Download Is the accounting equation in balance?

Investing and Financing Decisions
and the Balance Sheet
Chapter 2
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
2-1 McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Understanding the Business
To understand amounts appearing
on a company’s balance sheet we
need to answer these questions:
What
business
activities cause
changes in
the balance
sheet?
2-2
How do
specific
activities
affect each
balance?
How do
companies
keep track of
balance sheet
amounts?
The Conceptual Framework
Objective of Financial Reporting
To provide useful economic information to external users
for decision making and for assessing future cash flows.
Qualitative Characteristics
Elements of Statements
Relevancy
Asset
Reliability
Liability
Comparability
Stockholders’ Equity
Consistency
Revenue
Expense
Gain
2-3
Loss
The Conceptual Framework
Objective of Financial Reporting
To provide useful economic information to external users
for decision making and for assessing future cash flows.
Qualitative Characteristics
Relevancy
Reliability
Comparability
Consistency
2-4
Elements
of Statements
Primary
Characteristics
Elements of Statements
•Relevancy:
predictive
value,
Asset
Asset
feedback value,
and timeliness.
Liability
•Reliability: verifiability,
Liability
Stockholders’
Equity
representational
faithfulness,
Stockholders’ Equity
and neutrality.
Revenue
SecondaryRevenue
Characteristics
Expense
•Comparability:
across
Expense
companies. Gain
Gain
•Consistency: Loss
over time.
Loss
The Conceptual Framework
Objective of Financial Reporting
To provide useful economic information to external users
for decision making and for assessing future cash flows.
Asset: economic resource with
probable future benefits.
Liability: probable future sacrifices of
economic resources.
Stockholders’ Equity: financing
provided by owners and business
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.
2-5
Qualitative
Characteristics
Elements of Statements
Relevancy
Liability
Reliability
Stockholders’ Equity
Comparability
Revenue
Consistency
Expense
Asset
Gain
Loss
International Perspective
Reconsidering the Conceptual Framework
The Financial Accounting Standards Board (FASB) and the
International Accounting Standards Board (IASB) are working
on a joint project to develop a common conceptual framework
toward convergence of accounting standards.
Objective of Financial Reporting: To provide financial information about the
reporting entity that is useful to present and potential equity investors, lenders, and
other creditors in making decisions in their capacity as capital providers.
Qualitative Characteristics (limited by materiality and costs):
Fundamental (to be useful):
 Relevance
 Faithful representation
2-6
Enhancing (degrees of usefulness):
 Comparability
 Verifiability
 Timeliness
 Understandability
Elements of the Balance Sheet
A = L + SE
(Assets)
Economic resources
with probable future
benefits owned or
controlled by the
entity. Measured by
the historical cost
principle.
2-7
(Liabilities)
Probable debts or
obligations (claims
to a company’s
resources) that
result from a
company’s past
transactions and will
be paid with assets
or services. Entities
that a company
owes money to are
called creditors.
(Stockholders’ Equity)
The financing
provided by the
owners and by
business operations.
Often referred to as
contributed capital.
Papa John’s Balance Sheet
2-8
Nature of Business Transactions
Most transactions with
external parties involve an
exchange where the
business entity gives up
something but receives
something in return.
2-9
A Question of Ethics
2-10
Accounts
An organized format used by companies
to accumulate the dollar effects of
transactions.
Cash
Inventory
Equipment
2-11
Notes
Payable
Chart of Accounts
A chart of accounts lists all account titles and their
unique numbers.
2-12
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)
2-13
(Liabilities)
(Stockholders’ Equity)
Balancing the Accounting Equation
Step 1: Identify and classify accounts and effects
 Identify the accounts (by title) affected and
make sure at least two accounts change.
 Classify them by type of account. Was each
account an asset (A), a liability (L), or a
stockholders’ equity (SE)?
 Determine the direction of the effect. Did the
account increase [+] or decrease [-]?
Step 2: Verify account equation is in balance.
 Verify that the accounting equation (A = L + SE)
remains in balance.
2-14
Analyzing Transactions
(a) Papa John’s issues $2,000 of additional common stock to new investors
for cash.
Step 1: Identify and classify accounts and effects
1. Cash (+A) $2,000. 2. Contributed Capital (+SE) $2,000.
Step 2: Is the accounting equation in balance?
(a)
Effect
Cash
Investments
2,000
Equip.
2,000
Notes
Receivable
Notes
Payable
=
A = L + SE
2-15
Contributed
Capital
2,000
2,000
Retained
Earnings
Analyzing Transactions
(b) Papa John’s borrows $6,000 from the bank signing a three-year note.
Step 1: Identify and classify accounts and effects
1. Cash (+A) $6,000. 2. Notes Payable (+L) $6,000.
Step 2: Is the accounting equation in balance?
(a)
(b)
Effect
Cash
2,000
6,000
Investments
Equip.
Notes
Receivable
Notes
Payable
6,000
8,000
=
A = L + SE
2-16
Contributed
Capital
2,000
8,000
Retained
Earnings
Analyzing Transactions
(c) Papa John’s purchases new ovens, counters, refrigerators, and other
equipment costing $10,000, paying $2,000 in cash and signing a two-year
note for the balance.
Step 1: Identify and classify accounts and effects
1. Equipment (+A) $10,000. 2. Cash (-A) $2,000
Notes Payable (+L) $8,000.
Step 2: Is the accounting equation in balance?
(a)
(b)
(c
Effect
Cash
Investments
2,000
6,000
(2,000)
Equip.
Notes
Receivable
Notes
Payable
6,000
8,000
10,000
16,000
=
A = L + SE
2-17
Contributed
Capital
2,000
16,000
Retained
Earnings
Analyzing Transactions
(d) Papa John’s lends $3,000 cash to new franchisees who sign notes to be
repaid in five years.
Step 1: Identify and classify accounts and effects
1. Notes Receivable (+A) $3,000. 2. Cash (-A) $3,000.
Step 2: Is the accounting equation in balance?
(a)
(b)
(c
(d)
Effect
Cash
Investments
2,000
6,000
(2,000)
(3,000)
Equip.
Notes
Receivable
Notes
Payable
6,000
8,000
10,000
16,000
3,000
=
A = L + SE
2-18
Contributed
Capital
2,000
16,000
Retained
Earnings
Analyzing Transactions
(e) Papa John’s purchases the stock of another company as a long-term
investment, paying $1,000 in cash.
Step 1: Identify and classify accounts and effects
1. Investments (+A) $1,000. 2. Cash (-A) $1,000.
Step 2: Is the accounting equation in balance?
(a)
(b)
(c
(d)
(e)
Effect
Cash
Investments
2,000
6,000
(2,000)
(3,000)
(1,000)
1,000
Equip.
Notes
Receivable
Notes
Payable
6,000
8,000
10,000
16,000
3,000
=
A = L + SE
2-19
Contributed
Capital
2,000
16,000
Retained
Earnings
Analyzing Transactions
(f) The board of directors declares that Papa John’s will pay $3,000 in cash
dividends to shareholder next month.
Step 1: Identify and classify accounts and effects
1. Retained Earnings (-SE) $3,000. 2. Dividends Payable (+L) $3,000.
Step 2: Is the accounting equation in balance?
(a)
(b)
(c
(d)
(e)
(f)
Effect
Cash
Investments
2,000
6,000
(2,000)
(3,000)
(1,000)
1,000
Equip.
Notes
Receivable
Dividends
Payable
Notes
Payable
Retained
Earnings
6,000
8,000
10,000
3,000
3,000
16,000
=
A = L + SE
2-20
Contributed
Capital
2,000
(3,000)
16,000
The Accounting Cycle
Start of new period
During the Period
(Chapters 2 and 3)
•Analyze transactions
•Record journal entries in the general journal
•Post amounts to the general ledger
At the End of the Period
(Chapter 4)
•Prepare a trial balance to determine if debits equal credits
•Adjust revenues and expenses and related balance sheet
accounts (record in journal and post to ledger)
•Prepare a complete set of financial statements and disseminate it
to users
•Close revenues, gains, expenses, and losses to Retained Earnings
(record in journal and post to ledger)
2-21
How Do Companies Keep Track of
Account Balances?
General Journal
General
Ledger
T-accounts
2-22
Transaction Analysis Model
T-Account
(Any account)
debit
credit
“T-account” is merely a shorthand term for
the entire ledger account. The T-account has
a left side, called the debit side, and a right
side, called the credit side.
Debits and credits affect the Balance Sheet Model as follows:
Assets
(many accounts)
+
−
debit
credit
2-23
=
Liabilities
(many accounts)
−
+
debit
credit
+
Stockholders’ Equity
(two accounts)
Contributed Capital
Retained Earnings
−
+
−
+
debit
credit
debit
credit
Investments by
Dividends
Net income of
owners
declared
business
Summary
↑ with Debits
↑ with Credits
Stockholders’
Equity
↑ with Credits
Accounts have
debit balances
Accounts have
credit balances
Accounts have
credit balances
Assets
2-24
=
Liabilities
+
Analytical Tool: The Journal Entry
A journal entry might look like this:
(c) Property and Equipment (+A)
Cash (-A)
Notes Payable (+L)
Reference:
Letter,
number, or
date.
2-25
Debit
10,000
Credit
2,000
8,000
Account Titles:
Debited accounts on top.
Credited accounts on bottom
usually indented.
Amounts:
Debited amounts on left.
Credited amounts on right.
The T-Account
After journal entries are prepared, the
accountant posts (transfers) the dollar
amounts to each account affected by
the transaction.
(c) Property and Equipment (+A)
Cash (-A)
Notes Payable (+L)
2-26
Debit
10,000
Ledger
Credit
2,000
8,000
Post
Papa John’s issues $2,000 of additional common
stock to new investors for cash.
GENERAL JOURNAL
Date
(a)
Beg. Bal.
(a)
Posted
Account Titles and Explanation
Ref.
Cash (+A)
Contributed Capital (+E)
Cash
6,000
2,000
8,000
2-27
Debit
2,000
Credit
2,000
Contributed Capital
1,000 Beg. Bal.
2,000 (a)
3,000
The company borrows $6,000 from the local bank,
signing a three-year note.
(b) Cash (+A)
Notes Payable (+L)
Beg. Bal.
(a)
(b)
Cash
6,000
2,000
6,000
14,000
2-28
Debit
6,000
Credit
6,000
Notes Payable
146,000 Beg. Bal.
6,000 (b)
152,000
Classified Balance Sheet
In a classified balance sheet assets and liabilities
are classified into two categories – current and
noncurrent.
Current assets are
those to be used or
turned into cash within
the upcoming year,
whereas noncurrent
assets are those that
will last longer than
one year.
2-29
Current liabilities are
those obligations to be
paid or settled within
the next 12 months
with current assets.
k
2-30
International Perspective
Understanding Foreign Financial Statements
Although financial statements prepared using GAAP and IFRS
include the same elements (assets, liabilities, revenues,
expenses, etc.), a single, consistent format has not been
mandated. Consequently, various formats have evolved over
time, with those in the U.S. differing from those typically used
internationally. The formatting differences include:
2-31
Key Ratio Analysis
Current
Ratio
=
Current Assets
Current Liabilities
Current ratio for Papa John’s:
2006 = 0.83
2007 = 0.68
2008 = 0.75
The current ratio for Papa John’s shows a low level
of liquidity, below 1.
2-32
Focus on Cash Flows
Companies report cash inflows and outflows over a period
in their 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
2-33
–
+
–
+
+
–
+
–
–
Investing and Financing Activities
Papa John's International, Inc.
Consolidated Statement of Cash Flows
For the Month Ended January 31, 2009
(in thousands)
Operating activities
(None in this chapter.)
Investing Activities
Purchased property and equipment
$
Purchased investments
Lent funds to franchisees
Net cash used in investing activities
Financing Activities
Issued common stock
Borrowed from banks
Net cash provided by financing activities
Net increase in cash
Cash at beginning of month
Cash at end of month
$
Agrees with the amount of the balance sheet.
2-34
(2,000)
(1,000)
(3,000)
(6,000)
2,000
6,000
8,000
2,000
11,000
13,000
End of Chapter 2
2-35