Investing and Financing

Decisions
and the Balance Sheet
Chapter 2

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

 The Conceptual Framework
Objective of Financial Reporting
To provide useful economic information to external users for
decision making and for assessing future cash flows.

Elements
ElementsofofStatements
Statements
Qualitative
QualitativeCharacteristics
Characteristics Asset
Asset
Relevancy
Relevancy Liability
Liability
Reliability
Reliability Stockholders’
Stockholders’Equity
Equity
Comparability
Comparability Revenue
Revenue
Consistency
Consistency Expense
Expense
Gain
Gain
Loss
Loss

McGraw-Hill/Irwin Slide 2
 The Conceptual Framework

Assumptions
Assumptions
Separate
Separateentity:
entity:Activities
Activitiesof ofthe
thebusiness
businessare
are separate
separatefromfrom
activities
activitiesof
ofowners.
owners.
Continuity:
Continuity:The Theentity
entitywill
willnot
notgo
goout
outof
of business
businessininthe
thenear
near
future.
future.
Unit-of-measure:
Unit-of-measure:Accounting
Accountingmeasurements
measurementswillwillbe
beininthe
thenational
national
monetary
monetaryunitunit(i.e.,
(i.e.,$$ininthe
theU.S.).
U.S.).

Principle
Principle
Historical
Historical cost:
cost: Cash
Cashequivalent
equivalent cost
cost given
givenup up
isisthe
thebasis
basisfor
forthe
theinitial
initialrecording
recordingofof elements.
elements.

McGraw-Hill/Irwin Slide 3
 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)

McGraw-Hill/Irwin Slide 4
 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.

McGraw-Hill/Irwin Slide 5
 Analyzing Transactions
Papa John’s issues $2,000 of additional common
stock to new investors for cash.

Identify
Identify&&Classify
Classify the
theAccounts
Accounts
1.
1. Cash
Cash(asset).
(asset).
2.
2. Contributed
ContributedCapital
Capital (equity).
(equity).

Determine
Determine the
the Direction
Direction ofof the
the Effect
Effect
1.
1. Cash
Cashincreases.
increases.
2.
2. Contributed
Contributed Capital
Capital increases.
increases.

McGraw-Hill/Irwin Slide 6
 Analyzing Transactions
Papa John’s issues $2,000 of additional common
stock to new investors for cash.
Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000

Effect 2,000 = 2,000

A = L + SE
McGraw-Hill/Irwin Slide 7
 Analyzing Transactions
The company borrows $6,000 from the
local bank, signing a three-year note.

Identify
Identify &&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash (asset).
(asset).
2.
2. Notes
NotesPayable
Payable(liability).
(liability).

Determine
Determinethe
theDirection
Directionof
ofthe
theEffect
Effect
1.
1. Cash
Cashincreases.
increases.
2.
2. Notes
Notes Payable
Payable increases.
increases.

McGraw-Hill/Irwin Slide 8
 The Accounting Cycle

During the period: Close revenues, gains,

Analyze transactions. expenses and losses
Record journal entries in the general journal. to retained earnings.
Post amounts to the general ledger.

Prepare a complete
End of the period: set of financial statements.
Adjust revenues and expenses Disseminate statements
and related balance sheet accounts. to users.

McGraw-Hill/Irwin Slide 9
 The Debit-Credit Framework

A = L + SE
ASSETS LIABILITIES EQUITIES
Debit Credit Debit Credit Debit Credit
for for for for for for
Increase Decrease Decrease Increase Decrease Increase

Remember that Stockholders’ Equity

includes Contributed Capital and Retained
Earnings.
McGraw-Hill/Irwin Slide 10
 The Asset Section of a Classified
Balance Sheet
Papa John's International, Inc. and Subsidiaries
Consolidated Balance Sheet
(dollars in thousands)
January 31, December 28,
2007 2006
ASSETS
Current assets
Cash $ 15,000 $ 13,000
Accounts receivable 23,000 23,000
Supplies 27,000 27,000
Prepaid expenses 8,000 8,000
Other current assets 14,000 14,000
Total current assets 87,000 85,000
Long-term investments 2,000 1,000
Property, and equipment (net of
accumulated depreciation of $189,000) 208,000 198,000
Long-term notes receivable 15,000 12,000
Intangibles 67,000 67,000
Other assets 17,000 17,000
Total assets $ 396,000 $ 380,000

McGraw-Hill/Irwin Slide 11
 Liabilities and Stockholders’ Equity
Section of the Balance Sheet
Papa John's International, Inc. and Subsidiaries
Consolidated Balance Sheet
(dollars in thousands)
January 31, December 28,
2007 2006
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable $ 29,000 $ 29,000
Dividends payable 3,000 -
Accrued expenses payable 73,000 73,000
Total current liabilities 105,000 102,000

Unearned franchise fees 7,000 7,000

Long-term notes payable 110,000 96,000
Other long-term liabilities 27,000 27,000
Total liabilities 249,000 232,000
Stockholders' equity
Contributed capital 3,000 1,000
Retained earnings 144,000 147,000
Total stockholders' equity 147,000 148,000
Total liabilities and stockholders' equity $ 396,000 $ 380,000

McGraw-Hill/Irwin Slide 12
 Key Ratio Analysis
Financial
Average Total Assets
Leverage = Average Stockholders’ Equity
Ratio

(Beginning Balance + Ending Balance) ÷ 2

The 2006 financial leverage ratio for Papa John’s was:

($351,000 + $380,000) ÷ 2
= 2.37
($161,000 + $148,000) ÷ 2

The ratio tells us how well management is using debt to

increase assets the company employs to earn income.

McGraw-Hill/Irwin Slide 13
 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 –

McGraw-Hill/Irwin Slide 14
End of Chapter 2

© 2009 The McGraw-Hill Companies, Inc.