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
QualitativeCharacteristics
Characteristics

Elements
Elementsof
ofStatements
Statements

Relevancy
Relevancy

Asset
Asset

Reliability
Reliability

Liability
Liability

Comparability
Comparability

Stockholders
StockholdersEquity
Equity

Consistency
Consistency

Revenue
Revenue
Expense
Expense
Gain
Gain

McGraw-Hill/Irwin

Loss
Loss

Slide 2

The Conceptual Framework

Assumptions
Assumptions

Separate
Separateentity:
entity:Activities
Activitiesof
ofthe
thebusiness
businessare
are separate
separatefrom
from
activities
activitiesof
ofowners.
owners.
Continuity:
Continuity:The
Theentity
entitywill
willnot
notgo
goout
outof
of business
businessininthe
thenear
near
future.
future.
Unit-of-measure:
Unit-of-measure:Accounting
Accountingmeasurements
measurementswill
willbe
beininthe
thenational
national
monetary
monetaryunit
unit(i.e.,
(i.e.,$$ininthe
theU.S.).
U.S.).

Principle
Principle

Historical
Historicalcost:
cost: Cash
Cashequivalent
equivalentcost
costgiven
givenup
up
isisthe
thebasis
basisfor
forthe
theinitial
initialrecording
recordingof
of elements.
elements.

McGraw-Hill/Irwin

Slide 3

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)

McGraw-Hill/Irwin

(Liabilities)

(Stockholders
Equity)

Slide 4

Balancing the Accounting Equation

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

them
them by
by type
type of
of account
account (A,
(A, L,
L, SE).
SE).
Determine
Determine the
the direction
direction of
of the
the effect
effect
(increase
(increase or
or decrease)
decrease) on
on each
each account.
account.

Step
Step 2:
2: Balancing
Balancing
Verify
Verify that
that the
the accounting
accounting equation
equation (A
(A =
= LL

+
+ SE)
SE) remains
remains in
in balance.
balance.

McGraw-Hill/Irwin

Slide 5

Analyzing Transactions
Papa Johns issues $2,000 of additional common
stock to new investors for cash.
Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1. Cash
Cash(asset).
(asset).
2.
2. Contributed
ContributedCapital
Capital (equity).
(equity).
Determine
Determine the
the Direction
Direction of
of the
the Effect
Effect
1.
1. Cash
Cashincreases.
increases.
2.
2. Contributed
Contributed Capital
Capitalincreases.
increases.

McGraw-Hill/Irwin

Slide 6

Analyzing Transactions
Papa Johns issues $2,000 of additional common
stock to new investors for cash.
(a)

Effect

Cash
Investments
2,000

Equip.

2,000

Notes
Receivable

Notes
Payable

Contributed
Capital
2,000

Retained
Earnings

2,000

A = L + SE

McGraw-Hill/Irwin

Slide 7

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

Determine
Determinethe
theDirection
Directionof
ofthe
theEffect
Effect
1.
1. Cash
Cashincreases.
increases.
2.
2. Notes
NotesPayable
Payableincreases.
increases.
McGraw-Hill/Irwin

Slide 8

The Accounting Cycle

During the period:

Analyze transactions.
Record journal entries in the general journal.
Post amounts to the general ledger.

End of the period:

Adjust revenues and expenses

and related balance sheet accounts.

McGraw-Hill/Irwin

Close revenues, gains,

expenses and losses
to retained earnings.

Prepare a complete
set of financial statements.
Disseminate statements
to users.

Slide 9

The Debit-Credit Framework

A = L + SE
ASSETS

LIABILITIES

EQUITIES

Debit
Credit
for
for
Increase Decrease

Debit
Credit
for
for
Decrease Increase

Debit
Credit
for
for
Decrease Increase

Remember that Stockholders Equity

includes Contributed Capital and Retained
Earnings.
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Slide 10

The Asset Section of a Classified

Balance Sheet

McGraw-Hill/Irwin

Slide 11

Liabilities and Stockholders Equity

Section of the Balance Sheet

McGraw-Hill/Irwin

Slide 12

Key Ratio Analysis

Financial
Leverage
Ratio

Average Total Assets

Average Stockholders Equity

(Beginning Balance + Ending Balance) 2

The 2006 financial leverage ratio for Papa Johns 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.
McGraw-Hill/Irwin

Slide 13

Focus on Cash Flows

McGraw-Hill/Irwin

Slide 14

End of Chapter 2

2008 The McGraw-Hill Companies, Inc.