Financial Accounting Financial Accounting

chapter 2 Investing and Financing
Decisions and the Accounting

System
Financial Accounting
9e
10e
Libby • Libby • Hodge
2-1
Copyright ©2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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.
2-6 Identify investing and financing transactions and demonstrate how they
impact cash flows.
2-2
Understanding the Business
To understand
amounts
appearing on a
What
What company’s
business
business balance sheet:
activities
activities cause
cause
changes
changes inin
the
the balance
balance
sheet?
sheet? How
How dodo
specific
specific
activities
activities
affect
affect each
each
balance?
balance? How
How do
do
companies
companies
keep
keep track
track of
of
balance
balance sheet
sheet
amounts?
amounts?
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.
2-4
Exhibit 2.1 (1 of 2)
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
Attributes That Enhance Qualitative Characteristics:
Comparability (including consistency), Verifiability, Timeliness, and Understandability
2-5
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
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)
Time Period (in Ch. 3)
Principles: Mixed-Attribute Measurement (in Ch. 2)
Revenue Recognition and Expense Recognition (in Ch. 3)
Full Disclosure (in Ch. 5)
2-6
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
Exhibit 2.2
Chipotle Mexican Grill, Inc., Balance Sheet
*The information
has been adapted
from actual
statements and
simplified for this
chapter.
2-8
Unrecorded but Valuable Assets and Liabilities
FINANCIAL ANALYSIS
Many very valuable intangible assets, such as

trademarks, patents, and copyrights are not
$$$
reported on the balance sheet.
Intangible assets not reported:
 Internally developed over time
 Not purchased
Some liabilities, called off-balance-sheet

financing, are not reported as liabilities on the
balance sheet.
Off-balance-sheet financing:
 Some equipment or building
rentals
2-9
2-2 Identify what constitutes a business transaction and recognize common
balance sheet account titles used in business.
2-10
What Business Activities Cause Changes in
the Financial Statement Amounts?
Nature of
Business
Transactions include two types of events: Transactions
External Events: Exchanges between the entity

and one or more parties.
Ex: Purchase of a machine from a supplier.
Internal Events: Events that are not exchanges

between parties but that have a direct and
measurable effect on the entity.
Ex: Using up insurance paid in advance.
2-11
Accounts
Accounts
Accounts are
are used
used by
by companies
companies toto accumulate
accumulate
the
the dollar
dollar effect
effect of
of transactions.
transactions.
Cash Inventory
Notes
Equipment
Payable
2-12
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; Stockholder’s
Assets Liabilities Revenues Expenses
they represent Equity
amounts owed
by (receivable Cash Accounts Payable Common Stock Sales Revenue Cost of Goods
from) customers Short-Term Accrued Expenses Additional Paid-in Fee Revenue Sold
and others to the Investments Capital Interest Revenue Wages Expense
business. Accounts Payable Retained Earnings Rent Expense
Rent Revenue
Receivable Notes Payable Interest Expense
Service Revenue
Notes Receivable Taxes Payable Depreciation
Inventory (to be Unearned Expense
sold) Revenue Advertising
Supplies Bonds Payable 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.
2-13
2-3 Apply transaction analysis to simple business transactions in terms of
the accounting model: Assets = Liabilities + Stockholders' Equity.
2-14
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
2-15
Balancing the Accounting Equation
The accounting equation must remain in balance after each

transaction.
Step 1: Ask - What was received and what was given?

 Identify each account affected by title
(e.g., Cash and Notes Payable). Make sure at least two accounts
change.
 Classify each account by type: Asset (A), Liability (L), or
Stockholders’ Equity (SE)
(e.g. Cash is an asset and Notes Payable is a liability).
 Determine the direction of the effect: 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)
2-16
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.
2-17
(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
2-18
(b) Chipotle borrowed $2 from its local bank, signing a note to be paid in
three years (a noncurrent liability).

Received: Cash (+A) $2 Given: Long-Term Notes Payable (+L) $2

(a) +300 = +1 +299

(b) +2 = +2

2-19
(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.

Received: Land (+A) $8 Given: Cash (−A) $54
Buildings (+A) 34 Short-Term Notes Payable (+L) 1
Equipment (+A) 10
Intangible Assets (+A) 3

(a) +300 = +1 +299
(b) +2 = +2
(c) –54 +52 +3 = +1

2-20
(d) Chipotle paid $1 on the short-term note payable in (c) above (ignore any
interest on the loan in this chapter).

Received: Reduction in amount due: Given: Cash (−A) $1

Short-Term Notes Payable (−L) $1

(a) +300 = +1 +299

(b) +2 = +2
(c) –54 +52 +3 = +1
(d) –1 = –1

Assets –$1 = Liabilities −$1 + Stockholders’ Equity $0
2-21
(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.

Received: Short-Term Investments (+A) $9 Given: Cash (−A) $44

Long-Term Investments (+A) 35

(a) +300 = +1 +299
(b) +2 = +2
(c) –54 +52 +3 = +1
(d) –1 = –1
(e) –44 +44 =

2-22
(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.
Received: Lower undistributed earnings Given: Dividends Payable (+L) $2

Retained Earnings (−SE) $2
(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

Assets $0 = Liabilities $2 + Stockholders’ Equity −$2
Overall effects of (a)–( f): Assets $302 = Liabilities $4 + Stockholders’ Equity $298
$302 = $302
2-23
2-4 Determine the impact of business transactions on the balance sheet
using two basic tools: Journal entries and T-accounts.
2-24
How Do Companies Keep Track of Account Balances?
General
General Journal
Journal
(chronological
(chronological list
list of
of transactions)
transactions)
POS
General
General LedgerT
Ledger
or
or T-accounts
T-accounts
(a
(a record
record of
of effects
effects to
to
and
and balances
balances of
of each
each
account)
account)
2-25
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)
2-26
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)
2-27
Debits and Credits
In Summary:
2-28
The Journal Entry
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.
2-29
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

Balance 1
1-2-18 G1 1 2
General Ledger ADDITIONAL PAID-IN CAPITAL 302

Balance 1,305
1-2-18 G1 299 1,604
2-30
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).
2-31
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
2-32
Transaction Analysis Illustrated (1 of 3)
Debit Credit
(a) Cash (+A) 300
Common stock (+SE) 1
Additional paid-in capital (+SE) 299

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)
2-33
(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

Cash +2 Notes payable +2
+ Cash (A) – – Notes Payable (L) +

1/1/18 186 78 1/1/18
(a) 300 2 (b)
(b) 2
2-34
After analyzing all transactions from (a)–(f), the balance in our T-accounts will
appear as follows:
2-35
Using Big Data for Business Expansion
Data Analytics
Big
Big data
data analytics
examines
amounts
amounts of
analytics
examines large
large
of data
data to
to
With
With today’s
today’s
$$$
technology,
technology, it’s
it’s
uncover
uncover hidden
hidden
possible
possible to
to analyze
analyze
patterns,
patterns, correlations
correlations
your
your data
data and
and get
get
and
and other
other insights.
insights.
answers
answers from
from itit
almost
almost immediately!
immediately!
Companies
are making Data Analytics
more data- has exploded
driven These
in the past
decisions. decisions can
several years.
reduce costs
and transform
the business
for the future.
2-36
2-5 Prepare a trial balance and simple classified balance sheet and analyze
the company using the current ratio.
2-37
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.
2-38
Classified Balance Sheet
Assets and
liabilities are
classified into two
categories:
current and
noncurrent.
Current
Current assets
assets are
are those
those to
to be
be used
used oror
turned
turned into
into cash
cash within
within the
the upcoming
upcoming
year,
year, whereas
whereas noncurrent
noncurrent assets
assets are
are
those
those that
that will
will last
last longer
longer than
than one
one year.
year.
Current
Current liabilities
liabilities are
are those
those obligations
obligations
to
to be
be paid
paid or
or settled
settled within
within the
the next
next 12
12
months
months with
with current
current assets.
assets.
2-39
Chipotle Mexican
Grill’s First Quarter
2018 Balance
Sheet
(based on investing and
financing activities only)
2-40
Chipotle Mexican Grill’s First Quarter 2018 Balance
Exhibit 2.8 (2 of 3) Sheet
(based on investing and financing activities only)
2-41
Chipotle Mexican Grill’s First Quarter 2018 Balance
Exhibit 2.8 (3 of 3) Sheet
(based on investing and financing activities only)
2-42
International Perspective
2-43
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?
2-44
2-6 Identify investing and financing transactions and demonstrate how they
impact cash flows.
2-45
Investing and Financing Activities
FOCUS ON CASH FLOWS
Companies report cash inflows (+) and outflows (−)

$$$
over a period in their statement of cash flows.
2-46

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chapter 2 Investing and Financing

Decisions and the Accounting

2-2 Identify what constitutes a business transaction and recognize common

2-3 Apply transaction analysis to simple business transactions in terms of

2-4 Determine the impact of business transactions on the balance sheet

Objective of Financial Reporting to External Users: (in Ch. 2)

Objective of Financial Reporting to External Users: (in Ch. 2)

Many very valuable intangible assets, such as

Some liabilities, called off-balance-sheet

External Events: Exchanges between the entity

Ex: Purchase of a machine from a supplier.

Internal Events: Events that are not exchanges

Ex: Using up insurance paid in advance.

 Every transaction affects at least two accounts.

 The accounting equation must remain in balance after each

The accounting equation must remain in balance after each

Step 1: Ask - What was received and what was given?

Step 2: Verify - Is the accounting equation in balance? (A = L + SE)

To illustrate the use of the transaction analysis process, let’s consider

Step 1: What was received and what was given?

Received: Cash (+A) $300

Given: Additional stock shares:

Assets = Liabilities + Stockholders’ Equity

(a) +300 = +1 +299

Step 2: Is the accounting equation in balance?

Step 1: What was received and what was given?

Received: Cash (+A) $2 Given: Long-Term Notes Payable (+L) $2

Assets = Liabilities + Stockholders’ Equity

(a) +300 = +1 +299

Step 2: Is the accounting equation in balance?

(c) Chipotle purchased $8 in additional land, $34 in new buildings, $10 in

Step 1: What was received and what was given?

Assets = Liabilities + Stockholders’ Equity

Step 2: Is the accounting equation in balance?

Step 1: What was received and what was given?

Received: Reduction in amount due: Given: Cash (−A) $1

Assets = Liabilities + Stockholders’ Equity

(a) +300 = +1 +299

Step 2: Is the accounting equation in balance?

(e) Chipotle purchased the stock of other companies as investments, paying

Step 1: What was received and what was given?

Received: Short-Term Investments (+A) $9 Given: Cash (−A) $44

Assets = Liabilities + Stockholders’ Equity

Step 2: Is the accounting equation in balance?

Received: Lower undistributed earnings Given: Dividends Payable (+L) $2

Step 2: Is the accounting equation in balance?

Start of new period

During the Period

At the End of the Period

Common Stock and Retained

General Journal Page G1

General Ledger CASH 101

General Ledger COMMON STOCK 301

General Ledger ADDITIONAL PAID-IN CAPITAL 302

Start with a Draw a line across the T

+ Cash (A) – − Common Stock (SE) +

Use the same

− Accounts Payable (L) +

300 End bal.

Assets = Liabilities + Stockholders’ Equity

Assets = Liabilities + Stockholders’ Equity

+ Cash (A) – – Notes Payable (L) +

Does a company have the short-term resources