Investing and Financing Decisions

and the Balance Sheet

Chapter 02

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
2-1
 Understanding the Business

To understand amounts appearing

on a company’s balance sheet we
need to answer these questions:

What
How do How do
business
specific companies
activities cause
activities keep track of
changes in
affect each balance sheet
the balance
balance? amounts?
sheet?

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 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 Characteristics Elements of Statements

Relevancy Asset
Reliability Liability
Comparability Stockholders’ Equity
Consistency Revenue
Expense
Gain
Loss
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 The Conceptual Framework
Objective of Financial Reporting
To provide useful economic information to external users
for decision making and for assessing future cash flows.
Primary Characteristics
Qualitative Characteristics
•Relevancy: predictive value,
Relevancy Elements of Statements
feedback value, and timeliness.
Reliability •Reliability: verifiability,
Asset
representational faithfulness,
Liability
Comparability
and neutrality.
Consistency Stockholders’ Equity
SecondaryRevenue
Characteristics
•Comparability: across
Expense
companies.
•Consistency: Gain
over time.
Loss
2-4
 The Conceptual Framework
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

Qualitative Characteristics
probable future benefits.
Elements of Statements
Liability: probable future sacrifices of
economic resources.Relevancy Asset
Stockholders’ Equity: financing
provided by owners and business
operations.
Reliability Liability
Revenue: increase in assets or
Comparability
settlement of liabilities from ongoing Stockholders’ Equity
operations.
Expense: decrease in assets or
Consistency
increase in liabilities from ongoing
Revenue
operations.
Gain: increase in assets or settlement Expense
of liabilities from peripheral
activities.
Loss: decrease in assets or
Gain
increase in liabilities from peripheral
activities. Loss
2-5
 International Perspective
Reconsidering the Conceptual Framework

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.
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
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 Understandability
 Elements of the Balance Sheet

A = L + SE
(Assets) (Liabilities) (Stockholders’ Equity)

Economic resources Probable debts or The financing

with probable future obligations (claims provided by the
benefits owned or to a company’s owners and by
controlled by the resources) that business operations.
entity. Measured by result from a Often referred to as
the historical cost company’s past contributed capital.
principle. transactions and will
be paid with assets
or services. Entities
that a company
owes money to are
called creditors.

2-7
 Papa John’s Balance Sheet

2-8
 Nature of Business Transactions

Most transactions with

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

2-9
 A Question of Ethics

2-10
 Accounts
An organized format used by companies
to accumulate the dollar effects of
transactions.

Cash Inventory

Notes
Equipment Payable

2-11
 Chart of Accounts
A chart of accounts lists all account titles and their
unique numbers.

2-12
 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)

2-13
 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.
2-14
 Analyzing Transactions
(a) Papa John’s issues $2,000 of additional common stock to new investors
for cash.

Step 1: Identify and classify accounts and effects

1. Cash (+A) $2,000. 2. Contributed Capital (+SE) $2,000.

Step 2: Is the accounting equation in balance?

Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000

Effect 2,000 = 2,000

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A = L + SE
 Analyzing Transactions
(b) Papa John’s borrows $6,000 from the bank signing a three-year note.

Step 1: Identify and classify accounts and effects

1. Cash (+A) $6,000. 2. Notes Payable (+L) $6,000.

Step 2: Is the accounting equation in balance?

Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000

Effect 8,000 = 8,000

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A = L + SE
 Analyzing Transactions
(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
note for the balance.
Step 1: Identify and classify accounts and effects
1. Equipment (+A) $10,000. 2. Cash (-A) $2,000
Notes Payable (+L) $8,000.
Step 2: Is the accounting equation in balance?
Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000
(c (2,000) 10,000 8,000

Effect 16,000 = 16,000

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A = L + SE
 Analyzing Transactions
(d) Papa John’s lends $3,000 cash to new franchisees who sign notes to be
repaid in five years.

Step 1: Identify and classify accounts and effects

1. Notes Receivable (+A) $3,000. 2. Cash (-A) $3,000.

Step 2: Is the accounting equation in balance?

Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(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

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A = L + SE
 Analyzing Transactions
(e) Papa John’s purchases the stock of another company as a long-term
investment, paying $1,000 in cash.

Step 1: Identify and classify accounts and effects

1. Investments (+A) $1,000. 2. Cash (-A) $1,000.

Step 2: Is the accounting equation in balance?

Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital 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

Effect 16,000 = 16,000

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A = L + SE
 Analyzing Transactions
(f) The board of directors declares that Papa John’s will pay $3,000 in cash
dividends to shareholder next month.

Step 1: Identify and classify accounts and effects

1. Retained Earnings (-SE) $3,000. 2. Dividends Payable (+L) $3,000.

Step 2: Is the accounting equation in balance?

Notes Dividends Notes Contributed Retained
Cash Investments Equip. Receivable Payable Payable Capital 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

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A = L + SE
 The Accounting Cycle
Start of new period
During the Period
(Chapters 2 and 3)
•Analyze transactions
•Record journal entries in the general journal
•Post amounts to the general 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)

2-21
 How Do Companies Keep Track of
Account Balances?

General Journal General

Ledger

T-accounts

2-22
 Transaction Analysis Model
T-Account
(Any account)
“T-account” is merely a shorthand term for
the entire ledger account. The T-account has
debit credit a left side, called the debit side, and a right
side, called the credit side.

Debits and credits affect the Balance Sheet Model as follows:

Assets = Liabilities + Stockholders’ Equity

(many accounts) (many accounts) (two accounts)
+ − − + Contributed Capital Retained Earnings
debit credit debit credit − + − +
debit credit debit credit
Investments by Dividends Net income of
owners declared business

2-23
 Summary

Assets = Liabilities + Stockholders’

Equity
↑ with Debits ↑ with Credits ↑ with Credits

Accounts have Accounts have Accounts have

debit balances credit balances credit balances

2-24
 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

Account Titles:
Debited accounts on top.
Reference: Credited accounts on bottom
Letter, usually indented.
number, or Amounts:
date. Debited amounts on left.
Credited amounts on right.

2-25
 The T-Account
After journal entries are prepared, the
accountant posts (transfers) the dollar
amounts to each account affected by
the transaction.

Debit Credit Ledger

(c) Property and Equipment (+A) 10,000 Post
Cash (-A) 2,000
Notes Payable (+L) 8,000

2-26
 Papa John’s issues $2,000 of additional common
stock to new investors for cash.

GENERAL JOURNAL
Posted
Date Account Titles and Explanation Ref. Debit Credit
Cash (+A) 2,000
(a) Contributed Capital (+E) 2,000

Cash Contributed Capital

Beg. Bal. 6,000 1,000 Beg. Bal.
(a) 2,000 2,000 (a)

8,000 3,000

2-27
 The company borrows $6,000 from the local bank,
signing a three-year note.

Debit Credit
(b) Cash (+A) 6,000
Notes Payable (+L) 6,000

Cash Notes Payable

Beg. Bal. 6,000 146,000 Beg. Bal.
(a) 2,000 6,000 (b)
(b) 6,000

14,000 152,000

2-28
 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 Current liabilities are
the upcoming year, those obligations to be
whereas noncurrent paid or settled within
assets are those that the next 12 months
will last longer than with current assets.
one year.

2-29
 k

2-30
 International Perspective
Understanding 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:

2-31
 Key Ratio Analysis

Current Current Assets

Ratio = Current Liabilities

Current ratio for Papa John’s:

2006 = 0.83
2007 = 0.68
2008 = 0.75
The current ratio for Papa John’s shows a low level
of liquidity, below 1.
2-32
 Focus on Cash Flows
Companies report cash inflows and outflows over a period
in their statement of 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 –

2-33
 Investing and Financing Activities
Papa John's International, Inc.
Consolidated Statement of Cash Flows
For the Month Ended January 31, 2009
(in thousands)
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

Agrees with the amount of the balance sheet.

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 End of Chapter 02

2-35