Chap002

2-1

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Investing and Financing Decisions

and the Balance SheetChapter 2

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2-2

Understanding the Business

To understand amounts appearingon a company’s balance sheet weneed to answer these questions:

To understand amounts appearingon a company’s balance sheet weneed to answer these questions:

What business

activities causechanges inthe balance

sheet?

What business

activities causechanges inthe balance

sheet?

How dospecific

activitiesaffect eachbalance?

How dospecific

activitiesaffect eachbalance?

How do companies

keep track ofbalance sheet

amounts?

How do companies

keep track ofbalance sheet

amounts?

2-3

The Conceptual Framework

Qualitative Characteristics

Relevancy

Reliability

Comparability

Consistency


Relevancy

Reliability

Comparability

Consistency

Elements of Statements

Asset

Liability

Stockholders’ Equity

Revenue

Expense

Gain

Loss


Asset

Liability


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.

2-4


Relevancy

Reliability

Comparability

Consistency


Relevancy

Reliability

Comparability

Consistency


Asset

Liability


Revenue

Expense

Gain

Loss


Asset

Liability


Revenue

Expense

Gain

Loss




Asset

Liability


Revenue

Expense

Gain

Loss


Asset

Liability


Revenue

Expense

Gain

Loss


Primary Characteristics•Relevancy: predictive value, feedback value, and timeliness.•Reliability: verifiability, representational faithfulness, and neutrality.

Secondary Characteristics•Comparability: across companies.•Consistency: over time.

2-5


Relevancy

Reliability

Comparability

Consistency


Relevancy

Reliability

Comparability

Consistency


Asset

Liability


Revenue

Expense

Gain

Loss


Asset

Liability


Revenue

Expense

Gain

Loss




Asset: economic resource with probable future benefits.Liability: probable future sacrifices of economic resources.Stockholders’ Equity: financing provided by owners and business 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.

2-6

International PerspectiveReconsidering the Conceptual Framework

Objective of Financial Reporting: To provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers.

Qualitative Characteristics (limited by materiality and costs): Fundamental (to be useful): Enhancing (degrees of usefulness): Relevance Comparability Faithful representation Verifiability

Timeliness Understandability

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are working on a joint project to develop a common conceptual framework

toward convergence of accounting standards.

2-7

Elements of the Balance Sheet

AA = = LL + + SESE(Assets) (Liabilities) (Stockholders’ Equity)

Economic resources with probable future benefits owned or controlled by the entity. Measured by the historical cost principle.

Probable debts or obligations (claims to a company’s resources) that result from a company’s past transactions and will be paid with assets or services. Entities that a company owes money to are called creditors.

The financing provided by the owners and by business operations. Often referred to as contributed capital.

2-8

Papa John’s Balance Sheet

2-9

Nature of Business Transactions

Most transactions with external parties involve an

exchange exchange where the business entity gives up gives up something but receivesreceives

something in return.

2-10

A Question of Ethics

2-11

Accounts

Cash

Equipment

Inventory

Notes Payable

An organized format used by companies An organized format used by companies to accumulate the dollar effects of to accumulate the dollar effects of

transactions.transactions.

An organized format used by companies An organized format used by companies to accumulate the dollar effects of to accumulate the dollar effects of

transactions.transactions.

2-12

Chart of Accounts

A chart of accounts lists all account titles and their unique numbers.

2-13

Principles of Transaction Analysis

Every transaction affects at least two accounts (duality of effects).

The accounting equation must remain in balance after each transaction.

AA = = LL + + SESE(Assets) (Liabilities) (Stockholders’ Equity)

2-14

Balancing the Accounting Equation

Step 1: Identify and classify accounts and effects Identify the accounts (by title) affected and

make sure at least two accounts change. Classify them by type of account. Was each

account an asset (A), a liability (L), or a stockholders’ equity (SE)?

Determine the direction of the effect. Did the account increase [+] or decrease [-]?

Step 2: Verify account equation is in balance. Verify that the accounting equation (A = L + SE)

remains in balance.

Step 1: Identify and classify accounts and effects Identify the accounts (by title) affected and

make sure at least two accounts change. Classify them by type of account. Was each

account an asset (A), a liability (L), or a stockholders’ equity (SE)?

Determine the direction of the effect. Did the account increase [+] or decrease [-]?

Step 2: Verify account equation is in balance. Verify that the accounting equation (A = L + SE)

remains in balance.

2-15

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

Step 1: Identify and classify accounts and effects1. Cash (+A) $2,000. 2. Contributed Capital (+SE) $2,000.

Analyzing Transactions

AA == L L ++ SE SE

Cash Investments Equip.Notes

ReceivableNotes

PayableContributed

CapitalRetained Earnings

(a) 2,000 2,000

Effect =2,000 2,000

Step 2: Is the accounting equation in balance?

2-16

(b) Papa John’s borrows $6,000 from the bank signing a three-year note.(b) Papa John’s borrows $6,000 from the bank signing a three-year note.

Step 1: Identify and classify accounts and effects1. Cash (+A) $6,000. 2. Notes Payable (+L) $6,000.


AA == L L ++ SE SE


ReceivableNotes

PayableContributed


(a) 2,000 2,000 (b) 6,000 6,000

Effect =8,000 8,000


2-17

(c) Papa John’s purchases new ovens, counters, refrigerators, and other (c) Papa John’s purchases new ovens, counters, refrigerators, and other equipment costing $10,000, paying $2,000 in cash and signing a two-year equipment costing $10,000, paying $2,000 in cash and signing a two-year

note for the balance.note for the balance.

Step 1: Identify and classify accounts and effects1. Equipment (+A) $10,000. 2. Cash (-A) $2,000

Notes Payable (+L) $8,000.


AA == L L ++ SE SE



ReceivableNotes

PayableContributed


(a) 2,000 2,000 (b) 6,000 6,000 (c (2,000) 10,000 8,000

Effect =16,000 16,000

2-18

(d) Papa John’s lends $3,000 cash to new franchisees who sign notes to (d) Papa John’s lends $3,000 cash to new franchisees who sign notes to be repaid in five years.be repaid in five years.

Step 1: Identify and classify accounts and effects1. Notes Receivable (+A) $3,000. 2. Cash (-A) $3,000.


AA == L L ++ SE SE



ReceivableNotes

PayableContributed


(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

2-19

(e) Papa John’s purchases the stock of another company as a long-term (e) Papa John’s purchases the stock of another company as a long-term investment, paying $1,000 in cash.investment, paying $1,000 in cash.

Step 1: Identify and classify accounts and effects1. Investments (+A) $1,000. 2. Cash (-A) $1,000.


AA == L L ++ SE SE



ReceivableNotes

PayableContributed


(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

2-20

(f) The board of directors declares that Papa John’s will pay $3,000 in cash (f) The board of directors declares that Papa John’s will pay $3,000 in cash dividends to shareholder next month.dividends to shareholder next month.

Step 1: Identify and classify accounts and effects1. Retained Earnings (-SE) $3,000. 2. Dividends Payable (+L) $3,000.


AA == L L ++ SE SE



ReceivableDividends Payable

Notes Payable

Contributed Capital

Retained 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 =16,000 16,000

2-21

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)

2-22

How Do Companies Keep Track of Account Balances?

General JournalGeneral JournalGeneral JournalGeneral Journal

T-accountsT-accounts

General General LedgerLedger

2-23

Debits and credits affect the Balance Sheet Model as follows:

Transaction Analysis Model

Assets(many accounts)

= Liabilities(many accounts)

+ Stockholders’ Equity (two accounts)

+ − − + Contributed Capital Retained Earningsdebit credit debit credit − + − +

debit credit debit creditInvestments by

ownersDividends declared

Net income of business

T-Account(Any account)

debit credit

“T-account” is merely a shorthand term for the entire ledger account. The T-account has a left side, called the debit side, and a right side, called the credit side.

2-24

Summary

Assets = Liabilities + Stockholders’ Equity

↑ with Debits ↑ with Credits ↑ with Credits

Accounts have debit balances

Accounts have credit balances

Accounts have credit balances

2-25

Analytical Tool: The Journal Entry

A journal entry might look like this:

Debit Credit(c) Property and Equipment (+A) 10,000

Cash (-A) 2,000 Notes Payable (+L) 8,000

Reference:Reference:Letter, Letter, number, or number, or date.date.

Reference:Reference:Letter, Letter, number, or number, or date.date.

Account Titles:Account Titles:Debited accounts on top.Debited accounts on top.Credited accounts on bottom Credited accounts on bottom usually indented.usually indented.

Account Titles:Account Titles:Debited accounts on top.Debited accounts on top.Credited accounts on bottom Credited accounts on bottom usually indented.usually indented.

Amounts:Amounts:Debited amounts on left.Debited amounts on left.Credited amounts on right.Credited amounts on right.

Amounts:Amounts:Debited amounts on left.Debited amounts on left.Credited amounts on right.Credited amounts on right.

2-26

PostLedger

The T-Account

After journal entries are prepared, the accountant posts (transfers) the dollar amounts to each account affected by

the transaction.

Debit Credit(c) Property and Equipment (+A) 10,000

Cash (-A) 2,000 Notes Payable (+L) 8,000

2-27

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

8,000

Cash1,000 Beg. Bal.2,000 (a)

3,000

Contributed Capital

(a)

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

2-28

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

152,000

Notes PayableBeg. Bal. 6,000

(a) 2,000 (b) 6,000

14,000

Cash

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

2-29

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.

2-30

k

2-31

International PerspectiveUnderstanding Foreign Financial Statements

Although financial statements prepared using GAAP and IFRS include the same elements (assets, liabilities, revenues, expenses, etc.), a single, consistent format has not been

mandated. Consequently, various formats have evolved over time, with those in the U.S. differing from those typically used

internationally. The formatting differences include:

2-32

Key Ratio Analysis

CurrentRatio

Current AssetsCurrent Liabilities=

Current ratio for Papa John’s:Current ratio for Papa John’s:

The current ratio for Papa John’s shows a low levelof liquidity, below 1.

The current ratio for Papa John’s shows a low levelof liquidity, below 1.

2006 = 0.832007 = 0.682008 = 0.75

2-33

Focus on Cash Flows

Operating activities (Covered in the next chapter.)Investing Activities Purchasing long-term assets and investments for cash – Selling long-term assets and investments for cash + Lending cash to others – Receiving principal payments on loans made to others +Financing Activities Borrowing cash from banks + Repaying the principal on borrowings from banks – Issuing stock for cash + Repurchasing stock with cash – Paying cash dividends –

Companies report cash inflows and outflows over a period in their statement of cash flows.

2-34

Investing and Financing Activities

Operating activities (None in this chapter.)Investing Activities Purchased property and equipment (2,000)$ Purchased investments (1,000) Lent funds to franchisees (3,000) Net cash used in investing activities (6,000) Financing Activities Issued common stock 2,000 Borrowed from banks 6,000 Net cash provided by financing activities 8,000 Net increase in cash 2,000 Cash at beginning of month 11,000 Cash at end of month 13,000$

Papa John's International, Inc.Consolidated Statement of Cash FlowsFor the Month Ended January 31, 2009

(in thousands)

Agrees with the amount of the balance sheet.Agrees with the amount of the balance sheet.

2-35

End of Chapter 2

Chap002

Economy & Finance

stockholders equity

companys balance sheet

balance sheet chapter

papa johns balance sheet

accounting equation

chart of accounts

se step

future cash flows