ACCT1101

Sem 1, 2020/21
Dr. Jasmine Kwong chapter 2 Investing and Financing
Decisions and the Accounting
System

Financial Accounting
9e
10e
Libby • Libby • Hodge

2-1
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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.

2-2
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Understanding the Business
To understand
amounts
appearing on a
What
company’s
business
balance sheet:
activities cause
changes in
the balance
sheet? How do
specific
activities
affect each
balance? How do
companies
keep track of
balance sheet
amounts?

2-3
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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.

2-4
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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)

2-5
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Need a slide to explain terms :
Comparability (including consistency),
Verifiability, Timeliness, and Understandability
nature of the event

reliability vs relevance

original cost not realistic after 5 years due to depreciation

accumulated depreciation (expense)
2-6
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Elements of the Balance Sheet

A = L + SE
Stockholders’
Assets Liabilities Equity
Economic Debts or obligations The financing
resources with (claims to a provided by the
probable future company’s resources) owners and the
benefits owned that result from a operations of the
or controlled by company’s past business.
the entity. transactions and will
be paid with assets or
services. Entities that
a company owes
money to are called
creditors.

2-7
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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.

2-8
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Exhibit 2.2
Chipotle Mexican Grill, Inc., Balance Sheet
*The information
has been adapted
from actual
statements and
simplified for this
chapter.

due date

2-9
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 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.

2-10
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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.

2-11
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 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.

b.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.

2-12
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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.

2-13
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Learning Objective 2-2
2-2 Identify what constitutes a business transaction and recognize common
balance sheet account titles used in business.

2-14
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 What is an account?

• An account is a record of increases and

decreases in a specific asset, liability,
equity, revenue, or expense item.

2-15
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 Exhibit 2.3
Typical Account Titles
Title expense accounts by what was
incurred or used followed by the
Accounts with “payable” in the title are word “expense,” except for
always liabilities and represent amounts inventory sold, which is titled Cost
owed by the company to be paid to of Goods Sold.
Accounts with others in the future.
“receivable” in
the title are
always assets; Assets Liabilities Stockholder’s Revenues Expenses
they represent Equity
amounts owed
by (receivable Cash Accounts Payable Common Stock Sales Revenue Cost of Goods
Short-Term Accrued Expenses Additional Paid-in Fee Revenue Sold
from) customers
and others to the Investments Payable Capital Interest Revenue Wages Expense
business. Accounts Notes Payable Retained Earnings Rent Revenue Rent Expense
Receivable Taxes Payable Service Revenue Interest Expense
Notes Receivable Unearned Depreciation
Inventory (to be Revenue Expense
sold) Bonds Payable Advertising
Supplies Expense
Prepaid Expenses Accounts with “unearned” in the
is always an asset; it Prepaid Expenses Insurance
title are always liabilities Expense
represents amounts Long-Term
representing amounts paid in the
paid in advance by Investments Repair Expense
past to the company by others who
the company to Equipment expect future goods or services Income Tax
others for future Buildings from the company. Expense
benefits, such as
Land Title revenue accounts by
future insurance
coverage, rental of Intangibles their source followed by
property, or the word “revenue.”
advertising.

2-16
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 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).

2-17
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Learning Objective 2-3
2-3 Apply transaction analysis to simple business transactions in terms of
the accounting model: Assets = Liabilities + Stockholders' Equity.

2-18
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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

2-19
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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)

2-20
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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.

2-21
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 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 = Liabilities + Stockholders’ Equity

Property and Intangible Notes Dividends Common Additional Retained
Cash Investments Equipment Assets Payable Payable Stock Paid-in Capital Earnings

(a) +300 = +1 +299

Step 2: Is the accounting equation in balance?

Assets $300 = Liabilities $0 + Stockholders’ Equity $300

2-22
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 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) $2 Given: Long-Term Notes Payable (+L) $2

Assets = Liabilities + Stockholders’ Equity

Property and Intangible Notes Dividends Common Additional Retained
Cash Investments Equipment Assets Payable Payable Stock Paid-in Capital Earnings

(a) +300 = +1 +299

(b) +2 = +2

Step 2: Is the accounting equation in balance?

Assets $2 = Liabilities $2 + Stockholders’ Equity $0

2-23
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 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) $8 Given: Cash (−A) $54
Buildings (+A) 34 Short-Term Notes Payable (+L) 1
Equipment (+A) 10
Intangible Assets (+A) 3
Assets = Liabilities + Stockholders’ Equity
Property and Intangible Notes Dividends Common Additional Retained
Cash Investments Equipment Assets Payable Payable Stock Paid-in Capital Earnings
(a) +300 = +1 +299
(b) +2 = +2
(c) –54 +52 +3 = +1

Step 2: Is the accounting equation in balance?

Assets $1 = Liabilities $1 + Stockholders’ Equity $0

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 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: Given: Cash (−A) $1
Short-Term Notes Payable (−L) $1

Assets = Liabilities + Stockholders’ Equity

Property and Intangible Notes Dividends Common Additional Retained
Cash Investments Equipment Assets Payable Payable Stock Paid-in Capital Earnings
(a) +300 = +1 +299
(b) +2 = +2
(c) –54 +52 +3 = +1
(d) –1 = –1

Step 2: Is the accounting equation in balance?

Assets –$1 = Liabilities −$1 + Stockholders’ Equity $0

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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 long-
term 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) $9 Given: Cash (−A) $44
Long-Term Investments (+A) 35

Assets = Liabilities + Stockholders’ Equity

Property and Intangible Notes Dividends Common Additional Retained
Cash Investments Equipment Assets Payable Payable Stock Paid-in Capital Earnings
(a) +300 = +1 +299
(b) +2 = +2
(c) –54 +52 +3 = +1
(d) –1 = –1
(e) –44 +44 =

Step 2: Is the accounting equation in balance?

Assets $0 = Liabilities $0 + Stockholders’ Equity $0

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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 Given: Dividends Payable (+L) $2

Retained Earnings (−SE) $2
Assets = Liabilities + Stockholders’ Equity
Property and Intangible Notes Dividends Common Additional Retained
Cash Investments Equipment Assets Payable Payable Stock Paid-in Capital Earnings
(a) +300 = +1 +299
(b) +2 = +2
(c) –54 +52 +3 = +1
(d) –1 = –1
(e) –44 +44 =
(f) +2 –2
+203 +44 +52 +3 = +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
2-27
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 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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 Solutions to Quiz 2

Column 1: CR; CR; CR

Column 2: DR; DR; DR
Column 3: DR; CR; DR

2-29
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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.

2-30
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Exhibit 2.4
The Accounting Cycle

Start of new period

During the Period

(Chapters 2 and 3)
1. Analyze transactions
2 Record journal entries in the general journal
3 Post entries to the general ledger

At the End of the Period

(Chapter 4)
4 Prepare a trial balance (check if debits = credits)
5 Adjust revenues and expenses and related balance sheet
accounts (record in journal and post to ledger)
6 Prepare financial statements and disseminate them to users
7 Close revenues, expenses, gains, and losses to Retained
Earnings (record in journal and post to ledger)

2-31
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How Do Companies Keep Track of Account Balances?

General Journal
(chronological list of transactions)

POST
General Ledger
or T-accounts
(a record of effects to
and balances of each
account)

2-32
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P1
JOURNALIZING &
POSTING TRANSACTIONS

Assets = Liabilities + Equity

T- Account
(Left side) (Right side)
Debit Credit

Step 1: Analyze
Step 2: Apply double-
transactions and source
entry accounting
documents.

GENERAL JOURNAL Page 123

ACCOUNT NAME: ACCOUNT No.
Post.
Date Description Ref. Debit Credit
Date Description PR Debit Credit Balance

Step 4: Post entry to ledger Step 3: Record journal entry

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P1
General Ledger of Cash

CASH ACCOUNT No. 101

Date Description PR Debit Credit Balance

2011
Dec. 1 Initial investment G1 30,000 30,000
Dec. 2 Purchased supplies G1 2,500 27,500
Dec. 3 Purchased equipment G1 26,000 1,500
Dec. 10 Collection from customer G1 4,200 5,700

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 Debits and Credits

Account Title
(Left side) (Right side)
Debit Credit

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C4
Double-Entry Accounting
An account balance is the difference between the increases and
decreases in an account. Notice the T-Account.

2-36
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Exhibit 2.5
Basic Transaction Analysis Model

STOCKHOLDERS’ EQUITY
ASSETS LIABILITIES Contributed Capital Earned Capital
(many accounts) = (many accounts) + (2 accounts) (1 account)

Common Stock and Retained

+ – – +
Debit Credit Debit Credit Additional Paid-in Capital Earnings
+ – +
Credit Debit Credit
Investment Dividends Net income
by owners declared
(expanded
in Ch. 3)

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Debits and Credits
In Summary:

2-38
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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. Amounts:
Credited accounts on bottom, usually indented. Debited amounts on left.
Credited amounts on right.

Debit Credit
(a) Cash (+A) 300
Common stock (+SE) 1
Additional paid-in capital (+SE) 299

Reference:
Letter,
number, or
date.
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Exhibit 2.6
Posting Transaction Effects from the Journal to the Ledger

General Journal Page G1

Date Account Titles and Explanation Ref. Debit Credit
(in thousands)
1-2-18 Cash 101 300
Common stock 301 1
Additional paid-in Capital 302 299
(Investment by stockholders.)

General Ledger CASH 101

Date Explanation Ref. Debit Credit Balance
Balance 186
1-2-18 G1 300 486

General Ledger COMMON STOCK 301

Date Explanation Ref. Debit Credit Balance
Balance 1
1-2-18 G1 1 2

General Ledger ADDITIONAL PAID-IN CAPITAL 302

Date Explanation Ref. Debit Credit Balance
Balance 1,305
1-2-18 G1 299 1,604

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Exhibit 2.7
T-Accounts Illustrated

Start with a Draw a line across the T

beginning when you are ready to
balance. compute the ending balance.

+ Cash (A) – − Common Stock (SE) +

Beg. balance 186 1 Beg. balance
(a) 300 1 (a)
End. balance 486 2 End. balance

Use the same

reference as
in the journal Put the ending balance amount
entry. on the side of the T-account
that it represents (e.g., + side if
it is a positive number).

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Inferring Business Activities from T-Accounts
FINANCIAL ANALYSIS

− Accounts Payable (L) +

$$$
600 Beg. bal.
Cash payments to suppliers? 1,500 Purchases on account

300 End bal.

Solution:
Beginning Purchases Cash Payments Ending
Balance + on Account - to Suppliers = Balance
$600 + $1,500 - ? = $ 300
$2,100 - ? = $ 300
? = $1,800

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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 Credit
(a) Cash (+A) 300
Common stock (+SE) 1
Additional paid-in capital (+SE) 299

Assets = Liabilities + Stockholders’ Equity

Cash +300 Common Stock +1
Additional Paid-in Capital +299

Additional Paid-in
+ Cash (A) – – Common Stock (SE) + – Capital (SE) +
1/1/18 186 1 1/1/18 1,305 1/1/18
(a) 300 1 (a) 299 (a)

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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 Credit
(b) Cash (+A) 2
Notes payable (+L) 2

Assets = Liabilities + Stockholders’ Equity

Cash +2 Notes payable +2

+ Cash (A) – – Notes Payable (L) +

1/1/18 186 78 1/1/18
(a) 300 2 (b)
(b) 2

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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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 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.

2-46
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 Solutions to Quiz 3

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Learning Objective 2-5
2-5 Prepare a trial balance and simple classified balance sheet and analyze
the company using the current ratio.

2-48
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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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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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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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 Chipotle Mexican Grill’s First Quarter 2018
Exhibit 2.8 (2 of 3) Balance Sheet
(based on investing and financing activities only)

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 Chipotle Mexican Grill’s First Quarter 2018
Exhibit 2.8 (3 of 3) Balance Sheet
(based on investing and financing activities only)

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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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 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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