2. Understanding the Business To understand amounts appearing on a company’s 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?
3. Learning Objectives Define the objective of financial reporting, the elements of the balance sheet, and the related key accounting assumptions and principles. LO1
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. Qualitative Characteristics Relevancy Reliability Comparability Consistency Elements of Statements Asset Liability Stockholders’ Equity Revenue Expense Gain Loss
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6. The Conceptual Framework Qualitative Characteristics Relevancy Reliability Comparable Consistent 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. Asset: economic resource with probable future benefit. 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.
7. The Conceptual Framework Assumptions Separate 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 ($). Principle Historical cost: Cash equivalent cost given up is the basis for initial recording of elements.
8. Learning Objectives Identify what constitutes a business transaction and recognize common balance sheet account titles used in business. LO2
9. Nature of Business Transactions External events : exchanges of assets and liabilities between the business and one or more other parties. Borrow cash from the bank
10. Nature of Business Transactions Internal events : not an exchange between the business and other parties, but have a direct effect on the accounting entity. Loss due to fire damage.
11. Accounts An organized format used by companies to accumulate the dollar effects of transactions. Cash Equipment Inventory Notes Payable
13. Typical Account Titles Revenues Sales Revenue Fee Revenue Interest Revenue Rent Revenue Expenses Cost of Goods Sold Wages Expense Rent Expense Interest Expense Depreciation Expense Advertising Expense Insurance Expense Repair Expense Income Tax Expense The Income Statement
14. International Perspective While U.S. companies follow GAAP to prepare their financial statements, other countries have significant variations from the accounting and reporting rules of GAAP. Some countries use different account titles than those used by U.S. companies.
15. Learning Objectives Apply transaction analysis to simple business transactions in terms of the accounting model: Assets = Liabilities + Stockholders’ Equity LO3
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19. Balancing the Accounting Equation Let’s see how we keep the accounting equation in balance for Papa John’s. All amounts we use are expressed in thousands of dollars.
20. Identify & Classify the Accounts Determine the Direction of the Effect Papa John’s issues $2,000 of additional common stock to new investors for cash. Identify & Classify the Accounts 1. Cash (asset). 2. Contributed Capital (equity). Determine the Direction of the Effect 1. Cash increases. 2. Contributed Capital increases.
21. Papa John’s issues $2,000 of additional common stock to new investors for cash. A = L + SE
22. Identify & Classify the Accounts Determine the Direction of the Effect The company borrows $6,000 from the local bank, signing a three-year note. Identify & Classify the Accounts 1. Cash (asset). 2. Notes Payable (liability). Determine the Direction of the Effect 1. Cash increases. 2. Notes Payable increases.
23. A = L + SE The company borrows $6,000 from the local bank, signing a three-year note.
24. Determine the Direction of the Effect Identify & Classify the Accounts Papa John’s purchases $10,000 of new equipment, paying $2,000 in cash and signing a two-year note payable for the rest. Identify & Classify the Accounts 1. Equipment (asset). 2. Cash (asset). 3. Notes Payable (liability). Determine the Direction of the Effect 1. Equipment increases. 2. Cash decreases. 3. Notes Payable increases.
25. A = L + SE Papa John’s purchases $10,000 of new equipment, paying $2,000 in cash and signing a two-year note payable for the rest.
26. Identify & Classify the Accounts Determine the Direction of the Effect Papa John’s lends $3,000 to new franchisees who sign five-year notes agreeing to repay the loan. Identify & Classify the Accounts 1. Cash (asset). 2. Notes Receivable (asset). Determine the Direction of the Effect 1. Cash decreases. 2. Notes Receivable increases.
27. A = L + SE Papa John’s lends $3,000 to new franchisees who sign five-year notes agreeing to repay the loan.
28. Identify & Classify the Accounts Determine the Direction of the Effect Papa John’s purchases $1,000 of stock in other companies as an investment. Identify & Classify the Accounts 1. Cash (asset). 2. Investments (asset). Determine the Direction of the Effect 1. Cash decreases. 2. Investments increase.
29. A = L + SE Papa John’s purchases $1,000 of stock in other companies as an investment.
30. Identify & Classify the Accounts Determine the Direction of the Effect Papa John’s board of directors declares and pays $3,000 in dividends to shareholders. Identify & Classify the Accounts 1. Cash (asset). 2. Retained Earnings (equity). Determine the Direction of the Effect 1. Cash decreases. 2. Retained Earnings decreases.
31. A = L + SE Papa John’s board of directors declares and pays $3,000 in dividends to shareholders.
33. 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. Prepare a complete set of financial statements. Disseminate statements to users. Close revenues, gains, expenses and losses to retained earnings.
34. How Do Companies Keep Track of Account Balances? Journal entries T-accounts
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37. The Debit-Credit Framework A = L + SE Debits and credits affect the Balance Sheet Model as follows: ASSETS Debit for Increase Credit for Decrease EQUITIES Debit for Decrease Credit for Increase LIABILITIES Debit for Decrease Credit for Increase
38. The Debit-Credit Framework A = L + SE ASSETS Debit for Increase Credit for Decrease EQUITIES Debit for Decrease Credit for Increase LIABILITIES Debit for Decrease Credit for Increase Remember that Stockholders’ Equity includes Contributed Capital and Retained Earnings .
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41. Analytical Tool: The Journal Entry Provide a reference date for each transaction. Debits are written first. Credits are indented and written after debits. Total debits must equal total credits.
44. Papa John’s issues $2,000 of additional common stock to new investors for cash. (a)
45. The company borrows $6,000 from the local bank, signing a one-year note. (b)
46. Let’s see how to post this entry . . . Papa John’s purchases $10,000 of new equipment, paying $2,000 in cash and signing a two-year note payable for the rest. (c)
47. Papa John’s purchases $10,000 of new equipment, paying $2,000 in cash and signing a two-year note payable for the rest.
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49. This is the asset section of Papa John’s balance sheet.
50. This is the liability and stockholders’ equity section of Papa John’s balance sheet.
53. Key Ratio Analysis (Beginning Balance + Ending Balance) ÷ 2 Financial Leverage Ratio Average Total Assets Average Stockholders’ Equity = The 2004 financial leverage ratio for Papa John’s was: ($363,000 + $347,000) ÷ 2 ($158,000 + $159,000) ÷ 2 = 2.24 The ratio tells us how well management is using debt to increase assets the company employs to earn income.
54. Learning Objectives Identify investing and financing transactions and demonstrate how they are reported on the statement of cash flows. LO6
Chapter 2: Investing and Financing Decisions and the Balance Sheet.
Before we can adequately prepare a balance sheet, we must know what activities caused changes in it. Additionally, we have to know how specific activities affect each balance. Finally, we need to know how the company tracks balance sheet amounts. All financial transactions affect the balance sheet They cause the account balances to increase/decrease but the equation must always be in balances In journal entries and then through posting to accounts in the ledger
Our first learning objective in Chapter 2 is to define the objective of financial reporting, the elements of the balance sheet, and the related key accounting assumptions and principles.
Part I The objective of financial reporting is to provide useful economic information to external users for decision-making, and for assessing future cash flows of the company. Part II For economic information to be useful, it must be relevant, reliable, comparable and consistent. Part III The elements of our four basic financial statements include assets, liabilities, stockholders’ equity, revenues, expenses, gains and losses.
The primary characteristics of financial information are relevancy and reliability. To be relevant , financial information must have a predictive value, it must provide the user with feedback, and it must be presented in a timely manner. To be reliable , financial information must be verifiable, represent the underlying facts, and be neutral. The secondary characteristics of economic information are comparability and consistency. Comparability means that we can compare information across companies. Consistency means that the company uses the same accounting rules on measurements from one accounting period to the next.
Assets are economic resources that have a probable future benefit to the company. Liabilities are probable future sacrifices of economic resources. Stockholders’ equity represents the financing provided by the owners of the business. Revenues represent the increase in assets or settlement of liabilities from the ongoing operations of the company in its effort to make a profit. Expenses represent decreases in assets or increases in liabilities from the ongoing operations of the company to make a profit. Gains represent increases in assets or settlements of liabilities that are only peripheral to the operations of the business. Gains are not an integral part of the companies operations. Losses represent decreases in assets or increases in liabilities that are from peripheral activities not central to the operations of the business.
There are four basic assumptions that are central to the accounting process. The first is the separate entity assumption. This assumption states that activities of the business can be separated from activities of the owners of that business. The second assumption is the continuity assumption. In the absence of information to the contrary, we assume that the business will operate into the foreseeable future. The third assumption is the unit of measure assumption. This assumption states that accounting information measures only those transactions that are capable of being measured in monetary terms. In addition to our accounting assumptions, the historical cost principle requires us to record transactions at their cash equivalent cost from the date of the transaction between two parties in an arms-length exchange.
Our second learning objective in Chapter 2 is to identify what constitutes a business transaction and recognize common balance sheet account titles used in business.
In accounting we deal with external events. These events involve the exchange of assets and liabilities between the business and one or more other parties.
We also deal with internal events. Internal events do not involve an outside party, but directly affect the accounting entity.
In the process of accounting we use accounts to help us organize information about various transactions. These transactions can be both external and internal.
Here is a list of balance sheet accounts that are grouped as the assets, liabilities, and stockholders’ equity. In this course we will discuss all of these accounts in detail.
These two lists contain typical revenue and expense account titles that we would likely find on the income statement. As with the balance sheet accounts, we will discuss each of these revenue and expense accounts as we move through the course.
In the United States, companies must follow generally accepted accounting principles. Companies located in other countries may follow principles that are significantly different than those followed by United States companies. At this time, there is a movement to establish a set of international accounting standards. This movement was begun in 2002, and is an ongoing task of the International Accounting Standards Board.
Our third learning objective in Chapter 3 is to apply transaction analysis to simple business transactions in terms of the accounting model: Assets equal Liabilities plus Stockholders’ Equity.
As accountants, every transaction we deal with affects at least two accounts. As we record the transactions we must make sure that the accounting equation remains in balance.
Most transactions with external parties involved are exchanges where the business entity gives up something and receives something in return. That’s the duality of effect notion.
The accounting process involves the identification of the accounts affected by a transaction. We must determine whether the accounts are assets, liabilities or stockholders’ equity. After we determine the accounts affected, we determine the direction of the affect, such as whether the account increased or decreased. Finally, we must make sure the accounting equation remains in balance.
Let’s apply the process we just described to some transactions for Papa John’s. All the amounts that we will discuss are expressed in thousands of dollars.
Part I The first transaction is that Papa John’s issues $2,000 of additional common stock to new investors for cash. See whether you can identify and classify the accounts affected. Once you’ve done that, see if you can determine whether those accounts were increased or decreased. Part II The two accounts affected were the cash account, an asset, and contributed capital, an equity account. The cash account was increased as was the contributed capital account.
Notice the total assets of $2,000 is equal to total liabilities plus stockholders’ equity of $2,000.
Part I In the second transaction, Papa John’s borrows $6,000 from a local bank, signing a three-year note. Once again, see if you can identify the accounts involved and their nature, and whether the accounts increased or decreased. Part II The accounts involved cash, an asset, and notes payable, a liability. Both the cash account and notes payable increased as a result of this transaction.
After recording the transaction, the accounting equation is still in balance.
Part I In our third transaction, Papa John’s purchases $10,000 worth of new equipment for $2,000 cash and signs a two-year note payable for the remainder. See if you can identify and classify the accounts involved and determine whether those accounts increased or decreased. Part II Three accounts were involved in this transaction. The equipment account, an asset, the cash account, an asset, and notes payable, a liability. The equipment account increased by $10,000, the cash account decreased by $2000, and the notes payable account increased by $8,000.
After we record this transaction, the accounting equation is still in balance.
Part I In this transaction, Papa John’s lends $3,000 to a franchisee who signs a five-year note agreeing to repay the loan. Complete the identification, classification, and direction analysis. Part II Two accounts were impacted in this transaction: the cash account, an asset, decreased, and the notes receivable, an asset, increased.
After recording this transaction you can see the $3,000 decrease in cash and the $3,000 increase in notes receivable.
Part I In our next transaction Papa John’s purchases $1,000 stock in another company and will hold the stock as an investment. Try to complete the identification, classification and direction requirements. Part II To record this transaction, the cash account (an asset), decreased, and the investment account (also an asset), increased. The impact of this transaction exchanged one asset for another.
After recording the transaction, total assets have a balance of $16,000, and total liabilities plus stockholders’ equity have the same balance.
Part I In our final transaction, Papa John’s declares and pays a $3,000 dividend to its shareholders. By now you should be able to identify and classify the accounts involved and determine the direction of change. Part II This transaction causes the cash account, an asset, to decrease, and retained earnings, an equity account, to decrease as well.
Now you can see the recording of all of our transactions. On the asset side of the balance sheet we have cash, investments, equipment and notes receivable. On the liability side we have notes payable. Stockholders’ equity includes contributed capital and retained earnings.
Our fourth learning objective in Chapter 2 is to determine the impact of using two basic tools, journal entries and T-accounts.
Part I During the accounting period, we analyze and record business transactions. The transactions are initially recorded in the journal and then posted, or moved, to the ledger. Part II At the end of each accounting period, it’s necessary to adjust certain revenue and expense accounts and their related balance sheet accounts. Part III Once the adjustment process is complete, we can prepare a set of financial statements and disseminate those statements to the users. Part IV Finally, we close all revenues, expenses, gains and losses to retained earnings so that we can start the accounting process fresh again.
We keep track of transactions through the preparation of journal entries and the use of ledger accounts.
Throughout this course we are going to use the T-account as a tool to represent a ledger account. “T-account” is merely a shorthand term for the entire ledger account. The T-account has a left and a right side.
As a convention that we’ve adopted over the years we are going to refer to the left side of the T-account as the debit side and the right side of the T-account has the credit side. The words debit and credit have no specific meaning other than that they represent a left and right side of the ledger account.
As a further convention, we are going to agree that a debit to an asset account increases that account and credit to the asset account decreases that account. Remember, this is just an agreed-upon procedure. Once we have agreed upon this procedure, the algebra dictates that liabilities and stockholders’ equity be increased and decreased on opposite sides of the T-accounts. That is to say, a debit will decrease a liability account or stockholders’ equity account, and a credit will increase a liability account or stockholders’ equity account.
Remember that stockholders’ equity is made of contributed capital and retained earnings.
This is an example of the general journal. The general journal is known as the book of original entry. All transactions are first analyzed and placed in the general journal in chronological order.
Typical general journal entries might look something like this.
We begin the entry by recording the date of the transaction. Next, we record all of our debits. After we have recorded our debits, we record our credits. Notice that credits are indented slightly underneath the debits. Finally, we enter the dollar amounts in the appropriate column -- the debit column or the credit column.
After the journal entry has been prepared, it is posted, or moved, to the general ledger.
Let’s see how this process of recording journal entries and posting them to the ledger is carried out by accountants.
Part I Recall our first transaction where Papa John’s issued $2,000 of additional common stock to new investors for cash. We first record this transaction in the general journal. We debit, or increase, the cash account for $2000, and credit, or increase, contributed capital for $2,000. Part II The beginning balance in the cash account is $6,000. The beginning balance in contributed capital is $1,000. We post our transaction by moving the $2,000 to the debit, or left side, of the cash account. We complete the posting by moving the $2,000 to the credit, or right side, of the contributed capital account.
Part I Papa John’s borrowed $6,000 from a local bank, signing a one-year note. We record this entry in the general journal with the debit, or increase, to the cash account, and a credit, or increase, to the notes payable account. Part II We post the entry by placing the $6,000 on the debit, or left side, of the cash account, and posting the $6,000 credit to the right side of the notes payable account.
When Papa John’s purchased its equipment, we made a journal entry to debit equipment for $10,000, credit cash for $2,000 and credit notes payable for $8,000. The debit to the equipment account increases the asset account. The credit to the cash account decreases the asset account. The credit to the notes payable increases the liability.
You can see the posting of this journal entry on your screen now. Notice that the equipment account increased by $10,000, the cash account decreased by $2,000, and the notes payable account increased by $8,000.
We can prepare a balance sheet at any point in time by listing the balances in the asset, liability, and stockholders’ equity accounts.
Here is the asset section of the balance sheet of Papa John’s for the periods ended January 31, 2004 and December 28, 2003. At January 31, 2004 the total assets were $363,000,000.
Here is the liability and stockholders’ equity section of the balance sheet for the same periods. Notice that the total liabilities and stockholders’ equity at January 31, 2004 is $363,000,000. Papa John’s balance sheet proves that assets equal liabilities plus stockholders’ equity.
Our fifth learning objective in Chapter 5 is to prepare and analyze a simple balance sheet using the financial leverage ratio.
Notice that in our simplified balance sheets we’ve merely listed assets, liabilities, and stockholders’ equity. In addition, we’ve computed the change in these accounts from the end of 2003 to the end of January 2004.
Part I The financial leverage ratio is determined by dividing average total assets by average stockholders’ equity. When we are performing ratio analysis, we compute the average amounts by taking the beginning balance, adding the ending balance and dividing the total by two. Part II In 2004 the financial leverage ratio for Papa John’s was 2.24. This ratio tells us how well management is using debt to increase assets of the company and use those assets to earn income.
Our sixth learning objective in Chapter 2 is identifying investing and financing transactions and demonstrate how they are reported on the statement of cash flows.
On the statement of cash flows, investing activities involve the purchase or sale of long-term productive assets, the lending of monies to others, and receiving principal payments back from those loans. When we purchase a long-term productive asset, it’s a cash outflow; when we sell a productive asset, it’s a cash inflow. When we loan funds to others, it’s a cash outflow; when we receive principal payments on those loans, it’s a cash inflow. Financing activities involve borrowing and repaying amounts from financial institutions and the sale or repurchase of the company’s stock. In addition, the payment of a cash dividend is classified as a financing activity. When we borrow money from a financial institution, it’s a cash inflow, repaying the principal amount is a cash outflow. When the company sells stock, it’s a cash inflow; if the company repurchases its own stock, it’s a cash outflow. The payment of cash dividends is always a cash outflow.
On your screen is an abbreviated statement of cash flows for the one month ended January 31, 2004.
