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

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Understanding the Business

To understand amounts appearing on a companys balance sheet we need to answer these questions:
What business activities cause changes in the balance sheet?

How do specific activities affect each balance?

How do companies keep track of balance sheet amounts?

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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

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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

Primary Characteristics Elements of Statements Relevancy: predictive value, Asset feedback value, and timeliness. Reliability: verifiability, Liability representational faithfulness, Stockholders Equity and neutrality.
Revenue

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SecondaryExpense Characteristics Comparability: across companies. Gain Consistency: Loss over time.

The Conceptual Framework

Asset: economic resource with probable future benefits. Objective of Financial Reporting Liability: probable future sacrifices ofinformation to external users To provide useful economic economic resources. for decisionEquity: making and for assessing future cash flows. Stockholders financing provided by owners and business operations. Elements of Statements Qualitative Characteristics Revenue: increase in assets or settlement of liabilities from ongoing Asset Relevancy operations. Expense: decrease in assets or Liability Reliability increase in liabilities from ongoing Stockholders Equity Comparability operations. Gain: increase in assets or settlement Revenue Consistency of liabilities from peripheral Expense activities. Loss: decrease in assets or Gain increase in liabilities from peripheral Loss activities. 2-5

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
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Enhancing (degrees of usefulness): Comparability Verifiability Timeliness Understandability

Elements of the Balance Sheet

(Assets)

A = L + SE
(Liabilities) Probable debts or obligations (claims to a companys resources) that result from a companys past transactions and will be paid with assets or services. Entities that a company owes money to are called creditors.

(Stockholders Equity)

Economic resources with probable future benefits owned or controlled by the entity. Measured by the historical cost principle.

The financing provided by the owners and by business operations. Often referred to as contributed capital.

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Papa Johns Balance Sheet

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Nature of Business Transactions

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

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

Cash

Inventory

Equipment

Notes Payable

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Chart of Accounts
A chart of accounts lists all account titles and their unique numbers.

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Principles of Transaction Analysis

Every transaction affects at least two accounts (duality of effects). The accounting equation must remain in balance after each transaction.

(Assets)

A = L + SE
(Liabilities)

(Stockholders Equity)

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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.
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How Do Companies Keep Track of Account Balances?

General Journal General Ledger

T-accounts

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End of Chapter 2

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