Slide 1

Chapter 2: Investing and Financing Decisions

and the Balance Sheet (2017.10.17)

Slide 2

Learning Objectives

1. The Conceptual Framework of Accounting

2. Identify what constitutes a business transaction and

identify common balance sheet account titles used in

business.

3. Apply transaction analysis to simple business transactions

in terms of the accounting model Assets = Liabilities +

Stockholders' Equity.

4. Determine the impact of business transactions on the

balance sheet using two basic tools, journal entries and T-

accounts.

Slide 3Slide 3

The Conceptual Framework

Qualitative Characteristics

Relevancy

Reliability

Comparability

Consistency

Elements of Statements

Asset

Liability

Stockholders’ Equity

Revenue

Expense

Gain

Loss

Objective of Financial Reporting

To provide useful economic information to external users for

decision making and for assessing future cash flows.

Slide 4Slide 4

Elements of Statements

Asset

Liability

Stockholders’ Equity

Revenue

Expense

Gain

Loss

The Conceptual Framework

Qualitative Characteristics

Relevancy

Reliability

Comparability

Consistency

Objective of Financial Reporting

To 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,

and neutrality.

Secondary Characteristics

•Comparability: across

companies.

•Consistency: over time.

Slide 5Slide 5

Qualitative Characteristics

Relevancy

Reliability

Comparable

Consistent

The Conceptual Framework

Elements of Statements

Asset

Liability

Stockholders’ Equity

Revenue

Expense

Gain

Loss

Objective of Financial Reporting

To provide useful economic information to external users for

decision making and for assessing future cash flows.

Asset: economic resource with

probable future benefits.

Liability: probable future sacrifices of

economic resources.

Stockholders’ Equity: financing

provided by owners and operations.

Revenue: increase in assets or

settlement of liabilities from ongoing

operations.

Expense: decrease in assets or

increase in liabilities from ongoing

operations.

Gain: increase in assets or settlement

of liabilities from peripheral

activities.

Loss: decrease in assets or

increase in liabilities from peripheral

activities.

Slide 6Slide 6

The Conceptual Framework

Assumptions

1. Separate entity: Activities of the business are separate from activities

of owners.

2. Continuity: The entity will not go out of business in the near future.

3. Unit-of-measure: Accounting measurements will be in the national

monetary unit (i.e., $ in the U.S.).

4. Periodicity (Time period): The long life of a company can be

reported over a series of shorter time periods.

Slide 7Slide 7

Understanding the Business

To understand amounts appearing

on a company’s 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?

Slide 8Slide 8

Papa John’s Balance Sheet

Slide 9Slide 9

Nature of Business Transactions

External events: exchanges of assets

and liabilities between the business

and one or more other parties.

Borrow cash

from the bank

Slide 10Slide 10

Nature of Business Transactions

Internal events: not an exchange between

the business and other parties, but have

a direct effect on the accounting entity.

Loss due to

fire damage.

Slide 11Slide 11

Accounts

Cash

Equipment

Inventory

Notes Payable

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

transactions.

Slide 12Slide 12

Typical Account Titles

Slide 13Slide 13

Principles of Transaction Analysis

Every transaction (both internal and external) affects at least two

accounts (duality of effects).

Most transactions with external parties involve an exchange

where the business entity gives up something but receives something

else in return

The accounting equation must remain in balance after each

transaction.

A = L + SE(Assets) (Liabilities) (Stockholders’

Equity)

Slide 14

Analyzing Transactions

Step 1: Accounts and effects

Identify the accounts affected

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.

Slide 15Slide 15

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.

Analyzing Transactions

Slide 16Slide 16

A = L + SE

Cash Investments Equip.

Notes

Receivable

Notes

Payable

Contributed

Capital

Retained

Earnings

(a) 2,000 2,000

Effect =2,000 2,000

Analyzing Transactions

Papa John’s issues $2,000 of additional common

stock to new investors for cash.

Slide 17Slide 17

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.

Analyzing Transactions

Slide 18Slide 18

A = L + SE

Cash Investments Equip.

Notes

Receivable

Notes

Payable

Contributed

Capital

Retained

Earnings

(a) 2,000 2,000

(b) 6,000 6,000

Effect =8,000 8,000

Analyzing Transactions

The company borrows $6,000 from the local

bank, signing a three-year note.

Slide 19Slide 19

Papa John’s purchases $10,000 of new equipment, paying $2,000 in

cash and signing a two-year note payable for the rest.

Identify & Classify the Accounts

1. Equipment (asset).

2. Cash (asset).

3. Notes Payable (liability).

Determine the Direction of the Effect

1. Equipment increases.

2. Cash decreases.

3. Notes Payable increases.

Analyzing Transactions

Slide 20Slide 20

A = L + SE

Cash Investments Equip.

Notes

Receivable

Notes

Payable

Contributed

Capital

Retained

Earnings

(a) 2,000 2,000

(b) 6,000 6,000

(c) (2,000) 10,000 8,000

Effect =16,000 16,000

Analyzing Transactions

Papa John’s purchases $10,000 of new equipment, paying $2,000 in

cash and signing a two-year note payable for the rest.

Slide 21

Papa John’s board of directors declares and

pays $3,000 in dividends to shareholders.

Analyzing Transactions

Identify & Classify the Accounts

1. Cash (asset).

2. Retained Earnings (equity).

Determine the Direction of the Effect

1. Cash decreases.

2. Retained Earnings decreases.

Slide 22Slide 22

A = L + SE

Cash Investments Equip.

Notes

Receivable

Notes

Payable

Contributed

Capital

Retained

Earnings

(a) 2,000 2,000

(b) 6,000 6,000

(c) (2,000) 10,000 8,000

(d) (3,000) 3,000

(e) (1,000) 1,000

(f) (3,000) (3,000)

Effect =13,000 13,000

Papa John’s board of directors declares and

pays $3,000 in dividends to shareholders.

Analyzing Transactions

Slide 23Slide 23

The Accounting Cycle

Slide 24Slide 24

How Do Companies Keep Track of Account

Balances?

Journal entries

T-accounts

Slide 25Slide 25

T-account: a tool used to represent an account

The left side of the

T-account is always the debit

side.

The right side of the

T-account is always the credit

side.

Account Name

Left RightDebit Credit

Slide 26Slide 26

A = L + SE

Transaction Analysis Model

ASSETS

Debit

for

Increase

Credit

for

Decrease

EQUITIES

Debit

for

Decrease

Credit

for

Increase

LIABILITIES

Debit

for

Decrease

Credit

for

Increase

Debits and credits affect the Balance Sheet

Model as follows:

Slide 27Slide 27

The Debit-Credit Framework

Assets

+ DR - CR

Normal

Balance

Liabilities

- DR + CR

Normal

Balance

Shareholders’

Equity

- DR + CR

Normal

Balance

Retained Earnings

- DR + CR

Normal

Balance

Contributed Capital

- DR + CR

Normal

Balance

Revenues

- DR + CR

Normal

Balance

Expenses

+ DR - CR

Normal

Balance

Slide 28Slide 28

The Debit-Credit Framework

Debit Credit

Increase Assets

Expenses

Liabilities

Stockholders’ Equity

Revenue

Decrease Liabilities

Stockholders’ Equity

Revenue

Assets

Expenses

Slide 29Slide 29

Analytical Tool: The Journal Entry

A journal entry might look like this:

Debit Credit

(c) Property and Equipment (+A) 10,000

Cash (-A) 2,000

Notes Payable (+L) 8,000

Reference:

Letter,

number, or

date.

Account Titles:

Debited accounts on top.

Credited accounts on bottom.

Amounts:

Debited amounts on left.

Credited amounts on right.

Slide 30

PostLedger

The T-Account

After journal entries are prepared, the

accountant posts (transfers) the dollar

amounts to each account affected by the

transaction.

Debit Credit

(c) Property and Equipment (+A) 10,000

Cash (-A) 2,000

Notes Payable (+L) 8,000

Slide 31Slide 31

Beg. Bal. 6,000

(a) 2,000

8,000

Cash

1,000 Beg. Bal.

2,000 (a)

3,000

Contributed Capital

Posted

Ref. Debit Credit

Cash 2,000

Contributed Capital 2,000

Date Account Titles and Explanation

GENERAL JOURNAL

(a)

Papa John’s issues $2,000 of additional

common stock to new investors for cash.

Slide 32Slide 32

146,000 Beg. Bal.

6,000 (b)

152,000

Notes Payable

Beg. Bal. 6,000

(a) 2,000

(b) 6,000

14,000

Cash

Debit Credit

(b) Cash 6,000

Notes Payable 6,000

The company borrows $6,000 from the local

bank, signing a three-year note.

Slide 33Slide 33

Classified Balance Sheet

In a classified balance sheet assets and liabilities

are classified into two categories – current and

noncurrent.

Current assets are those to be used or turned into

cash within the upcoming year, whereas noncurrent assets are those that will last longer than one year.

Current liabilities are those obligations to be paid or

settled within the next 12 months with current

assets.

Slide 34

Slide 35Slide 35

Key Ratio Analysis

Current

RatioCurrent Assets

Current Liabilities=

Current ratio for Papa John’s:

The current ratio for Papa John’s shows a low level

of liquidity, below 1.

2006 = 0.83

2007 = 0.68

2008 = 0.75

Slide 36Slide 36

Focus on Cash Flows

Operating activities

(Covered in the next chapter.)

Investing Activities

Purchasing long-term assets and investments for cash –

Selling long-term assets and investments for cash +

Lending cash to others –

Receiving principal payments on loans made to others +

Financing Activities

Borrowing cash from banks +

Repaying the principal on borrowings from banks –

Issuing stock for cash +

Repurchasing stock with cash –

Paying cash dividends –

Slide 37Slide 37

Investing and Financing Activities

Slide 38

External Financing Can Be Costly to You!

Source: Reuters News

Slide 39

What happens to the stock price?

Why?

Slide 40

Average Annual Stock Returns for Firms with

High and Low External Financing

-1.34%

-14.85%

7.66%

22.51%

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Hang Seng Index High EXF Low EXF Low-High

Period: Jan 2001-Dec 2008

Sample: Largest 400 firms on Hong Kong Stock Exchange

Slide 41

Review and practice questions

In class review problems:

E2-18; P2-3, 4

Practice problems after class

E2-5, 8, 9, 15; P2-1,2,5; AP2-2

Prepare for the next class

Quiz I: in class，June11[next Monday]

Read Chapter 3

Try the following problems: E3-2; P3-4,5.

Slide 42

P2-3 Juarez Plasticos Company has been operating for three years. At

December 31, 2013, the accounting records reflected the following:

Cash $38,000 Intangibles $6,000

Investments (short-term) 4,000 Accounts payable 30,000

Accounts receivable 6,000 Accrued liabilities payable 4,000

Inventory 48,000 Notes payable (short-term) 14,000

Notes receivable (long-term) 2,000 Long-term notes payable 92,000

Equipment 96,000 Contributed capital180,00

0

Factory building 180,000 Retained earnings 60,000

During the year 2014, the company had the following summarized activities:

a. Purchased short-term investments for $18,000 cash.

b. Lent $14,000 to a supplier who signed a two-year note.

c. Purchased equipment that cost $36,000; paid $12,000 cash and signed a one-year

note for the balance.

d. Hired a new president at the end of the year. The contract was for $170,000 per year

plus options to purchase company stock at a set price based on company performance.

e. Issued an additional 2,000 shares of capital stock for $24,000 cash.

f. Borrowed $24,000 cash from a local bank, payable in three months.

g. Purchased a patent (an intangible asset) for $6,000 cash.

h. Built an addition to the factory for $50,000; paid $18,000 in cash and signed a three-

year note for the balance.

i. Returned defective equipment to the manufacturer, receiving a cash refund of $2,000.

Slide 43

Required:

Create T-accounts for each of the accounts on the balance

sheet and enter the balances at the end of 2013 as beginning

balances for 2014.

Record each of the events for 2014 in T-accounts (including

referencing) and determine the ending balances.

Explain your response to event (d).

Prepare a classified balance sheet at December 31, 2014.

Compute the financial current ratio for 2014. What does this

suggest about Juarez Plasticos?

Slide 44

Slide 45

Slide 46

Slide 47

P2-4 Identifying Effects of Transactions on the

Statement of Cash Flows (AP2-4)

Refer to P2-3.

Required:

Using the events (a) through (i) in P2-3, indicate whether

each is an investing (I) of financing (F) activity for the year

and the direction of the effect on cash flows (+ for increase

and – for decrease). If there is no effect on cash flows, write

NE.

Slide 48

During the year 2014, the company had the following summarized activities:

a. Purchased short-term investments for $18,000 cash.

b. Lent $14,000 to a supplier who signed a two-year note.

c. Purchased equipment that cost $36,000; paid $12,000 cash and signed a one-

year note for the balance.

d. Hired a new president at the end of the year. The contract was for $170,000

per year plus options to purchase company stock at a set price based on

company performance.

e. Issued an additional 2,000 shares of capital stock for $24,000 cash.

f. Borrowed $24,000 cash from a local bank, payable in three months.

g. Purchased a patent (an intangible asset) for $6,000 cash.

h. Built an addition to the factory for $50,000; paid $18,000 in cash and signed

a three-year note for the balance.

i. Returned defective equipment to the manufacturer, receiving a cash refund

of $2,000.

Slide 49

Slide 50

E2-18

Foot Locker, Inc., is a large global retailer of athletic footwear and apparel

selling directly to customers and through the Internet. It includes the Foot

Locker family of stores, Champs Sports, and Eastbay. The following are

several of Foot Locker’s investing and financing activities as reflected in a

recent annual statement of cash flows.

Reduction of long-term debt.

Sale of short-term investments.

Issuance of common stock.

Capital expenditures (for property, plant, and equipment).

Dividends paid on common stock.

Required:

For each of these, indicate whether the activity is investing (I) or financing

(F) and the direction of the effect on cash flows (+ for increases cash; - for

decreases cash).

Slide 51

E2-18

Activity Type of Activity

Effect on Cash

(a) Reduction of long-term debt F

(b) Sale of short-term investments I +

(c) Issuance of common stock F +

(d) Capital expenditures (for property, plant, and equipment) I

(e) Dividends paid on common stock. F