Investing and Financing Decisions and the Balance Sheet

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Chapter 2

• Investing and Financing Decisions and the Balance
  Sheet

2
Business Background
To understand amounts appearing on a companys
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
Objective of External Financial Reporting To
provide useful economic information to external
users for decision making and for assessing
future cash flows.
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The Conceptual Framework
Objective of External 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.

Elements of Statements Asset Liability Stockholder
s Equity Revenue Expense Gain Loss
Qualitative Characteristics Relevancy Reliability
Comparability Consistency
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The Conceptual Framework
Asset economic resource with probable
future benefit. Liability probable future
sacrifices of economic resources. Stockholder
s 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 External Financial Reporting To
provide useful economic information to external
users for decision making and for assessing
future cash flows.
Qualitative Characteristics Relevancy Reliability
Comparable Consistent
Elements of Statements Asset Liability Stockholder
s Equity Revenue Expense Gain Loss
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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 (). Time period The long life of a company
can be reported over a series of shorter time
periods.
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The Conceptual Framework
Principles Historica
l cost Cash equivalent cost given up is the
basis for initial recording of
elements. Revenue recognition Record when
measurable, realizable (transaction
takes place and collection probable),
and earned (substantially accomplished
what is necessary to be entitled to
benefits). Matching Record expenses when
incurred in earning revenue. Full disclosure
Provide information sufficiently important
to influence a decision.
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The Conceptual Framework
Constraints Cost-be
nefit Benefits to users should outweigh costs of
providing information. Materiality
Relatively small amounts not likely to
influence decisions are to be recorded in most
cost beneficial way. Industry peculiarities
Industry specific measurements and
reporting deviations may be acceptable. Conservati
sm Exercise care not to overstate assets
and revenues or understate liabilities and
expenses.
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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
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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.
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Accounts

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

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Accounts

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

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 from U.S. companies.
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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
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Duality of Effects

• Most transactions with external parties
  involve an exchange where the business entity
  both gives up something and receives something in
  return.

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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.

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Balancing the Accounting Equation
Lets see how we keep the accounting equation in
balance for Papa Johns. All amounts are in
thousands of dollars.
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Papa Johns issues 2,000 of additional common
stock to new investors for cash.
Identify Classify the Accounts
Determine the Direction of the Effect
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Papa Johns issues 2,000 of additional common
stock to new investors for cash.
A L SE
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The company borrows 6,000 from the local bank,
signing a three-year note.
Identify Classify the Accounts
Determine the Direction of the Effect
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The company borrows 6,000 from the local bank,
signing a three-year note.
A L SE
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Papa Johns 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
Determine the Direction of the Effect
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Papa Johns purchases 10,000 of new equipment,
paying 2,000 in cash and signing a two-year note
payable for the rest.
A L SE
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Papa Johns lends 3,000 to new franchisees who
sign five-year notes agreeing to repay the loan.
Identify Classify the Accounts
Determine the Direction of the Effect
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Papa Johns lends 3,000 to new franchisees who
sign five-year notes agreeing to repay the loan.
A L SE
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Papa Johns purchases 1,000 of stock in other
companies as an investment.
Identify Classify the Accounts
Determine the Direction of the Effect
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Papa Johns purchases 1,000 of stock in other
companies as an investment.
A L SE
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Papa Johns board of directors declares and pays
3,000 in dividends to shareholders.
Identify Classify the Accounts
Determine the Direction of the Effect
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Papa Johns board of directors declares and pays
3,000 in dividends to shareholders.
A L SE
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How Do Companies Keep Track of Account Balances?
Journal entries
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Direction of Transaction Effects

• A T-account is a tool used to represent an
  account.

Account Name
Left
Right
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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
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The Debit-Credit Framework
Debits and credits affect the Balance Sheet Model
as follows
A L SE
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The Debit-Credit Framework
A L SE
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Analytical Tool The Journal Entry

• A typical journal looks like this

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Analytical Tool The Journal Entry

• A journal entry might look like this

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Analytical Tool The Journal Entry
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Analytical Tool The T-Account

• After journal entries are prepared, the
  accountant posts (transfers) the dollar amounts
  to each account that was affected by the
  transaction.

Ledger
Post
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Transaction Analysis Illustrated
Lets prepare some journal entries for Papa
Johns and post them to the ledger.
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Papa Johns issues 2,000 of additional common
stock to new investors for cash.
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The company borrows 6,000 from the local bank,
signing a one-year note.
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Papa Johns purchases 10,000 of new equipment,
paying 2,000 in cash and signing a two-year note
payable for the rest.
Papa Johns purchases 10,000 of new equipment,
paying 2,000 in cash and signing a two-year note
payable for the rest.
Lets see how to post this entry . . .
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Papa Johns 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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Balance Sheet Preparation

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

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These balances come from Papa Johns ledger
accounts on January 31, 2001.
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Focus on Cash Flows