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Investing and Financing

Decisions
and the Balance Sheet
Chapter 2

McGraw-Hill/Irwin

2009 The McGraw-Hill Companies, Inc.

Understanding the Business


To understand amounts appearing
on a companys 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?

2-2
2

The Conceptual Framework


Objective of Financial Reporting

To provide useful economic information to external users


for decision making and for assessing future cash flows.
Qualitative
QualitativeCharacteristics
Characteristics

Elements
Elementsof
ofStatements
Statements

Relevancy
Relevancy

Asset
Asset

Reliability
Reliability

Liability
Liability

Comparability
Comparability

Stockholders
StockholdersEquity
Equity

Consistency
Consistency

Revenue
Revenue
Expense
Expense
Gain
Gain
Loss
Loss

2-3
3

The Conceptual Framework


Objective of Financial Reporting

To provide useful economic information to external users


for decision making and for assessing future cash flows.
Qualitative
QualitativeCharacteristics
Characteristics
Relevancy
Relevancy
Reliability
Reliability
Comparability
Comparability
Consistency
Consistency

Primary Characteristics
Relevancy: predictive value,
Elements
Elementsof
ofStatements
Statements
feedback value, and
Asset
Asset
timeliness.
Reliability: verifiability,
Liability
Liability
representational
faithfulness,
Stockholders
StockholdersEquity
Equity
and neutrality.
Revenue
Revenue

SecondaryExpense
Characteristics
Expense
Comparability: across
Gain
companies. Gain
Consistency: Loss
over
Loss time.

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4

The Conceptual Framework


Asset: economic resource with
Objective
ObjectiveofofFinancial
FinancialReporting
Reporting
probable future benefits.
To
useful
Liability:
probable
future economic
sacrifices
of information
Toprovide
provide
useful
economic
informationto
toexternal
externalusers
users
economic
resources.
for
making
fordecision
decision
makingand
andfor
forassessing
assessingfuture
futurecash
cashflows.
flows.
Stockholders Equity: financing
provided by owners and operations.
Revenue:
increase
in assets or
Elements
Qualitative
Characteristics
Elementsof
ofStatements
Statements
Qualitative Characteristics
settlement of liabilities from ongoing
Asset
operations. Relevancy
Asset
Relevancy
Expense: decrease
in assets or
Liability
Reliability
Liability
Reliability
increase in liabilities from ongoing
Stockholders
operations.Comparable
StockholdersEquity
Equity
Comparable
Gain: increase
in assets or settlement
Revenue
Consistent
Revenue
Consistent
of liabilities from peripheral
Expense
activities.
Expense
Loss: decrease in assets or
Gain
Gain
increase in liabilities from peripheral
Loss
activities.
Loss
2-5
5

The Conceptual Framework


Assumptions
Assumptions

Separate
Separateentity:
entity:Activities
Activitiesof
ofthe
thebusiness
businessare
are separate
separatefrom
from
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
measurementswill
willbe
beininthe
thenational
national
monetary
monetaryunit
unit(i.e.,
(i.e.,$$ininthe
theU.S.).
U.S.).

Principle
Principle

Historical
Historicalcost:
cost: Cash
Cashequivalent
equivalentcost
costgiven
givenup
up
isisthe
thebasis
basisfor
forthe
theinitial
initialrecording
recordingof
of elements.
elements.

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6

Nature of Business Transactions


External
events exchanges of assets
External events:
and liabilities between the business
and one or more other parties.

Borrow cash

from the bank


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7

Nature of Business Transactions


Internal
events not an exchange between
Internal events:
the business and other parties, but have
a direct effect on the accounting entity.
Loss due to
fire damage.

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8

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

Cash

Inventory

Equipment

Notes
Payable

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9

Typical Account Titles


The Balance Sheet
Assets
Assets

Liabilities

Cash
Short-Term Investment
Accounts Receivable
Notes Receivable
Inventory (to be sold)
Supplies
Prepaid Expenses
Long-Term Investments
Equipment
Buildings
Land
Intangibles

Accounts Payable
Accrued Expenses
Notes Payable
Taxes Payable
Unearned Revenue
Bonds Payable
Stockholders
Stockholders Equity

Contributed Capital
Retained Earnings

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10

Typical Account Titles


The Income Statement
Revenues
Revenues

Expenses

Sales Revenue
Fee Revenue
Interest Revenue
Rent Revenue

Cost of Goods Sold


Wages Expense
Rent Expense
Interest Expense
Depreciation Expense
Advertising Expense
Insurance Expense
Repair Expense
Income Tax Expense

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11

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)

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Duality of Effects

Most transactions
with external parties
involve an exchange
where the business
entity gives up
something but
receives something in
return.
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13

Balancing the Accounting Equation


Step
Step 1:
1: Accounts
Accounts and
and effects
effects
Identify
Identify the
the accounts
accounts affected
affected and
and classify
classify

them
them by
by type
type of
of account
account (A,
(A, L,
L, SE).
SE).
Determine
Determine the
the direction
direction of
of the
the effect
effect
(increase
(increase or
or decrease)
decrease) on
on each
each account.
account.

Step
Step 2:
2: Balancing
Balancing
Verify
Verify that
that the
the accounting
accounting equation
equation (A
(A =
= LL

+
+ SE)
SE) remains
remains in
in balance.
balance.

2-14

Analyzing Transactions
Papa Johns issues $2,000 of additional common
stock to new investors for cash.
Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset).
(asset).
2.
2. Contributed
ContributedCapital
Capital (equity).
(equity).
Determine
Determine the
the Direction
Direction of
of the
the Effect
Effect
1.
1. Cash
Cashincreases.
increases.
2.
2. Contributed
Contributed Capital
Capitalincreases.
increases.

2-15
15

Analyzing Transactions
Papa Johns issues $2,000 of additional common
stock to new investors for cash.
(a)

Effect

Cash
Investments
2,000

Equip.

2,000

Notes
Receivable

Notes
Payable

Contributed
Capital
2,000

Retained
Earnings

2,000

A = L + SE
2-16
16

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
NotesPayable
Payableincreases.
increases.

2-17
17

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

Effect

Cash
Investments
2,000
6,000

Equip.

8,000

Notes
Receivable

Notes
Payable

Contributed
Capital
2,000

Retained
Earnings

6,000

8,000

A = L + SE
2-18
18

Analyzing Transactions
Papa Johns purchases $10,000 of new equipment, paying
$2,000 in cash and signing a two-year note payable for the rest.
Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Equipment
Equipment(asset).
(asset).
2.
2. Cash
Cash(asset).
(asset).
3.
3. Notes
NotesPayable
Payable(liability).
(liability).
Determine
Determine the
the Direction
Direction of
of the
the Effect
Effect
1.
1. Equipment
Equipmentincreases.
increases.
2.
2. Cash
Cashdecreases.
decreases.
3.
3. Notes
NotesPayable
Payableincreases.
increases.
2-19
19

Analyzing Transactions
Papa Johns purchases $10,000 of new equipment, paying
$2,000 in cash and signing a two-year note payable for the rest.
(a)
(b)
(c)

Effect

Cash
Investments
2,000
6,000
(2,000)

Equip.

16,000

Notes
Receivable

Notes
Payable

Contributed
Capital
2,000

Retained
Earnings

6,000
8,000

10,000

16,000

A = L + SE
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20

Papa Johns lends $3,000 to new franchisees


who sign five-year notes agreeing to repay
the loan.
Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset)
(asset)
2.
2. Notes
NotesReceivable
Receivable(asset)
(asset)

Determine
Determine the
the Direction
Direction of
of the
the Effect
Effect
1.
1. Cash
Cashdecreases.
decreases.
2.
2. Notes
NotesReceivable
Receivableincreases.
increases.

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21

Papa Johns lends $3,000 to new franchisees


who sign five-year notes agreeing to repay
the loan.
(a)
(b)
(c)
(d)

Effect

Cash
Investments
2,000
6,000
(2,000)
(3,000)

Equip.

16,000

Notes
Receivable

Notes
Payable

Contributed
Capital
2,000

Retained
Earnings

6,000
8,000

10,000
3,000

16,000

A = L + SE
2-22
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Papa Johns purchases $1,000 of stock in


other companies as an investment.
Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset)
(asset)
2.
2. Investments
Investments(asset)
(asset)

Determine
Determine the
the Direction
Direction of
of the
the Effect
Effect
1.
1. Cash
Cashdecreases.
decreases.
2.
2. Investments
Investmentsincrease.
increase.

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23

Papa Johns purchases $1,000 of stock in


other companies as an investment.

(a)
(b)
(c)
(d)
(e)
Effect

Cash
Investments
2,000
6,000
(2,000)
(3,000)
(1,000)
1,000

Equip.

16,000

Notes
Receivable

Notes
Payable

Contributed
Capital
2,000

Retained
Earnings

6,000
8,000

10,000
3,000

16,000

A = L + SE
2-24
24

Analyzing Transactions
Papa Johns board of directors declares and
pays $3,000 in dividends to shareholders.
Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset).
(asset).
2.
2. Retained
RetainedEarnings
Earnings(equity).
(equity).

Determine
Determinethe
theDirection
Direction of
of the
theEffect
Effect
1.
1. Cash
Cashdecreases.
decreases.
2.
2. Retained
RetainedEarnings
Earningsdecreases.
decreases.
2-25

Analyzing Transactions
Papa Johns board of directors declares and
pays $3,000 in dividends to shareholders.
(a)
(b)
(c)
(d)
(e)
(f)
Effect

Cash
Investments
2,000
6,000
(2,000)
(3,000)
(1,000)
1,000
(3,000)

Equip.

13,000

Notes
Receivable

Notes
Payable

Contributed
Capital
2,000

Retained
Earnings

6,000
8,000

10,000
3,000

(3,000)

13,000

A = L + SE
2-26
26

The Accounting Cycle


During the period:

Analyze transactions.
Record journal entries in the general journal.
Post amounts to the general ledger.

End of the period:

Adjust revenues and expenses


and related balance sheet accounts.

Close revenues, gains,


expenses and losses
to retained earnings.

Prepare a complete
set of financial statements.
Disseminate statements
to users.

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27

How Do Companies Keep Track of


Account Balances?
T-accounts

Journal entries

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28

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

Debit

Credit

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29

Transaction Analysis Model


Debits
Debits and
and credits
credits affect
affect the
the Balance
Balance Sheet
Sheet
Model
Model as
as follows:
follows:

A = L + SE
ASSETS

LIABILITIES

EQUITIES

Debit
Credit
for
for
Increase Decrease

Debit
Credit
for
for
Decrease Increase

Debit
Credit
for
for
Decrease Increase

2-30
30

The Debit-Credit Framework

A = L + SE
ASSETS

LIABILITIES

EQUITIES

Debit
Credit
for
for
Increase Decrease

Debit
Credit
for
for
Decrease Increase

Debit
Credit
for
for
Decrease Increase

Remember that Stockholders Equity


includes Contributed Capital and Retained
Earnings.
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31

Analytical Tool: The Journal Entry


A journal entry might look like this:

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

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

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32

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

Post

2-33

Papa Johns issues $2,000 of additional


common stock to new investors for
cash.

(a)

Beg. Bal.
(a)

Cash
6,000
2,000

8,000

Contributed Capital
1,000 Beg. Bal.
2,000 (a)

3,000

2-34
34

The company borrows $6,000 from the


local bank, signing a three-year note.

Beg. Bal.
(a)
(b)

Cash
6,000
2,000
6,000

14,000

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

152,000

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35

Balance Sheet Preparation

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

Balance
BalanceSheet
Sheet

2-36
36

The Asset Section of a Classified


Balance Sheet

2-37
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Liabilities and Stockholders Equity


Section of the Balance Sheet

2-38
38

Key Ratio Analysis


Financial
Leverage
Ratio

Average Total Assets


Average Stockholders Equity

(Beginning Balance + Ending Balance) 2

The 2006 financial leverage ratio for Papa Johns 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.
2-39
39

Focus on Cash Flows

2-40
40

Investing and Financing Activities

2-41
41

End of Chapter 2

McGraw-Hill/Irwin

2009 The McGraw-Hill Companies, Inc.