The document discusses key concepts related to analyzing business transactions and their impact on a company's balance sheet. It introduces the balance sheet framework of assets equaling liabilities plus stockholders' equity. Several examples are provided of journal entries for common business transactions and their posting to T-accounts to illustrate how the accounting equation remains balanced. The objectives are to understand how specific business activities affect balance sheet accounts and how companies track changes through journal entries and T-accounts.

1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Investing and
Financing
Decisions and
the Balance Sheet
Chapter 2

2. 2-2
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?

3. 2-3
Learning Objectives
Define the objective of financial reporting, the
elements of the balance sheet, and the related
key accounting assumptions and principles.

4. 2-4
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.

5. 2-5
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.

6. 2-6
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 benefit.
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.

7. 2-7
The Conceptual Framework
Assumptions
Separate entity: Activities of the business are
separate from activities of owners.
Continuity: The entity will not go out of
business in the near future.
Unit-of-measure: Accounting measurements
will be in the national monetary unit ($).
Principle
Historical cost: Cash equivalent cost given up
is the basis for initial recording of
elements.

8. 2-8
Learning Objectives
Identify what constitutes a business
transaction and recognize common balance
sheet account titles used in business.

9. 2-9
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

10. 2-10
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.

11. 2-11
Accounts
Cash
Equipment
Inventory
Notes
Payable
An organized format used by companies to
accumulate the dollar effects of
transactions.

12. 2-12
Typical Account Titles
Assets
Cash
Short-Term Investment
Accounts Receivable
Notes Receivable
Inventory (to be sold)
Supplies
Prepaid Expenses
Long-Term Investments
Equipment
Buildings
Land
Intangibles
Liabilities
Accounts Payable
Accrued Expenses
Notes Payable
Taxes Payable
Unearned Revenue
Bonds Payable
Stockholders’ Equity
Contributed Capital
Retained Earnings
The Balance Sheet

13. 2-13
Typical Account Titles
Revenues
Sales Revenue
Fee Revenue
Interest Revenue
Rent Revenue
Expenses
Cost of Goods Sold
Wages Expense
Rent Expense
Interest Expense
Depreciation Expense
Advertising Expense
Insurance Expense
Repair Expense
Income Tax Expense
The Income Statement

14. 2-14
International Perspective
While U.S. companies follow
GAAP to prepare their
financial statements, other
countries have significant
variations from the
accounting and reporting
rules of GAAP.
Some countries use different
account titles than those used
by U.S. companies.

15. 2-15
Learning Objectives
Apply transaction analysis to simple business
transactions in terms of the accounting model:
Assets = Liabilities + Stockholders’ Equity

16. 2-16
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) (Liabilities) (Stockholders’
Equity)

17. 2-17
Duality of Effects
Most transactions
with external parties
involve an
exchange where the
business entity
gives up something
but receives
something in return.

18. 2-18
Balancing the Accounting Equation
 Accounts and effects
 Identify the accounts affected and classify them by
type of account (A, L, SE).
 Determine the direction of the effect (increase or
decrease) on each account.
 Balancing
 Verify that the accounting equation (A = L + SE)
remains in balance.

19. 2-19
Balancing the Accounting Equation
Let’s see how we keep the
accounting equation in
balance for Papa John’s.
All amounts we use are expressed in
thousands of dollars.

20. 2-20
Identify & Classify the Accounts
Determine the Direction of the Effect
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.

21. 2-21
Papa John’s issues $2,000 of additional
common stock to new investors for cash.
A = L + SE
Cash Investments Equip.
Notes
Receivable
Notes
Payable
Contributed
Capital
Retained
Earnings
(a) 2,000 2,000
Effect =
2,000 2,000

22. 2-22
Identify & Classify the Accounts
Determine the Direction of the Effect
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.

23. 2-23
A = L + SE
The company borrows $6,000 from the local
bank, signing a three-year note.
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

24. 2-24
Determine the Direction of the Effect
Identify & Classify the Accounts
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.

25. 2-25
A = L + SE
Papa John’s purchases $10,000 of new equipment,
paying $2,000 in cash and signing a two-year note
payable for the rest.
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

26. 2-26
Identify & Classify the Accounts
Determine the Direction of the Effect
Papa John’s lends $3,000 to new
franchisees who sign five-year notes
agreeing to repay the loan.
Identify & Classify the Accounts
1. Cash (asset).
2. Notes Receivable (asset).
Determine the Direction of the Effect
1. Cash decreases.
2. Notes Receivable increases.

27. 2-27
A = L + SE
Papa John’s lends $3,000 to new
franchisees who sign five-year notes
agreeing to repay the loan.
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
Effect =
16,000 16,000

28. 2-28
Identify & Classify the Accounts
Determine the Direction of the Effect
Papa John’s purchases $1,000 of stock in
other companies as an investment.
Identify & Classify the Accounts
1. Cash (asset).
2. Investments (asset).
Determine the Direction of the Effect
1. Cash decreases.
2. Investments increase.

29. 2-29
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
Effect =
16,000 16,000
Papa John’s purchases $1,000 of stock in
other companies as an investment.

30. 2-30
Identify & Classify the Accounts
Determine the Direction of the Effect
Papa John’s board of directors declares and
pays $3,000 in dividends to shareholders.
Identify & Classify the Accounts
1. Cash (asset).
2. Retained Earnings (equity).
Determine the Direction of the Effect
1. Cash decreases.
2. Retained Earnings decreases.

31. 2-31
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.

32. 2-32
Learning Objectives
Determine the impact of using two basic tools,
journal entries and T-accounts.

33. 2-33
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.
Prepare a complete
set of financial statements.
Disseminate statements
to users.
Close revenues, gains,
expenses and losses
to retained earnings.

34. 2-34
How Do Companies Keep Track of Account
Balances?
Journal entries
T-accounts

35. 2-35
A T-account is a tool used to represent an
account.
Account Name
Left Right
Direction of Transaction Effects

36. 2-36
Direction of Transaction Effects
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 Right
Debit Credit

37. 2-37
A = L + SE
The Debit-Credit Framework
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:

38. 2-38
A = L + SE
The Debit-Credit Framework
ASSETS
Debit
for
Increase
Credit
for
Decrease
EQUITIES
Debit
for
Decrease
Credit
for
Increase
LIABILITIES
Debit
for
Decrease
Credit
for
Increase
Remember that Stockholders’ Equity includes Contributed
Capital and Retained Earnings.

39. 2-39
A typical journal looks like this:
Analytical Tool: The Journal Entry
Posted
Ref. Debit Credit
Date Account Titles and Explanation
GENERAL JOURNAL

40. 2-40
Analytical Tool: The Journal Entry
A journal entry might look like this:
Posted
Ref. Debit Credit
Jan. 1 Cash 20,000
Contributed Capital 20,000
Date Account Titles and Explanation
GENERAL JOURNAL

41. 2-41
Posted
Ref. Debit Credit
Jan. 1 Cash 20,000
Contributed Capital 20,000
Date Account Titles and Explanation
GENERAL JOURNAL
Analytical Tool: The Journal Entry
Provide a reference
date for each transaction.
Debits are written first.
Credits are indented and
written after debits.
Total debits must equal
total credits.

42. 2-42
Post
Ledger
Analytical Tool: The T-Account
After journal entries are prepared, the
accountant posts (transfers) the dollar
amounts to each account affected by the
transaction.
Posted
Ref. Debit Credit
Jan. 1 Cash 20,000
Contributed Capital 20,000
Date Account Titles and Explanation
GENERAL JOURNAL

43. 2-43
Transaction Analysis Illustrated
Let’s prepare some
journal entries for
Papa John’s and
post them to the
ledger.

44. 2-44
Papa John’s issues $2,000 of additional
common stock to new investors for cash.
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)

45. 2-45
146,000 Beg. Bal.
6,000 (b)
152,000
Notes Payable
The company borrows $6,000 from the local
bank, signing a one-year note.
Beg. Bal. 6,000
(a) 2,000
(b) 6,000
14,000
Cash
Posted
Ref. Debit Credit
Cash 6,000
Notes Payable 6,000
Date Account Titles and Explanation
GENERAL JOURNAL
(b)

46. 2-46
Let’s see how to post this entry . . .
Papa John’s purchases $10,000 of new equipment,
paying $2,000 in cash and signing a two-year note
payable for the rest.
Posted
Ref. Debit Credit
Equipment 10,000
Cash 2,000
Notes Payable 8,000
Date Account Titles and Explanation
GENERAL JOURNAL
(c)

47. 2-47
Beg. Bal. 246,000
(c) 10,000
256,000
Equipment
146,000 Beg. Bal.
6,000 (b)
8,000 (c)
160,000
Notes Payable
Beg. Bal. 6,000
(a) 2,000 2,000 (c)
(b) 6,000
12,000
Cash
Papa John’s purchases $10,000 of new equipment,
paying $2,000 in cash and signing a two-year note
payable for the rest.

48. 2-48
Balance Sheet Preparation
It is possible to prepare a
balance sheet at any
point in time from the
balances in the
accounts.

49. 2-49
This is the asset section of Papa John’s
balance sheet.
January 31, December 28,
2004 2003
ASSETS
Current assets
Cash 9,000
$ 7,000
$
Accounts receivable 20,000 20,000
Supplies 17,000 17,000
Prepaid expenses 11,000 11,000
Other current assets 7,000 7,000
Total current assets 64,000 62,000
Long-term investments 9,000 8,000
Property, and equipment (net of
accumulated depreciation of $149,000) 214,000 204,000
Long-term notes receivable 14,000 11,000
Intangibles 49,000 49,000
Other assets 13,000 13,000
Total assets 363,000
$ 347,000
$
Papa John's International, Inc. and Subsidiaries
Consolidated Balance Sheet
(dollars in thousands)

50. 2-50
This is the liability and stockholders’ equity
section of Papa John’s balance sheet.
January 31, December 28,
2004 2003
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable 28,000
$ 28,000
$
Dividends payable 3,000 -
Accrued expenses payable 53,000 53,000
Total current liabilities 84,000 81,000
Unearned franchise fees 6,000 6,000
Long-term notes payable 75,000 61,000
Other long-term liabilities 40,000 40,000
Total liabilities 205,000 188,000
Stockholders' equity
Contributed capital 3,000 1,000
Retained earnings 155,000 158,000
Total stockholders' equity 158,000 159,000
Total liabilities and stockholders' equity 363,000
$ 347,000
$
Papa John's International, Inc. and Subsidiaries
Consolidated Balance Sheet
(dollars in thousands)

51. 2-51
Learning Objectives
Prepare and analyze a simple balance sheet
using the financial leverage ratio.

52. 2-52
Change in Balance Sheet Amounts
Stockholders'
Assets = Liabilities + Equtiy
End of January 2004 363,000
$ 205,000
$ 158,000
$
End of 2003 347,000 188,000 159,000
Change 16,000.00
$ 17,000.00
$ (1,000.00)
$

53. 2-53
Key Ratio Analysis
Financial
Leverage
Ratio
Average Total Assets
Average Stockholders’ Equity
=
(Beginning Balance + Ending Balance) ÷ 2
The 2004 financial leverage ratio for Papa John’s was:
($363,000 + $347,000) ÷ 2
($158,000 + $159,000) ÷ 2
= 2.24
The ratio tells us how well management is using debt to
increase assets the company employs to earn income.

54. 2-54
Learning Objectives
Identify investing and financing transactions
and demonstrate how they are reported
on the statement of cash flows.

55. 2-55
Statement of 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 –

56. 2-56
Statement of Cash Flows
Operating activities
(None in this chapter.)
Investing Activities
Purchased property and equipment (2,000)
$
Purchased investments (1,000)
Lent funds to franchisees (3,000)
Net cash used in investing activities (6,000)
Financing Activities
Issued common stock 2,000
Borrowed from banks 6,000
Net cash provided by financing activities 8,000
Net increase in cash 2,000
Cash at beginning of month 7,000
Cash at end of month 9,000
$
Papa John's International, Inc.
Consolidated Statement of Cash Flows
For the Month Ended January 31, 2004
(in thousands)

57. 2-57
End of Chapter 2