Chap002 libby power

Investing and Financing Decisions Investing and Financing Decisions and the Balance Sheetand the Balance Sheet

Chapter 2

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

22-2

Understanding the Business

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?

32-3

The Conceptual Framework

Qualitative Characteristics

Relevancy

Reliability

Comparability

Consistency

Elements of Statements

Asset

Liability

Stockholders’ Equity

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.

42-4


Asset

Liability


Revenue

Expense

Gain

Loss



Relevancy

Reliability

Comparability

Consistency



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

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

52-5


Relevancy

Reliability

Comparable

Consistent



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 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.

62-6


AssumptionsSeparate entity: Activities of the business are separate from activities of owners.Continuity: The entity will not go out of business in the near future.Unit-of-measure: Accounting measurements will be in the national monetary unit (i.e., $ in the U.S.).

PrincipleHistorical cost: Cash equivalent cost given up

is the basis for the initial recording of elements.

72-7

Nature of Business Transactions

External eventsExternal events: exchanges of assetsand liabilities between the business

and one or more other parties.

Borrow cash

from the bank

82-8

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.

92-9

Accounts

Cash

Equipment

Inventory

Notes Payable

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

effects of transactions.effects of transactions.

102-10

Typical Account Titles

AssetsAssets

CashCashShort-Term InvestmentShort-Term InvestmentAccounts ReceivableAccounts ReceivableNotes ReceivableNotes ReceivableInventory (to be sold)Inventory (to be sold)SuppliesSuppliesPrepaid ExpensesPrepaid ExpensesLong-Term InvestmentsLong-Term InvestmentsEquipmentEquipmentBuildingsBuildingsLandLandIntangiblesIntangibles

LiabilitiesLiabilities

Accounts PayableAccounts PayableAccrued ExpensesAccrued ExpensesNotes PayableNotes PayableTaxes PayableTaxes PayableUnearned Revenue Unearned Revenue Bonds PayableBonds Payable

Stockholders’ EquityStockholders’ Equity

Contributed CapitalContributed CapitalRetained EarningsRetained Earnings

The Balance SheetThe Balance Sheet

112-11

Typical Account Titles

RevenuesRevenues

Sales RevenueSales RevenueFee RevenueFee RevenueInterest RevenueInterest RevenueRent RevenueRent Revenue

ExpensesExpenses

Cost of Goods SoldCost of Goods SoldWages ExpenseWages ExpenseRent ExpenseRent ExpenseInterest ExpenseInterest ExpenseDepreciation ExpenseDepreciation ExpenseAdvertising ExpenseAdvertising ExpenseInsurance ExpenseInsurance ExpenseRepair ExpenseRepair ExpenseIncome Tax ExpenseIncome Tax Expense

The Income StatementThe Income Statement

122-12

Principles of Transaction Analysis

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

The accounting equation must remain in balance after each transaction.

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

Equity)

132-13

Duality of Effects

Most transactions with external parties involve an exchange exchange where the business entity gives up gives up something but receivesreceives

something in return.

2-14

Balancing the Accounting Equation

Step 1: Accounts and effectsStep 1: Accounts and effects Identify the accounts affected and classify them by Identify the accounts affected and classify them by

type of account (A, L, SE).type of account (A, L, SE). Determine the direction of the effect (increase or Determine the direction of the effect (increase or

decrease) on each account.decrease) on each account.

Step 2: BalancingStep 2: Balancing Verify that the accounting equation (A = L + SE) Verify that the accounting equation (A = L + SE)

remains in balance. remains in balance.

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

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

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

Analyzing Transactions

162-16

AA == L L ++ SE SE

Cash Investments Equip.Notes

ReceivableNotes

PayableContributed

CapitalRetained Earnings

(a) 2,000 2,000

Effect =2,000 2,000


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

172-17

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

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

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


182-18

AA == L L ++ SE SE


ReceivableNotes

PayableContributed


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

Effect =8,000 8,000


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

192-19

Papa John’s purchases $10,000 of new equipment, paying Papa John’s purchases $10,000 of new equipment, paying $2,000 in cash and signing a two-year note payable$2,000 in cash and signing a two-year note payable for the rest.for the rest.

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.


202-20

A A == 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


Papa John’s purchases $10,000 of new equipment, paying Papa John’s purchases $10,000 of new equipment, paying $2,000 in cash and signing a two-year note payable$2,000 in cash and signing a two-year note payable for the rest.for the rest.

2-21

Papa John’s board of directors declares andPapa John’s board of directors declares andpays $3,000 in dividends to shareholders.pays $3,000 in dividends to shareholders.


Identify & Classify the Accounts

Determine the Direction of the Effect

Identify & Classify the Accounts1. Cash (asset).2. Retained Earnings (equity).

Determine the Direction of the Effect1. Cash decreases.2. Retained Earnings decreases.

222-22

A = L + SEA = L + 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 (f) (3,000) (3,000)

Effect =13,000 13,000

Papa John’s board of directors declares andPapa John’s board of directors declares andpays $3,000 in dividends to shareholders.pays $3,000 in dividends to shareholders.


232-23

The Accounting Cycle

During the period:During the period:AnalyzeAnalyze transactions.RecordRecord journal entries in the general journal.PostPost amounts to the general ledger.

End of the period:End of the period:AdjustAdjust revenues and expensesand related balance sheet accounts.

PreparePrepare a completeset of financial statements.DisseminateDisseminate statementsto users.

CloseClose revenues, gains,expenses and lossesto retained earnings.

242-24

How Do Companies Keep Track of Account Balances?

Journal entriesJournal entries

T-accountsT-accounts

252-25

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 RightDebit Credit

262-26

AA = = LL + + SESE

Transaction Analysis Model

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

272-27

AA = = LL + + SESEASSETSASSETS

Debit for

Increase

Credit for

Decrease

EQUITIESEQUITIES

Debit for

Decrease

Credit for

Increase

LIABILITIESLIABILITIES

Debit for

Decrease

Credit for

Increase

The Debit-Credit Framework

Remember that Stockholders’ Equity includes Contributed Capital and Retained Earnings.

282-28

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.

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

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

2-29

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

302-30

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.

312-31

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.

322-32

Balance Sheet Preparation

It is possible to prepare a balance

sheet at any point in time from the

balances in the accounts.

Balance Sheet

332-33

January 31, December 28,2007 2006

ASSETSCurrent 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$

Papa John's International, Inc. and SubsidiariesConsolidated Balance Sheet

(dollars in thousands)

The Asset Section of a Classified Balance Sheet

342-34

January 31, December 28,2007 2006

LIABILITIES AND STOCKHOLDERS' EQUITYCurrent 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$

Papa John's International, Inc. and SubsidiariesConsolidated Balance Sheet

(dollars in thousands)

Liabilities and Stockholders’ Equity Section of the Balance Sheet

352-35

Key Ratio Analysis

FinancialLeverage

Ratio

Average Total AssetsAverage Stockholders’ Equity=

(Beginning Balance + Ending Balance) ÷ 2

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

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

= 2.37

The ratio tells us how well management is using debt toincrease assets the company employs to earn income.

362-36

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 –

372-37

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 13,000 Cash at end of month 15,000$

Papa John's International, Inc.Consolidated Statement of Cash FlowsFor the Month Ended January 31, 2007

(in thousands)

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

End of Chapter 2

Education

Chap002 libby power