ACCT1101
Dr. Jasmine Kwong
chapter
2
Investing and Financing
Decisions and the Accounting
System
Financial Accounting
9e
11e
Libby • Libby • Hodge
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2-1
Learning Objectives
After studying this chapter, you should be able to:
2-1 Define the objective of financial reporting, the elements of the balance
sheet, and the related key accounting assumptions and principles.
2-2 Identify what constitutes a business transaction and recognize common
balance sheet account titles used in business.
2-3 Apply transaction analysis to simple business transactions in terms of
the accounting model: Assets = Liabilities + Stockholders' Equity.
2-4 Determine the impact of business transactions on the balance sheet
using two basic tools: Journal entries and T-accounts.
2-5 Prepare a trial balance and simple classified balance sheet and analyze
the company using the current ratio.
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2-2
Understanding the Business
What
business
activities cause
changes in
the balance
sheet?
To understand
amounts
appearing on a
company’s
balance sheet:
How do
specific
activities
affect each
balance?
How do
companies
keep track of
balance sheet
amounts?
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2-3
Learning Objective 2-1
2-1 Define the objective of financial reporting, the elements of the balance
sheet, and the related key accounting assumptions and principles.
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2-4
Exhibit 2.1
Financial Accounting and Reporting Conceptual Framework
Objective of Financial Reporting to External Users: (in Ch. 2)
To provide financial information about the reporting entity that is useful to existing and potential
investors, lenders, and other creditors in making decisions about providing resources to the entity.
➢ Pervasive Cost-Benefit Constraint: Benefits of providing information should outweigh its costs
Fundamental Qualitative Characteristics of Useful Information: (in Ch. 2)
Relevance (including materiality) and Faithful Representation (see next slide)
Attributes That Enhance Qualitative Characteristics:
Comparability (including consistency), Verifiability, Timeliness, and Understandability
Elements to Be Measured and Reported:
Assets, Liabilities, Stockholders’ Equity, Investments by Owners, and Distributions to Owners (in Ch. 2)
Revenues, Expenses, Gains, and Losses (in Ch. 3)
Comprehensive Income (in Ch. 5)
Recognition, Measurement, and Disclosure Concepts:
Assumptions: Separate Entity, Going Concern, and Monetary Unit (in Ch.2 – see next slide)
Time Period (in Ch. 3)
Principles: Mixed-Attribute Measurement (in Ch. 2 – see next slide)
Revenue Recognition and Expense Recognition (in Ch. 3)
Full Disclosure (in Ch. 5)
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2-5
Need a slide to explain terms :
Comparability (including consistency),
Verifiability, Timeliness, and Understandability
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2-6
Elements of the Balance Sheet
A = L + SE
Assets
Economic
resources with
probable future
benefits owned
or controlled by
the entity.
Liabilities
Debts or obligations
(claims to a
company’s resources)
that result from a
company’s past
transactions and will
be paid with assets or
services. Entities that
a company owes
money to are called
creditors.
Stockholders’
Equity
The financing
provided by the
owners and the
operations of the
business.
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2-7
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.
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2-8
Exhibit 2.2
Chipotle Mexican Grill, Inc., Balance Sheet
*The information
has been adapted
from actual
statements and
simplified for this
chapter.
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2-9
Financial Analysis - Unrecorded but
Valuable Assets and Liabilities
Many very valuable intangible assets, such as trademarks, patents, and
copyrights that are developed inside a company (not purchased), are not
reported on the balance sheet. For example, General Electric’s balance sheet
reveals no listing for the GE trademark because it was developed internally
over time through research, development, and advertising (it was not
purchased). Likewise, the Coca-Cola Company does not report any asset for
its patented Coke formula, although it does report more than $6.5 billion in
various trademarks that it has purchased.
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2-10
Nearly all companies have some form of off-balance-sheet financing—
obligations not reported as liabilities on the balance sheet. For many
companies, renting facilities or equipment can fall into this category, and it
can be quite significant. For example, Delta Air Lines included in a note to
the financial statements in a recent annual report that over $16.2 billion in
future cash flows of aircraft rental leases were not reported on the balance
sheet as debt, an amount equal to nearly 41 percent of its total liabilities that
were reported on the balance sheet. This also illustrates the importance of
reading the notes, not just the financial statements, when analyzing a
company’s financial information and predicting future cash flows.
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2-11
Self-study Quiz 1
a.Paul Knepper contributes $50,000 cash to establish
Florida Flippers, Inc., a new scuba business organized as
a corporation; in exchange, he receives 25,000 shares of
common stock with a par value of $0.10 per share.
Florida Flippers buys a small building near the ocean for
$250,000, paying $25,000 cash and signing a 10-year note
payable for the rest.
b.
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2-12
Solutions to self-study quiz 1
(a) Step 1:
Received: Cash (+A) $50,000; Given: Common Stock (+SE)
$2,500 and Additional Paid-in Capital (+SE) $47,500.
Step 2:
Yes. The equation remains in balance; Assets (on the left) and
Stockholders’ Equity (on the right) increase by the same
amount, $50,000.
(b) Step 1:
Received: Building (+A) $250,000; Given: Cash (−A) $25,000
and Notes Payable (+L) $225,000.
Step 2:
Yes. Assets (on the left) increase by $225,000 (+$250,000 −
$25,000) and Liabilities (on the right) increase by $225,000.
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2-13
Learning Objective 2-2
2-2 Identify what constitutes a business transaction and recognize common
balance sheet account titles used in business.
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2-14
What is an account?
• An account is a record of increases and
decreases in a specific asset, liability,
equity, revenue, or expense item.
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2-15
Exhibit 2.3
Typical Account Titles
Accounts with
“receivable” in
the title are
always assets;
they represent
amounts owed
by (receivable
from) customers
and others to the
business.
Prepaid Expenses
is always an asset; it
represents amounts
paid in advance by
the company to
others for future
benefits, such as
future insurance
coverage, rental of
property, or
advertising.
Accounts with “payable” in the title are
always liabilities and represent amounts
owed by the company to be paid to
others in the future.
Assets
Cash
Short-Term
Investments
Accounts
Receivable
Notes Receivable
Inventory (to be
sold)
Supplies
Prepaid Expenses
Long-Term
Investments
Equipment
Buildings
Land
Intangibles
Liabilities
Accounts Payable
Accrued Expenses
Payable
Notes Payable
Taxes Payable
Unearned
Revenue
Bonds Payable
Stockholder’s
Equity
Common Stock
Additional Paid-in
Capital
Retained Earnings
Accounts with “unearned” in the
title are always liabilities
representing amounts paid in the
past to the company by others who
expect future goods or services
from the company.
Title expense accounts by what was
incurred or used followed by the
word “expense,” except for
inventory sold, which is titled Cost
of Goods Sold.
Revenues
Sales Revenue
Fee Revenue
Interest Revenue
Rent Revenue
Service Revenue
Expenses
Cost of Goods
Sold
Wages Expense
Rent Expense
Interest Expense
Depreciation
Expense
Advertising
Expense
Insurance
Expense
Repair Expense
Income Tax
Expense
Title revenue accounts by
their source followed by
the word “revenue.”
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2-16
Additional Paid-in Capital
• The is the excess amount over par value of the
shares issued.
• Eg. If par value is $1/share and the selling
price is $4/share then additional paid-in
capital = $3/share ($4 - $1).
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2-17
Learning Objective 2-3
2-3 Apply transaction analysis to simple business transactions in terms of
the accounting model: Assets = Liabilities + Stockholders' Equity.
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2-18
Principles of Transaction Analysis
Every transaction has at least two effects (dual effects) on the
basic accounting equation.
❖ Every transaction affects at least two accounts.
Correctly identifying those accounts and the direction of the
effect (whether an increase or a decrease) is critical!
❖ The accounting equation must remain in balance after each
transaction.
A = L + SE
Assets
Liabilities
Stockholders’
Equity
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2-19
Balancing the Accounting Equation
The accounting equation must remain in balance after each
transaction.
Step 1: Ask ▪ Which accounts are being affected ?
(e.g., Cash and Notes Payable). Make sure at least two accounts
change.
▪ What category (A/L/SE or else) the affected accounts belong to ?
(e.g. Cash is an asset and Notes Payable is a liability).
▪ Which direction (+/-) the accounts are affected by ?
The account increased (+) or decreased (−)
(e.g. Cash increased and Notes Payable increased).
Step 2: Verify - Is the accounting equation in balance? (A = L + SE)
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2-20
Analyzing Chipotle’s Transactions (1 of 7)
To illustrate the use of the transaction analysis process, let’s consider
transactions of Chipotle that are also common to most businesses.
Assume that Chipotle engages in the following events during the first
quarter of 2018, the first three months following the balance sheet in
Exhibit 2.2.
Account titles are from that balance sheet. All amounts are in millions,
except per share data.
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2-21
Analyzing Chipotle’s Transactions (2 of 7)
(a) Chipotle issued (sold) 100 additional shares of common stock with a
par value of $0.01 per share at a market value of $3.00 per share,
receiving $300 in cash from investors.
Step 1: What was received and what was given?
(account name, type of account, amount, and direction of effect)
Received:
Cash (+A)
$300
Given: Additional stock shares:
Common Stock (+SE)
$1 (100 shares × $0.01 per share)
Additional Paid-in Capital (+SE) $299 (100 shares × $2.99 per share)
Assets
Cash
(a)
+300
=
Property and Intangible
Investments Equipment
Assets
Liabilities
Notes
Payable
Dividends
Payable
=
+
Stockholders’ Equity
Common
Additional
Retained
Stock
Paid-in Capital Earnings
+1
+299
Step 2: Is the accounting equation in balance?
Assets $300 = Liabilities $0 + Stockholders’ Equity $300
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2-22
Analyzing Chipotle’s Transactions (3 of 7)
(b) Chipotle borrowed $2 from its local bank, signing a note to be paid in
three years (a noncurrent liability).
Step 1: What was received and what was given?
(account name, type of account, amount, and direction of effect)
Received:
Cash (+A)
Assets
Cash
(a)
(b)
+300
+2
$2
Given: Long-Term Notes Payable (+L)
=
Property and Intangible
Investments Equipment
Assets
Liabilities
Notes
Payable
=
=
Dividends
Payable
+
$2
Stockholders’ Equity
Common
Additional
Retained
Stock
Paid-in Capital Earnings
+1
+299
+2
Step 2: Is the accounting equation in balance?
Assets $2 = Liabilities $2 + Stockholders’ Equity $0
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2-23
Analyzing Chipotle’s Transactions (4 of 7)
(c) Chipotle purchased $8 in additional land, $34 in new buildings, $10 in
new equipment, and $3 in additional intangible assets; paid $54 in cash and
signed a $1 short-term note payable for the remainder amount owed.
Step 1: What was received and what was given?
(account name, type of account, amount, and direction of effect)
Received:
Land (+A)
Buildings (+A)
Equipment (+A)
Intangible Assets (+A)
Assets
Cash
(a)
(b)
(c)
+300
+2
–54
$8
34
10
3
=
Property and Intangible
Investments Equipment
Assets
+52
+3
Given: Cash (−A)
$54
Short-Term Notes Payable (+L)
1
Liabilities
Notes
Payable
=
=
=
Dividends
Payable
+
Stockholders’ Equity
Common
Additional
Retained
Stock
Paid-in Capital Earnings
+1
+299
+2
+1
Step 2: Is the accounting equation in balance?
Assets $1 = Liabilities $1 + Stockholders’ Equity $0
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2-24
Analyzing Chipotle’s Transactions (5 of 7)
(d) Chipotle paid $1 on the short-term note payable in (c) above (ignore any
interest on the loan in this chapter).
Step 1: What was received and what was given?
(account name, type of account, amount, and direction of effect)
Received:
Reduction in amount due:
Short-Term Notes Payable (−L)
Assets
Cash
(a)
(b)
(c)
(d)
+300
+2
–54
–1
=
Property and Intangible
Investments Equipment
Assets
+52
+3
$1
$1
Liabilities
Notes
Payable
=
=
=
=
Given: Cash (−A)
Dividends
Payable
+
Stockholders’ Equity
Common
Additional
Retained
Stock
Paid-in Capital Earnings
+1
+299
+2
+1
–1
Step 2: Is the accounting equation in balance?
Assets –$1 = Liabilities −$1 + Stockholders’ Equity $0
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2-25
Analyzing Chipotle’s Transactions (6 of 7)
(e) Chipotle purchased the stock of other companies as investments, paying
$44 cash; of this, $9 was in short-term investments and $35 was in longterm investments.
Step 1: What was received and what was given?
(account name, type of account, amount, and direction of effect)
Received:
Short-Term Investments (+A)
Long-Term Investments (+A)
Assets
Cash
(a)
(b)
(c)
(d)
(e)
+300
+2
–54
–1
–44
=
Property and Intangible
Investments Equipment
Assets
+52
+44
+3
$9
35
Liabilities
Notes
Payable
=
=
=
=
=
Dividends
Payable
Given: Cash (−A)
+
$44
Stockholders’ Equity
Common
Additional
Retained
Stock
Paid-in Capital Earnings
+1
+299
+2
+1
–1
Step 2: Is the accounting equation in balance?
Assets $0 = Liabilities $0 + Stockholders’ Equity $0
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2-26
Analyzing Chipotle’s Transactions (7 of 7)
(f) Chipotle does not pay dividends but instead reinvests profits into growing
the business. However, for illustration purposes, assume Chipotle’s board of
directors declared that the Company will pay $2 in cash as dividends to
shareholders next quarter.
Step 1: What was received and what was given?
(account name, type of account, amount, and direction of effect)
Received:
Lower undistributed earnings
Retained Earnings (−SE)
$2
Assets
Cash
(a)
(b)
(c)
(d)
(e)
(f)
+300
+2
–54
–1
–44
=
Property and Intangible
Investments Equipment
Assets
+52
+3
+44
Liabilities
Notes
Payable
=
=
=
=
=
Given: Dividends Payable (+L)
+
Dividends
Payable
Stockholders’ Equity
Common
Additional
Retained
Stock
Paid-in Capital Earnings
+1
+299
+2
+1
–1
+2
+203
+44
+52
+3
=
$2
+2
+2
–2
+1
+299
–2
Step 2: Is the accounting equation in balance?
Assets $0 = Liabilities $2 + Stockholders’ Equity −$2
Overall effects of (a)–( f): Assets $302 = Liabilities $4 + Stockholders’ Equity $298
$302 = $302
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2-27
Self-study Quiz 2
The following is a list of accounts from a balance sheet of The
Wendy’s Company. Indicate on the line provided whether each
of the following usually has a debit (DR) or credit (CR) balance.
_____ Accounts Payable
_____ Retained Earnings
_____ Accrued Expenses Payable
_____ Properties (land, buildings, and equipment)
_____ Inventories
_____ Notes Receivable (due in five years)
_____ Cash
_____ Long-Term Debt
_____ Accounts Receivable
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2-28
Solutions to Quiz 2
Column 1: CR; CR; CR
Column 2: DR; DR; DR
Column 3: DR; CR; DR
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2-29
Learning Objective 2-4
2-4 Determine the impact of business transactions on the balance sheet
using two basic tools: Journal entries and T-accounts.
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2-30
Exhibit 2.4
The Accounting Cycle
Start of new period
1.
2
3
4
5
6
7
During the Period
(Chapters 2 and 3)
Analyze transactions
Record journal entries in the general journal
Post entries to the general ledger
At the End of the Period
(Chapter 4)
Prepare a trial balance (check if debits = credits)
Adjust revenues and expenses and related balance sheet
accounts (record in journal and post to ledger)
Prepare financial statements and disseminate them to users
Close revenues, expenses, gains, and losses to Retained
Earnings (record in journal and post to ledger)
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2-31
How Do Companies Keep Track of Account Balances?
POST
General Journal
(chronological list of transactions)
General Ledger
or T-accounts
(a record of effects to
and balances of each
account)
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2-32
P1
JOURNALIZING &
POSTING TRANSACTIONS
Assets
=
Liabilities
+
Equity
T- Account
(Left side)
(Right side)
Debit
Credit
Step 1: Analyze
transactions and source
documents.
ACCOUNT NAME:
Date
Step 2: Apply doubleentry accounting
GENERAL JOURNAL
ACCOUNT No.
Description
PR
Debit
Credit
Balance
Step 4: Post entry to ledger
Date
Description
Page
Post.
Ref.
Debit
123
Credit
Step 3: Record journal entry
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2-33
General Ledger of Cash
P1
CASH
Date
ACCOUNT No. 101
Description
PR
Debit
G1
30,000
Credit
Balance
2,500
26,000
30,000
27,500
1,500
5,700
2011
Dec. 1
Dec. 2
Dec. 3
Dec. 10
Initial investment
Purchased supplies
Purchased equipment
Collection from customer
G1
G1
G1
4,200
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2-34
Debits and Credits
Account Title
(Left side)
(Right side)
Debit
Credit
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2-35
C4
Double-Entry Accounting
An account balance is the difference between the increases and
decreases in an account. Notice the T-Account.
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2-36
Exhibit 2.5
Basic Transaction Analysis Model
STOCKHOLDERS’ EQUITY
ASSETS
(many accounts)
+
Debit
–
Credit
=
LIABILITIES
(many accounts)
–
Debit
+
Credit
+
Contributed Capital
(2 accounts)
Earned Capital
(1 account)
Common Stock and
Additional Paid-in Capital
Retained
Earnings
+
Credit
Investment
by owners
–
Debit
Dividends
declared
+
Credit
Net income
(expanded
in Ch. 3)
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2-37
Debits and Credits
In Summary:
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2-38
The Journal Entry
(a) Chipotle issued (sold) 100 additional shares of common stock with a
par value of $0.01 per share at a market value of $3.00 per share,
receiving $300 in cash from investors.
Account Titles:
Debited accounts on top.
Credited accounts on bottom, usually indented.
Amounts:
Debited amounts on left.
Credited amounts on right.
Debit
(a) Cash (+A)
Common stock (+SE)
Additional paid-in capital (+SE)
Credit
300
1
299
Reference:
Letter,
number, or
date.
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2-39
Exhibit 2.6
Posting Transaction Effects from the Journal to the Ledger
General Journal
Date
Account Titles and Explanation
(in thousands)
1-2-18
Cash
Common stock
Additional paid-in Capital
(Investment by stockholders.)
General Ledger
Date
Explanation
Balance
1-2-18
General Ledger
Date
Explanation
Balance
1-2-18
General Ledger
Date
Explanation
Balance
1-2-18
Ref.
Debit
101
301
302
300
1
299
CASH
Ref.
G1
Ref.
G1
Debit
Page G1
Credit
101
Balance
186
486
Credit
300
COMMON STOCK
Debit
Credit
1
301
Balance
1
2
ADDITIONAL PAID-IN CAPITAL
302
Ref.
Debit
Credit
Balance
1,305
G1
299
1,604
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2-40
Exhibit 2.7
T-Accounts Illustrated
Draw a line across the T
when you are ready to
compute the ending balance.
Start with a
beginning
balance.
+ Cash (A) –
Beg. balance
(a)
End. balance
Use the same
reference as
in the journal
entry.
186
300
486
− Common Stock (SE) +
1
1
2
Beg. balance
(a)
End. balance
Put the ending balance amount
on the side of the T-account
that it represents (e.g., + side if
it is a positive number).
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2-41
Inferring Business Activities from T-Accounts
FINANCIAL ANALYSIS
$$$
− Accounts Payable (L) +
600
Cash payments to suppliers?
1,500
300
Beg. bal.
Purchases on account
End bal.
Solution:
Beginning
Purchases
Cash Payments Ending
Balance
+ on Account - to Suppliers
= Balance
$600
+ $1,500
$2,100
-
?
?
?
= $ 300
= $ 300
= $1,800
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2-42
Transaction Analysis Illustrated (1 of 3)
(a) Chipotle issued (sold) 100 additional shares of common stock with a
par value of $0.01 per share at a market value of $3.00 per share,
receiving $300 in cash from investors.
Debit
(a) Cash (+A)
Credit
300
Common stock (+SE)
1
Additional paid-in capital (+SE)
Assets
Cash
=
299
Liabilities
+
+300
Stockholders’ Equity
Common Stock
+1
Additional Paid-in Capital
+ Cash (A) –
1/1/18
(a)
186
300
– Common Stock (SE) +
1
1
1/1/18
(a)
+299
Additional Paid-in
– Capital (SE) +
1,305
299
1/1/18
(a)
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2-43
Transaction Analysis Illustrated (2 of 3)
(b) Chipotle borrowed $2 from its local bank, signing a note to be paid in
three years (a noncurrent liability).
Debit
(b) Cash (+A)
2
Notes payable (+L)
Assets
Cash
1/1/18
(a)
(b)
=
+2
+ Cash (A) –
186
300
2
Credit
2
Liabilities
Notes payable
+
Stockholders’ Equity
+2
– Notes Payable (L) +
78 1/1/18
2
(b)
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2-44
Transaction Analysis Illustrated (3 of 3)
After analyzing all transactions from (a)–(f), the balance in our T-accounts will
appear as follows:
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2-45
Self-study Quiz 3
(a) Paul Knepper contributes $50,000 cash to establish
Florida Flippers, Inc., a new scuba business organized as
a corporation; he receives in exchange 25,000 shares of
stock with a $0.10 per share par value.
(b)Florida Flippers buys a small building near the ocean for
$250,000, paying $25,000 in cash and signing a 10-year
note payable for the rest.
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2-46
Solutions to Quiz 3
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2-47
Learning Objective 2-5
2-5 Prepare a trial balance and simple classified balance sheet and analyze
the company using the current ratio.
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2-48
Trial Balance
• The trial balance is a
listing of the ending
balance in each
account in the
general ledger.
• List accounts in
financial statement
order (assets,
liabilities,
stockholders’ equity,
revenues and
expenses).
• The purpose of the
trial balance is to
make sure the debits
and credits are
equal.
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2-49
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.
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2-50
Exhibit 2.8 (1 of 3)
Chipotle Mexican
Grill’s First
Quarter 2018
Balance Sheet
(based on investing and
financing activities only)
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2-51
Exhibit 2.8 (2 of 3)
Chipotle Mexican Grill’s First Quarter 2018
Balance Sheet
(based on investing and financing activities only)
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2-52
Exhibit 2.8 (3 of 3)
Chipotle Mexican Grill’s First Quarter 2018
Balance Sheet
(based on investing and financing activities only)
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2-53
Current Ratio
KEY RATIO ANALYSIS
$$$
Current Ratio =
Current Assets
Current Liabilities
Does a company have the short-term resources
to pay its short-term debt?
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2-54
Self-study Quiz 4
Yum! Brands, Inc., is the world’s largest quick-service
restaurant company that develops, franchises, and operates over
45,000 units in more than 135 countries and territories through
three restaurant concepts (KFC, Pizza Hut, and Taco Bell). The
company reported the following balances on its recent balance
sheets (in millions). Compute Yum! Brands’ current ratio for the three
years presented. Round your answers to three decimal
places.
What do these results suggest about Yum! Brands’ liquidity in
the current year and over time?
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Solutions to Quiz 4
Yum! Brands’ current ratio is above 1.0 and has been rising over the three
years, suggesting the company currently has sufficient current assets to
settle short-term obligations and a stronger level of liquidity over time.
Even in 2015 when the ratio was below 1.0, there was no concern about
liquidity because Yum! Brands is a cash-oriented business and maintains a
strong cash management system.
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