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Chapter 2 Investing and Financing Decisions and the Accounting System

Slide 2: Financial Reporting Objectives


The primary objective of financial reporting is to provide information that is useful to external parties making
credit and investment decisions. Credit decisions involve lending financial resources or extending credit in sales
transactions. Investing decisions involve purchasing stock to obtain an ownership interest in an enterprise.
Users of financial statements and financial information are assumed to have a reasonable understanding of
accounting concepts and practices and financial matters which is the reason for a class like this to be included in
graduate business programs.
Financial information is used to predict a companys future results (predictive value) and to compare actual
performance to expectations (feedback value).
Slide 3: Accounting Assumptions and Principles
Financial accounting practices have several underlying assumptions and principles.
The SeparateEntity Assumption states that business transactions are to be accounted for separately from the
transactions of owners. As an example, assets owned by a shareholder are not reported on a corporations
balance sheet. This is also referred to as the EconomicEntity Assumption.
Slide 4: Accounting Assumptions and Principles (continued)
The UnitofMeasure assumption states that accounting information will be measured and accounted for in the
national monetary unit. In the United States, the dollar is the required unitofmeasure. The unit of measure is
assumed to be stable. In reality this is an invalid assumption as the value of currencies fluctuate all of the time.
From a practical standpoint it would be very cumbersome for accountants to continually restate financial
statement amounts to reflect changes in the value of the monetary unit. More importantly, it would be very
difficult for financial statements users to utilize information that is not comparable from one period to another.
The UnitofMeasure Assumption is also referred to as the MonetaryUnit Assumption.
Slide 5: Accounting Assumptions and Principles (continued)
Financial statements are prepared on the assumption that the business is a going concern, meaning it will
continue in operation for the foreseeable future and will be able to realize assets and discharge liabilities in the
normal course of operations. Different bases of measurement may be appropriate when the entity is not
expected to continue in operation for the foreseeable future. Where a company is not a going concern, the
breakup basis is used where all assets and liabilities are stated at Net Realizable Value.
Slide 6: Elements of the Balance Sheet
As stated in chapter 1, the balance sheet reports a companys resources (assets) and claims to those resources
(liabilities and owners equity). Assets are probable future economic benefits, owned or controlled by an entity
as a result of past transactions or events. The definition of an asset includes the phrase controlled by to
include the reporting of assets that not owned outright but instead are controlled through lease agreements or
stock ownership. We will cover these types of circumstances in a future chapter.
Assets are recorded at historical cost which is the amount of cash paid when the asset was acquired plus the
dollar value of any noncash consideration given in the transaction. An example of a noncash component of a
transaction would be the value of an old asset tradedin when a new asset was acquired.
Assets are reported in the order of liquidity; the sooner an asset is expected to convert to cash or be consumed
the earlier it is reported

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Slide 7: Elements of the Balance Sheet (continued)


Current assets are expected to be converted to cash or consumed in the next year or operating cycle whichever
is longer. The operating cycle refers to the amount of time it takes a company to spend cash to acquire
inventory, sell the inventory and collect cash from its customers. Current assets are reported in the order of
liquidity and are highlighted in a classified balance sheet.
Typical current assets are:
1. Cash and cash equivalents are coin and currency on hand as well as amounts held in nonrestricted bank
accounts
2. Accounts receivable represents amounts due from customers for credit sales. Accounts receivable are
adjusted for the amount that a company estimates it will not be able to collect.
3. Inventory represents the cost of products or goods that are held and available for resale.
4. Prepaid expenses represent costs incurred to pay for services (rent, insurance, advertising) in advance of
receiving them
5. Supplies are consumables such as paper, toner cartridges, pens, etc that a company has on hand for use
as they are needed.
6. Shortterm investments are in marketable securities (stocks and bonds) that management intends to
hold for 90 days or less.
Slide 8: Elements of the Balance Sheet (continued)
Longterm assets are expected to be converted to cash or consumed beyond the next year or operating cycle
whichever is longer. Many internally developed soft assets such as knowledgeable employees and established
brand names are not reported on the balance sheet because their costs were expensed as they were created or
developed.
Typical longterm assets are:
1. Property, plant and equipment
2. Intangibles (patents, copyrights, trade names)
3. Investments in other companies stocks and bonds
Slide 9: Elements of the Balance Sheet (continued)
Liabilities are probable future economic sacrifices resulting from past transactions or events that will be settled
by transferring assets or providing services. Liabilities are normally reported in the order of when they come due
(maturity).
Slide 10: Elements of the Balance Sheet (continued)
Current liabilities are obligations that will be settled in the next year or operating cycle whichever is longer and
are reported in the order that they come due. A classified balance sheet separately identifies current assets and
current liabilities to make it easier to assess a firms liquidity.
Typical current liabilities are:

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1. Accounts payable are obligations to vendors from purchasing goods and services on credit
2. Wages payable are obligations to employees for compensation that has been earned since the last
payroll cycle
3. Unearned revenues are obligations to customers that have prepaid for products and services
4. Interest payable are amounts owed on interest bearing obligations
5. Warranty obligations represent the anticipated costs of repairing products covered by a warranty
6. Taxes payable are amounts owed to federal state and local taxing authorities
7. Current portion of longterm debt is the amount of longterm obligations that come due in the next year
Slide 11: Elements of the Balance Sheet (continued)
Longterm liabilities are obligations that will be settled beyond the next year or operating cycle whichever is
longer.
Many longterm liabilities are reported at their present value meaning that interest to be paid in the future on
such obligations is not included in the amounts presented on the balance sheet. Only the principle amount of an
obligation is reported. We will cover longterm liability valuation in greater detail in a future chapter.
Typical longterm liabilities are:
1. Bonds payable represent an obligation to repay a principal amount at a future date and pay interest. The
amount reported is the present value of these payments.
2. Deferred taxes reflect higher taxes due in the future because of differences in the timing of when
revenue and expenses are recognized for tax purposes versus GAAP.
3. Pension obligations represent the present value of future benefits employees have earned, net of assets
the company has set aside to pay the benefits.
4. Lease obligations are the present value of lease payments owed on leases that transfer significant rights
and obligations of ownership to the company. Leases will be covered in more detail in a future chapter.
5. Contingencies are obligations that the ultimate outcome is yet to be determined. Examples include
expected litigation settlements and environmental claims.
Slide 12: Elements of the Balance Sheet (continued)
Stockholders equity represents the portion of a firms assets financed by its owners (contributed capital) and its
business operations (retained earnings).
Owners invest in a business enterprise in the hope of earning a return (by receiving dividends and / or capital
gains from the value of their shares increasing) or to gain influence or control over its operations.
Slide 13: Business Transactions
A transaction is any event that affects the financial position of a business that can be reliably recorded in
monetary terms.
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Transactions result from:


1. External events an exchange of assets or services for assets, services or promises to pay
between the business and an outside party
2. Internal events typically relate to the use or consumption of an asset
Slide 14: Transaction Analysis
Transaction analysis is the process of determining the economic effect of an event on the business in terms of
the accounting equation elements. Transactions are recorded in an organizations accounts. An account is a
summary record of changes (increases and decreases) in a particular asset, liability or owners equity item (i.e.
cash, accounts payable, paidin capital). An account balance is the total of all entries made to the account to
date. At the end of the accounting period, account balances are used to prepare the companys financial
statements.
Slide 15: Chart of Accounts
Companies establish a chart of accounts to identify the accounts available for recording transactions. The chart
of accounts varies across companies as a function of the size, nature, and complexity of the organization.
Companies add additional accounts as their circumstances change. The chart of accounts is organized with
balance sheet accounts listed first (asset accounts, then liability accounts followed by owners equity accounts)
followed by the income statement accounts.
Slide 16: Managers & Transaction Analysis
Management decisions often result in transactions that affect the financial statements. These decisions fall into
three broad categories which correspond with the major sections of the statement of cash flows;
1. Financing Decisions relate to raising and servicing capital
2. Investing Decisions relate to the acquisition and disposal of tangible and intangible longterm
assets and longterm investments. Examples of tangible assets are plant and equipment,
intangibles include patents and trademarks.
3. Operating Decisions relate to producing and / or selling products and / or services to
customers
Accountants use transaction analysis to determine the proper way to record and report economic events.
Managers use transaction analysis to determine how their decisions will affect the financial statements.
Financing decision example the decision to issue stock to retire debt, which increases contributed capital and
decreases liabilities. This decision would reduce the firms degree of financial leverage (the extent to which debt
is used in its capital structure).
Investing decision example acquiring the stock of another company to gain influence over the entity reduces
current assets (cash) and increases longterm assets (investments). This decision would reduce the firms current
ratio (liquidity).
Operating decision example purchasing additional inventory on credit increases current assets (inventory) and
increases current liabilities (accounts payable). This decision reduces the firms liquidity (current ratio).
Managers use transaction analysis as a means of achieving desired results and avoiding unintended
consequences.

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Slide 17: Transaction Analysis (continued)


The basic accounting equation and two principles are the foundation of the transaction analysis model where:
Assets = Liabilities + Stockholders Equity
1. Every transaction affects at least two accounts. Correctly identifying the accounts and the direction of
the affect (increase of decrease) is critical to properly recording a transaction or determining its affect
on the financial statements.
2. The accounting equation must remain in balance (equilibrium) after each transaction is recorded.
Slide 18: Transaction Analysis (continued)
Assume that ABC, Inc. is formed and its owners contribute $50,000 to the company in exchange for stock. The
dual effect on the accounting equation is an increase of $50,000 in the asset account Cash and an increase of
$50,000 in the stockholders equity account Contributed Capital. Note that after the affects of the transaction
are determines, the accounting equation remains in equilibrium.
Slide 19: Transaction Analysis (continued)
Notice the effect of the transaction on the balance sheet of this newly formed company. It has $50,000 of assets
(cash) that was financed by its owners through a contribution of capital. We can see that the liabilities and
stockholders equity section explains how the company obtained the resources it reports in the asset section of
the balance sheet.
Slide 20: Transaction Analysis (continued)
The previous transaction was a financing activity. Now assume that ABC engages in an investing activity. A
$10,000 machine is purchased for cash of $2,000 and a loan of $8,000. An asset account Equipment is created
and increased by $10,000. The cash account is decreased by $2,000. Assets overall increased by $8,000. A
liability account Loan Payable is created and increased by $8,000. Notice that the accounting equation remains
in equilibrium after this transaction is recorded, with assets and liabilities plus Stockholders equity both
equaling $58,000.
Slide 21: Transaction Analysis (continued)
After two transactions, ABCs balance sheet indicates that the company has $58,000 of assets, of which $8,000
was financed by creditors and $50,000 was financed by owner contributions
Slide 22: Transaction Analysis (continued)
Now assume that ABC engages in an operating activity. The company purchases $20,000 of inventory for $5,000
cash and $15,000 to be paid in 30 days. An asset account Inventory is created and increased by $20,000. The
cash account is decreased by $5,000. Assets overall increased by $15,000. A liability account Accounts Payable
is created and increased by $15,000. Notice that the accounting equation remains in equilibrium after this
transaction is recorded, with assets and liabilities plus Stockholders equity both equaling $73,000.
Slide 23: Transaction Analysis (continued)
ABCs balance sheet now reports total assets of $73,000, of which $23,000 have been financed by creditors and
$50,000 have been financed by owners.
Up to this point, ABC has only engaged in transactions that have affected balance sheet accounts. After the
initial investment of $50,000 by its owners the company has increased its assets by increasing its obligations to
other parties (liabilities). To create wealth for its owners, ABC must engage in activities that result in earning
profits that can be paid out as dividends or reinvested to grow the company.

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Slide 24: The Father of Accounting


In 1494 an Italian monk, Fr. Luca Pacioli, developed the Method of Venice to reduce errors in
recording
transactions. Pacioli recognized that in recording increases and decreases to accounts it was common for the
accounting equation to end up out of equilibrium (not in balance). He devised a method that made it easier to
determine if equilibrium was maintained when individual transactions are recorded. Pacioli, referred to as the
Father of Accounting authored the first accounting textbook that was illustrated by none other than Leonardo
Da Vinci.
Slide 25: Debits and Credits
In Paciolis system each account has two columns in which to record the effects of transactions, one for
increases and one for decreases. The term debit refers to entries being made in the left side column. The term
credit refers to entries being made in the right side column. A T account is often used to represent the left
side and right side columns of an account.
Slide 26: Debits and Credits (continued)
Debits are used to increase accounts on the left side of the accounting equation (assets). Credits are used to
increase accounts on the right side of the accounting equation (liabilities and stockholders equity). Accounts are
decreased by doing the opposite; assets are credited, liabilities and equities are debited. When a transaction is
recorded two or more accounts are affected and debits and credits must be equal. By making sure debits and
credits are equal when each transaction is recorded, equilibrium of the accounting equation is assured.
Slide 27: Recording Transactions
At the start of our previous examples we assumed that ABC, Inc. was formed and its owners contributed
$50,000 to the company in exchange for stock. To record this transaction, the cash account is debited to
increase its balance by $50,000. The contributed capital account is credited to increase its balance by the same
amount. Notice that debits and credits are equal and the accounting equation is in equilibrium. Also notice how
using debits and credits makes this happen. In this entry we debited an asset account and credited an equity
account, both for the same amount. Because debits (left hand entries) increase accounts on the left side of the
equation and credits (right hand entries) increase accounts on the right side of the equation, the entry above
maintained equilibrium by simply having its debit and credit components equal in amount. They increased the
left side of the equation by the same amount the right side was increased.
Slide 28: Recording Transactions (continued)
In our second example, ABC purchased a machine for $10,000 (cash of $2,000 and a loan of $8,000). The
machine account is increased with a debit of $10,000. The cash account is decreased with a credit of $2,000.
Overall, assets are increased by a net (debit) amount of $8,000. On the right side of the accounting equation, the
loan payable account is increased with a credit of $8,000. Both sides of the equation have been increased by
$8,000. The cash account has a net debit balance of $48,000. Assets total $58,000, liabilities and equity total
$58,000. The accounting equation is in equilibrium. This was accomplished by simply making sure that debits
and credits were equal when the purchase was recorded. Debits totaled $8,000 and credits totaled $8,000.
Slide 29: Recording Transactions (continued)
In our third example, ABC purchased $20,000 of inventory for $5,000 cash and $15,000 to be paid in 30 days.
The inventory account is increased with a debit of $20,000. The cash account is decreased with a credit of
$5,000. Overall, assets are increased by a net (debit) amount of $15,000. On the right side of the accounting
equation, the accounts payable account is increased with a credit of $15,000. Both sides of the equation have
been increased by $15,000. The cash account has a net debit balance of $43,000. Assets total $73,000, liabilities
and equity total $73,000. The accounting equation is in equilibrium. This was accomplished by simply making
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sure that debits and credits were equal when the purchase of inventory was recorded. Debits totaled $15,000
and credits totaled $15,000.
Slide 30: Journal Entries
For demonstration purposes, the preceding examples showed the effects of transactions being recorded in T
accounts. In practice, accountants record the effects of transactions using journal entries. Journal entries are
recorded in chronological order in the General Journal as transactions occur.
A journal entry identifies the date on which the transaction occurred, the accounts affected and the amount of
debit or credit being recorded for each account. Debited accounts are listed first, then credited accounts.
Amounts are recorded in the appropriate column to indicate that the account is being debited or credited for
that particular line of the entry. Note that the names of credited accounts are indented (to the right) to
correspond with the right hand entries in the credit column for those line items. A description of the transaction
appears below the entry
Slide 31: Journal Entries (continued)
Recall that in the first transaction, ABC, Inc was formed and its owners contributed $50,000 cash in exchange for
shares of stock. The cash account is debited and the contributed capital account is credited, both for $50,000.
In the second transaction, ABC purchased a machine for $10,000. $2,000 was paid in cash and a loan of $8,000
was taken for the balance. To record the transaction, the machine account is debited for $10,000, the cash
account is credited for $2,000 and the loan payable account is credited for $8,000.
In the last transaction, ABC purchased inventory for $20,000. $5,000 was paid in cash and the balance was billed
on invoice that will be paid later. To record the transaction, the inventory account was debited for $20,000, the
cash account was credited for $5,000 and the accounts payable account was credited for $15,000.
Slide 32: General Ledger
Debits and credits recorded to specific accounts in the general journal are transferred to the general ledger. The
general ledger is a permanent record of all the accounts used in the accounting system. The general ledger is
organized by account with balance sheet accounts listed first followed by the income statement accounts.
We can see that each of the three journal entries affected the cash account. After debits and credits are posted
from the general journal to the general ledger cash account it is has an ending balance of $43,000. The inventory
and machine accounts were affected by one transaction each. Debits to the accounts were posted from the
general journal accordingly.
Slide 33: General Ledger (continued)
Credits to the accounts payable, loan payable and the contributed capital accounts are posted from the general
journal entries to the general ledger in their respective accounts. To reiterate, the purpose of the general journal
is to record transactions in chronological order and provide a transcript if you will of the economic events that
occurred during the period. The general ledger is the permanent record of every account in the accounting
system. For each account we can examine how it has been affected by transactions and what its current balance
is. Account balances from the general ledger are used at the end of the accounting period to prepare financial
statements.

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Slide 34: The Accounting Cycle


The accounting cycle is performed during each period for which financial statements will be produced. During
the period transactions are analyzed and recorded in the general journal. Debits and credits from the general
journal are posted to the general ledger.
At the end of the period, adjustments are made to revenues and expenses and related balance sheet accounts.
A complete set of financial statements are prepared and disseminated to interested parties. Income statement
account balances are then closed to the retained earnings account making the system ready for the next period.
Slide 35: Preparing the Balance Sheet
As indicated in the previous slide, adjustments to account balances are necessary to prepare accurate financial
statements (adjusting entries will be covered next week). Lets assume that there are no adjustments needed to
prepare ABCs balance sheet. Balances from the general ledger are used to prepare a trial balance. The trial
balance summarizes the account balances from the general ledger making it easier to prepare financial
statements. The trial balance also verifies the equality of debits and credits. In this example, debits and credits
are equal, therefore the accounting equation is in equilibrium. To prepare a classified balance sheet, information
from the trial balance is organized in the proper format.
Slide 36: Analyzing the Balance Sheet
Current Ratio
ABCs current ratio is 4.2 to 1, well above the general target of 2 to 1. While ABC is well positioned to meet its
near term obligations, bigger is not always better when it comes to financial ratios. A current ratio that is too
high may indicate excessive holdings of cash, inventory and accounts receivable which ties up resources that
could be used more effectively elsewhere.
Slide 37: Analyzing the Balance Sheet
Financial Leverage
The financial leverage ratio measures the extent to which a companys assets are financed by equity. A company
with no debt at all (100% equity financing) would have a ratio of 1.00. A company with a capital structure that is
50% equity and 50% debt would have a ratio of 2.00.The higher the ratio, the greater the amount of debt
(leverage) the company has in its capital structure. Using debt to increase the amount of assets a company has
to earn a profit can be beneficial to its owners.
Increased leverage however increases risk due to the companys obligation to pay interest and repay or
refinance its debts when they come due.
Slide 38: Analyzing the Balance Sheet
Financial Leverage (continued)
ABCs leverage ratio is 1.46, indicating it has $1.46 of assets for every $1.00 of equity. ABCs leverage ratio
should be compared to the leverage ratio of its competitors, evaluated over time for trends and compared to
industry averages.
Slide 39: Statement of Cash Flows
Recall that the Statement of Cash Flows explains how the cash account balance changed during the accounting
period. The statement also helps us understand changes in other balance sheet account balances as well. ABC,
Inc. completed its first period of operations therefore its balance sheet account balances at the beginning of the
period were all equal to zero.
Notice that the ending cash balance on the statement of cash flows ties to the cash balance reported on the
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balance sheet. The net cash flow reported on the statement of cash flows explains the $43,000 increase in the
cash balance. The statement also explains why the paidin capital account increased by $50,000. We also gain
insight as to why the equipment account increased by $10,000 and the loan payable account increased by
$8,000. The $5,000 paid to suppliers helps to explain the $20,000 increase in the Inventory account and the
$15,000 increase in Accounts Payable account.
We will cover the statement of cash flows in more detail in a future chapter.
The End

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