chapter 2 mcgraw-hill/irwin © 2009 the mcgraw-hill companies, inc

INVESTING AND FINANCING DECISIONS

AND THE BALANCE SHEETChapter 2

THE CONCEPTUAL FRAMEWORK

Qualitative CharacteristicsRelevancyReliabilityComparabilityConsistency

Objective of 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.

THE CONCEPTUAL FRAMEWORK

Assumptions__________________: Activities of the business are separate from activities of owners.

_______________: The entity will not go out of business in the near future.

________________: Accounting measurements will be in the national monetary unit (i.e., $ in the U.S.).

Assumptions__________________: Activities of the business are separate from activities of owners.

_______________: The entity will not go out of business in the near future.

________________: Accounting measurements will be in the national monetary unit (i.e., $ in the U.S.).

Principle______________: Cash equivalent cost given up

is the basis for the initial recording of elements.

Principle______________: Cash equivalent cost given up

is the basis for the initial recording of elements.

ELEMENTS OF A BALANCE SHEET ASSET: Economic resources with probable

future benefits owned or controlled by an entity as a result of past transactions.

LIABILITY: Probable debts or obligations (claims to a company’s resources) that result from an entity’s past transactions AND will be paid for with assets or services.

STOCKHOLDERS’ EQUITY: Financing provided by the owners (contributed capital) and by business operations (Retained Earnings).

ASSETS ON THE BALANCE SHEET Listed in order of liquidity (how soon an

asset is expected to be turned into cash or used)

Categorized as CURRENT (used or turned into cash with 1 year) and LONG-TERM.

LIABILITIES ON THE BALANCE SHEET Listed in order of maturity (how soon

the obligation will be paid)

Classified as CURRENT or LONG-TERM

STOCKHOLDERS’ EQUITY ON THE BALANCE SHEET For simplicity, usually only includes two

accounts: Contributed Capital and Retained Earnings

Will get more complex later in the quarter.

NATURE OF BUSINESS TRANSACTIONS

External events: exchanges of assetsand liabilities between the businessand one or more other parties.

Borrow cash

from the bank

NATURE OF BUSINESS TRANSACTIONS

Internal events: not an exchange betweenthe business and other parties, but havea direct effect on the accounting entity.

Loss due to fire damage.

TYPICAL ACCOUNT TITLES

AssetsCashShort-Term InvestmentAccounts ReceivableNotes ReceivableInventory (to be sold)SuppliesPrepaid ExpensesLong-Term InvestmentsEquipmentBuildingsLandIntangibles

LiabilitiesAccounts PayableAccrued ExpensesNotes PayableTaxes PayableUnearned Revenue Bonds Payable

Stockholders’ EquityContributed CapitalRetained Earnings

The Balance Sheet

TYPICAL ACCOUNT TITLES

RevenuesSales RevenueFee RevenueInterest RevenueRent Revenue

ExpensesCost of Goods SoldWages ExpenseRent ExpenseInterest ExpenseDepreciation ExpenseAdvertising ExpenseInsurance ExpenseRepair ExpenseIncome Tax Expense

The Income Statement

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)

DUALITY OF EFFECTS Most transactions with external parties involve an exchange where the business

entity gives up something but

receives something in return.

FOCUS ON CASH FLOWSOperating 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 –

BALANCING THE ACCOUNTING EQUATION

Step 1: Accounts and effects Identify the accounts affected and classify

them by type of account (A,L,SE,Rev,Exp,Div).

Determine the direction of the effect (increase or decrease) on each account.

Step 2: BalancingVerify that the accounting equation (A = L

+ SE) remains in balance.

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

Identify & Classify the Accounts1. _____________2. ________________

Determine the Direction of the Effect1. ________________2. ________________

ANALYZING TRANSACTIONS

A = L + SE

Cash Investments Equip.Notes

ReceivableNotes

PayableContributed

CapitalRetained Earnings

(a) 2,000 2,000

Effect =2,000 2,000

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

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

Identify & Classify the Accounts1. _____________2. ________________

Determine the Direction of the Effect1. _______________2. ___________________

A = L + SE

ReceivableNotes

PayableContributed

(a) 2,000 2,000 (b) 6,000 6,000

Effect =8,000 8,000

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

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. __________________2. ___________________3. ___________________

Determine the Direction of the Effect1. _______________2. ________________3. __________________

A = L + SE

ReceivableNotes

PayableContributed

(a) 2,000 2,000 (b) 6,000 6,000 (c) (2,000) 10,000 8,000

Effect =16,000 16,000

Papa John’s purchases $10,000 of new equipment, paying $2,000 in cash and signing a two-year note payable for the rest.

Papa John’s board of directors declares andpays $3,000 in dividends to shareholders.

Identify & Classify the AccountsIdentify & Classify the Accounts

Determine the Direction of the EffectDetermine the Direction of the Effect

Identify & Classify the Accounts1. _______________2. ____________________

Determine the Direction of the Effect1. _________________2. _________________________

A = L + SE

ReceivableNotes

PayableContributed

(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

Papa John’s board of directors declares andpays $3,000 in dividends to shareholders.

LET’S DO E2-2 (PAGE 84-85)

A) A COMPANY ORDERS AND RECEIVES 10 PERSONAL COMPUTERS FOR OFFICE USE FOR WHICH IT SIGNS A NOTE PROMISING TO PAY $25,000 WITHIN THREE MONTHS.

Accounts Account Type

Incr./Decr. Amount

Transaction Type: Operating/Investing/Financing?

B) A COMPANY PURCHASES FOR $21,000 CASH A NEW DELIVERY TRUCK THAT HAS A LIST, OR STICKER, PRICE OF $24,000.

Incr./Decr. Amount

C) A WOMEN’S CLOTHING RETAILER ORDERS 30 NEW DISPLAY STANDS FOR $300 EACH FOR FUTURE DELIVERY.

Incr./Decr. Amount

D) A NEW COMPANY IS FORMED AND SELLS 100 SHARES OF STOCK FOR $12 PER SHARE TO INVESTORS.

Incr./Decr. Amount

E) A MANUFACTURING COMPANY SIGNS A CONTRACT FOR THE CONSTRUCTION OF A NEW WAREHOUSE FOR $500,000. AT THE SIGNING, THE COMPANY WRITES A CHECK FOR $50,000 TO THE CONSTRUCTION COMPANY AS THE INITIAL PAYMENT FOR THE CONSTRUCTION (RECEIVING CONSTRUCTION IN PROGRESS). ANSWER THE QUESTION FROM THE STANDPOINT OF THE MANUFACTURING COMPANY.

Accounts Account Type Incr./Decr. Amount

F) A PUBLISHING FIRM PURCHASES FOR $40,000 CASH THE COPYRIGHT (AN INTANGIBLE ASSET) TO A MANUSCRIPT FOR AN INTRODUCTORY ACCOUNTING TEXT.

Incr./Decr. Amount

G) A MANUFACTURING FIRM PAYS STOCKHOLDERS A $100,000 CASH DIVIDEND.

Incr./Decr. Amount

H) A COMPANY PURCHASES 100 SHARES OF APPLE, INC. COMMON STOCK FOR $5,000 CASH.

Incr./Decr. Amount

I) A COMPANY PURCHASES A PIECE OF LAND FOR $50,000 CASH. AN APPRAISER FOR THE BUYER VALUED THE LAND AT $52,500.

Incr./Decr. Amount

J) A MANUFACTURING COMPANY ACQUIRES THE PATENT (AN INTANGIBLE ASSET) ON A NEW DIGITAL SATELLITE SYSTEM FOR TELEVISION RECEPTION, PAYING $500,000 CASH AND SIGNING A $400,000 NOTE PAYABLE DUE IN ONE YEAR.

Incr./Decr. Amount

K) A LOCAL COMPANY IS A SOLE PROPRIETORSHIP (ONE OWNER); ITS OWNER BUYS A CAR FOR $10,000 FOR PERSONAL USE. ANSWER FROM THE COMPANY’S POINT OF VIEW.

Incr./Decr. Amount

L) A COMPANY BORROWS $1,000 FROM A LOCAL BANK AND SIGNS A SIX MONTH NOTE FOR THE LOAN.

Incr./Decr. Amount

M) A COMPANY PAYS $1,500 PRINCIPAL ON ITS NOTE PAYABLE (IGNORE INTEREST). – WHAT ABOUT INTEREST?

Incr./Decr. Amount

chapter 2 mcgraw-hill/irwin © 2009 the mcgraw-hill companies, inc

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