Introduction to Financial Accounting, 3e

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The Balance Sheet and External Financing

• Chapter 3

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Identify and explain the meaning of the
accounting elements shown on the balance sheet.
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Introduction to theBalance Sheet
The balance sheet is the financial tool that
focuses on the present condition of a business.
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The Accounting Elements
Assets
Probable future economic benefits obtained or
controlled by a particular entity as a result of
past transactions events.
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The Accounting Elements
Liabilities
Claims of Non-owners on the business. Probable
future sacrifices of economic benefits arising
from present obligations of a particular entity
to transfer assets or provide services to other
entities in the future as a result of
past transactions or events.
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The Accounting Elements
Equity
Claims of owners on the entity. The residual
interest in the assets of an entity that remains
after deducting its liabilities.
Investment by owners
Earned equity
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Organization of theBalance Sheet
Assets Liabilities Owners equity
Assets Liabilities Owners equity
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The Accounting Equation
Assume you are buying a car for 8,000, paying
3,000 in cash and borrowing 5,000 from the bank.
What is the accounting equation?
Assets Liabilities Owners equity
8,000 5,000 3,000
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The Claims Liability and Equity
3,000
5,000
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Best Buy Co., Inc.Accounting Equation
Assets Liabilities Equity
4,839,587 3,017,659 1,821,928
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Account Form Balance Sheet
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Report Form Balance Sheet
Assets Asset one, etc. Total
assets Liabilities Liability one,
etc. Total liabilities Owners
equity Total liabilities and owners
equity
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Prepare a basic balance sheet for a
proprietorship, partnership, and a corporation,
and demonstrate how the balance sheet
provides information about the financial position
of a business.
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Starting a Proprietorship or Partnership
Investments by Owners
Assume that Jessicas Beauty Supply
began operations on January 1, 2003, with
a 10,000 investment from Jessica.
How would the first balance sheet appear?
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Starting a Proprietorship or Partnership
Investments by Owners
Jessicas Beauty Supply Balance Sheet January 1,
2003
Assets Liabilities 0
Cash 10,000 Owners equity
Jessica, capital 10,000 Total
liabilities and Total assets 10,000 owners
equity 10,000
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Starting a Proprietorship or Partnership
Investments by Owners
Assume that Jessica invests 6,000 and a partner,
Stephanie, invests 4,000 on January 1, 2003.
How would the first balance sheet appear?
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Starting a Proprietorship or Partnership
Investments by Owners
Jessica and Stephanies Beauty Supply Balance
Sheet January 1, 2003
Assets Liabilities 0
Cash 10,000 Owners equity Jessica,
capital 6,000 Stephanie, capital
4,000 Total liabilities and Total
assets 10,000 owners equity 10,000
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Starting a Corporation
Corporations are legal entities, separate from
their owners.
Incorporators obtain a corporate charter from one
of the 50 states to create a corporation.
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Learning Objective 3
Describe how a corporation is formed and how the
equity of a corporate balance sheet is structured.
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Corporate Organizational Structure
Charter
Incorporators
Bylaws
Stocks
Board of directors
President
Officers
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Corporate Capital Structure
Authorized shares
Issued shares
Outstanding shares
Treasury stock
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Corporate Capital Structure
Paid-in capital
Retained earnings
Dividends
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Classes of Stocks
Common stock
Preferred stock
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Constructing the Corporate Balance Sheet
Assume that Jessica and Stephanie agree that
Jessica will purchase 4,000 shares of the
companys one-dollar par common stock for 40,000
and Stephanie will purchase 200 shares of the
companys 8, 100 par preferred stock for
105 per share or 21,000 on January 1, 2003.
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Constructing the Corporate Balance Sheet
Jessicas Beauty Supply, Inc. Balance
Sheet January 1, 2003
Assets Liabilities 0
Cash 61,000 Stockholders equity Pref
erred stock 20,000 Paid-in capital
preferred 1,000 Common stock
4,000 Paid-in capital common
36,000 Total stockholders equity
61,000 Total liabilities and Total
assets 61,000 stockholders equity 61,000
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Learning Objectives 4 and 5
Describe various forms of debt and equity
financing and their effects on the balance sheet.
Perform basic interest calculations.
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Borrowing from Financial Institutions
Consumer borrowing
Personal
Commercial borrowing
Business
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Promissory Notes
A promissory note is a written agreement or debt
instrument between a lender and a borrower that
sets forth the terms of the liability and the
stipulations for the borrower to repay both
principal and interest.
Collateral
Mortgage
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The Cost of Borrowing
Boston Brothers borrowed 5,000 on January 2,
2003, by signing an 8, three-month note.
How much interest is due at the end of the period?
P R T I
5,000 .08 3/12 100
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Borrowing by Issuing Bonds
A bond is a type of promissory note, usually a
1,000 interest-bearing debt instrument.
The main differences between borrowing with bonds
and promissory notes are the length of the loan
and the amount of money borrowed.
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Borrowing by Issuing Bonds
Debenture bonds
Indentures
Nominal interest rate
Effective interest rate
Bonds market price
Premium
Discount
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Borrowing by Issuing Bonds
Assume Yoko Industries issues 1,000, 12, 10-year
1,000 bonds at 95.
What is the total cost of borrowing?
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Borrowing by Issuing Bonds
Interest (1,000,000 12 10
years) 1,200,000 Principal (1,000 bonds
1,000 face) 1,000,000 Total cash outflow
from issuer of bonds 2,200,000 Less Original
bond proceeds from investors (1,000,000
95) 950,000 Net cost to the issuer and
return on investment to the investors 1,2
50,000
Assume the bonds sell at 104.
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Borrowing by Issuing Bonds
What is the total cost of borrowing?
Interest (1,000,000 12 10
years) 1,200,000 Principal (1,000 bonds
1,000 face) 1,000,000 Total cash outflow
from issuer of bonds 2,200,000 Less Original
bond proceeds from investors (1,000,000
104) 1,040,000 Net cost to the issuer and
return on investment to the investors 1,1
60,000
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Constructing the Balance Sheet Reflecting Debt
Assume that on January 1, 2003, Jessicas
Beauty Supply, Inc., borrowed 50,000 on a
9, one-year promissory note and issued
200, 1,000 10-year, 8 bonds at par (200,000).
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Corporate Balance Sheet With Notes and Bonds
Payable
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Using Cash to Acquire Assets
Assume that on January 1, 2003, Jessicas Beauty
Supply, Inc., used cash to purchase the following
Land 50,000 Building 120,000 Computer
equipment 35,000 Truck 25,000
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Using Cash to Acquire Assets
Assets Liabilities Owners
Equity Sale of Stock Common
40,000 00 40,000 Preferred
21,000 00 21,000 Borrowing
Promissory note 50,000 50,000
00 Bond issue 200,000 200,000
00 Purchase of assets Cash (230,000) 0
0 00 Land 50,000 00
00 Building 120,000 00 00
Equipment 35,000 00 00
Truck 25,000 00
00 Total 311,000 250,000 61,000
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Corporate Balance SheetWith Various Assets
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Learning Objective 6
Compare and contrast two investment alternatives
equity investments and debt investments
including return on and return of
investments for each alternative.
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Equity and Debt Investment Compared
Equity investment
Debt investment
Interest
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Learning Objective 7
Read and understand a basic statement of cash
flows and describe the information it includes.
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Statement of Cash Flows
The statement of cash flows shows a companys
sources and uses of cash during a particular
period of time.
Inflows
Outflows
Cash
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Content of the Statementof Cash Flows
Operating activities
Cash flow
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Statement of Cash Flows for Jessica Corporation
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Statement of Cash Flows for Jessica Corporation
Net cash flows from operating activities
00 Net cash flows from investing activities
(230,000) Cash flows from financing activities
Sale of common stock 40,000 Sale of
preferred stock 21,000 Borrowing on note
payable 50,000 Sale of bonds
200,000 Net cash flows from financing
activities 311,000 Net change in
cash 81,000 Cash at the beginning
of the period 00 Cash at the end of the
period 81,000
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Learning Objective 8
Perform basic financial analysis relating to
financing activities.
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Ratio Analysis
The key concept of ratio analysis is that
the relationship of one number to another may be
just as important as the absolute dollar amounts
of those numbers.
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Debt Ratio
The debt ratio measures the proportion of
companys assets financed by debt.
Total liabilities Total assets
Jessicas Beauty Supply, Inc., debt
ratio 250,000 311,000 80.4
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Debt-to-Equity Ratio
This ratio expresses the relationship between
liabilities and equity.
Total liabilities Total equity
Jessicas Beauty Supply, Inc., debt-to-equity
ratio 250,000 61,000 4.1 to 1
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End of Chapter 3