction, Papa John’s borrows $6,000 from a local bank, signing a three-year note.The accounts involved cash, an asset, and notes payable, a liability. Both the cash account and notes payable increased as a result of this transaction.
9 The Accounting CycleDuring the period: Analyze transactions. Record journal entries in the general journal. Post amounts to the general ledger.Close revenues, gains, expenses and losses to retained earnings.End of the period: Adjust revenues and expenses and related balance sheet accounts.Part IDuring the accounting period, we analyze and record business transactions. The transactions are initially recorded in the journal and then posted, or moved, to the ledger.Part IIAt the end of each accounting period, it’s necessary to adjust certain revenue and expense accounts and their related balance sheet accounts.Part IIIOnce the adjustment process is complete, we can prepare a set of financial statements and disseminate those statements to the users.Part IVFinally, we close all revenues, expenses, gains and losses to retained earnings so that we can start the accounting process fresh again.Prepare a complete set of financial statements. Disseminate statements to users.
10 The Debit-Credit Framework A = L + SEASSETSDebit for IncreaseCredit for DecreaseEQUITIESDebit for DecreaseCredit for IncreaseLIABILITIESRemember that Stockholders’ Equity includes Contributed Capital and Retained Earnings.Remember that stockholders’ equity is made of contributed capital and retained earnings.
11 The Asset Section of a Classified Balance Sheet Here is the asset section of the balance sheet of Papa John’s for the periods ended January 31, 2007 and December 28, At January 31, 2007, the total assets were $396,000,000.
12 Liabilities and Stockholders’ Equity Section of the Balance Sheet Here is the liability and stockholders’ equity section of the balance sheet for the same periods. Notice that the total liabilities and stockholders’ equity at January 31, 2007 is $396,000,000. Papa John’s balance sheet proves that assets equal liabilities plus stockholders’ equity.
13 Key Ratio AnalysisFinancial Leverage RatioAverage Total Assets Average Stockholders’ Equity=(Beginning Balance + Ending Balance) ÷ 2The 2006 financial leverage ratio for Papa John’s was:($351,000 + $380,000) ÷ 2 ($161,000 + $148,000) ÷ 2=2.37The ratio tells us how well management is using debt to increase assets the company employs to earn income.Part IThe financial leverage ratio is determined by dividing average total assets by average stockholders’ equity. When we are performing ratio analysis, we compute the average amounts by taking the beginning balance, adding the ending balance and dividing the total by two.Part IIIn 2006, the financial leverage ratio for Papa John’s was This ratio tells us how well management is using debt to increase assets of the company and use those assets to earn income. When interpreting the financial leverage ratio, the higher proportion of assets financed by debt, the higher the ratio. Generally, companies with a financial leverage ratio grater than 2.0 have a heavier reliance on debt than equity.
14 Focus on Cash FlowsOn the statement of cash flows, investing activities involve the purchase or sale of long-term productive assets, the lending of monies to others, and receiving principal payments back from those loans. When we purchase a long-term productive asset, it’s a cash outflow; when we sell a productive asset, it’s a cash inflow. When we loan funds to others, it’s a cash outflow; when we receive principal payments on those loans, it’s a cash inflow.Financing activities involve borrowing and repaying amounts from financial institutions and the sale or repurchase of the company’s stock. In addition, the payment of a cash dividend is classified as a financing activity. When we borrow money from a financial institution, it’s a cash inflow; repaying the principal amount is a cash outflow. When the company sells stock, it’s a cash inflow; if the company repurchases its own stock, it’s a cash outflow. The payment of cash dividends is always a cash outflow.