Chapter 2: Investing and Financing Decisions and the Balance Sheet.
Before we can adequately prepare a balance sheet, we must know what activities caused changes in it. Additionally, we have to know how specific activities affect each balance. Finally, we need to know how the company tracks balance sheet amounts.
Part I The objective of financial reporting is to provide useful economic information to external users for decision-making, and for assessing future cash flows of the company. Part II For economic information to be useful, it must be relevant, reliable, comparable and consistent. Part III The elements of our four basic financial statements include assets, liabilities, stockholders’ equity, revenues, expenses, gains and losses.
The primary characteristics of financial information are relevancy and reliability. To be relevant , financial information must have a predictive value, it must provide the user with feedback, and it must be presented in a timely manner. To be reliable , financial information must be verifiable, represent the underlying facts, and be neutral. The secondary characteristics of economic information are comparability and consistency. Comparability means that we can compare information across companies. Consistency means that the company uses the same accounting rules on measurements from one accounting period to the next.
Assets are economic resources that have probable future benefits to the company. Liabilities are probable future sacrifices of economic resources. Stockholders’ equity represents the financing provided by the owners of the business. Revenues represent the increase in assets or settlement of liabilities from the ongoing operations of the company in its effort to make a profit. Expenses represent decreases in assets or increases in liabilities from the ongoing operations of the company to make a profit. Gains represent increases in assets or settlements of liabilities that are only peripheral to the operations of the business. Gains are not an integral part of the companies operations. Losses represent decreases in assets or increases in liabilities that are from peripheral activities not central to the operations of the business.
There are four basic assumptions that are central to the accounting process. The first is the separate entity assumption. This assumption states that activities of the business can be separated from activities of the owners of that business. The second assumption is the continuity assumption. In the absence of information to the contrary, we assume that the business will operate into the foreseeable future. The third assumption is the unit of measure assumption. This assumption states that accounting information measures only those transactions that are capable of being measured in monetary terms. In addition to our accounting assumptions, the historical cost principle requires us to record transactions at their cash equivalent cost from the date of the transaction between two parties in an arms-length exchange.
In accounting we deal with external events. These events involve the exchange of assets and liabilities between the business and one or more other parties.
We also deal with internal events. Internal events do not involve an outside party, but directly affect the accounting entity.
In the process of accounting we use accounts to help us organize information about various transactions. These transactions can be both external and internal.
Here is a list of balance sheet accounts that are grouped as the assets, liabilities, and stockholders’ equity. In this course we will discuss all of these accounts in detail.
These two lists contain typical revenue and expense account titles that we would likely find on the income statement. As with the balance sheet accounts, we will discuss each of these revenue and expense accounts as we move through the course.
As accountants, every transaction we deal with affects at least two accounts. As we record the transactions we must make sure that the accounting equation remains in balance.
Most transactions with external parties involved are exchanges where the business entity gives up something and receives something in return. That’s the duality of effect notion.
The accounting process involves the identification of the accounts affected by a transaction. We must determine whether the accounts are assets, liabilities or stockholders’ equity. After we determine the accounts affected, we determine the direction of the effect, such as whether the account increased or decreased. Finally, we must make sure the accounting equation remains in balance.
Papa John’s first transaction is to issue $2,000 of additional common stock to new investors for cash. The two accounts affected were the cash account, an asset, and contributed capital, an equity account. The cash account was increased as was the contributed capital account.
Notice the total assets of $2,000 is equal to total liabilities plus stockholders’ equity of $2,000.
In the second transaction, Papa John’s borrows $6,000 from a local bank, signing a three-year note. The accounts involved cash, an asset, and notes payable, a liability. Both the cash account and notes payable increased as a result of this transaction.
After recording the transaction, the accounting equation is still in balance.
Part I. In our third transaction, Papa John’s purchases $10,000 worth of new equipment for $2,000 cash and signs a two-year note payable for the remainder. Part II. Three accounts were involved in this transaction. The equipment account, an asset, the cash account, an asset, and notes payable, a liability. The equipment account increased by $10,000, the cash account decreased by $2000, and the notes payable account increased by $8,000.
After we record this transaction, the accounting equation is still in balance.
Part I In our final transaction, Papa John’s declares and pays a $3,000 dividend to its shareholders. By now you should be able to identify and classify the accounts involved and determine the direction of change. Part II This transaction causes the cash account, an asset, to decrease, and retained earnings, an equity account, to decrease as well.
Now you can see the recording of all of our transactions. On the asset side of the balance sheet we have cash, investments, equipment and notes receivable. On the liability side we have notes payable. Stockholders’ equity includes contributed capital and retained earnings.
Part I During the accounting period, we analyze and record business transactions. The transactions are initially recorded in the journal and then posted, or moved, to the ledger. Part II At the end of each accounting period, it’s necessary to adjust certain revenue and expense accounts and their related balance sheet accounts. Part III Once the adjustment process is complete, we can prepare a set of financial statements and disseminate those statements to the users. Part IV Finally, we close all revenues, expenses, gains and losses to retained earnings so that we can start the accounting process fresh again.
We keep track of transactions through the preparation of journal entries and the use of ledger accounts.
Throughout this course we are going to use the T-account as a tool to represent a ledger account. “T-account” is merely a shorthand term for the entire ledger account. The T-account has a left and a right side. As a convention that we’ve adopted over the years we are going to refer to the left side of the T-account as the debit side and the right side of the T-account has the credit side. The words debit and credit have no specific meaning other than that they represent a left and right side of the ledger account.
As a further convention, we are going to agree that a debit to an asset account increases that account and credit to the asset account decreases that account. Remember, this is just an agreed-upon procedure. Once we have agreed upon this procedure, the algebra dictates that liabilities and stockholders’ equity be increased and decreased on opposite sides of the T-accounts. That is to say, a debit will decrease a liability account or stockholders’ equity account, and a credit will increase a liability account or stockholders’ equity account.
Remember that stockholders’ equity is made of contributed capital and retained earnings.
Typical general journal entries might look something like this. It is useful to include a date or some form of reference for each transaction. The debited accounts are written first with the amounts on the left side of the two columns. The credited accounts are written below the debits and are usually indented in a manual system.
After the journal entry has been prepared, it is posted, or moved, to the general ledger.
Part I Recall our first transaction where Papa John’s issued $2,000 of additional common stock to new investors for cash. We first record this transaction in the general journal. We debit, or increase, the cash account for $2,000, and credit, or increase, contributed capital for $2,000. Part II The beginning balance in the cash account is $6,000. We post our transaction by moving the $2,000 to the debit, or left side, of the cash account. Part III. The beginning balance in contributed capital is $1,000. We complete the posting by moving the $2,000 to the credit, or right side, of the contributed capital account.
Part I Papa John’s borrowed $6,000 from a local bank, signing a three-year note. We record this entry in the general journal with the debit, or increase, to the cash account, and a credit, or increase, to the notes payable account. Part II We post the entry by placing the $6,000 on the debit, or left side, of the cash account,. Part III. Next, we post the $6,000 credit to the right side of the notes payable account.
We can prepare a balance sheet at any point in time by listing the balances in the asset, liability, and stockholders’ equity accounts.
Here is the asset section of the balance sheet of Papa John’s for the periods ended January 31, 2007, and December 28, 2006. At January 31, 2007 the total assets were $396,000,000.
Here is the liability and stockholders’ equity section of the balance sheet for the same periods. Notice that the total liabilities and stockholders’ equity at January 31, 2007 is $396,000,000. Papa John’s balance sheet proves that assets equal liabilities plus stockholders’ equity.
Part I The financial leverage ratio is determined by dividing average total assets by average stockholders’ equity. When we are performing ratio analysis, we compute the average amounts by taking the beginning balance, adding the ending balance and dividing the total by two. Part II In 2006, the financial leverage ratio for Papa John’s was 2.37. This ratio tells us how well management is using debt to increase assets of the company and use those assets to earn income. When interpreting the financial leverage ratio, the higher proportion of assets financed by debt, the higher the ratio. Generally, companies with a financial leverage ratio grater than 2.0 have a heavier reliance on debt than equity.
On the statement of cash flows, investing activities involve the purchase or sale of long-term productive assets, the lending of monies to others, and receiving principal payments back from those loans. When we purchase a long-term productive asset, it’s a cash outflow; when we sell a productive asset, it’s a cash inflow. When we loan funds to others, it’s a cash outflow; when we receive principal payments on those loans, it’s a cash inflow. Financing activities involve borrowing and repaying amounts from financial institutions and the sale or repurchase of the company’s stock. In addition, the payment of a cash dividend is classified as a financing activity. When we borrow money from a financial institution, it’s a cash inflow; repaying the principal amount is a cash outflow. When the company sells stock, it’s a cash inflow; if the company repurchases its own stock, it’s a cash outflow. The payment of cash dividends is always a cash outflow.
On your screen is an abbreviated statement of cash flows for the one month ended January 31, 2007.
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? 2-2 2
The Conceptual Framework Objective of Financial ReportingTo provide useful economic information to external usersfor decision making and for assessing future cash flows. Qualitative Characteristics Elements of Statements Relevancy Asset Reliability Liability Comparability Stockholders’ Equity Consistency Revenue Expense Gain Loss 2-3 3
The Conceptual Framework Objective of Financial ReportingTo provide useful economic information to external usersfor decision making and for assessing future cash flows. Primary Characteristics Qualitative Characteristics •Relevancy: predictive value, Elements of Statements feedback value, and Relevancy Asset timeliness. Reliability •Reliability: verifiability, Liability Comparability representational faithfulness, Stockholders’ Equity and neutrality. Consistency Revenue SecondaryExpense Characteristics •Comparability: across Gain companies. •Consistency: Loss time. over 2-4 4
The Conceptual FrameworkAsset: economic resource with probable future benefits.Objective of Financial ReportingLiability: probable future economic information to external users To provide useful sacrifices of for decision making and for assessing future cash flows. economic resources.Stockholders’ Equity: financing provided by owners and operations.Revenue: increase in assets or Qualitative Characteristics Elements of Statements settlement of liabilities from ongoing operations. Relevancy AssetExpense: decrease in assets or Reliability Liability increase in liabilities from ongoing operations. Comparable Stockholders’ EquityGain: increase in assets or settlement Consistent Revenue of liabilities from peripheral activities. ExpenseLoss: decrease in assets or Gain increase in liabilities from peripheral activities. Loss 2-5 5
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. 2-6 6
Nature of Business Transactions External events: exchanges of assets events and liabilities between the business and one or more other parties. Borrow cash from the bank 2-7 7
Nature of Business Transactions Internal events: not an exchange between events the business and other parties, but have a direct effect on the accounting entity.Loss due tofire damage. 2-8 8
Accounts An organized format used by companies to accumulate the dollar effects of transactions. Cash Inventory Notes Equipment Payable 2-9 9
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 2-11 11
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) 2-12 12
Duality of Effects Most transactions withexternal parties involvean exchange where thebusiness entity gives upsomething but receives something in return. 2-13 13
Balancing the Accounting EquationStep 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. 2-14
Analyzing Transactions Papa John’s issues $2,000 of additional common stock to new investors for cash.Identify & Classify the Accounts1. Cash (asset).2. Contributed Capital (equity). Determine the Direction of the Effect 1. Cash increases. 2. Contributed Capital increases. 2-15 15
Analyzing Transactions 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 2,000Effect 2,000 = 2,000 A = L + SE 2-16 16
Analyzing Transactions The company borrows $6,000 from the local bank, signing a three-year note.Identify & Classify the Accounts1. Cash (asset).2. Notes Payable (liability). Determine the Direction of the Effect 1. Cash increases. 2. Notes Payable increases. 2-17 17
Analyzing Transactions 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 6,000Effect 8,000 = 8,000 A = L + SE 2-18 18
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.Identify & Classify the Accounts1. 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. 2-19 19
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. 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 8,000Effect 16,000 = 16,000 A = L + SE 2-20 20
Analyzing Transactions Papa John’s board of directors declares and pays $3,000 in dividends to shareholders.Identify & Classify the Accounts1. Cash (asset).2. Retained Earnings (equity). Determine the Direction of the Effect 1. Cash decreases. 2. Retained Earnings decreases. 2-21
Analyzing Transactions 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 2-22 22
The Accounting Cycle During the period: Close revenues, gains,Analyze transactions. expenses and lossesRecord 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 statementsand related balance sheet accounts. to users. 2-23 23
How Do Companies Keep Track of AccountBalances? T-accounts Journal entries 2-24 24
Direction of Transaction Effects The left side of the The right side of theT-account is always the debit T-account is always the credit side. side. Account Name Left Right Debit Credit 2-25 25
Transaction Analysis Model Debits and credits affect the Balance Sheet Model as follows: A = L + SE ASSETS LIABILITIES EQUITIES Debit Credit Debit Credit Debit Credit for for for for for forIncrease Decrease Decrease Increase Decrease Increase 2-26 26
The Debit-Credit Framework A = L + SE ASSETS LIABILITIES EQUITIES Debit Credit Debit Credit Debit Credit for for for for for forIncrease Decrease Decrease Increase Decrease Increase Remember that Stockholders’ Equity includes Contributed Capital and Retained Earnings. 2-27 27
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 Account Titles: Debited accounts on top.Reference: Credited accounts on bottom.Letter,number, or Amounts:date. Debited amounts on left. Credited amounts on right. 2-28 28
The T-Account After journal entries are prepared, the accountant posts (transfers) the dollar amounts to each account affected by the transaction. Debit Credit Ledger(c) Property and Equipment (+A) 10,000 Post Cash (-A) 2,000 Notes Payable (+L) 8,000 2-29
Papa John’s issues $2,000 of additional commonstock to new investors for cash. (a) Cash Contributed CapitalBeg. Bal. 6,000 1,000 Beg. Bal. (a) 2,000 2,000 (a) 8,000 3,000 2-30 30
The company borrows $6,000 from the localbank, signing a three-year note. Cash Notes PayableBeg. Bal. 6,000 146,000 Beg. Bal. (a) 2,000 6,000 (b) (b) 6,000 14,000 152,000 2-31 31
Balance Sheet Preparation It is possible to prepare a balance Balance Sheet sheet at any point in time from the balances in the accounts. 2-32 32
The Asset Section of a Classified Balance Sheet Papa Johns International, Inc. and Subsidiaries Consolidated Balance Sheet (dollars in thousands) 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 2-33 33
Liabilities and Stockholders’ Equity Section ofthe Balance Sheet Papa Johns International, Inc. and Subsidiaries Consolidated Balance Sheet (dollars in thousands) 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 2-34 34
Key Ratio Analysis Financial Average Total Assets Leverage = Average Stockholders’ Equity Ratio (Beginning Balance + Ending Balance) ÷ 2The 2006 financial leverage ratio for Papa John’s was: ($351,000 + $380,000) ÷ 2 = 2.37 ($161,000 + $148,000) ÷ 2 The ratio tells us how well management is using debt to increase assets the company employs to earn income. 2-35 35
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 – 2-36 36
Investing and Financing Activities Papa Johns International, Inc. Consolidated Statement of Cash Flows For the Month Ended January 31, 2007 (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 13,000 Cash at end of month $ 15,000 2-37 37