Chapter 02 – Investing and Financing Decisions and the Accounting System
2-1
CHAPTER 2
INVESTING AND FINANCING DECISIONS
AND THE ACCOUNTING SYSTEM
Learning Objectives and Related Assignment Materials
Learning Objectives
Mini-
Exercises
Exercises
Problems
Alternate
Problems
Cases and
Projects
Continuing
Case
1. Define the objective of
financial reporting, the
elements of the balance
sheet, and the related
key accounting
assumptions and
principles.
1, 2
1
1
1
1, 2, 5, 7
2. Identify what constitutes
a business transaction
and recognize common
balance sheet account
titles used in business.
2, 3, 4
1, 2, 3,
20
1, 2, 3, 5
1, 2, 3
1, 2, 3, 4,
6, 9
3. Apply transaction
analysis to simple
business transactions in
terms of the accounting
model: Assets =
Liabilities +
Stockholders’ Equity.
2, 5
1, 4, 5
2
2
4. Determine the impact of
business transactions on
the balance sheet using
two basic tools: Journal
entries and T-accounts.
1, 2, 6, 7,
8, 9
1, 3, 6, 7,
8, 9, 10,
11, 12,
13, 15,
16, 17
1, 3, 5
1
6
1
5. Prepare a trial balance
and simple classified
balance sheet and
analyze the company
using the current ratio.
10, 11
9, 10, 13,
14, 15,
20
2, 3, 5
2, 3
1, 2, 3, 4,
5, 6, 7, 9
1
6. Identify investing and
financing transactions
and demonstrate how
they impact cash flows.
13
18, 19,
20
4, 6
4
1, 2, 3, 4,
9
1
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-2
Synopsis of Chapter Revisions
Focus Company: Chipotle Mexican Grill
▪ New focus company Chipotle Mexican Grill (replacing Papa John’s International in 7e), with
integration of financial information for the first quarter of 2012 (not for a month as in 7e).
▪ Use of Chipotle Mexican Grill eliminates complications of franchise accounting involved in the Papa
John’s example in the 7e.
▪ Chipotle’s business strategy is based on sustainable practices that are of growing interest to businesses
and society.
▪ Cash flow statement coverage limited to identifying transactions as operating, investing, or financing.
▪ Discussion and illustration of issuing common stock using accounts students will likely see in real
statements—Common Stock and Additional Paid-in Capital (not Contributed Capital, which was used
in 7e). The demonstration case and EOC material have been changed to reflect coverage of these new
accounts.
▪ Update of the conceptual framework to reflect the new definitions from the FASB.
▪ Trial balance introduced (moved from Chapter 4 in 7e) and updated as needed as part of the continuing
illustration of Chipotle Mexican Grill’s quarterly transactions.
▪ T-accounts added after each transaction to illustrate posting the effects.
▪ New GUIDED HELP feature provides free access to step-by-step video instruction on transaction
analysis and recording, posting, and classifying accounts for investing and financing activities
▪ New CONTINUING CASE added to the end-of-chapter problems. In this case, students prepare
journal entries, post to T-accounts, prepare a trial balance and classified balance sheet, identify
investing and financing activities affecting cash flows, and compute and interpret the current ratio
based on the balance sheet for Penny’s Pool Service.
▪ New and updated real companies, as well as modified accounts, names, and amounts for fictional
companies in end-of-chapter exercises, problems, and cases with requirements reflecting the changes
in topics emphasized in each chapter.
PowerPoint Slides
Learning Objectives
PowerPoint® Slides
1. Define the objective of financial reporting, the elements of the balance
sheet, and the related key accounting assumptions and principles.
2-1 through 2-5
2. Identify what constitutes a business transaction and recognize common
balance sheet account titles used in business.
2-6 through 2-8
3. Apply transaction analysis to simple business transactions in terms of the
accounting model: Assets = Liabilities + Stockholders’ Equity.
2-9 through 2-16
4. Determine the impact of business transactions on the balance sheet using
two basic tools: Journal entries and T-accounts.
2-17 through 2-26
5. Prepare a trial balance and simple classified balance sheet and analyze the
company using the current ratio.
2-27 through 2-31
6. Identify investing and financing transactions and demonstrate how they
impact cash flows.
2-32
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-3
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Related Video Programs
McGraw-Hill/Irwin Financial Accounting Video Series
Program #2 – Transaction Analysis (9:35)
This video program may be shown in connection with chapter 2 or chapter 3.
The video features Platinum Technology during its general discussion of transactions. The video begins
by defining and providing examples of assets, liabilities, equity, revenue, and expense. Then, the term,
business transaction, is explained. The distinction between what is and what isn’t a transaction is stressed.
Platinum Technology is a real world company that must determine whether given events should be
recorded as transactions. After the accounting equation is illustrated, its similarity to the balance sheet is
noted. Then, transaction analysis is performed for a number of transactions. Most, but not all, of the
transactions illustrated affect the balance sheet.
Program #3 – Recording Transactions (11:13)
The video begins with a brief discussion of the nature of the ledger. Next, the usefulness of the T-account
as a tool and the meanings of the terms debit and credit are explained. After illustrating the analysis of a
single transaction in T-account format, the rules of debit and credit are explained and illustrated.
Transaction analysis is illustrated (using a T-account format) for a number of transactions that affect the
balance sheet. The effects on the accounting equation are included for the transactions. Then, the purpose
of the journal is addressed and journal entries are illustrated for the first few transactions that were
analyzed previously. The posting process is addressed briefly. After explaining the purpose of the trial
balance, its preparation is illustrated. After in-depth illustrations of the preparation of the financial
statements that summarize the transactions that were analyzed, a review of the entire process is provided.
Chapter Take-Aways
1. Define the objective of financial reporting, the elements of the balance sheet, and the related
key accounting assumptions and principles.
Objective
▪ The primary objective of financial reporting to external users is 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.
Qualitative characteristics of useful financial information:
▪ Relevance (including materiality) that allows users to assess past activities and/or predict future
activities.
▪ Faithful representation requires information to be complete, neutral, and free from error.
▪ To enhance the qualitative characteristics, information should also be comparable (to other
companies and over time), verifiable, timely, and understandable.
Key recognition, measurement, and disclosure concepts:
Assumptions—
▪ Separate-entity assumption—transactions of the business are accounted for separately from
transactions of the owner.
▪ Continuity (going-concern) assumption—a business is expected to continue to operate into the
foreseeable future.
▪ Stable monetary unit assumption—financial information is reported in the national monetary unit
without adjustment for changes in purchasing power.
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-4
Chapter Take-Aways, continued
Principles—
▪ Mixed-attribute measurement model—most balance sheet elements are recorded following the
historical cost (or cost) principle—financial statement elements should be recorded at the cash
equivalent cost on the date of the transaction; however, these values may be adjusted to other
amounts such as market value depending on certain conditions.
Elements of the balance sheet:
▪ Assets—probable future economic benefits owned or controlled by the entity as a result of past
transactions.
▪ Liabilities—probable future sacrifices of economic benefits arising from present obligations of a
business as a result of past transactions.
▪ Stockholders’ equity—residual interest of owners in the assets of the entity after settling liabilities;
the financing provided by the owners (contributed capital) and by business operations (earned
capital).
2. Identify what constitutes a business transaction and common balance sheet account titles used
in business.
▪ An exchange between a business and one or more external parties to a business, or
▪ A measurable internal event, such as adjustments for the use of assets in operations.
An account is a standardized format that organizations use to accumulate the dollar effects of
transactions related to each financial statement item. Typical balance sheet account titles include the
following:
▪ Assets: Cash, Accounts Receivable, Inventory, Prepaid Expenses, Investments, Property (buildings
and land) and Equipment, and Intangible (rights without physical substance).
▪ Liabilities: Accounts Payable, Notes Payable, Accrued Expenses Payable, Unearned Revenues,
and Taxes Payable.
▪ Stockholders’ Equity: Common Stock, Additional Paid-in Capital, and Retained Earnings.
3. Apply transaction analysis to simple business transactions in terms of the accounting model:
Assets = Liabilities + Stockholders’ Equity.
To determine the economic effect of a transaction on an entity in terms of the accounting equation,
each transaction is analyzed to determine the accounts (at least two) that are affected. In an exchange,
the company receives something and gives up something. If the accounts, direction of the effects, and
amounts are correctly analyzed, the accounting equation must stay in balance. The transaction
analysis model is:
ASSETS
(many accounts)
=
LIABILITIES
(many accounts)
+
STOCKHOLDERS’ EQUITY
(two accounts)
+
debit
–
credit
–
debit
+
credit
Common Stock
and Additional
Paid-in Capital
Retained
Earnings
–
debit
+
credit
Investments
by owners
–
debit
Dividends
declared
+
credit
Net income
of business
Systematic transaction analysis includes (1) determining the accounts that were received and were
given in the exchange, including the type of each account (A, L, or SE), amounts, and direction of the
effect, and (2) determining that the accounting equation remains in balance.
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-5
Chapter Take-Aways, continued
4. Determine the impact of business transactions on the balance sheet using two basic tools:
Journal entries and T-accounts.
▪ Journal entries express the effects of a transaction on accounts in a debits-equal-credits format.
The accounts and amounts to be debited are listed first. Then the accounts and amounts to be
credited are listed below the debits and indented, resulting in debits on the left and credits on the
right. Each entry needs a reference (date, number, or letter).
Debit
Credit
(a)
Cash (+A)
62,300
Common Stock (+SE)
100
Additional Paid-in Capital (+SE)
62,200
▪ T-accounts summarize transactions effects for each account. These tools can be used to determine
balances and draw inferences about a company’s activities.
Liabilities and
+ (dr) Assets (cr) − − (dr) Stockholders’ Equity (cr) +
Beginning balance
Beginning balance
Increases
Decreases
Decreases
Increases
Ending balance
Ending balance
5. Prepare a trial balance and simple classified balance sheet and analyze the company using the
current ratio.
Classified balance sheets are structured with:
▪ Assets categorized as current assets (those to be used or turned into cash within the year, with
inventory always considered a current asset) and noncurrent assets, such as long-term investments,
property and equipment, and intangible assets.
▪ Liabilities categorized as current liabilities (those that will be paid with current assets) and long-
term liabilities.
▪ Stockholders’ equity accounts are listed as Common Stock first followed by Retained Earnings.
The current ratio (Total Current Assets Total Current Liabilities) measures a company’s liquidity –
the ability of the company to pay its short-term obligations with current assets.
6. Identify investing and financing transactions and demonstrate how they impact cash flows.
A statement of cash flows reports the sources and uses of cash for the period by the type of activity
that generated the cash flow: operating, investing, and financing. Investing activities are purchasing
and selling long-term assets and making loans and receiving principal payments from others.
Financing activities are borrowing and repaying the principal on loans, issuing and repurchasing
stock, and paying dividends.
Key Ratio
Current ratio measures the ability of the company to pay its short-term obligations with current assets.
Although a ratio above 1.0 indicates sufficient current assets to meet obligations when they come due,
many companies with sophisticated cash management systems have ratios below 1.0.
Current Ratio = Total Current Assets Total Current Liabilities
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-6
Finding Financial Information
BALANCE SHEET
Current Assets
Cash
Short-term investments
Accounts receivable
Notes receivable
Inventory
Prepaid expenses
Noncurrent Assets
Long-term investments
Property and equipment
Intangibles
Current Liabilities
Accounts payable
Accrued expenses payable
Short-term notes payable
Unearned revenue
Noncurrent Liabilities
Long-term debt (notes payable)
Stockholders’ Equity
Common Stock
Additional paid-in capital
Retained earnings
INCOME STATEMENT
To be presented in
Chapter 3
STATEMENT OF CASH FLOWS
Under Operating Activities
To be presented in Chapter 3
Under Investing Activities
+ Sales of noncurrent assets and investments for cash
− Purchases of noncurrent assets and investments for cash
− Loans to others
+ Receipt of loan principal payments from others
Under Financing Activities
+ Borrowing from banks
− Repayment of loan principal to banks
+ Issuance of stock
− Repurchasing stock
NOTES
To be discussed in
future chapters
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-7
Chapter Outline
Teaching Notes
LO1 – Define the objective of financial reporting, the elements of the balance sheet, and the
related key accounting assumptions and principles.
I. Overview of Accounting Concepts––Concepts Emphasized in
Chapter 2
Conceptual Framework
summarized in Exhibit 2.1
A. Objective of Financial Reporting
1. Primary objective of external financial reporting is to
provide useful economic information about a business to
help external parties make sound financial decisions
2. Decision makers – users of accounting information;
include existing and potential investors, lenders, and other
creditors.
3. Most are interested in information needed to assess
amount, timing, and uncertainty of business’s future cash
inflows and outflows.
B. Qualitative Characteristics of Financial Information
1. Relevant information – Can influence a decision; it is
timely and has predictive and/or feedback value
2. Faithful representation – requires information to be
complete, neutral, and free from error
3. Qualitative aspects that enhance the usefulness of
information that is relevant and faithfully representative
include: comparability, verifiability, timeliness, and
understandability
C. Recognition and Measurement Concepts
1. Separate-entity assumption – business transactions are
accounted for separately from the transactions of owners
2. Continuity (going concern) assumption – unless there is
evidence to the contrary, business is expected to continue
operating into the foreseeable future
3. Stable monetary unit assumption – each business entity
accounts for and reports its financial results primarily in
terms of the national monetary unit without any
adjustments for changes in purchasing power
4. Mixed-attribute measurement model:
a. Applied to measuring different assets and liabilities
b. Historical cost principle (or cost principle) – most
balance sheet elements are recorded at the cash
equivalent value on the date of the transaction
D. Elements of the Balance Sheet
Chipotle’s Balance Sheet
illustrated in Exhibit 2.2
1. Assets – probable future economic benefits owned or
controlled by an entity as a result of past transactions or
events
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-8
2. Assets are listed in order of liquidity – how soon an asset
is expected by management to be turned into cash or used
i. Current assets –will be used or turned into cash
within one year
See Financial Analysis
ii. All other assets are considered long term (or
noncurrent); that is, they are to be used or turned
into cash beyond the coming year.
feature “Unrecorded But
Valuable Assets and
Liabilities”
3. Liabilities – probable future sacrifices of economic
benefits as a result of past transactions or events;
obligations to pay cash or provide goods or services
a. Creditors – entities that a company owes money
b. Liabilities are usually listed on the balance sheet in
order of maturity – how soon an obligation is to be
paid
i. Current liabilities – obligations that will be settled
by providing cash, goods, other current assets, or
services within the coming year
ii. All other liabilities are considered long term (or
noncurrent)
4. Stockholders’ equity (also called shareholders’ equity or
owners’ equity) – the residual interest in the assets of the
entity after subtracting liabilities
a. Financing provided by owners – referred to as
contributed capital
b. Financing provided by operations –referred to as
earned capital or retained earnings
Refer students to Pause for
Feedback – Self-Study Quiz
i. When companies earn profits, they can be
distributed to owners as dividends or reinvested in
the business
Portion of profits reinvested in the business is
called retained earnings
ii. Companies with a growth strategy often pay little
or no dividends to retain funds for expansion
LO2 – Identify what constitutes a business transaction and recognize common balance sheet
account titles used in business.
II. What Business Activities Cause Changes in Financial Statement
Amounts?
A. Nature of Business Transactions
1. A transaction is:
a. An exchange of assets or services for assets, services,
or promises to pay between a business and one or
more external parties to a business or
b. A measurable internal event such as the use of assets
in operations
2. Only economic resources and debts resulting from past
transactions are recorded on the balance sheet
a. External events – exchanges of assets, goods, or
services by one party for assets, services, or promises
to pay (liabilities) by one or more other parties
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-9
b. Internal events – include certain events that are not
exchanges between the business and other parties but
nevertheless have a direct and measurable effect on
the entity
c. Some important events have a future economic impact
on a company, but are not reflected in the financial
statements (e.g., an exchange of promises)
B. Accounts
1. Account – a standardized format that organizations use to
accumulate the dollar effect of transactions on each
financial statement item
Illustrated in Exhibit 2.3
2. Chart of accounts – a list of all account titles and their
unique numbers; are usually organized by financial
statement element (asset, liability, stockholders’ equity,
revenue, and expense accounts in that order)
3. Every company creates its own chart of accounts to fit the
nature of its business activities
4. The accounts in the financial statements of large
companies are actually summations of a number of
specific accounts in their recordkeeping system
LO3 – Apply transaction analysis to simple business transactions in terms of the accounting
model: Assets = Liabilities + Stockholders’ Equity.
III. How Do Transactions Affect Accounts?
A. Principles of Transaction Analysis
Show Video Program #2
1. Transaction analysis is the process of studying a
transaction to determine its economic effect on the entity
in terms of the accounting equation
2. Two principles underlying the transaction analysis:
a. Every transaction affects at least two accounts;
correctly identifying those accounts and the direction
of the effect (increase or decrease) is critical
Stress the importance of a
clear understanding of these
principles
b. The accounting equation must remain in balance after
each transaction
3. Dual effects concept – every transaction has at least two
effects on the basic accounting equation
4. Most transactions with external parties involve an
exchange by which the business entity both receives
something and gives up something in return
a. If Chipotle purchases tomatoes for cash, it receives
food supplies (an increase in an asset) and gives up
cash (a decrease in an asset)
b. If Chipotle purchases tomatoes on credit (that is,
money is owed to suppliers) for cash, it would engage
in two separate transactions at different points in time
i. It receives food supplies (an increase in an asset)
and gives a promise to pay later (an increase in a
liability)
ii. Later, It pays cash (a decrease in an asset) and
eliminates the promise (a decrease in a liability)
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-10
c. Not all important business activities result in a
transaction that affects the financial statements
i. Most importantly, signing a contract involving the
exchange of two promises to perform does not
result in an accounting transaction that is recorded
ii. For example, if Chipotle sent an order for tomatoes
to its food supplier and the supplier accepted the
order but did not fill it immediately, no transaction
took place
5. Balancing the Accounting Equation
a. Step 1: Ask – What was received and what was given?
i. Identify the account affected by title, making sure
that at least two accounts change
ii. Classify them by type of account – Asset (A), a
liability (L), or a stockholders’ equity (SE)
account?
iii. Determine the direction of the effect – Did the
account increase (+) or decrease (−)?
b. Step 2: Verify – Is the accounting equation in balance?
(A = L + SE)
B. Analyzing Chipotle’s Transactions
Use Supplemental
1. Transaction (a) Chipotle issued 10,000 additional shares
of $.01 par value common stock, receiving $62,300 in
cash from investors
Enrichment Activity #1
Use Supplemental
Enrichment Activity#2
a. Related terminology
i. Par value – a legal amount per share established by
the board of directors; it represents the minimum
amount a stockholder must contribute and has no
relationship to the market price of the stock
ii. Common stock – the account that is equal to the
number of shares issued by a corporation times the
par value per share
iii. Additional paid-in capital (paid-in capital,
contributed capital in excess of par) – the amount
of capital contributed by the shareholders less the
par value of the stock
a. Step 1: What was received and what was given?
Received: Cash (+A) $62,300
Given: Additional stock shares, Common Stock (+SE)
$100 (10,000 shares x $.10) and Additional Paid-in
Capital $62,200 ($62,300 – $62,200)
b. Step 2: Is the accounting equation in balance?
Yes. The left side increased by $62,300 and the right
side increased by $62,300
Assets = Liabilities + Stockholders’ Equity
Cash (A) + 62,300 = Common Stock (SE) + 100 +
Additional Paid-in Capital (SE) + 62,200
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-11
2. Transaction (b) Chipotle borrowed $2,000 from its local
bank, signing a note to be paid in three years
a. Step 1: What was received and what was given?
Received: Cash (+A) $2,000
Given: Written promise to the bank, Notes Payable
(+L) $2,000
b. Step 2: Is the accounting equation in balance?
Yes. The left side increased by $2,000 and the right
side increased by $2,000
Assets = Liabilities + Stockholders’ Equity
Cash (A) + 2,000 = Notes Payable (L) + 2,000
3. Transaction (c) Chipotle purchased new ovens, counters,
refrigerators, and other equipment costing $63,100,
paying $55,100 in cash and signing a note for the rest
a. Step 1: What was received and what was given?
Received: Property and Equipment (+A) $63,100
Given: (1) Cash (−A) $55,100 (2) Notes Payable (+L)
$8,000
b. Step 2: Is the accounting equation in balance?
Yes. The left side increased by $55,100 and the right
side increased by $55,100
Assets = Liabilities + Stockholders’ Equity
Cash (A) − $55,100 + Property and Equipment (A)
+ $63,100 = Notes Payable (L) + $8,000
4. Transaction (d) Chipotle paid $400 to the local bank for
the amount borrowed in transaction (b) (ignore interest)
a. Step 1: What was received and what was given?
Received: Reduction in bank loan: Notes Payable (−L)
$400
Given: Cash (−A) $400
b. Step 2: Is the accounting equation in balance?
Yes. The equation stays in balance because assets
increase and decrease by the same amount, $400
Assets = Liabilities + Stockholders’ Equity
Cash (A) − $400 = Notes Payable (L) − $400
5. Transaction (e) Chipotle purchased the stock of other
companies, paying $60,400 in cash
a. Step 1: What was received and what was given?
Received: Investments (+A) $60,400
Given: Cash (−A) $60,400
b. Step 2: Is the accounting equation in balance?
Yes. The equation stays in balance because assets
increase and decrease by the same amount, $60,400
Assets = Liabilities + Stockholders’ Equity
Cash (A) − 60,400 + Investments (A) + 60,400= No
change
Refer students to Pause for
Feedback – Self-Study Quiz
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-12
6. Transaction (f) Chipotle’s board of directors declared that
the Company will pay $3,000 in cash dividends to
shareholders next quarter
Note that Chipotle does
actually not pay dividends; it
reinvests profits
a. Step 1: What was received and what was given?
Received: Lower claim from stockholders, Retained
Earnings (−SE) $3,000
Given: Dividends Payable (+L) $3,000
b. Step 2: Is the accounting equation in balance?
Yes. The equation stays in balance because liabilities
increase and stockholders’ equity decreases by the
same amount, $3,000
Assets = Liabilities + Stockholders’ Equity
No change = Dividends Payable (L) + $3,000 +
Retained Earnings (SE) − $3,000
Refer students to Pause for
Feedback – Self-Study Quiz
LO4 – Determine the impact of business transactions on the balance sheet using two basic
tools: Journal entries and T-accounts.
IV. How Do Companies Keep Track of Account Balances?
A. The accounting cycle – the process followed by entities to
analyze and record transactions, adjust the records at the end
of the period, prepare financial statements, and prepare the
records for the next cycle; during the accounting cycle:
Accounting cycle illustrated
in Exhibit 2.4
1. Transactions are analyzed and recorded in the general
journal in chronological order
2. The related accounts are updated in the general ledger
B. The Direction of Transaction Effects
Illustrated in Exhibit 2.5
1. Each account is set up as a “T” with the following
structure:
a. Increases in asset accounts are on the left because
assets are on the left side of the accounting equation
b. Increases in liability and stockholders’ equity
accounts are on the right because liability and
stockholders’ equity are on the right side of the
accounting equation
2. Names for each side of an account:
a. Debit (dr) is on the left side of the T
b. Credit (cr) is on the right side of the T
3. Rules for increases and decreases:
a. Asset accounts increase on the left (debit) side; they
have debit balances
b. Liability and stockholders’ equity accounts increase
on the right (credit) side, creating credit balances
4. Summary:
Assets
=
Liabilities
+
Stockholders’
Equity
Increase with
debits
Increase with
credits
Increase with
credits
Accounts have
debit balances
Accounts have
credit balances
Accounts have
credit balances
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-13
5. If the correct accounts and effects are identified, the
accounting equation will remain in balance because the
total debits will equal the total credits in a transaction
Refer students to Pause for
Feedback – Self-Study Quiz
C. Analytical Tools:
1. Transactions are recorded in chronological order in a
general journal (or simply, journal)
Show Video Program #3
2. Journal entry – an accounting method for expressing the
effects of a transaction on accounts in a debits-equal-
credits format
a. It is useful to include a date or some form of reference
for each transaction
b. The debited accounts are written first (on top) with the
amounts recorded in the left column
c. The credited accounts are written below the debits and
are usually indented with the credited amounts written
in the right column
d. Compound entry – a journal entry that affects more
than two accounts
3. T-account – A tool for summarizing transaction effects
for each account, determining balances, and drawing
inferences about a company’s activities
T-accounts illustrated in
Exhibit 2.7
See Financial Analysis
feature “Inferring Business
Activities from T-Accounts”
a. By themselves, journal entries do not provide the
balances in accounts
b. After journal entries are recorded, the dollar amounts
are posted (transferred) to each account affected by the
transaction to determine the new account balances
c. As a group, the accounts are called a general ledger
d. Posting illustrated in Exhibit 2.6
D. Transaction Analysis Illustrated
Use Supplemental
Enrichment Activity #3
Use Supplemental
Enrichment Activity#4
1. Transaction (a) Chipotle issued 10,000 additional shares
of $.01 par value common stock, receiving $62,300 in
cash from investors
dr Cash (+A)
62,300
cr Common Stock (+SE)
100
cr Additional Paid-in Capital
(SE)
62,200
Assets = Liabilities + Stockholders’ Equity
Cash (A) + 62,300 = Common Stock (SE) + 100 +
Additional Paid-in Captial + 62,200 (SE)
2. Transaction (b) Chipotle borrowed $2,000 from its local
bank, signing a note to be paid in three years
dr Cash (+A)
2,000
cr Notes Payable (–L)
2,000
Assets = Liabilities + Stockholders’ Equity
Cash (A) + 2,000 = Notes Payable (L) + 2,000
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-14
3. Transaction (c) Chipotle purchased new ovens, counters,
refrigerators, and other equipment costing $63,100,
paying $55,100 in cash and signing a note for the rest
dr Property & Equipment (+A)
63,100
cr Cash (–A)
55,100
cr Notes Payable (+L)
8,000
Assets = Liabilities + Stockholders’ Equity
Cash (A) − $63,100 + Property and Equipment (A)
+ $55,100 = Notes Payable (L) + $8,000
4. Transaction (d) Chipotle paid $400 to the local bank for
the amount borrowed in transaction (b) (ignore interest)
dr Notes Payable (+A)
400
cr Cash (–A)
400
Assets = Liabilities + Stockholders’ Equity
Cash (A) − $400 = Notes Payable (L) − $400
5. Transaction (e) Chipotle purchased the stock of other
companies, paying $60,400 in cash; the company intends
to hold $20,900 of the stock as long-term investments and
the rest as short-term investments
dr Short-term Investments (+A)
39,500
dr Long-term Investments (+A)
20,900
cr Cash (–A)
60,400
Assets = Liabilities + Stockholders’ Equity
Cash (A) − 60,400 + Short-term Investments (A) +
39,500 + Short-term Investments (A) + 20,900 = No
change
6. Transaction (a) Chipotle’s board of directors declared that
the Company will pay $3,000 in cash dividends to
shareholders next quarter
dr Retained Earnings (–SE)
3,000
cr Dividends Payable (+L)
3,000
Assets = Liabilities + Stockholders’ Equity
No change = Dividends Payable (L) + $3,000 + Retained
Earnings (SE) − $3,000
Refer students to Pause for
Feedback – Self-Study Quiz
7. Posting of these transactions to the T-accounts is
illustrated in the text after the analysis of transaction (f)
Use Supplemental
Enrichment Activity #5
LO5 – Prepare a trial balance and simple classified balance sheet and analyze the company
using the current ratio.
V. How Is the Balance Sheet Prepared and Analyzed?
a. Trial Balance
1. Trial balance – list of all accounts with their balances to
provide a check on the equality of the debits and credits
Use Supplemental
Enrichment Activity #7
2. A trial balance spreadsheet is created first for internal
purposes before preparing statements for external users
2. A trial balance lists the names of the T-accounts in one
column in financial statement order (assets, liabilities,
stockholders’ equity, revenues, and expenses), with their
ending debit or credit balances in the next two columns
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-15
3. Debit balances are indicated in the left column and credit
balances are indicated in the right column
4. Then the two columns are totaled to provide a check on
the equality of the debits and credits
5. Errors in a computer-generated trial balance may exist if
wrong accounts and/or amounts are used in the journal
entries
A. Classified Balance Sheet
Chipotle’s Balance Sheet
1. Prepared from the trial balance
illustrated in Exhibit 2.8
2. The assets and liabilities are classified into two
categories: current and noncurrent
Use Supplemental
Enrichment Activity #7
3. Dollar signs are indicated at the top and bottom of the
asset section and top and bottom of the liabilities and
shareholders’ equity section
See Financial Analysis
feature “Understanding
Foreign Financial
Statements”
4. Includes comparative data; when multiple periods are
presented, the most recent balance sheet amounts are
usually listed on the left
B. Current Ratio
1. Current Ratio = Current Assets – Current Liabilities
2. Creditors and security analysts use the current ratio to
measure the ability of the company to pay its short-term
obligations with short-term assets
Use Supplemental
Enrichment Activity #8
3. Generally, the higher the ratio, the more cushion a
company has to pay its current obligations if future
economic conditions take a downturn
4. While a high ratio normally suggests good liquidity, too
high of a ratio suggests inefficient use of resources
5. An old rule of thumb was that companies should have a
current ratio between 1.0 and 2.0; today, many strong
companies have current ratios below 1.0
Refer students to Pause for
Feedback – Self-Study Quiz
LO6 – Identify investing and financing transactions and demonstrate how they impact cash
flows.
VI. Focus on Cash Flows – Investing and Financing Activities
A. The statement of cash flows divides all transactions that
affect cash into three categories:
1. Operating activities (covered in Chapter 3)
2. Investing activities include buying and selling noncurrent
assets and investments
3. Financing activities include borrowing and repaying debt,
including short-term bank loans, issuing and repurchasing
stock, and paying dividends
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-16
4. Effects of transactions in this chapter on the statement of
cash flows:
Refer students to Pause for
Feedback – Self-Study Quiz
Operating Activities
(None of the transactions impact operating activities)
Investing Activities
Purchasing long-term assets and investments for
cash
Selling long-term assets and investments for cash
Lending cash to others
Receiving principal payments on loans made to
others
Financing Activities
Borrowing cash from banks
Repaying the principal on borrowings from banks
Issuing stock for cash
Repurchasing stock with cash
Paying cash dividends
−
+
−
+
+
−
+
−
−
−
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-17
Supplemental Enrichment Activities
Note: These activities would be suitable for individual or group activities.
1. Handout 2-1
Use this handout for an in-class activity designed to review the analysis of various investing and
financing transactions. The solution follows the handout master.
2. Handout 2-2
This activity is a continuation of Activity #1. Use this handout for an in-class activity designed to
continue the review of the analysis of various investing and financing transactions. The solution
follows the handout master.
3. Handout 2-3
Use Handout 2-3 for an in-class activity designed to review the debit/credit framework. Note that
these transactions are the same as those analyzed on Handout 2-1. However, it can be assigned even if
Activity #1 was not assigned. The solution follows the handout master.
4. Handout 2-4
This activity is a continuation of Activity #3. Use this handout for an in-class activity designed to
review the debit/credit framework. Note that these transactions are the same as those analyzed on
Handout 2-2. However, it can be assigned even if Activity #2 was not assigned. The solution follows
the handout master.
5. Handout 2-5
Use this handout for an in-class activity designed to review the posting of various investing and
financing transactions to T-accounts. This activity is a continuation of Activity #3 and Activity #4; it
should be assigned only if both of those activities were assigned. The solution follows the handout
master.
6. Handout 2-6
Use this handout for an in-class activity designed to review the preparation of a trial balance. This
activity is a continuation of Activity #5; it should be assigned only if that activity was assigned. The
solution follows the handout master.
7. Handout 2-7
Use this handout for an in-class activity designed to review the preparation of a classified balance
sheet. This activity is a continuation of Activity #6; it should be assigned only if that activity was
assigned. The solution follows the handout master.
8. Use Handout 2-8
Use this handout for an in-class activity designed to review the calculation and interpretation of the
current ratio. This activity is a continuation of Activity #7; it should be assigned only if that activity
was assigned. The solution follows the handout master.
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-18
HANDOUT 2 – 1
ANALYZING TRANSACTIONS
Analyze each of the following transactions of World Wide Webster by performing each of the following
steps. Then, use the chart on the following page to keep track of the amount in each account:
(a) Stockholder invests $10,000 into the business in exchange for 10,000 shares of $1 par value common
stock.
1.
Decide if a transaction took place.
2.
Identify the accounts affected.
3.
Classify each account affected.
4.
Identify direction and amount.
5.
Ensure the accounting equation is in balance.
(b) Borrow $15,000, using a note payable to the bank.
1.
Decide if a transaction took place.
2.
Identify the accounts affected.
3.
Classify each account affected.
4.
Identify direction and amount.
5.
Ensure the accounting equation is in balance.
(c) Acquire a $15,000 truck and $5,000 worth of equipment.
1.
Decide if a transaction took place.
2.
Identify the accounts affected.
3.
Classify each account affected.
4.
Identify direction and amount.
5.
Ensure the accounting equation is in balance.
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-19
HANDOUT 2 – 1, continued
(d) Purchase $300 worth of supplies on credit. “On credit” (or “on account”) means that you receive the
supplies now, and pay for them later.
1.
Decide if a transaction took place.
2.
Identify the accounts affected.
3.
Classify each account affected.
4.
Identify direction and amount.
5.
Ensure the accounting equation is in balance.
(e) Sign contract for first website design for $10,000.
1.
Decide if a transaction took place.
2.
Identify the accounts affected.
3.
Classify each account affected.
4.
Identify direction and amount.
5.
Ensure the accounting equation is in balance.
Chart
Assets
=
Liabilities
+
SE
Ref.
Cash
+
Supplies
+
Property,
Plant &
Equipment
=
Accounts
Payable
+
Notes
Payable
+
Common
Stock
(a)
(b)
(c)
(d)
(e)
Chapter 02 – Investing and Financing Decisions and the Accounting System
2-20
HANDOUT 2 – 1 SOLUTION, continued
ANALYZING TRANSACTIONS
Analyze each of the following transactions of World Wide Webster by performing each of the following.
Then, use the chart on the following page to keep track of the amount in each account:
(a) Stockholder invests $10,000 into the business in exchange for 10,000 shares of $1 par value common
stock.
1.
Decide if a transaction took place.
Yes – received cash and gave stock.
2.
Identify the accounts affected.
Cash and Common Stock
3.
Classify each account affected.
Cash is an Asset (A) and Common Stock is
Stockholders’ Equity (SE)
4.
Identify direction and amount.
Cash (A) + $10,000 = Common Stock (SE) + $10,000.
5.
Ensure the accounting equation is in
balance.
Yes – see below.
(b) Borrow $15,000 signing a note payable to the bank that is due in three months.
1.
Decide if a transaction took place.
Yes – received cash and gave a note payable.
2.
Identify the accounts affected.
Cash and Notes Payable
3.
Classify each account affected.
Cash is an Asset (A) and Notes Payable is a Liability (L)
4.
Identify direction and amount.
Cash (A) + $15,000 = Notes payable + $15,000.
5.
Ensure the accounting equation is in
balance.
Yes – see below.
(c) Acquire a $15,000 truck and $5,000 worth of equipment.
1.
Decide if a transaction took place.
Yes – paid cash and received truck and equipment.
2.
Identify the accounts affected.
Cash and Equipment
3.
Classify each account affected.
Cash is an Asset (A) and Equipment is an Asset (A)
4.
Identify direction and amount.
Cash (A) – $20,000 and Equipment (A) + $20,000
5.
Ensure the accounting equation is
in balance.
Yes – see below.