Chapter 2Separate entity: Transactions of the business are separate from transactions of owners....
Transcript of Chapter 2Separate entity: Transactions of the business are separate from transactions of owners....
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Chapter 2
Investing and Financing Decisions and the Balance Sheet
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Business Background
To understand amounts appearingon a company’s balance sheet weneed to answer these questions:
What business
activities causechanges inthe balance
sheet?
How dospecificactivities
affect eachbalance?
How do companies
keep track ofbalance sheet
amounts?
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The Conceptual Framework
Qualitative Characteristics
Relevancy
Reliability
Comparable
Consistent
Qualitative Characteristics
Relevancy
Reliability
Comparable
Consistent
Elements of Statements
Asset
Liability
Stockholders’ Equity
Revenue
Expense
Gain
Loss
Elements of Statements
Asset
Liability
Stockholders’ Equity
Revenue
Expense
Gain
Loss
Objective of External Financial ReportingTo provide useful economic information to external users for decision making and for assessing future cash flows.
Objective of External Financial ReportingTo provide useful economic information to external users for decision making and for assessing future cash flows.
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Elements of Statements
Asset
Liability
Stockholders’ Equity
Revenue
Expense
Gain
Loss
Elements of Statements
Asset
Liability
Stockholders’ Equity
Revenue
Expense
Gain
Loss
The Conceptual Framework
Qualitative Characteristics
Relevancy
Reliability
Comparable
Consistent
Qualitative Characteristics
Relevancy
Reliability
Comparable
Consistent
Objective of External Financial ReportingTo provide useful economic information to external users for decision making and for assessing future cash flows.
Objective of External Financial ReportingTo 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, andneutrality.
Secondary Characteristics•Comparability: across companies.
•Consistency: over time.
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Qualitative Characteristics
Relevancy
Reliability
Comparable
Consistent
Qualitative Characteristics
Relevancy
Reliability
Comparable
Consistent
The Conceptual Framework
Elements of Statements
Asset
Liability
Stockholders’ Equity
Revenue
Expense
Gain
Loss
Elements of Statements
Asset
Liability
Stockholders’ Equity
Revenue
Expense
Gain
Loss
Objective of External Financial ReportingTo provide useful economic information to external users for decision making and for assessing future cash flows.
Objective of External Financial ReportingTo provide useful economic information to external users for decision making and for assessing future cash flows.
Asset: economic resource with probable future benefit.
Liability: probable future sacrifices of economic resources.
Stockholders’ Equity: financingprovided by owners and operations.
Revenue: increase in assets orsettlement of liabilities from ongoing operations.
Expense: decrease in assets orincrease in liabilities from ongoing operations.
Gain: increase in assets or settlement of liabilities from peripheraltransactions.
Loss: decrease in assets or increase in liabilities from peripheral transactions.
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The Conceptual Framework
AssumptionsSeparate entity: Transactions of the business are
separate from transactions of owners.Continuity: The entity will not go out of business in the
near future.Unit-of-measure: Accounting measures are in the
national monetary unit ($).Time period: The long life of a company can be
reported over a series of shorter time periods.
AssumptionsSeparate entity: Transactions of the business are
separate from transactions of owners.Continuity: The entity will not go out of business in the
near future.Unit-of-measure: Accounting measures are in the
national monetary unit ($).Time period: The long life of a company can be
reported over a series of shorter time periods.
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The Conceptual Framework
PrinciplesHistorical cost: Cash equivalent cost given up is the basis
for initial recording of elements.Revenue recognition: Record revenues when earned and
measurable (exchange complete, earnings complete and collection probable).
Matching: Record expenses when incurred in earning revenue.
Full disclosure: Disclose relevant economic information.
PrinciplesHistorical cost: Cash equivalent cost given up is the basis
for initial recording of elements.Revenue recognition: Record revenues when earned and
measurable (exchange complete, earnings complete and collection probable).
Matching: Record expenses when incurred in earning revenue.
Full disclosure: Disclose relevant economic information.
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The Conceptual Framework
ConstraintsCost-benefit: Benefits of recording and reporting information
should outweigh costs.Materiality: Relatively small amounts not likely to influence
decisions are to be recorded in most cost/beneficial way.Industry peculiarities: Differences in accounting and reporting
for certain items are permitted if there is a clear precedent in the industry.
Conservatism: Exercise care not to overstate assets andrevenues or understate liabilities and expenses.
ConstraintsCost-benefit: Benefits of recording and reporting information
should outweigh costs.Materiality: Relatively small amounts not likely to influence
decisions are to be recorded in most cost/beneficial way.Industry peculiarities: Differences in accounting and reporting
for certain items are permitted if there is a clear precedent in the industry.
Conservatism: Exercise care not to overstate assets andrevenues or understate liabilities and expenses.
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Nature of Business Transactions
External eventsExternal events: exchanges of assetsand liabilities between the business
and one or more other parties.
Borrow money
from the bank
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Nature of Business Transactions
Internal eventsInternal events: not an exchange betweenthe business and other parties, but havea direct effect on the accounting entity.
Loss due to fire damage.
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AccountsAn organized format used by companies to
accumulate the dollar effects of transactions.
Cash
EquipmentInventory
Notes Payable
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Transaction Analysis
➊ Every transaction affects at least two accounts (duality of effects).
➋ The accounting equation must remain in balance after each transaction.
A = L + SEA = L + SE
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Duality of Effects
Most transactions with external parties involve an exchangewhere the business entity both gives up gives up
something and receivesreceives something
in return.
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Balancing the Accounting Equation!Accounts and effects
"Identify the accounts affected."Classify each as an asset, liability or equity
account."Determine the direction of the effect (increase or
decrease) on each account.#Determine that the accounting equation
remains in balance.
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Balancing the Accounting Equation
Let’s see how we keep theaccounting equation in
balance for Papa John’s.
All amounts are in thousands of dollars.
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Identify & Classify the AccountsIdentify & Classify the Accounts
Determine the Direction of the EffectDetermine the Direction of the Effect
Papa John’s issues $1,300 of additional common stock to new investors for cash.
Identify & Classify the Accounts1. Cash (asset)2. Contributed Capital (equity)
Identify & Classify the Accounts1. Cash (asset)2. Contributed Capital (equity)
Determine the Direction of the Effect1. Cash increases.2. Contributed Capital increases.
Determine the Direction of the Effect1. Cash increases.2. Contributed Capital increases.
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Papa John’s issues $1,300 of additional common stock to new investors for cash.
Assets = Liabilities + Stockholders' EquityCash Investments Equip. Notes Rec. Notes Pay. Contributed Capital
(a) 1,300 1,300
Effect =1,300 1,300
A = L + SEA = L + SE
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Identify & Classify the AccountsIdentify & Classify the Accounts
Determine the Direction of the EffectDetermine the Direction of the Effect
The company borrows $1,000 from the local bank, signing a one-year note.
Identify & Classify the Accounts1. Cash (asset)2. Notes Payable (liability)
Identify & Classify the Accounts1. Cash (asset)2. Notes Payable (liability)
Determine the Direction of the Effect1. Cash increases.2. Notes Payable increases.
Determine the Direction of the Effect1. Cash increases.2. Notes Payable increases.
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Assets = Liabilities + Stockholders' EquityCash Investments Equip. Notes Rec. Notes Pay. Contributed Capital
(a) 1,300 1,300 (b) 1,000 1,000
Effect =2,300 2,300
A = L + SEA = L + SE
The company borrows $1,000 from the local bank, signing a one-year note.
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Determine the Direction of the EffectDetermine the Direction of the Effect
Identify & Classify the AccountsIdentify & Classify the Accounts
Papa John’s purchases $5,700 of new equipment, paying $1,500 in cash and the rest on a note
payable.
Identify & Classify the Accounts1. Equipment (asset)2. Cash (asset)3. Notes Payable (liability)
Identify & Classify the Accounts1. Equipment (asset)2. Cash (asset)3. Notes Payable (liability)
Determine the Direction of the Effect1. Equipment increases.2. Cash decreases.3. Notes Payable increases.
Determine the Direction of the Effect1. Equipment increases.2. Cash decreases.3. Notes Payable increases.
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Assets = Liabilities + Stockholders' EquityCash Investments Equip. Notes Rec. Notes Pay. Contributed Capital
(a) 1,300 1,300 (b) 1,000 1,000 (c) (1,500) 5,700 4,200
Effect =6,500 6,500
A = L + SEA = L + SE
Papa John’s purchases $5,700 of new equipment, paying $1,500 in cash and the rest on a note
payable.
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Identify & Classify the AccountsIdentify & Classify the Accounts
Determine the Direction of the EffectDetermine the Direction of the Effect
Papa John’s lends $450 to new franchises who sign notes.
Identify & Classify the Accounts1. Cash (asset)2. Notes Receivable (asset)
Identify & Classify the Accounts1. Cash (asset)2. Notes Receivable (asset)
Determine the Direction of the Effect1. Cash decreases.2. Notes Receivable increases.
Determine the Direction of the Effect1. Cash decreases.2. Notes Receivable increases.
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Assets = Liabilities + Stockholders' EquityCash Investments Equip. Notes Rec. Notes Pay. Contributed Capital
(a) 1,300 1,300 (b) 1,000 1,000 (c) (1,500) 5,700 4,200 (d) (450) 450
Effect =6,500 6,500
A = L + SEA = L + SE
Papa John’s lends $450 to new franchises who sign notes.
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Identify & Classify the AccountsIdentify & Classify the Accounts
Determine the Direction of the EffectDetermine the Direction of the Effect
Papa John’s purchases $3,000 of stock in other companies as an investment.
Identify & Classify the Accounts1. Cash (asset)2. Investments (asset)
Identify & Classify the Accounts1. Cash (asset)2. Investments (asset)
Determine the Direction of the Effect1. Cash decreases.2. Investments increase.
Determine the Direction of the Effect1. Cash decreases.2. Investments increase.
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Assets = Liabilities + Stockholders' EquityCash Investments Equip. Notes Rec. Notes Pay. Contributed Capital
(a) 1,300 1,300 (b) 1,000 1,000 (c) (1,500) 5,700 4,200 (d) (450) 450 (e) (3,000) 3,000
Effect =6,500 6,500
A = L + SEA = L + SE
Papa John’s purchases $3,000 of stock in other companies as an investment.
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How Do Companies Keep Track of Account Balances?
Journal entries
T-accounts
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A TA T--account is a tool used to account is a tool used to represent an account.represent an account.
Account NameLeft Right
Direction of Transaction Effects
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Direction of Transaction Effects
The left side of the T-account is always the
debit side.
Account NameLeft Right
Debit
The right side of the T-account is always the
credit side.
Credit
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A = L + SEA = L + SE
The Debit-Credit Framework
ASSETSASSETS
Debit for
Increase
Credit for
Decrease
EQUITIESEQUITIES
Debit for
Decrease
Credit for
Increase
LIABILITIESLIABILITIES
Debit for
Decrease
Credit for
Increase
Debits and credits affect the Balance Sheet Model as follows:
Debits and credits affect the Balance Sheet Model as follows:
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A typical journal looks like this:
Analytical Tool: The Journal Entry
Page 1
Debit CreditDate Description
GENERAL JOURNAL
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Analytical Tool: The Journal Entry
A journal entry might look like this:
Page 1
Debit CreditJan. 1 Cash 20,000
Contributed Capital 20,000
Date Description
GENERAL JOURNAL
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Page 1
Debit CreditJan. 1 Cash 20,000
Contributed Capital 20,000
Date Description
GENERAL JOURNAL
Analytical Tool: The Journal Entry
Provide a referencedate for each transaction.
Debits are written first.
Credits are indented andwritten after debits.
Total debits must equaltotal credits.
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PostLedger
Analytical Tool: The T-Account
After journal entries are prepared, the accountant posts (transfers) the dollar amounts to each account that
was affected by the transaction.
Page 1
Debit CreditJan. 1 Cash 20,000
Contributed Capital 20,000
Date Description
GENERAL JOURNAL
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Transaction Analysis Illustrated
Let’s prepare some Let’s prepare some journal entries for journal entries for Papa John’s and Papa John’s and post them to the post them to the
ledger.ledger.
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Page 1
Debit CreditCash 1,300
Contributed Capital 1,300
Date Description
GENERAL JOURNAL
Papa John’s issues $1,300 of additional common stock to new investors for cash.
Beg. Bal. 34,000 (a) 1,300
35,300
Cash164,500 Beg. Bal.
1,300 (a)
165,800
Contributed Capital
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Page 1
Debit CreditCash 1,000
Notes Payable 1,000
Date Description
GENERAL JOURNAL
Beg. Bal. 34,000 (a) 1,300 (b) 1,000
36,300
Cash- Beg. Bal.
1,000 (b)
1,000
Notes Payable
The company borrows $1,000 from the local bank, signing a one-year note.
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Page 1
Debit CreditEquipment 5,700
Cash 1,500 Notes Payable 4,200
Date Description
GENERAL JOURNAL
Papa John’s purchases $5,700 of new equipment, paying $1,500 in cash and the rest on a note
payable.
Let’s see how to post this entry . . .
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Beg. Bal. 34,000 (a) 1,300 1,500 (c) (b) 1,000
34,800
Cash- Beg. Bal.
1,000 (b)4,200 (c)
5,200
Notes Payable
Papa John’s purchases $5,700 of new equipment, paying $1,500 in cash and the rest on a note
payable.
Beg. Bal. 169,200 (c) 5,700
174,900
Equipment
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Balance Sheet Preparation
It is possible to prepare a balance sheet at any point in time from the balances in the
accounts.
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AssetsCurrent assets: Cash and cash equivalents 31,250$ Accounts receivable 17,300 Inventories 9,700 Prepaid expenses 4,800 Other current assets 2,100 Total current assets 65,150 Investments 50,300 Net property and equipment 174,900 Notes receivable 12,450 Other assets 22,400 Total assets 325,200$
Liabilities and Stockholders' EquityCurrent liabilities: Accounts payable 18,100$ Accrued expenses payable 25,500 Total current liabilities 43,600$ Unearned franchise and development fees 6,600 Other long-term liabilities 11,200 Stockholders' equity:Contributed capital 165,800 Retained earnings 98,000 Total stockholders' equity 263,800 Total liabilities and stockholders' equity 325,200$
PAPA JOHN'S INTERNATIONAL, INC. AND SUBSIDIARIESConsolidated Balance Sheets
January 31, 1999(Dollars in thousands)
These balances come from Papa
John’s ledger accounts on
January 31, 1999.
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Some Misconceptions
An accountant is a trainedprofessional who can designinformation systems, analyze
complex transactions, andinterpret financial data.
Don’t confuse bookkeeping with accounting.Bookkeeping involves the routine, clerical
part of accounting and requires only minimal knowledge of accounting, but . . .
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Some Misconceptions
Almost allaccounting
numbersare influencedby estimates.
NO!
Are all transactions subject toprecise and objective measurement?
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Some Misconceptions
Some people believe that financial statements report the market value of the company.
Financial statementsreally report the cost of assets,
liabilities andstockholders’ equity.
Financial statementsreally report the cost of assets,
liabilities andstockholders’ equity.
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End of Chapter 2