Chapter 2

Investing and Financing Decisions

and the Balance Sheet
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Business Background

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?

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 The Conceptual Framework
Objective
Objectiveof
ofExternal
ExternalFinancial
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
ElementsofofStatements
Statements
Relevancy
Relevancy Asset
Asset
Reliability
Reliability Liability
Liability
Comparable
Comparable Stockholders’
Stockholders’Equity
Equity
Consistent
Consistent Revenue
Revenue
Expense
Expense
Gain
Gain
Irwin/McGraw-Hill
Loss
© TheLoss
McGraw-Hill Companies, Inc., 2001
 The Conceptual Framework
Objective
Objectiveof
ofExternal
ExternalFinancial
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
•Reliability: verifiability,
Liability
Liability
representational faithfulness, and
Comparable
Comparable Stockholders’
Stockholders’ Equity
Equity
neutrality.
Consistent
Consistent Revenue
Revenue
SecondaryExpense
Characteristics
Expense
•Comparability: across
Gain
companies. Gain
Irwin/McGraw-Hill •Consistency: Loss
over
Loss
© The time.
McGraw-Hill Companies, Inc., 2001
 The Conceptual Framework
Asset: economic resource with
probableObjective of
future benefit.
Objective of External
External Financial
Financial Reporting
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 Elementsof ofStatements
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’EquityEquity
Gain: increase in assets or settlement
Consistent Revenue
Consistent Revenue
of liabilities from peripheral
transactions. Expense
Expense
Loss: decrease in assets or Gain
Gain
increase in liabilities from peripheral
transactions.
Irwin/McGraw-Hill
Loss
© TheLoss
McGraw-Hill Companies, Inc., 2001
 The Conceptual Framework
Assumptions
Assumptions
Separate
Separate entity:
entity:Transactions
Transactionsof ofthe
thebusiness
businessare
are
separate
separatefrom
fromtransactions
transactionsof ofowners.
owners.
Continuity:
Continuity:The
Theentity
entitywill
willnot
notgogoout
outof
ofbusiness
businessininthe
the
near
nearfuture.
future.
Unit-of-measure:
Unit-of-measure:Accounting
Accountingmeasures
measuresare arein
inthe
the
national
nationalmonetary
monetaryunit unit($).
($).
Time
Timeperiod:
period:The
Thelong
longlife
lifeof
ofaacompany
companycan canbebe
reported
reportedover
overaaseries
seriesofofshorter
shortertime
timeperiods.
periods.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 The Conceptual Framework

Principles
Principles
Historical
Historicalcost:
cost:Cash
Cashequivalent
equivalentcost
costgiven
givenupupisisthe
thebasis
basis
for
forinitial
initialrecording
recordingof
ofelements.
elements.
Revenue
Revenuerecognition:
recognition:Record
Recordrevenues
revenueswhen
whenearned
earnedand
and
measurable
measurable(exchange
(exchangecomplete,
complete,earnings
earningscomplete
complete
and
andcollection
collectionprobable).
probable).
Matching:
Matching:Record
Recordexpenses
expenseswhen
whenincurred
incurredin
inearning
earning
revenue.
revenue.
Full
Fulldisclosure:
disclosure:Disclose
Discloserelevant
relevanteconomic
economicinformation.
information.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 The Conceptual Framework
Constraints
Constraints
Cost-benefit:
Cost-benefit: Benefits
Benefitsofofrecording
recordingandandreporting
reportinginformation
information
should
shouldoutweigh
outweighcosts.
costs.
Materiality:
Materiality:Relatively
Relatively small
smallamounts
amountsnot notlikely
likelyto
toinfluence
influence
decisions
decisionsare
aretotobe
berecorded
recordedin inmost
mostcost/beneficial
cost/beneficialway.
way.
Industry
Industrypeculiarities:
peculiarities:Differences
Differences in in accounting
accounting and and reporting
reporting
for
forcertain
certainitems
itemsare
arepermitted
permittedififthere
thereisisaaclear
clear
precedent
precedentin inthe
theindustry.
industry.
Conservatism:
Conservatism: Exercise
Exercisecare
carenot
notto
tooverstate
overstateassets
assetsand and
revenues
revenuesor orunderstate
understateliabilities
liabilitiesand
andexpenses.
expenses.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Nature of Business Transactions

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

Borrow money

from the bank

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 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.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

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

Notes Payable

Cash

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Transaction Analysis

➊Every transaction affects at least two

accounts (duality of effects).
➋The accounting equation must remain
in balance after each transaction.

A = L + SE
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Duality of Effects

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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Balancing the Accounting Equation
!Accounts and effects
"Identify the accounts affected.
"Classify each as an asset, liability or equity
account.
"Determine the direction of the effect (increase or
decrease) on each account.
#Determine that the accounting equation
remains in balance.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Balancing the Accounting Equation

Let’s see how we keep the

accounting equation in
balance for Papa John’s.

All amounts are in

thousands of dollars.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Papa John’s issues $1,300 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
Determinethe
theDirection
Directionofofthe
theEffect
Effect
1.
1. Cash
Cashincreases.
increases.
2.
2. Contributed
ContributedCapital
Capitalincreases.
increases.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Papa John’s issues $1,300 of additional
common stock to new investors for cash.

Assets = Liabilities + Stockholders' Equity

Cash Investments Equip. Notes Rec. Notes Pay. Contributed Capital
(a) 1,300 1,300

Effect 1,300 = 1,300

A = L + SE
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 The company borrows $1,000 from the local
bank, signing a one-year note.

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

Determine
Determinethe
theDirection
Directionof
ofthe
theEffect
Effect
1.
1. Cash
Cashincreases.
increases.
2.
2. Notes
NotesPayable
Payableincreases.
increases.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 The company borrows $1,000 from the local
bank, signing a one-year note.

Assets = Liabilities + Stockholders' Equity

Cash Investments Equip. Notes Rec. Notes Pay. Contributed Capital
(a) 1,300 1,300
(b) 1,000 1,000

Effect 2,300 = 2,300

A = L + SE
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Papa John’s purchases $5,700 of new equipment,
paying $1,500 in cash and the rest on a note
payable.

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
Determinethe
theDirection
Directionof
ofthe
theEffect
Effect
1.
1. Equipment
Equipmentincreases.
increases.
2.
2. Cash
Cashdecreases.
decreases.
3.
3. Notes
NotesPayable
Payableincreases.
increases.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Papa John’s purchases $5,700 of new equipment,
paying $1,500 in cash and the rest on a note
payable.

Assets = Liabilities + Stockholders' Equity

Cash Investments Equip. Notes Rec. Notes Pay. Contributed Capital
(a) 1,300 1,300
(b) 1,000 1,000
(c) (1,500) 5,700 4,200

Effect 6,500 = 6,500

A = L + SE
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Papa John’s lends $450 to new franchises
who sign notes.

Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset)
(asset)
2.
2. Notes
NotesReceivable
Receivable(asset)
(asset)

Determine
Determinethe
theDirection
Directionof
ofthe
theEffect
Effect
1.
1. Cash
Cashdecreases.
decreases.
2.
2. Notes
NotesReceivable
Receivableincreases.
increases.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Papa John’s lends $450 to new franchises
who sign notes.

Assets = Liabilities + Stockholders' Equity

Cash Investments Equip. Notes Rec. Notes Pay. Contributed Capital
(a) 1,300 1,300
(b) 1,000 1,000
(c) (1,500) 5,700 4,200
(d) (450) 450

Effect 6,500 = 6,500

A = L + SE
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 Papa John’s purchases $3,000 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
DeterminethetheDirection
Directionof
ofthe
theEffect
Effect
1.
1. Cash
Cashdecreases.
decreases.
2.
2. Investments
Investmentsincrease.
increase.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Papa John’s purchases $3,000 of stock in
other companies as an investment.

Assets = Liabilities + Stockholders' Equity

Cash Investments Equip. Notes Rec. Notes Pay. Contributed Capital
(a) 1,300 1,300
(b) 1,000 1,000
(c) (1,500) 5,700 4,200
(d) (450) 450
(e) (3,000) 3,000
Effect 6,500 = 6,500

A = L + SE
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001
 How Do Companies Keep Track
of Account Balances?

Journal entries

T-accounts

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Direction of Transaction Effects

A T-account is a tool used to

represent an account.

Account Name
Left Right

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Direction of Transaction Effects

The left side of the The right side of the

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

Account Name
Left Right
Debit Credit

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Analytical Tool: The Journal
Entry
A typical journal looks like this:

GENERAL JOURNAL Page 1

Date Description Debit Credit

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Analytical Tool: The Journal
Entry
A journal entry might look like this:

GENERAL JOURNAL Page 1

Date Description Debit Credit

Jan. 1 Cash 20,000
Contributed Capital 20,000

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Analytical Tool: The Journal
Entry
Provide a reference Debits are written first.
date for each transaction.

GENERAL JOURNAL Page 1

Date Description Debit Credit

Jan. 1 Cash 20,000
Contributed Capital 20,000

Total debits must equal

Credits are indented and total credits.
written after debits.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 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.

GENERAL JOURNAL Page 1 Ledger

Date
Jan. 1 Cash
Description Debit
20,000
Credit Post
Contributed Capital 20,000

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Transaction Analysis Illustrated

Let’s prepare some

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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Papa John’s issues $1,300 of additional
common stock to new investors for cash.

GENERAL JOURNAL Page 1

Date Description Debit Credit

Cash 1,300
Contributed Capital 1,300

Cash Contributed Capital

Beg. Bal. 34,000 164,500 Beg. Bal.
(a) 1,300 1,300 (a)

35,300 165,800

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 The company borrows $1,000 from the local
bank, signing a one-year note.

GENERAL JOURNAL Page 1

Date Description Debit Credit

Cash 1,000
Notes Payable 1,000

Cash Notes Payable

Beg. Bal. 34,000 - Beg. Bal.
(a) 1,300 1,000 (b)
(b) 1,000

36,300 1,000

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Papa John’s purchases $5,700 of new equipment,
paying $1,500 in cash and the rest on a note
payable.

GENERAL JOURNAL Page 1

Date Description Debit Credit

Equipment 5,700
Cash 1,500
Notes Payable 4,200

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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Papa John’s purchases $5,700 of new equipment,
paying $1,500 in cash and the rest on a note
payable.
Equipment
Beg. Bal. 169,200
(c) 5,700

174,900

Cash Notes Payable

Beg. Bal. 34,000 - Beg. Bal.
(a) 1,300 1,500 (c) 1,000 (b)
(b) 1,000 4,200 (c)

34,800 5,200

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Balance Sheet Preparation

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

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
January 31, 1999
(Dollars in thousands)
Assets
Current assets:
Cash and cash equivalents $ 31,250
Accounts receivable 17,300
Inventories 9,700
These balances Prepaid expenses
Other current assets
4,800
2,100
come from Papa Total current assets 65,150
Investments 50,300
John’s ledger Net property and equipment 174,900
Notes receivable 12,450
accounts on Other assets 22,400
Total assets $ 325,200
January 31, 1999. Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 18,100
Accrued expenses payable 25,500
Total current liabilities $ 43,600
Unearned franchise and development fees 6,600
Other long-term liabilities 11,200
Stockholders' equity:
Contributed capital 165,800
Retained earnings 98,000
Total stockholders' equity 263,800
Irwin/McGraw-Hill Total liabilities and stockholders' equity Companies,
© The McGraw-Hill $ Inc.,
325,200
2001
 Some Misconceptions
Don’t confuse bookkeeping with accounting.
Bookkeeping involves the routine, clerical
part of accounting and requires only
minimal knowledge of accounting, but . . .

An accountant is a trained
professional who can design
information systems, analyze
complex transactions, and
interpret financial data.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Some Misconceptions
Are all transactions subject to
precise and objective measurement?

Almost all
accounting
numbers NO!
are influenced
by estimates.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 Some Misconceptions
Some people believe that financial statements
report the market value of the company.

Financial
Financial statements
statements
really
really report
report the
the cost
cost of
of assets,
assets,
liabilities
liabilities and
and
stockholders’
stockholders’ equity.
equity.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001

 End of Chapter 2

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001