©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones3 - 1 Chapter 3 The Balance Sheet and External Financing

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones3 - 2 Learning Objective 1 Identify and explain the meaning of the accounting elements shown on the balance sheet.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones3 - 3 Introduction to the Balance Sheet The balance sheet is the financial tool that focuses on the present condition of a business.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones3 - 4 The Accounting Elements 1. Assets 1. Assets 2. Liabilities 2. Liabilities 3. Equity 3. Equity 4. Investment by owners 4. Investment by owners 5. Distributions to owners 5. Distributions to owners 6. Comprehensive income 6. Comprehensive income 7. Revenues 7. Revenues 8. Expenses 8. Expenses 9. Gains 9. Gains 10. Losses

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones3 - 5 The Accounting Elements Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions events.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones3 - 6 The Accounting Elements Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones3 - 7 The Accounting Elements The residual interest in the assets of an entity that remains after deducting its liabilities. Investment by owners Earnedequity

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones3 - 8 Organization of the Balance Sheet

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones3 - 9 The Accounting Equation Assume you are buying a car for $8,000, paying $3,000 in cash and borrowing $5,000 from the bank. What is the accounting equation?

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Liability and Equity

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Best Buy Co., Inc. Accounting Equation $4,839,587 = $3,017,659 + $1,821,928 $4,839,587

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Account Form Balance Sheet The Toland Company Balance Sheet December 31, 2003 AssetsLiabilities Asset one $$$Liability one $$$ Asset two $$$Liability two $$$ Asset three $$Total liabilities $$$$ Asset four $$Owners’ equity $$$ Asset five $$Total liabilities and Total assets$$$$$ owners’ equity$$$$$ These amounts must be equal

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Report Form Balance Sheet Assets: Asset one, etc.$$$$$ Total assets$$$$$ Liabilities: Liability one, etc. $$$$ Total liabilities $$$$ Owners’ equity $$$ Total liabilities and owners’ equity$$$$$ owners’ equity$$$$$ These two amounts must be equal

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 2 Prepare a basic balance sheet for a proprietorship, partnership, and a corporation, and demonstrate how the balance sheet provides information about the financial position of a business.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Starting a Proprietorship or Partnership: Investments by Owners Assume that Jessica’s Beauty Supply began operations on January 1, 2003, with a $10,000 investment from Jessica. How would the first balance sheet appear?

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Jessica’s Beauty Supply Balance Sheet January 1, 2003 Assets:Liabilities:$ 0 Cash$10,000Owner’s equity: Cash$10,000Owner’s equity: Jessica, capital 10,000 Jessica, capital 10,000 Total liabilities and Total assets$10,000 owner’s equity$10,000 Starting a Proprietorship or Partnership: Investments by Owners

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Assume that Jessica invests $6,000 and a partner, Stephanie, invests $4,000 on January 1, How would the first balance sheet appear? Starting a Proprietorship or Partnership: Investments by Owners

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Jessica and Stephanie’s Beauty Supply Balance Sheet January 1, 2003 Assets:Liabilities:$ 0 Cash$10,000Owner’s equity: Cash$10,000Owner’s equity: Jessica, capital 6,000 Stephanie, capital 4,000 Total liabilities and Total assets$10,000 owner’s equity$10,000 Starting a Proprietorship or Partnership: Investments by Owners

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Starting a Corporation Corporations are legal entities, separate from their owners. Incorporators obtain a corporate charter from one of the 50 states to create a corporation.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 3 Describe how a corporation is formed and how the equity of a corporate balance sheet is structured.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Corporate Organizational Structure Incorporators Officers President Board of directors Stocks Bylaws Charter Submit application (Articles of Incorporation)

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Corporate Capital Structure Authorized shares Issued shares Outstanding shares Treasury stock

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Corporate Capital Structure Paid-in capital Retained earnings Dividends

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Classes of Stocks Common stock Preferred stock Par value No par 1. Receive dividends before common stockholders. 2. Priority in receiving assets in the event of liquidation.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Constructing the Corporate Balance Sheet Assume that Jessica and Stephanie agree that Jessica will purchase 4,000 shares of the company’s one-dollar par common stock for $40,000 and Stephanie will purchase 200 shares of the company’s 8%, $100 par preferred stock for $105 per share or $21,000 on January 1, 2003.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Assets:Liabilities:$ 0 Cash$61,000Stockholders’ equity: Cash$61,000Stockholders’ equity: Preferred stock$20,000 Paid-in capital – preferred 1,000 Common stock 4,000 Paid-in capital – common 36,000 Total stockholders’ equity$ 61,000 Total liabilities and Total assets$61,000 stockholders’ equity$61,000 Constructing the Corporate Balance Sheet Jessica’s Beauty Supply, Inc. Balance Sheet January 1, 2003

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objectives 4 and 5 Describe various forms of debt and equity financing and their effects on the balance sheet. Perform basic interest calculations.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Borrowing from Financial Institutions Consumer borrowing Personal Commercial borrowing Business

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Promissory Notes A promissory note is a written agreement or debt instrument between a lender and a borrower that sets forth the terms of the liability and the stipulations for the borrower to repay both principal and interest. CollateralMortgage

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones The Cost of Borrowing Boston Brothers borrowed $5,000 on January 2, 2003, by signing an 8%, three-month note. How much interest is due at the end of the period?

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Borrowing by Issuing Bonds A bond is a type of promissory note, usually a $1,000 interest-bearing debt instrument. The main differences between borrowing with bonds and promissory notes are the length of the loan and the amount of money borrowed.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Borrowing by Issuing Bonds Debenture bonds Nominal interest rate Effective interest rate Bond’s market price PremiumDiscount Indentures

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Borrowing by Issuing Bonds Assume Yoko Industries issues 1,000, 12%, 10-year $1,000 bonds at 95. What is the total cost of borrowing?

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Borrowing by Issuing Bonds Interest ($1,000,000 × 12% × 10 years)$1,200,000 Principal (1,000 bonds × $1,000 face) 1,000,000 Total cash outflow from issuer of bonds$2,200,000 Less:Original bond proceeds from investors ($1,000,000 × 95%) – 950,000 Net cost to the issuer and return on investment to the investors$1,250,000 investment to the investors$1,250,000 Assume the bonds sell at 104.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Borrowing by Issuing Bonds Interest ($1,000,000 × 12% × 10 years)$1,200,000 Principal (1,000 bonds × $1,000 face) 1,000,000 Total cash outflow from issuer of bonds$2,200,000 Less:Original bond proceeds from investors ($1,000,000 × 104%)–1,040,000 Net cost to the issuer and return on investment to the investors$1,160,000 investment to the investors$1,160,000 What is the total cost of borrowing?

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Constructing the Balance Sheet Reflecting Debt Assume that on January 1, 2003, Jessica’s Beauty Supply, Inc., borrowed $50,000 on a 9%, one-year promissory note and issued 200, $1, year, 8% bonds at par ($200,000).

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Corporate Balance Sheet With Notes and Bonds Payable Assets:Liabilities: Cash$311,000 Notes payable$ 50,000 Cash$311,000 Notes payable$ 50,000 Bonds payable Bonds payable Total liabilities$250,000 Stockholders’ equity: Preferred stock 20,000 Preferred stock 20,000 Paid-in capital – preferred 1,000 Paid-in capital – preferred 1,000 Common stock 4,000 Common stock 4,000 Paid-in capital – common 36,000 Paid-in capital – common 36,000 Total stockholders’ equity$ 61,000 Total liabilities and Total assets$311,000 stockholders’ equity$311,000 Jessica’s Beauty Supply, Inc. Balance Sheet January 1, 2003

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Using Cash to Acquire Assets Assume that on January 1, 2003, Jessica’s Beauty Supply, Inc., used cash to purchase the following: Land$ 50,000 Building$120,000 Computer equipment$ 35,000 Truck$ 25,000

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Using Cash to Acquire Assets Assets=Liabilities+Owners’ Assets=Liabilities+Owners’ Equity Equity Sale of Stock: Common$ 40,000=00+$40,000 Common$ 40,000=00+$40,000 Preferred 21,000=00+ 21,000 Preferred 21,000=00+ 21,000Borrowing: Promissory note 50,000= 50, Promissory note 50,000= 50, Bond issue 200,000= 200, Bond issue 200,000= 200, Purchase of assets: Cash(230,000)00 00 Cash(230,000)00 00 Land 50, Land 50, Building 120, Building 120, Equipment 35, Equipment 35, Truck 25, Truck 25, Total$311,000=$250,000+$61,000

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Corporate Balance Sheet With Various Assets Assets:Liabilities: Cash$ 81,000 Notes payable$ 50,000 Cash$ 81,000 Notes payable$ 50,000 Land 50,000 Bonds payable Land 50,000 Bonds payable Building 120,000Total liabilities$250,000 Building 120,000Total liabilities$250,000 Equipment 35,000Stockholders’ equity: Equipment 35,000Stockholders’ equity: Truck 25,000 Preferred stock 20,000 Truck 25,000 Preferred stock 20,000 Paid-in capital – preferred 1,000 Paid-in capital – preferred 1,000 Common stock 4,000 Common stock 4,000 Paid-in capital – common 36,000 Paid-in capital – common 36,000 Total stockholders’ equity$ 61,000 Total liabilities and Total assets$311,000 stockholders’ equity$311,000 Jessica’s Beauty Supply, Inc. Balance Sheet January 1, 2003

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 6 Compare and contrast two investment alternatives – equity investments and debt investments – including return on and return of investments for each alternative.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Equity and Debt Investment Compared Equity investment Debt investment Interest Dividends Stock appreciation

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 7 Read and understand a basic statement of cash flows and describe the information it includes.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Statement of Cash Flows The statement of cash flows shows a company’s sources and uses of cash during a particular period of time. Inflows Cash Outflows

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Content of the Statement of Cash Flows Operating activities Financing activities Cashflow Investing activities

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Statement of Cash Flows for Jessica Corporation Statement of Cash Flows for Jessica Corporation Cash flows from operating activities – none Net cash flows from operating activities 00$ 00 operating activities 00$ 00 Cash flows from investing activities Purchase of land$ (50,000) Purchase of land$ (50,000) Purchase of building (120,000) Purchase of building (120,000) Purchase of equipment (35,000) Purchase of equipment (35,000) Purchase of truck (25,000) Purchase of truck (25,000) Net cash flows from investing activities$(230,000) investing activities$(230,000) Jessica Corporation Statement of Cash Flows For the Year Ended January 1, 2003

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Statement of Cash Flows for Jessica Corporation Statement of Cash Flows for Jessica Corporation Net cash flows from operating activities$ 00 Net cash flows from investing activities (230,000) Cash flows from financing activities Sale of common stock$ 40,000 Sale of common stock$ 40,000 Sale of preferred stock 21,000 Sale of preferred stock 21,000 Borrowing on note payable 50,000 Borrowing on note payable 50,000 Sale of bonds 200,000 Sale of bonds 200,000 Net cash flows from financing activities 311,000 financing activities 311,000 Net change in cash$ 81,000 Cash at the beginning of the period 00 Cash at the end of the period$ 81,000

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Learning Objective 8 Perform basic financial analysis relating to financing activities.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Ratio Analysis The key concept of ratio analysis is that the relationship of one number to another may be just as important as the absolute dollar amounts of those numbers.

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Debt Ratio The debt ratio measures the proportion of company’s assets financed by debt. Total liabilities ÷ Total assets Jessica’s Beauty Supply, Inc., debt ratio: $250,000 ÷ $311,000 = 80.4%

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones Debt-to-Equity Ratio This ratio expresses the relationship between liabilities and equity. Total liabilities ÷ Total equity Jessica’s Beauty Supply, Inc., debt-to-equity ratio: $250,000 ÷ $61,000 = 4.1 to 1

©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones End of Chapter 3