Investing and Financing Decisions and the Balance Sheet Chapter 2: Investing and Financing Decisions and the Balance Sheet. Chapter 2 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

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 Elements of Statements Asset Liability Stockholders’ Equity Revenue Expense Gain Loss 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 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.). 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. Principle Historical cost: Cash equivalent cost given up is the basis for the initial recording of elements.

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 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. (Assets) (Liabilities) (Stockholders’ Equity)

Balancing the Accounting Equation Step 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. 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.

Analyzing Transactions Papa John’s issues $2,000 of additional common stock to new investors for cash. Identify & Classify the Accounts 1. Cash (asset). 2. Contributed Capital (equity). Determine the Direction of the Effect 1. Cash increases. 2. Contributed Capital increases. 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.

Analyzing Transactions Papa John’s issues $2,000 of additional common stock to new investors for cash. A = L + SE Notice the total assets of $2,000 is equal to total liabilities plus stockholders’ equity of $2,000.

Analyzing Transactions The company borrows $6,000 from the local bank, signing a three-year note. Identify & Classify the Accounts 1. Cash (asset). 2. Notes Payable (liability). Determine the Direction of the Effect 1. Cash increases. 2. Notes Payable increases. 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.

The Accounting Cycle During the period: Analyze transactions. Record journal entries in the general journal. Post amounts to the general ledger. Close revenues, gains, expenses and losses to retained earnings. End of the period: Adjust revenues and expenses and related balance sheet accounts. 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. Prepare a complete set of financial statements. Disseminate statements to users.

The Debit-Credit Framework A = L + SE ASSETS Debit for Increase Credit for Decrease EQUITIES Debit for Decrease Credit for Increase LIABILITIES Remember that Stockholders’ Equity includes Contributed Capital and Retained Earnings. Remember that stockholders’ equity is made of contributed capital and retained earnings.

The Asset Section of a Classified Balance Sheet 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.

Liabilities and Stockholders’ Equity Section of the Balance Sheet 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.

Key Ratio Analysis Financial Leverage Ratio Average Total Assets Average Stockholders’ Equity = (Beginning Balance + Ending Balance) ÷ 2 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 to increase assets the company employs to earn income. 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.

Focus on Cash Flows 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.

End of Chapter 2 End of chapter 2.