After each transaction the accounting equation must remain in balance

10e

Financial Accounting

Libby • Libby •

chapter 2

Investing and Financing Decisions and the Accounting System

9e

Financial Accounting

Libby • Libby • Hodge

chapter

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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.

2-6 Identify investing and financing transactions and demonstrate how they impact cash flows.

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To understand amounts appearing on a company’s balance sheet:

Understanding the Business

What

business

activities cause

changes in

the balance

sheet?

How do

specific

activities

affect each

balance?

How do

companies

keep track of

balance sheet

amounts?

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The “fast-casual” segment of the $2.7 trillion restaurant industry generates approximately $52 billion in sales annually. What identifies a restaurant as fast-casual? Typically, customers still order at the register as in a fast-food restaurant and the food is made to order and served in modern and upscale surroundings. Checks typically range between $8 and $16. Chipotle Mexican Grill has been a leader in this segment, although competition has increased and growth in this industry segment has slowed in recent years.

In this chapter, we will focus on Chipotle Mexican Grill. Unlike most restaurant chains, Chipotle does not franchise the business. All restaurants are company-owned. Before we can adequately prepare a balance sheet, we must know what activities caused changes in it. Additionally, we have to know how specific activities affect each balance. Finally, we need to know how the company keeps track of balance sheet amounts.

In particular, we focus on some typical asset acquisition activities (often called investing activities), along with related financing activities, such as borrowing funds from creditors or selling stock to investors to provide the cash necessary to acquire the assets. We examine those activities that affect only balance sheet amounts. Operating activities that affect both the income statement and the balance sheet are covered in Chapters 3 and 4.

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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.

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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

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Qualitative Characteristics of Useful Information

For accounting information to be useful, it must be relevant and be a faithful representation. Relevant information is capable of influencing decisions by allowing users to assess past activities and/or predict future activities. To be reported, the information should also be material in amount, depending on the nature of the item and company. Faithful representation requires that the information be complete, neutral, and free from error.

Comparability, verifiability, timeliness, and understandability are qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented. For example, our discussions of ratio analysis will emphasize the importance of comparing ratios for the same company over time, as well as with those of competitors. Such comparisons are valid only if the information is prepared on a consistent and comparable basis. These characteristics of useful information guide the FASB in deciding what financial information should be reported.

Exhibit 2.1 provides an overview of the key concepts in the framework that will be discussed in each of the next four chapters. A clear understanding of these accounting concepts will be helpful as you study, and they also will help you in future chapters as we examine more complex business activities. 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.

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Exhibit 2.1 (2 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

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)

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Recognition and Measurement Concepts

There are three assumptions and a measurement concept that underlie much of our application of the definitions for the elements of the financial statements. First, we make the separate entity assumption, which states that each business’s activities must be accounted for separately from the activities of its owners, all other persons, and other entities. Second, under the going concern assumption (sometimes called the continuity assumption), unless there is evidence to the contrary, we assume that the business will continue operating into the foreseeable future, long enough to meet its contractual commitments and plans. Under the monetary unit assumption, each business entity accounts for and reports its financial results primarily in terms of the national monetary unit (e.g., dollars in the United States, yen in Japan, and euros in Germany), without any adjustment for changes in purchasing power (e.g., inflation).

Finally, accountants measure the elements of the balance sheet using what is called a mixed-attribute measurement model. Most balance sheet elements are recorded at their cost (historical cost), which is the cash-equivalent value on the date of the transaction.

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Elements of the Balance Sheet

A = L + SE

Assets

Liabilities

Stockholders’ Equity

Economic resources with probable future benefits owned or controlled by the entity.

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.

The financing provided by the owners and the operations of the business.

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Assets are economic resources with probable future benefits owned or controlled by an entity as a result of past transactions. In other words, they are the acquired resources the entity can use to operate in the future. Current assets are those resources that Chipotle will use or turn into cash within one year (the next 12 months). Current assets include Cash, Short-Term Investments (in the stocks and bonds of other companies), Accounts Receivable (due from customers and others), Supplies, Prepaid Expenses (for rent, insurance, and advertising paid in advance of use), and Other Current Assets (a summary of several smaller accounts). For manufacturers that produce and sell goods and merchandisers who sell already-completed goods, Inventory (for goods to be sold) also would be listed. All other assets are considered long term (or noncurrent). That is, they are to be used or turned into cash after the coming year. For Chipotle, that includes using property and equipment (Land, Buildings, and Equipment) and Intangibles (nonphysical assets such as trademarks and patents) over several years.

Liabilities are probable 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. Liabilities are usually listed on the balance sheet in order of maturity (how soon an obligation is to be paid).

Stockholders’ equity (also called shareholders’ equity or owners’ equity) is the financing provided by the owners and by business operations. Financing Provided by Owners is referred to as contributed capital. Owners invest in the business by providing cash and sometimes other assets, receiving in exchange shares of stock as evidence of ownership. Financing Provided by Operations is referred to as earned capital or retained earnings. When companies earn profits, they can be distributed to owners as dividends or reinvested in the business. The portion of profits reinvested in the business is called Retained Earnings.

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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.

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The balance sheet is a “snapshot” at any given point in time of the company’s assets, liabilities, and stockholders’ equity. Balance sheets may be prepared monthly, quarterly, or annually. Most companies list assets in order of liquidity, or how soon an asset is expected by management to be turned into cash or used. Note that inventory is always considered a current asset, regardless of how long it takes to produce and sell the inventory. All other assets are considered long term (or noncurrent). That is, they are to be used or turned into cash beyond the coming year.

Just as assets are reported in order of liquidity, liabilities are usually listed on the balance sheet in order of maturity (how soon an obligation is to be paid). Current liabilities are obligations that will be settled by providing cash, goods, or services within the coming year.

Owner-provided cash (and sometimes other assets) is referred to as contributed capital. Contributed capital is usually composed of common stock and additional paid-in capital. Owners who invest (or buy stock) in a company hope to benefit from their investment in two ways: receipts of dividends, which are a distribution of a company’s earnings (a return on the shareholders’ investment), and gains from selling the stock for more than they paid (known as capital gains). Earnings that are not distributed to the owners but instead are reinvested in the business by management are called retained earnings.

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FINANCIAL ANALYSIS

$$$

Unrecorded but Valuable Assets and Liabilities

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

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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.

Nearly all companies have off-balance-sheet financing. The most common form of such financing is in the form of leases. These obligations are not reported as liabilities on the balance sheet.

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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.

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Nature of Business Transactions

What Business Activities Cause Changes in the Financial Statement Amounts?

Transactions include two types of events:

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.

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Accounting focuses on certain events that have an economic impact on the entity. Those events that are recorded as part of the accounting process are called transactions.

As the definitions of assets and liabilities indicate, only economic resources and debts resulting from past transactions are recorded on the balance sheet. Transactions include two types of events:

External events: These are exchanges of assets, goods, or services by one party for assets, services, or promises to pay (liabilities) from one or more other parties. Examples include the purchase of a machine from a supplier, sale of merchandise to customers, borrowing cash from a bank, and investment of cash in the business by the owners.

Internal events: These include certain events that are not exchanges between the business and other parties but nevertheless have a direct and measurable effect on the entity. Examples include using up insurance paid in advance and using buildings and equipment over several years.

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Accounts are used by companies to accumulate

the dollar effect of transactions.

Accounts

Cash

Equipment

Notes

Payable

Inventory

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In the process of accounting, we use accounts to help us organize information about various transactions. Once you select a name for an account, you must use that exact name in all transactions affecting that account.

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Exhibit 2.3

Typical Account Titles

Cost of Goods Sold

Wages Expense

Rent Expense

Interest Expense

Depreciation Expense

Advertising Expense

Insurance Expense

Repair Expense

Income Tax Expense

Cash

Short-Term Investments

Accounts Receivable

Notes Receivable

Inventory (to be sold)

Supplies

Prepaid Expenses

Long-Term Investments

Equipment

Buildings

Land

Intangibles

Accounts Payable

Accrued Expenses Payable

Notes Payable

Taxes Payable

Unearned Revenue

Bonds Payable

Common Stock

Additional Paid-in Capital

Retained Earnings

Sales Revenue

Fee Revenue

Interest Revenue

Rent Revenue

Service Revenue

Assets

Liabilities

Stockholder’s

Equity

Revenues

Expenses

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.

Accounts with “payable” in the title are

always liabilities and represent amounts owed by the company to be paid to others in the future.

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

“receivable” in the title are always assets; they represent amounts owed by (receivable from) customers and others to the business.

Title revenue accounts by their source followed by the word “revenue.”

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.

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This slide lists various account titles that are quite common and are used by most companies. The exhibit also provides special notes to help you in learning account titles. When you are completing assignments and are unsure of an account title, refer to this listing for help.

To facilitate the recording of transactions, each company establishes a chart of accounts, which is a list of all account titles and their unique numbers. The accounts are usually organized by financial statement element, with asset accounts listed first, followed by liability, stockholders’ equity, revenue, and expense accounts in that order. Every company creates its own chart of accounts to fit the nature of its business activities. Once you select a name for an account, you must use that exact name in all transactions affecting that account.

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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.

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Principles of Transaction Analysis

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

Every transaction has at least two effects (dual effects) on the basic accounting equation.

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Transaction analysis is the process of studying a transaction to determine its economic effect on the entity in terms of the accounting equation (also known as the fundamental accounting model).

The two principles underlying the transaction analysis process:

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.

As we record the transactions, we must make sure that the accounting equation remains in balance.

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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)

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The idea that every transaction has at least two effects on the basic accounting equation is known as the dual effects concept. Most transactions involve an exchange, by which one party receives something while giving up something in return.

The accounting equation must remain in balance after each transaction. That is, total assets (resources) must equal total liabilities and stockholders’ equity (claims to resources). If all correct accounts have been identified and the appropriate direction of the effect on each account has been determined, the equation should remain in balance.

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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.

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This slide is an introduction to the next set of slides showing transactions from the first quarter for Chipotle.

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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)

Step 2: Is the accounting equation in balance?

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

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

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When a corporation issues common stock, the transaction affects separate accounts:

Received from shareholders: Cash for the market value of the shares given (100 shares × $3.00 market value = $300)

Given to shareholders: Additional stock shares: Common Stock for the number of shares issued times the par value per share (100 shares × $0.01 par value = $1)

Additional Paid-in Capital for the excess received above par (100 shares × $2.99 excess over par value = $299)

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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)

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

Step 2: Is the accounting equation in balance?

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

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Events (a) and (b) are financing transactions. Companies that need cash for investing purposes (to buy or build additional facilities) often seek funds by selling stock to investors as in event (a) or by borrowing from creditors as in event (b). Notice that the accounting equation is in balance after the identification and classification of the accounts involved in the transactions.

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(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)

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

Step 2: Is the accounting equation in balance?

Received: Land (+A) $8

Buildings (+A) 34

Equipment (+A) 10

Intangible Assets (+A) 3

Given: Cash (−A) $54

Short-Term Notes Payable (+L) 1

Analyzing Chipotle’s Transactions (4 of 7)

(a) +300 = +1 +299

(b) +2 = +2

(c) –54 +52 +3 = +1

Assets = Liabilities + Stockholders’ Equity

Property and Intangible Notes Dividends Common Additional Retained

Cash Investments Equipment Assets Payable Payable Stock Paid-in Capital Earnings

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Purchasing and selling property and equipment and investments in the stock of other companies are investing activities. In the investing transaction (c), notice how more than two accounts were effected.

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(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)

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

Step 2: Is the accounting equation in balance?

Received: Reduction in amount due:

Short-Term Notes Payable (−L) $1

Given: Cash (−A) $1

Analyzing Chipotle’s Transactions (5 of 7)

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

–1 = –1

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Here, Chipotle paid $1 on the short-term notes payable from (c) above. So in this transaction, we have an asset (Cash) decreasing by $1 in order to decrease the liability account short-term notes payable.

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(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)

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

Analyzing Chipotle’s Transactions (6 of 7)

Step 2: Is the accounting equation in balance?

Received: Short-Term Investments (+A) $9

Long-Term Investments (+A) 35

Given: Cash (−A) $44

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

–1 = –1

–44 +44 =

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In transaction (e), Chipotle purchased the stock of other companies as a long-term investment, paying $44 in cash. Of the total paid, $9 is considered a short-term investment by management and the remainder, $35 is considered a long-term investment. The Cash account (an asset) decreased by $44, while the Short-Term Investments (an asset) increased by $9 and the Long-Term Investments (an asset) increased by $35. Because we are exchanging one asset (Cash) for another asset (Short-Term and Long-Term Investments), there is no change in the total assets, liabilities, and stockholders’ equity.

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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)

Step 2: Is the accounting equation in balance?

Assets = Liabilities + Stockholders’ Equity

Property and Intangible Notes Dividends Common Additional Retained

Cash Investments Equipment Assets Payable Payable Stock Paid-in Capital Earnings