Investing and Financing Decisions Investing and Financing Decisions and the Balance Sheetand the Balance Sheet

Chapter 2

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Slide 2McGraw-Hill/Irwin Slide 2

The Conceptual Framework

Qualitative Characteristics

Relevancy

Reliability

Comparability

Consistency

Qualitative Characteristics

Relevancy

Reliability

Comparability

Consistency

Elements of Statements

Asset

Liability

Stockholders’ Equity

Revenue

Expense

Gain

Loss

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.

McGraw-Hill/Irwin Slide 3McGraw-Hill/Irwin Slide 3

The Conceptual Framework

AssumptionsSeparate 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.).

AssumptionsSeparate 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.).

PrincipleHistorical cost: Cash equivalent cost given up

is the basis for the initial recording of elements.

PrincipleHistorical cost: Cash equivalent cost given up

is the basis for the initial recording of elements.

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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.

AA = = LL + + SESE(Assets) (Liabilities) (Stockholders’

Equity)

McGraw-Hill/Irwin Slide 5McGraw-Hill/Irwin Slide 5

Balancing the Accounting Equation

Step 1: Accounts and effectsStep 1: Accounts and effects Identify the accounts affected and classify them by Identify the accounts affected and classify them by

type of account (A, L, SE).type of account (A, L, SE). Determine the direction of the effect (increase or Determine the direction of the effect (increase or

decrease) on each account.decrease) on each account.

Step 2: BalancingStep 2: Balancing Verify that the accounting equation (A = L + SE) Verify that the accounting equation (A = L + SE)

remains in balance. remains in balance.

Step 1: Accounts and effectsStep 1: Accounts and effects Identify the accounts affected and classify them by Identify the accounts affected and classify them by

type of account (A, L, SE).type of account (A, L, SE). Determine the direction of the effect (increase or Determine the direction of the effect (increase or

decrease) on each account.decrease) on each account.

Step 2: BalancingStep 2: Balancing Verify that the accounting equation (A = L + SE) Verify that the accounting equation (A = L + SE)

remains in balance. remains in balance.

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

Identify & Classify the Accounts1. Cash (asset).2. Contributed Capital (equity).

Identify & Classify the Accounts1. Cash (asset).2. Contributed Capital (equity).

Determine the Direction of the Effect1. Cash increases.2. Contributed Capital increases.

Determine the Direction of the Effect1. Cash increases.2. Contributed Capital increases.

Analyzing Transactions

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AA == L L ++ SE SE

Cash Investments Equip.Notes

ReceivableNotes

PayableContributed

CapitalRetained Earnings

(a) 2,000 2,000

Effect =2,000 2,000

Analyzing Transactions

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

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

Identify & Classify the Accounts1. Cash (asset).2. Notes Payable (liability).

Identify & Classify the Accounts1. Cash (asset).2. Notes Payable (liability).

Determine the Direction of the Effect1. Cash increases.2. Notes Payable increases.

Determine the Direction of the Effect1. Cash increases.2. Notes Payable increases.

Analyzing Transactions

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The Accounting Cycle

During the period:During the period:AnalyzeAnalyze transactions.RecordRecord journal entries in the general journal.PostPost amounts to the general ledger.

During the period:During the period:AnalyzeAnalyze transactions.RecordRecord journal entries in the general journal.PostPost amounts to the general ledger.

End of the period:End of the period:AdjustAdjust revenues and expensesand related balance sheet accounts.

End of the period:End of the period:AdjustAdjust revenues and expensesand related balance sheet accounts.

PreparePrepare a completeset of financial statements.DisseminateDisseminate statementsto users.

CloseClose revenues, gains,expenses and lossesto retained earnings.

McGraw-Hill/Irwin Slide 10McGraw-Hill/Irwin Slide 10

AA = = LL + + SESEASSETSASSETS

Debit for

Increase

Credit for

Decrease

EQUITIESEQUITIES

Debit for

Decrease

Credit for

Increase

LIABILITIESLIABILITIES

Debit for

Decrease

Credit for

Increase

The Debit-Credit Framework

Remember that Stockholders’ Equity includes Contributed Capital and Retained Earnings.

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January 31, December 28,2007 2006

ASSETSCurrent 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 SubsidiariesConsolidated Balance Sheet

(dollars in thousands)

The Asset Section of a Classified Balance Sheet

McGraw-Hill/Irwin Slide 12McGraw-Hill/Irwin Slide 12

January 31, December 28,2007 2006

LIABILITIES AND STOCKHOLDERS' EQUITYCurrent 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 SubsidiariesConsolidated Balance Sheet

(dollars in thousands)

Liabilities and Stockholders’ Equity Section of the Balance Sheet

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Key Ratio Analysis

FinancialLeverage

Ratio

Average Total AssetsAverage Stockholders’ Equity=

(Beginning Balance + Ending Balance) ÷ 2

The 2006 financial leverage ratio for Papa John’s was: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.The ratio tells us how well management is using debt toincrease assets the company employs to earn income.

McGraw-Hill/Irwin Slide 14McGraw-Hill/Irwin Slide 14

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 –

© 2009 The McGraw-Hill Companies, Inc.

End of Chapter 2