Investing and

Financing
Decisions and
the Balance Sheet

Chapter 2

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.   

 2-2

Understanding the Business

To understand amounts appearing

on a company’s balance sheet we
need to answer these questions:

What
How do How do
business
specific companies
activities cause
activities keep track of
changes in
affect each balance sheet
the balance
balance? amounts?
sheet?
 2-3

Learning Objectives

Define
Define the
the objective
objective of
of financial
financial reporting,
reporting, the
the
elements
elements of
of the
the balance
balance sheet,
sheet, and
and the
the related
related
key
key accounting
accounting assumptions
assumptions andand principles.
principles.
 2-4

The Conceptual Framework

Objective
Objectiveof
ofFinancial
FinancialReporting
Reporting
To
Toprovide
provideuseful
usefuleconomic
economicinformation
informationto
toexternal
externalusers
users
for
fordecision
decisionmaking
makingand
andfor
forassessing
assessingfuture
futurecash
cashflows.
flows.

Qualitative
QualitativeCharacteristics
Characteristics Elements
Elementsof
ofStatements
Statements
Relevancy
Relevancy Asset
Asset
Reliability
Reliability Liability
Liability
Comparability
Comparability Stockholders’
Stockholders’Equity
Equity
Consistency
Consistency Revenue
Revenue
Expense
Expense
Gain
Gain
Loss
Loss
 2-5

The Conceptual Framework

Objective
Objectiveof
ofFinancial
FinancialReporting
Reporting
To
Toprovide
provideuseful
usefuleconomic
economicinformation
informationto
toexternal
externalusers
users
for
fordecision
decisionmaking
makingand
andfor
forassessing
assessingfuture
futurecash
cashflows.
flows.
Primary Characteristics
Qualitative
QualitativeCharacteristics
Characteristics Elements
Elements of
ofStatements
Statements
•Relevancy: predictive value,
Relevancy
Relevancy feedback value,Asset
and timeliness.
Asset
Reliability •Reliability: verifiability,
Liability
Reliability Liability
representational faithfulness,
Comparability
Comparability Stockholders’
Stockholders’ Equity
Equity
and
Consistency
Consistency neutrality. Revenue
Revenue
Expense
Expense
Secondary Characteristics
•Comparability:Gain
Gain
across
companies. Loss
Loss
 2-6

The Conceptual Framework

Asset: economic resource with
probable future Objective
benefit.
Objective ofofFinancial
FinancialReporting
Reporting
Liability:
To probable
provide future
useful sacrifices
economic of information to external users
To provide
economic resources.useful economic information to external users
for
fordecision
decision
Stockholders’
making
making
Equity:
and
andfor
financing forassessing
assessingfuture
futurecash
cashflows.
flows.
provided by owners and operations.
Revenue: increase in assets or Elements
Qualitative Characteristics
Qualitative Characteristics ElementsofofStatements
Statements
settlement of liabilities from ongoing
operations. Relevancy
Relevancy Asset
Asset
Expense: decrease in assets or
Reliability Liability
Reliability Liability
increase in liabilities from ongoing
operations.Comparable
Comparable Stockholders’
Stockholders’Equity
Equity
Gain: increase in assets or settlement
Consistent Revenue
Consistent Revenue
of liabilities from peripheral
activities. Expense
Expense
Loss: decrease in assets or Gain
increase in liabilities from peripheral Gain
activities. Loss
Loss
 2-7

The Conceptual Framework

Assumptions
Assumptions
Separate
Separate entity:
entity: Activities
Activities of
of the
the business
business are
are
separate
separate from
from activities
activities ofof owners.
owners.
Continuity:
Continuity: The The entity
entity will
will not
not gogo out
out ofof
business
business inin the
the near
near future.
future.
Unit-of-measure:
Unit-of-measure: Accounting
Accounting measurements
measurements
will
will be
be in
in the
the national
national monetary
monetary unit unit ($).
($).

Principle
Principle
Historical
Historical cost:
cost: Cash
Cash equivalent
equivalent cost
cost given
given up
up
is
is the
the basis
basis for
for initial
initial recording
recording of
of
elements.
elements.
 2-8

Learning Objectives

Identify
Identify what
what constitutes
constitutes aa business
business transaction
transaction
and
and recognize
recognize common
common balance
balance sheet
sheet account
account
titles
titles used
used in
in business.
business.
 2-9

Nature of Business Transactions

External events:
events exchanges of assets
and liabilities between the business
and one or more other parties.

Borrow cash

from the bank

 2-10

Nature of Business Transactions

Internal events:
events not an exchange between
the business and other parties, but have
a direct effect on the accounting entity.

Loss due to
fire damage.
 2-11

Accounts

An organized format used by companies to

accumulate the dollar effects of
transactions.

Cash Inventory

Notes
Equipment Payable
 2-12

Typical Account Titles

The Balance Sheet

Assets Liabilities
Cash Accounts Payable
Short-Term Investment Accrued Expenses
Accounts Receivable Notes Payable
Notes Receivable Taxes Payable
Inventory (to be sold) Unearned Revenue
Supplies Bonds Payable
Prepaid Expenses
Long-Term Investments Stockholders’ Equity
Equipment Contributed Capital
Buildings Retained Earnings
Land
Intangibles
 2-13

Typical Account Titles

The Income Statement

Revenues Expenses
Sales Revenue Cost of Goods Sold
Fee Revenue Wages Expense
Interest Revenue Rent Expense
Rent Revenue Interest Expense
Depreciation Expense
Advertising Expense
Insurance Expense
Repair Expense
Income Tax Expense
 2-14

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.
 2-15

Learning Objectives

Apply
Apply transaction
transaction analysis
analysis toto simple
simple business
business
transactions
transactions inin terms
terms ofof the
the accounting
accounting model:
model:
Assets
Assets == Liabilities
Liabilities ++ Stockholders’
Stockholders’ Equity
Equity
 2-16

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)
 2-17

Duality of Effects

Most transactions
with external parties
involve an
exchange where the
business entity
gives up something
but receives
something in return.
 2-18

Balancing the Accounting Equation

 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.
 Balancing
 Verify that the accounting equation (A = L + SE)
remains in balance.
 2-19

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.
 2-20

Papa John’s issues $2,000 of additional

common stock to new investors for cash.

Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset).
(asset).
2.
2. Contributed
ContributedCapital
Capital (equity).
(equity).

Determine
Determine the
the Direction
Direction of
of the
theEffect
Effect
1.
1. Cash
Cashincreases.
increases.
2.
2. Contributed
ContributedCapital
Capitalincreases.
increases.
 2-21

Papa John’s issues $2,000 of additional

common stock to new investors for cash.

Notes Notes Contributed Retained

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

Effect 2,000 = 2,000

A = L + SE
 2-22

The company borrows $6,000 from the local

bank, signing a three-year note.

Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset).
(asset).
2.
2. Notes
NotesPayable
Payable(liability).
(liability).

Determine
Determine the
the Direction
Direction of
of the
theEffect
Effect
1.
1. Cash
Cashincreases.
increases.
2.
2. Notes
NotesPayable
Payableincreases.
increases.
 2-23

The company borrows $6,000 from the local

bank, signing a three-year note.

Notes Notes Contributed Retained

Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000

Effect 8,000 = 8,000

A = L + SE
 2-24

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
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Equipment
Equipment(asset).
(asset).
2.
2. Cash
Cash(asset).
(asset).
3.
3. Notes
NotesPayable
Payable(liability).
(liability).

Determine
Determine the
the Direction
Direction of
of the
theEffect
Effect
1.
1. Equipment
Equipmentincreases.
increases.
2.
2. Cash
Cashdecreases.
decreases.
3.
3. Notes
NotesPayable
Payableincreases.
increases.
 2-25

Papa John’s purchases $10,000 of new equipment,

paying $2,000 in cash and signing a two-year note
payable for the rest.

Notes Notes Contributed Retained

Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000
(c) (2,000) 10,000 8,000

Effect 16,000 = 16,000

A = L + SE
 2-26

Papa John’s lends $3,000 to new

franchisees who sign five-year notes
agreeing to repay the loan.
Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset).
(asset).
2.
2. Notes
NotesReceivable
Receivable(asset).
(asset).

Determine
Determine the
the Direction
Direction of
of the
theEffect
Effect
1.
1. Cash
Cashdecreases.
decreases.
2.
2. Notes
NotesReceivable
Receivableincreases.
increases.
 2-27

Papa John’s lends $3,000 to new

franchisees who sign five-year notes
agreeing to repay the loan.
Notes Notes Contributed Retained
Cash Investments Equip. Receivable Payable Capital Earnings
(a) 2,000 2,000
(b) 6,000 6,000
(c) (2,000) 10,000 8,000
(d) (3,000) 3,000

Effect 16,000 = 16,000

A = L + SE
 2-28

Papa John’s purchases $1,000 of stock in

other companies as an investment.

Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset).
(asset).
2.
2. Investments
Investments(asset).
(asset).

Determine
Determine the
the Direction
Direction of
of the
theEffect
Effect
1.
1. Cash
Cashdecreases.
decreases.
2.
2. Investments
Investmentsincrease.
increase.
 2-29

Papa John’s purchases $1,000 of stock in

other companies as an investment.

Notes Notes Contributed Retained

Cash Investments Equip. Receivable Payable Capital 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

Effect 16,000 = 16,000

A = L + SE
 2-30

Papa John’s board of directors declares and

pays $3,000 in dividends to shareholders.

Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset).
(asset).
2.
2. Retained
RetainedEarnings
Earnings (equity).
(equity).

Determine
Determine the
the Direction
Direction of
of the
theEffect
Effect
1.
1. Cash
Cashdecreases.
decreases.
2.
2. Retained
RetainedEarnings
Earningsdecreases.
decreases.
 2-31

Papa John’s board of directors declares and

pays $3,000 in dividends to shareholders.

Notes Notes Contributed Retained

Cash Investments Equip. Receivable Payable Capital 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

A = L + SE
 2-32

Learning Objectives

Determine
Determine the
the impact
impact of
of using
using two
two basic
basic tools,
tools,
journal
journal entries
entries and
and T-accounts.
T-accounts.
 2-33

The Accounting Cycle

During the period: Close revenues, gains,

Analyze transactions. expenses and losses
Record journal entries in the general journal. to retained earnings.
Post amounts to the general ledger.

Prepare a complete
End of the period: set of financial statements.
Adjust revenues and expenses Disseminate statements
and related balance sheet accounts. to users.
 2-34

How Do Companies Keep Track of Account

Balances?

Journal entries

T-accounts
 2-35

Direction of Transaction Effects

A T-account is a tool used to represent an

account.

Account Name
Left Right
 2-36

Direction of Transaction Effects

The left side of the The right side of the

T-account is always the debit T-account is always the credit
side. side.

Account Name
Left Right
Debit Credit
 2-37

The Debit-Credit Framework

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

A = L + SE
ASSETS LIABILITIES EQUITIES
Debit Credit Debit Credit Debit Credit
for for for for for for
Increase Decrease Decrease Increase Decrease Increase
 2-38

The Debit-Credit Framework

A = L + SE
ASSETS LIABILITIES EQUITIES
Debit Credit Debit Credit Debit Credit
for for for for for for
Increase Decrease Decrease Increase Decrease Increase

Remember that Stockholders’ Equity includes Contributed

Capital and Retained Earnings.
 2-39

Analytical Tool: The Journal Entry

A typical journal looks like this:

GENERAL JOURNAL
Posted
Date Account Titles and Explanation Ref. Debit Credit
 2-40

Analytical Tool: The Journal Entry

A journal entry might look like this:

GENERAL JOURNAL
Posted
Date Account Titles and Explanation Ref. Debit Credit
Jan. 1 Cash 20,000
Contributed Capital 20,000
 2-41

Analytical Tool: The Journal Entry

Provide a reference Debits are written first.

date for each transaction.

GENERAL JOURNAL
Posted
Date Account Titles and Explanation Ref. Debit Credit
Jan. 1 Cash 20,000
Contributed Capital 20,000

Total debits must equal

Credits are indented and total credits.
written after debits.
 2-42

Analytical Tool: The T-Account

After journal entries are prepared, the

accountant posts (transfers) the dollar
amounts to each account affected by the
transaction.

GENERAL JOURNAL
Ledger
Posted
Date Account Titles and Explanation Ref.
Jan. 1 Cash
Debit
20,000
Credit
Post
Contributed Capital 20,000
 2-43

Transaction Analysis Illustrated

Let’s prepare some

journal entries for
Papa John’s and
post them to the
ledger.
 2-44

Papa John’s issues $2,000 of additional

common stock to new investors for cash.

(a)

Cash Contributed Capital

Beg. Bal. 6,000 1,000 Beg. Bal.
(a) 2,000 2,000 (a)

8,000 3,000
 2-45

The company borrows $6,000 from the local

bank, signing a one-year note.

(b)

Cash Notes Payable

Beg. Bal. 6,000 146,000 Beg. Bal.
(a) 2,000 6,000 (b)
(b) 6,000

14,000 152,000
 2-46

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)

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

 2-47

Papa John’s purchases $10,000 of new equipment,

paying $2,000 in cash and signing a two-year note
payable for the rest.
Equipment
Beg. Bal. 246,000
(c) 10,000

256,000

Cash Notes Payable

Beg. Bal. 6,000 146,000 Beg. Bal.
(a) 2,000 2,000 (c) 6,000 (b)
(b) 6,000 8,000 (c)

12,000 160,000
 2-48

Balance Sheet Preparation

It is possible to prepare a
balance sheet at any
point in time from the
balances in the
accounts.
 2-49

This is the asset section of Papa John’s

balance sheet.
Papa John's International, Inc. and Subsidiaries
Consolidated Balance Sheet
(dollars in thousands)
January 31, December 28,
2004 2003
ASSETS
Current assets
Cash $ 9,000 $ 7,000
Accounts receivable 20,000 20,000
Supplies 17,000 17,000
Prepaid expenses 11,000 11,000
Other current assets 7,000 7,000
Total current assets 64,000 62,000
Long-term investments 9,000 8,000
Property, and equipment (net of
accumulated depreciation of $149,000) 214,000 204,000
Long-term notes receivable 14,000 11,000
Intangibles 49,000 49,000
Other assets 13,000 13,000
Total assets $ 363,000 $ 347,000
 2-50

This is the liability and stockholders’ equity

section of Papa John’s balance sheet.
Papa John's International, Inc. and Subsidiaries
Consolidated Balance Sheet
(dollars in thousands)
January 31, December 28,
2004 2003
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable $ 28,000 $ 28,000
Dividends payable 3,000 -
Accrued expenses payable 53,000 53,000
Total current liabilities 84,000 81,000

Unearned franchise fees 6,000 6,000

Long-term notes payable 75,000 61,000
Other long-term liabilities 40,000 40,000
Total liabilities 205,000 188,000
Stockholders' equity
Contributed capital 3,000 1,000
Retained earnings 155,000 158,000
Total stockholders' equity 158,000 159,000
Total liabilities and stockholders' equity $ 363,000 $ 347,000
 2-51

Learning Objectives

Prepare
Prepare and
and analyze
analyze aa simple
simple balance
balance sheet
sheet
using
using the
the financial
financial leverage
leverage ratio.
ratio.
 2-52

Change in Balance Sheet Amounts

Stockholders'
Assets = Liabilities + Equtiy
End of January 2004 $ 363,000 $ 205,000 $ 158,000
End of 2003 347,000 188,000 159,000
Change $ 16,000.00 $ 17,000.00 $ (1,000.00)
 2-53

Key Ratio Analysis

Financial
Average Total Assets
Leverage =
Average Stockholders’ Equity
Ratio

(Beginning Balance + Ending Balance) ÷ 2

The 2004 financial leverage ratio for Papa John’s was:

($363,000 + $347,000) ÷ 2
= 2.24
($158,000 + $159,000) ÷ 2

The ratio tells us how well management is using debt to

increase assets the company employs to earn income.
 2-54

Learning Objectives

Identify
Identify investing
investing and
and financing
financing transactions
transactions
and
and demonstrate
demonstrate how
how they
they are
are reported
reported
on
on the
the statement
statement of
of cash
cash flows.
flows.
 2-55

Statement of 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 –
 2-56

Statement of Cash Flows

Papa John's International, Inc.
Consolidated Statement of Cash Flows
For the Month Ended January 31, 2004
(in thousands)
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 7,000
Cash at end of month $ 9,000
 2-57

End of Chapter 2