chapter 2separate entity: transactions of the business are separate from transactions of owners....

© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill

Chapter 2

Investing and Financing Decisions and the Balance Sheet


Business Background

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

What business

activities causechanges inthe balance

sheet?

How dospecificactivities

affect eachbalance?

How do companies

keep track ofbalance sheet

amounts?


The Conceptual Framework

Qualitative Characteristics

Relevancy

Reliability

Comparable

Consistent


Relevancy

Reliability

Comparable

Consistent

Elements of Statements

Asset

Liability

Stockholders’ Equity

Revenue

Expense

Gain

Loss


Asset

Liability


Revenue

Expense

Gain

Loss

Objective of External Financial ReportingTo provide useful economic information to external users for decision making and for assessing future cash flows.




Asset

Liability


Revenue

Expense

Gain

Loss


Asset

Liability


Revenue

Expense

Gain

Loss



Relevancy

Reliability

Comparable

Consistent


Relevancy

Reliability

Comparable

Consistent



Primary Characteristics•Relevancy: predictive value,feedback value, and timeliness.

•Reliability: verifiability,representational faithfulness, andneutrality.

Secondary Characteristics•Comparability: across companies.

•Consistency: over time.



Relevancy

Reliability

Comparable

Consistent


Relevancy

Reliability

Comparable

Consistent



Asset

Liability


Revenue

Expense

Gain

Loss


Asset

Liability


Revenue

Expense

Gain

Loss



Asset: economic resource with probable future benefit.

Liability: probable future sacrifices of economic resources.

Stockholders’ Equity: financingprovided by owners and operations.

Revenue: increase in assets orsettlement of liabilities from ongoing operations.

Expense: decrease in assets orincrease in liabilities from ongoing operations.

Gain: increase in assets or settlement of liabilities from peripheraltransactions.

Loss: decrease in assets or increase in liabilities from peripheral transactions.



AssumptionsSeparate entity: Transactions of the business are

separate from transactions of owners.Continuity: The entity will not go out of business in the

near future.Unit-of-measure: Accounting measures are in the

national monetary unit ($).Time period: The long life of a company can be

reported over a series of shorter time periods.

AssumptionsSeparate entity: Transactions of the business are

separate from transactions of owners.Continuity: The entity will not go out of business in the

near future.Unit-of-measure: Accounting measures are in the

national monetary unit ($).Time period: The long life of a company can be

reported over a series of shorter time periods.



PrinciplesHistorical cost: Cash equivalent cost given up is the basis

for initial recording of elements.Revenue recognition: Record revenues when earned and

measurable (exchange complete, earnings complete and collection probable).

Matching: Record expenses when incurred in earning revenue.

Full disclosure: Disclose relevant economic information.

PrinciplesHistorical cost: Cash equivalent cost given up is the basis

for initial recording of elements.Revenue recognition: Record revenues when earned and

measurable (exchange complete, earnings complete and collection probable).

Matching: Record expenses when incurred in earning revenue.

Full disclosure: Disclose relevant economic information.



ConstraintsCost-benefit: Benefits of recording and reporting information

should outweigh costs.Materiality: Relatively small amounts not likely to influence

decisions are to be recorded in most cost/beneficial way.Industry peculiarities: Differences in accounting and reporting

for certain items are permitted if there is a clear precedent in the industry.

Conservatism: Exercise care not to overstate assets andrevenues or understate liabilities and expenses.

ConstraintsCost-benefit: Benefits of recording and reporting information

should outweigh costs.Materiality: Relatively small amounts not likely to influence

decisions are to be recorded in most cost/beneficial way.Industry peculiarities: Differences in accounting and reporting

for certain items are permitted if there is a clear precedent in the industry.

Conservatism: Exercise care not to overstate assets andrevenues or understate liabilities and expenses.


Nature of Business Transactions

External eventsExternal events: exchanges of assetsand liabilities between the business

and one or more other parties.

Borrow money

from the bank


Nature of Business Transactions

Internal eventsInternal events: not an exchange betweenthe business and other parties, but havea direct effect on the accounting entity.

Loss due to fire damage.


AccountsAn organized format used by companies to

accumulate the dollar effects of transactions.

Cash

EquipmentInventory

Notes Payable


Transaction Analysis

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

➋ The accounting equation must remain in balance after each transaction.

A = L + SEA = L + SE


Duality of Effects

Most transactions with external parties involve an exchangewhere the business entity both gives up gives up

something and receivesreceives something

in return.


Balancing the Accounting Equation!Accounts and effects

"Identify the accounts affected."Classify each as an asset, liability or equity

account."Determine the direction of the effect (increase or

decrease) on each account.#Determine that the accounting equation

remains in balance.


Balancing the Accounting Equation

Let’s see how we keep theaccounting equation in

balance for Papa John’s.

All amounts are in thousands of dollars.


Identify & Classify the AccountsIdentify & Classify the Accounts

Determine the Direction of the EffectDetermine the Direction of the Effect

Papa John’s issues $1,300 of additional common stock to new investors for cash.

Identify & Classify the Accounts1. Cash (asset)2. Contributed Capital (equity)

Identify & Classify the Accounts1. Cash (asset)2. Contributed Capital (equity)

Determine the Direction of the Effect1. Cash increases.2. Contributed Capital increases.

Determine the Direction of the Effect1. Cash increases.2. Contributed Capital increases.



Assets = Liabilities + Stockholders' EquityCash Investments Equip. Notes Rec. Notes Pay. Contributed Capital

(a) 1,300 1,300

Effect =1,300 1,300





The company borrows $1,000 from the local bank, signing a one-year note.

Identify & Classify the Accounts1. Cash (asset)2. Notes Payable (liability)

Identify & Classify the Accounts1. Cash (asset)2. Notes Payable (liability)

Determine the Direction of the Effect1. Cash increases.2. Notes Payable increases.

Determine the Direction of the Effect1. Cash increases.2. Notes Payable increases.



(a) 1,300 1,300 (b) 1,000 1,000

Effect =2,300 2,300






Papa John’s purchases $5,700 of new equipment, paying $1,500 in cash and the rest on a note

payable.

Identify & Classify the Accounts1. Equipment (asset)2. Cash (asset)3. Notes Payable (liability)

Identify & Classify the Accounts1. Equipment (asset)2. Cash (asset)3. Notes Payable (liability)

Determine the Direction of the Effect1. Equipment increases.2. Cash decreases.3. Notes Payable increases.

Determine the Direction of the Effect1. Equipment increases.2. Cash decreases.3. Notes Payable increases.



(a) 1,300 1,300 (b) 1,000 1,000 (c) (1,500) 5,700 4,200

Effect =6,500 6,500



payable.




Papa John’s lends $450 to new franchises who sign notes.

Identify & Classify the Accounts1. Cash (asset)2. Notes Receivable (asset)

Identify & Classify the Accounts1. Cash (asset)2. Notes Receivable (asset)

Determine the Direction of the Effect1. Cash decreases.2. Notes Receivable increases.

Determine the Direction of the Effect1. Cash decreases.2. Notes Receivable increases.



(a) 1,300 1,300 (b) 1,000 1,000 (c) (1,500) 5,700 4,200 (d) (450) 450

Effect =6,500 6,500


Papa John’s lends $450 to new franchises who sign notes.




Papa John’s purchases $3,000 of stock in other companies as an investment.

Identify & Classify the Accounts1. Cash (asset)2. Investments (asset)

Identify & Classify the Accounts1. Cash (asset)2. Investments (asset)

Determine the Direction of the Effect1. Cash decreases.2. Investments increase.

Determine the Direction of the Effect1. Cash decreases.2. Investments increase.



(a) 1,300 1,300 (b) 1,000 1,000 (c) (1,500) 5,700 4,200 (d) (450) 450 (e) (3,000) 3,000

Effect =6,500 6,500


Papa John’s purchases $3,000 of stock in other companies as an investment.


How Do Companies Keep Track of Account Balances?

Journal entries

T-accounts


A TA T--account is a tool used to account is a tool used to represent an account.represent an account.

Account NameLeft Right

Direction of Transaction Effects


Direction of Transaction Effects

The left side of the T-account is always the

debit side.

Account NameLeft Right

Debit

The right side of the T-account is always the

credit side.

Credit



The Debit-Credit Framework

ASSETSASSETS

Debit for

Increase

Credit for

Decrease

EQUITIESEQUITIES

Debit for

Decrease

Credit for

Increase

LIABILITIESLIABILITIES

Debit for

Decrease

Credit for

Increase

Debits and credits affect the Balance Sheet Model as follows:

Debits and credits affect the Balance Sheet Model as follows:


A typical journal looks like this:

Analytical Tool: The Journal Entry

Page 1

Debit CreditDate Description

GENERAL JOURNAL



A journal entry might look like this:

Page 1

Debit CreditJan. 1 Cash 20,000

Contributed Capital 20,000

Date Description

GENERAL JOURNAL


Page 1



Date Description

GENERAL JOURNAL


Provide a referencedate for each transaction.

Debits are written first.

Credits are indented andwritten after debits.

Total debits must equaltotal credits.


PostLedger

Analytical Tool: The T-Account

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

was affected by the transaction.

Page 1



Date Description

GENERAL JOURNAL


Transaction Analysis Illustrated

Let’s prepare some Let’s prepare some journal entries for journal entries for Papa John’s and Papa John’s and post them to the post them to the

ledger.ledger.


Page 1

Debit CreditCash 1,300


Date Description

GENERAL JOURNAL


Beg. Bal. 34,000 (a) 1,300

35,300

Cash164,500 Beg. Bal.

1,300 (a)

165,800

Contributed Capital


Page 1

Debit CreditCash 1,000

Notes Payable 1,000

Date Description

GENERAL JOURNAL

Beg. Bal. 34,000 (a) 1,300 (b) 1,000

36,300

Cash- Beg. Bal.

1,000 (b)

1,000

Notes Payable



Page 1

Debit CreditEquipment 5,700

Cash 1,500 Notes Payable 4,200

Date Description

GENERAL JOURNAL


payable.

Let’s see how to post this entry . . .


Beg. Bal. 34,000 (a) 1,300 1,500 (c) (b) 1,000

34,800

Cash- Beg. Bal.

1,000 (b)4,200 (c)

5,200

Notes Payable


payable.

Beg. Bal. 169,200 (c) 5,700

174,900

Equipment


Balance Sheet Preparation

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

accounts.


AssetsCurrent assets: Cash and cash equivalents 31,250$ Accounts receivable 17,300 Inventories 9,700 Prepaid expenses 4,800 Other current assets 2,100 Total current assets 65,150 Investments 50,300 Net property and equipment 174,900 Notes receivable 12,450 Other assets 22,400 Total assets 325,200$

Liabilities and Stockholders' EquityCurrent liabilities: Accounts payable 18,100$ Accrued expenses payable 25,500 Total current liabilities 43,600$ Unearned franchise and development fees 6,600 Other long-term liabilities 11,200 Stockholders' equity:Contributed capital 165,800 Retained earnings 98,000 Total stockholders' equity 263,800 Total liabilities and stockholders' equity 325,200$

PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIESConsolidated Balance Sheets

January 31, 1999(Dollars in thousands)

These balances come from Papa

John’s ledger accounts on

January 31, 1999.


Some Misconceptions

An accountant is a trainedprofessional who can designinformation systems, analyze

complex transactions, andinterpret financial data.

Don’t confuse bookkeeping with accounting.Bookkeeping involves the routine, clerical

part of accounting and requires only minimal knowledge of accounting, but . . .


Some Misconceptions

Almost allaccounting

numbersare influencedby estimates.

NO!

Are all transactions subject toprecise and objective measurement?


Some Misconceptions

Some people believe that financial statements report the market value of the company.

Financial statementsreally report the cost of assets,

liabilities andstockholders’ equity.

Financial statementsreally report the cost of assets,

liabilities andstockholders’ equity.


End of Chapter 2

chapter 2separate entity: transactions of the business are separate from transactions of owners....

Documents