Investing and Financing Decisions and the Balance Sheet

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Investing and Financing Decisions

and the Balance Sheet

Chapter 2

McGraw
-
Hill/Irwin

© 2009 The McGraw
-
Hill Companies, Inc.

2

2
-
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

2
-
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.

4

2
-
4

The Conceptual Framework

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.

Primary Characteristics


Relevancy:
predictive value,


feedback value, and timeliness.


Reliability:
verifiability,


representational faithfulness, and
neutrality.


Secondary Characteristics


Comparability:
across companies.


Consistency:
over time.

5

2
-
5

Qualitative Characteristics

Relevancy

Reliability

Comparable

Consistent

The Conceptual Framework

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
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.

6

2
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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

2
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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

2
-
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

2
-
9

Accounts

Cash

Equipment

Inventory

Notes
Payable

An organized format used by companies
to accumulate the dollar effects of
transactions.

10

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10

Typical Account Titles

Assets

Cash

Short
-
Term Investment

Accounts Receivable

Notes Receivable

Inventory (to be sold)

Supplies

Prepaid Expenses

Long
-
Term Investments

Equipment

Buildings

Land

Intangibles

Liabilities

Accounts Payable

Accrued Expenses

Notes Payable

Taxes Payable

Unearned Revenue

Bonds Payable

Stockholders’ Equity

Contributed Capital

Retained Earnings

The Balance Sheet

11

2
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11

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

12

2
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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)

13

2
-
13

Duality of Effects


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

something in return.

2
-
14

Balancing the Accounting Equation

Step 1: Accounts
and effects


Identify the accounts affected and classify them by
type of account (A, L, SE).


Determine the direction of the effect (increase or
decrease) on each account.

Step 2: Balancing


Verify that the accounting equation (A = L + SE)
remains in balance.

15

2
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15

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.

Analyzing Transactions

16

2
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16

A

=

L
+

SE

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


2,000


Effect
=
2,000
2,000
Analyzing Transactions

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

17

2
-
17


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.

Analyzing Transactions

18

2
-
18

A

=

L
+

SE

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


2,000


(b)
6,000


6,000


Effect
=
8,000
8,000
Analyzing Transactions


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

19

2
-
19


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.

Analyzing Transactions

20

2
-
20

A

=

L
+

SE

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


2,000


(b)
6,000


6,000


(c)
(2,000)


10,000


8,000


Effect
=
16,000
16,000
Analyzing Transactions


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

for the rest.

2
-
21

Papa John’s board of directors declares and

pays $3,000 in dividends to shareholders.

Analyzing Transactions

Identify & Classify the Accounts



Determine the Direction of the Effect



Identify & Classify the Accounts

1. Cash (asset).

2. Retained Earnings (equity).

Determine the Direction of the Effect

1. Cash decreases.

2. Retained Earnings decreases.

22

2
-
22

A = L + SE

Cash
Investments
Equip.
Notes
Receivable
Notes
Payable
Contributed
Capital
Retained
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
=
13,000
13,000
Papa John’s board of directors declares and

pays $3,000 in dividends to shareholders.

Analyzing Transactions

23

2
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23

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.

24

2
-
24

How Do Companies Keep Track of Account
Balances?

Journal entries

T
-
accounts

25

2
-
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

Right

Debit

Credit

26

2
-
26

A

=

L

+
SE

Transaction Analysis Model

ASSETS

Debit
for
Increase

Credit
for
Decrease

EQUITIES

Debit
for
Decrease

Credit
for
Increase

LIABILITIES

Debit
for
Decrease

Credit
for
Increase

Debits and credits affect the Balance Sheet
Model as follows:

27

2
-
27

A

=

L

+
SE

ASSETS

Debit
for
Increase

Credit
for
Decrease

EQUITIES

Debit
for
Decrease

Credit
for
Increase

LIABILITIES

Debit
for
Decrease

Credit
for
Increase

The Debit
-
Credit Framework

Remember that
Stockholders’ Equity

includes
Contributed Capital

and
Retained Earnings
.

28

2
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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:

Letter,
number, or
date.

Account Titles:

Debited accounts on top.

Credited accounts on bottom.

Amounts:

Debited amounts on left.

Credited amounts on right.

2
-
29

Post

Ledger

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


30

2
-
30

Beg. Bal.
6,000


(a)
2,000


8,000


Cash
1,000


Beg. Bal.
2,000


(a)
3,000


Contributed Capital
Posted
Ref.
Debit
Credit
Cash
2,000


Contributed Capital
2,000


Date
Account Titles and Explanation
GENERAL JOURNAL
(a)

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

31

2
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31

146,000


Beg. Bal.
6,000


(b)
152,000


Notes Payable
Beg. Bal.
6,000


(a)
2,000


(b)
6,000


14,000


Cash
Debit
Credit
(b)
Cash
6,000


Notes Payable
6,000


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

32

2
-
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

33

2
-
33

January 31,
December 28,
2007
2006
ASSETS
Current 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 Subsidiaries
Consolidated Balance Sheet
(dollars in thousands)
The Asset Section of a Classified Balance Sheet

34

2
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34

January 31,
December 28,
2007
2006
LIABILITIES AND STOCKHOLDERS' EQUITY
Current 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 Subsidiaries
Consolidated Balance Sheet
(dollars in thousands)
Liabilities and Stockholders’ Equity Section of
the Balance Sheet

35

2
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35

Key Ratio Analysis

Financial

Leverage

Ratio

Average Total Assets

Average Stockholders’ Equity

=

(Beginning Balance + Ending Balance)
÷

2

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 to

increase assets the company employs to earn income.

36

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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

37

2
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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 Flows
For the Month Ended January 31, 2007
(in thousands)
© 2009 The McGraw
-
Hill Companies, Inc.

McGraw
-
Hill/Irwin

End of Chapter 2