1. Investing and Financing Decisions and the Balance Sheet Chapter 2 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

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. The Conceptual Framework Elements of Statements Asset Liability Stockholders’ Equity Revenue Expense Gain Loss Qualitative Characteristics Relevancy Reliability Comparability Consistency Objective of Financial Reporting To provide useful economic information to external users for decision making and for assessing future cash flows.

5. The Conceptual Framework 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. Objective of Financial Reporting To provide useful economic information to external users for decision making and for assessing future cash flows. Elements of Statements Asset Liability Stockholders’ Equity Revenue Expense Gain Loss Qualitative Characteristics Relevancy Reliability Comparable Consistent

6. 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 (i.e., $ in the U.S.). Principle Historical cost: Cash equivalent cost given up is the basis for the initial recording of elements.

7. 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

8. 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.

9. Accounts Cash Inventory Notes Payable Equipment An organized format used by companies to accumulate the dollar effects of transactions.

10. Typical Account Titles The Balance Sheet AssetsCashShort-Term InvestmentAccounts ReceivableNotes ReceivableInventory (to be sold)SuppliesPrepaid ExpensesLong-Term InvestmentsEquipmentBuildingsLandIntangibles LiabilitiesAccounts PayableAccrued ExpensesNotes PayableTaxes PayableUnearned Revenue Bonds Payable Stockholders’ EquityContributed CapitalRetained Earnings

11. Typical Account Titles The Income Statement RevenuesSales RevenueFee RevenueInterest RevenueRent Revenue ExpensesCost of Goods SoldWages ExpenseRent ExpenseInterest ExpenseDepreciation ExpenseAdvertising ExpenseInsurance ExpenseRepair ExpenseIncome Tax Expense

13. The accounting equation must remain in balance after each transaction.A = L + SE (Assets) (Liabilities) (Stockholders’Equity)

14. Duality of Effects Most transactions with external parties involve an exchange where the business entity gives up something but receivessomething in return.

17. A= L + SE Analyzing Transactions Papa John’s issues $2,000 of additional common stock to new investors for cash.

18. Identify & Classify the Accounts 1. Cash (asset). 2. Notes Payable (liability). Determine the Direction of the Effect 1. Cash increases. 2. Notes Payable increases. The company borrows $6,000 from the local bank, signing a three-year note. Analyzing Transactions

19. A= L + SE Analyzing Transactions The company borrows $6,000 from the local bank, signing a three-year note.

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

21. A = L + SE Analyzing Transactions Papa John’s purchases $10,000 of new equipment, paying $2,000 in cash and signing a two-year note payablefor the rest.

22. Analyzing Transactions Papa John’s board of directors declares andpays $3,000 in dividends to shareholders. Identify & Classify the Accounts Identify & Classify the Accounts 1. Cash (asset). 2. Retained Earnings (equity). Determine the Direction of the Effect Determine the Direction of the Effect 1. Cash decreases. 2. Retained Earnings decreases.

23. Papa John’s board of directors declares andpays $3,000 in dividends to shareholders. A = L + SE Analyzing Transactions

24. The Accounting Cycle Closerevenues, gains,expenses and lossesto retained earnings. Preparea completeset of financial statements.Disseminatestatementsto users. End of the period:Adjustrevenues and expensesand related balance sheet accounts. During the period:Analyzetransactions.Record journal entries in the general journal.Post amounts to the general ledger.

25. How Do Companies Keep Track of Account Balances? T-accounts Journal entries

26. Direction of Transaction Effects The left side of the T-account is always the debit side. The rightside of the T-account is always the credit side. Account Name Right Left Debit Credit

27. Transaction Analysis Model ASSETS EQUITIES LIABILITIES Debit for Increase Credit for Decrease Debit for Decrease Credit for Increase Debit for Decrease Credit for Increase Debits and credits affect the Balance Sheet Model as follows: A = L + SE

28. ASSETS EQUITIES LIABILITIES Debit for Increase Credit for Decrease Debit for Decrease Credit for Increase Debit for Decrease Credit for Increase Remember that Stockholders’ Equity includes Contributed Capital and Retained Earnings. A = L + SE The Debit-Credit Framework

29. Analytical Tool: The Journal Entry A journal entry might look like this: Account Titles: Debited accounts on top.Credited accounts on bottom. Reference: Letter, number, or date. Amounts: Debited amounts on left. Credited amounts on right.

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

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

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

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

34. The Asset Section of a Classified Balance Sheet

35. Liabilities and Stockholders’ Equity Section of the Balance Sheet

36. Key Ratio Analysis FinancialLeverageRatio Average Total AssetsAverage Stockholders’ Equity = 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. (Beginning Balance + Ending Balance) ÷ 2

37. Focus on Cash Flows

38. Investing and Financing Activities

39. End of Chapter 2