chapter 2: investing and financing decisions and the...

CHAPTER 2

INVESTING AND FINANCING DECISIONS AND THE BALANCE SHEET

CHAPTER CONTENTS

WHAT’S NEW IN THIS EDITION 2.2

CHAPTER SUMMARY 2.2

CHAPTER LEARNING OBJECTIVES 2.3

CHAPTER LECTURE OUTLINE 2.4

ADDITIONAL TEACHING NOTES 2.9

TEACHING RESOURCES CHART 2.14

IDEAS FOR INCORPORATING THE STUDY GUIDE 2.15

END OF CHAPTER MATERIALS CHART 2.16

END OF CHAPTER MATERIALS COMPARISON CHART 2.16

KEY WORD SEARCH IDEAS 2.17

POWERPOINT SLIDE SHOW 2.17

© The McGraw-Hill Companies, Inc., 2009Instructor’s Manual, Chapter 2 1

Chapter 2: Investing and Financing Decisions and the Balance Sheet

WHAT’S NEW IN THIS EDITION

New simplified Exhibit 2.1 Additional account title simplification in balance sheet Modified International Perspective to introduce IFRS Updated Financial Analysis and Ethics features Modified transaction analysis illustration to be clearer and more systematic Revised Exhibit 2.4, 2.5, and 2.6 for improved clarity Added explanation boxes for analytical tools (journal entries and T-accounts) Modified solutions to self-study quizzes to be consistent with presentation of journal

entries and equation effects End-of-chapter is substantially revised: multiple choice section now includes three

computational questions, 60% of mini-exercises, exercises, and problems have new numerical data, and all new annual report cases

CHAPTER SUMMARY

This chapter reviews the conceptual framework relevant to the balance sheet (the objective of external financial reporting, definitions of balance sheet elements, and the cost principle). The chapter discusses the accounting model and illustrates its application in the accounting system for a business. For accounting purposes, transactions are defined as (1) exchanges of assets and liabilities between the business and other individuals and organizations, and (2) certain events that do not occur between the business and other parties but exert a direct effect on the entity (such as recording adjustments to reflect the use of equipment in operations).

Application of the accounting model (Assets = Liabilities + Stockholders’ Equity) is illustrated for Papa John’s International. The application involves (1) transaction analysis, (2) journal entries, and (3) the accounts (T-account format). Each transaction causes at least two different accounts to be affected in terms of the accounting model. The model often is referred to as a double-entry system because each transaction has a dual effect. The process used in transaction analysis involves (1) identifying the accounts affected and classifying each as an asset, liability, or stockholders’ equity account and (2) determining that the accounting equation remains in balance.

The transaction analysis model (built on the accounting model) and the mechanics of the debit-credit concepts in T-account format can be summarized as follows:

© The McGraw-Hill Companies, Inc., 20092 Financial Accounting 6/e

Transaction Analysis Model

Assets (A) = Liabilities (L) = Stockholders’ Equity (SE)Increase Decrease Decrease Increase Decrease IncreaseDebit Credit Debit Credit Debit Credit

T-Account Format

Assets (A) Liabilities (L) Stockholders’ Equity (SE)Beg. Bal. Beg. Bal. Beg. BalIncrease Decrease Decrease Increase Decrease IncreaseDebit Credit Debit Credit Debit CreditEnd. Bal. End. Bal End. Bal.

CHAPTER LEARNING OBJECTIVES

LO1 Define the objective of financial reporting, the elements of the balance sheet, and the related key accounting assumptions and principles.

LO2 Identify what constitutes a business transaction and recognize common balance sheet account titles used in business.

LO3 Apply transaction analysis to simple business transactions in terms of the accounting model: Assets = Liabilities + Stockholders’ Equity.

LO4 Determine the impact of business transactions on the balance sheet using two basic tools, journal entries and T-accounts.

LO5 Prepare a simple classified balance sheet and analyze the company using the financial leverage ratio.

LO6 Identify investing and financing transactions and demonstrate how they are reported on the statement of cash flows.


CHAPTER LECTURE OUTLINE

I. UNDERSTANDING THE BUSINESS

1. An understanding of a company’s financial statements requires knowledge of business activities and their effects on account balances.

2. Financial statement analysis will allow the decision maker to arrive at decisions about a company. This evaluation can be used to compare one company to other companies.

3. Analysis of investing and financing activities of a business should be explored.4. The concepts presented in Exhibit 2-1 are the framework of objectives, terms, concepts

and principles used in financial accounting and reporting.

II. LO1 DEFINE THE OBJECTIVE OF FINANCIAL REPORTING, THE ELEMENTS OF THE BALANCE SHEET, AND THE RELATED KEY ACCOUNTING ASSUMPTIONS AND PRINCIPLES.

A. Primary objective of financial reporting1. To provide useful economic information about a business to help external parties

(investors and creditors) make sound financial decisions.a. These decision makers are expected to have a reasonable understanding of

accounting concepts and procedures.b. Decision makers need to be able to use financial information to help them predict

future cash flows related to investing and financing.

B. Elements of the Balance Sheet1. Balance sheet elements present the basic accounting equation (A = L + SE).

a. Assets: economic resources with probable future benefits owned by the entity as a result of past transactions.1. Listed on the balance sheet in the order of liquidity.2. Current assets are assets that will be used or turned into cash within one year.3. Historical cost principle: requires assets to be recorded at historical cost that,

on the date of the transaction, is cash paid plus the current dollar value of all noncash consideration given in exchange.

b. Liabilities: are probable debts or obligations of the entity that result from past transactions, which will be paid with assets or services.1. Listed on balance sheet in the order of maturity dates.2. Current liabilities are obligations that will be paid in cash or other current

assets or satisfied by providing cash, goods, or services within one year.c. Stockholders equity (Owners Equity): the owners’ residual interest in net assets

(assets minus liabilities).Two categories:

a. Contributed capitali. Results from owners’ providing assets to the company in exchange for

stock (evidence of ownership).ii. The investments of the owners.


b. Retained earningsi. The cumulative earnings that are not distributed to the owners and are

reinvested in the business.ii. Increased by net income and reduced by declared dividends.

C. The Related Key Accounting Assumptions and Principles1. Underlying assumptions of accounting help the decision maker to understand what

accounting information reports as well as the inherent limitations. 2. Recall assumptions noted earlier in the text. There are four basic accounting

assumptions, the first three relate directly to the balance sheeta. Separate-entity assumption – “business” transactions are separate from “owner”

transactions.b. Unit-of-measure assumption – accounting information will be measured and

reported in the national monetary unit of that company.c. Continuity (going-concern) assumption – a business is expected to continue

operations in the foreseeable future without forced liquidation.d. Time period assumption

3. There are four basic accounting principles. The first directly relates to the balance sheet:a. Historical Cost Principle: The historical cost principle states that the cash (or

cash-equivalent cost) should be used to initially record financial statement elements. This historical cost amount is measured on the initial transaction date and does not typically reflect market value changes.

b. Revenue Recognition Principlec. Matching Principled. Full Disclosure Principle

III.LO2 IDENTIFY WHAT CONSTITUTES A BUSINESS TRANSACTION AND RECOGNIZE COMMON BALANCE SHEET ACCOUNT TITLES USED IN BUSINESS.

A. Nature of business transactions1. Transactions are certain recorded economic “events” which impact an entity.

a. External events: exchanges of assets, goods, or services by one party for assets, services, or a promise to pay (liability) by one or more other parties.Examples: sales, borrowing, owner investments.

b. Internal events: certain events that are not exchanges between the business and other parties but nevertheless have a direct and measurable effect on the entity.Example: Adjustments to record usage of assets (depreciation).

c. Some events are not reflected in the financial statements.Example: The signing of a contract.


B. Accounts1. Account: a standardized format that organizations use to accumulate the dollar

effects of transactions on each financial statement item.2. Chart of accounts: a listing of the account titles and their unique numbers that a

company uses to record the transactions of its business operations.a. Each company has its own chart of accounts.b. Balance sheet accounts are listed first.

1. Assets are listed first, in the order of their liquidity.2. Liabilities are listed next, in order of maturity.3. Stockholders’ equity lists contributed capital and retained earnings.4. Revenues5. Expenses

c. In formal record keeping, unique numbers are used for each account listed in the Chart of Accounts.

C. Common Balance Sheet accounts:1. Assets:

a. Cashb. Receivables are always assets.c. Prepaid Expenses is an asset because it represents amounts paid to others for

future benefits.d. Buildingse. Land

2. Liabilities:a. Accounts with “payable” in the title are always liabilities.b. Accounts with “unearned” in the title are liabilities. They are amounts paid in the

past to the company by others expecting future goods or services from the company.

3. Stockholders’ Equitya. Common Stock, Preferred Stockb. Retained Earnings

IV. LO3 APPLY TRANSACTION ANALYSIS TO SIMPLE BUSINESS TRANSACTIONS IN TERMS OF THE ACCOUNTING MODEL:

ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY.

A. Historical record keeping provides information to managers1. In order to evaluate the effects of past decisions and2. To plan for the future.3. Important for managers to understand how past transactions affect financial statement

items (accounts) and how future events may impact those accounts.

B. Principles of Transaction Analysis1. Involves studying a transaction to determine its economic effect on the entity in terms

of the basic accounting equation (A = L + SE).2. Principles of transaction analysis:


a. Dual effect: each transaction affects at least two accounts.1. Identification of the appropriate accounts and the direction of the effects

(increase or decrease) is key.2. The fact that every transaction has at least two effects on the basic accounting

equation is the essence of the double-entry system of record keeping.3. Whether the transaction is external (involves an exchange) or internal

(involves an adjustment), the duality of effects results.b. Accounting equation: must remain in balance after each transaction. After each

transaction, the accounting equation must be tested for equality.C. Analyze Papa John’s transactions: In this chapter, several transactions are analyzed

using the principles of the transaction analysis approach.

V. LO4 DETERMINE THE IMPACT OF BUSINESS TRANSACTIONS ON THE BALANCE SHEET USING TWO BASIC TOOLS, JOURNAL ENTRIES AND T-ACCOUNTS.

Journal entries and T-accounts: the two tools to aid in reflecting the results of transaction analysis.

Analyze → Journalize → Post

A. Analyze: The Direction of Transaction Effects1. It is important to understand which accounts increase and decrease because of a

transaction.2. By referencing the accounting equation, increases are on the left for assets (which are

on the left side of the accounting equation) and increase are on the right for liabilities and stockholders’ equity (which are on the right side of the equation. Decrease work in the opposite manner.

B. Journalize1. Debit means the left side of an account; Credit means the right side of an account.2. By referencing the accounting equation, debits increase asset accounts and credits

increase liability and stockholders’ equity accounts.3. The normal balance of an account is on the increase side; therefore, asset accounts

normally have debit balances, and liability and stockholders’ equity accounts usually have credit balances.

4. Total debits must equal total credits in a transaction. This is necessary to keep the accounting equation in balance at all times.

C. Post: Analytical Tool: The T-account.1. Posting is the act of transferring journal entry amounts to the appropriate accounts in

the ledger.2. Journal entries show all of the accounts affected by a transaction, but do not provide

account balances. 3. Account balances are found in the ledger (a group of accounts). The ledger is referred

to as the “final” book of entry.4. A T-account is a simplified version of a ledger account.

a. This tool allows for summarization of journal entry effects on an account. The balance of the account can be determined with T-accounts.


b. Important for managers to understand how past transactions affect financial statement items (accounts) and how future events may impact those accounts.

D. Transaction Analysis Illustrated1. Use transaction analysis as well as the journal entry and T-account tools to process

typical transactions.2. There are beginning balances in many balance sheet accounts since the ending

balances carry over to the new period.3. It is essential to understand:

a. The accounting modelb. The transaction analysis processc. Recording the dual effects of each transactiond. The dual-balancing system

VI. LO5 PREPARE A SIMPLE CLASSIFIED BALANCE SHEET AND ANALYZE THE COMPANY USING THE FINANCIAL LEVERAGE RATIO

A. How is the balance sheet prepared?1. Account balances for asset, liability, and stockholders’ equity accounts are used to

prepare a balance sheet.2. If comparative balance sheets are prepared, the most recent amounts are usually

presented first (in the left column) with the older amounts to the right.3. The balance sheet presents the accounting equation: A = L + SE4. Account balances will change during the accounting period, but the accounting

equation must still remain in balance.

B. Financial Leverage Ratio measures the relationship of assets to equity. The higher the portion of assets financed with stockholders’ equity, the lower the ratio. The higher the ratio, the more debt financing. Debt financing is riskier.

VII. LO6 IDENTIFY INVESTING AND FINANCING TRANSACTIONS AND DEMONSTRATE HOW THEY ARE REPORTED ON THE STATEMENT OF CASH FLOWS.

A. Investing Activities: 1. Purchases/ sales of non-current assets.2. Lending cash to others3. Receiving principal payments on loans made to others

B. Financing Activities:1. Borrowing and repaying debt.2. Issuing and repurchasing stock.3. Paying dividends.

C. Only report transactions where cash is involved.


ADDITIONAL TEACHING NOTES

After each learning objective, the students can be given a hands-on exercise to reinforce the topic. It is suggested that the students be provided with the solutions immediately to reinforce the concepts. After covering the material and going over the in-class exercises, the students should be encouraged to attempt the Demonstration Case at the end of the chapter before trying the homework problems.

General

1. Bookkeeping does not equal accounting. Rather, bookkeeping is an important part (a subset) of accounting.

a. Bookkeeping is the routine, clerical function of recording and posting journal entries. A basic knowledge of accounting is necessary to perform these bookkeeping tasks.

b. Accounting involves the design of accounting systems, analysis of complex transactions, interpretation of financial data, financial reporting, auditing, taxation, and management consulting. A high degree of knowledge, professional judgment, and experience are needed to perform these accounting functions.

2. The results of the accounting processes do not reflect "exact" information.

a. Many estimates are used that influence account balances.

b. Generally, the amounts on financial statements do not represent current market values. They typically present historical cost amounts.

c. It is important to gain an understanding of what financial statements reflect and fail to present. The user needs to understand financial statement limitations.

3. Accounting is neither inflexible nor is it a “cut and dried” subject. Instead, it is a dynamic and creative area of study. It requires dedicated involvement for the users of financial statements as well as those who prepare the statements. Problem solving and communication skills are extremely important in accounting.


1. Point out that most decision makers are neither ignorant nor superhuman. They often are average investors (or creditors); however, they are expected to have the tools to evaluate what goes on in the business world.

2. Distinguish between “going concern” and liquidation valuations.

3. Point out that some companies present amounts on the balance sheet in dollars, thousands of dollars, etc. The student should be sure to reference the balance sheet heading for this information.



1. Note that the chart of accounts often differs widely by industry.

2. Distinguish between historical costs recorded in the accounts and current fair market value.


1. Owners are “external” to a company because of the separate-entity concept. There should be no commingling of assets or liabilities of owners and companies.

2. After discussing the effects of a transaction on the accounting equation, the instructor may wish to use the following in class exercise:

1. Individuals invest $50,000 to start the business. They receive Capital Stock from the company in exchange.

2. The company borrows $75,000 and signs a note agreeing to pay back the money.

3. Purchased $15,000 worth of supplies on credit.

4. Land is purchased for $25,000 cash.

Required: Show how each transaction affects the accounting equation.

Solution:

Assets = Liabilities +StockholdersEquity

Cash Supplies LandNotesPayable

AcctsPayable

CommonStock

50,000 50,000 75,000 75,000

15,000 15,000 (25,000) 25,000 100,000 15,000 25,000 = 75,000 15,000 + 50,000 140,000 = 90,000 + 50,000 140,000 = 140,000



1.

This is a way to help your students learn the debit/credit rules with the help of an acronym. Assets and expenses work the same while liabilities, revenues

and capital share the same rules.

2. T-accounts are great visual learning devices. Encourage students to use them throughout the course.

3. It is quite important that students identify accounts (as A, L, or SE) when doing transaction analysis and preparing journal entries. It typically makes the analysis process clearer and the journal entry preparation easier for them at this stage of learning.

4. Briefly mention how subsidiary ledgers support the details of general ledger accounts such as accounts receivable, accounts payable, and equipment.

5. After discussing journal entries and posting to the ledger, the instructor may wish to continue the previous exercise. The students should journalize the transactions and post them to T-accounts.

Solution:Jan 1 Cash 50,000

Capital Stock 50,000

Jan 10 Cash 75,000Notes Payable 75,000

Jan 15 Supplies 15,000Accounts Payable 15,000

Jan 17 Land 25,000Cash 25,000


ALICEIncreaseDebit

IncreaseCredit

ALIC

E

Legend for Alice:A AssetsL LiabilitiesI Income or RevenueC Capital or Stockholders’ EquityE Expenses

ASSETSCash Supplies Land50,000 25,000 15,000 25,00075,000Bal. 100,000

LIABILITIES STOCKHOLDERS’ EQUITY

Notes Payable Accounts Payable Capital Stock75,000 15,000 50,000

LO5 prepare a simple classified Balance Sheet and analyze the company using the financial leverage ratio.

1. The instructor may wish to continue the previous example and prepare a simple balance sheet from the T-account balances. The name of the company is Sample Company and the date of the balance sheet is 12/31/06.

Solution:Sample Company

Balance SheetDecember 31, 2006

Assets LiabilitiesCash $ 100,000 Accounts Payable $ 15,000Supplies 15,000 Notes Payable 75,000Land 25,000 Total Liabilities $ 90,000Total Assets $ 140,000

Stockholders’ EquityCapital Stock $ 50,000

Total Liabilities + Stockholders’ Equity $ 140,000


1. This chapter presents an excellent experience with several cash transactions that affect the statement of cash flows. There are references to cash flows throughout the text. Comprehensive coverage of the statement of cash flows is in Chapter 13.

2. The instructor may wish to continue the previous example and identify which transactions would affect the statement of cash flows and which would be investing or financing


Posting to an account in the ledger puts all of the transactions affecting a specific account in one place.

Note that in a single account the debits do not usually equal the credits.

transactions. Why would the purchase of supplies on account not affect the statement of cash flows?

Solution:

The issuance of stock and the note payable both represent inflows of cash from financing activities.

The purchase of land for cash represents an outflow of cash from investing activities.

The purchase of supplies on account does not affect the statement of cash flows because no cash is received and no cash is paid out.


TEACHING RESOURCES CHART


Chapter Features Financial Analysis – Unrecorded but Valuable AssetsA Question of Ethics – The “Greening of GAAP”Self-Study Quiz – Classify Balance Sheet items

PowerPoint Slides 2.1 – 2.6


Chapter Features International Perspective – Understanding foreign financial statements.



Chapter Features Self-Study Quiz – Transaction AnalysisPowerPoint Slides 2.14 – 2.22Video Segment Video Segment #2 Transaction Analysis


Chapter Features Self-Study Quiz - Transaction Analysis, Posting to T-Accounts

Financial Analysis – Inferring Business Activities from T-AccountsPowerPoint Slides 2.24 – 2.31

LO5 Prepare a simple classified Balance Sheet and analyze the company using the financial leverage ratio.

Chapter Features Key Ratio Analysis – Financial leverage ratioSelf-Study Quiz – Financial leverage ratio



Chapter Features Focus On Cash Flows - Investing and Financing ActivitiesSelf-Study Quiz - Classification of Cash Flows



Video Segment #2 Transaction Analysis (run time 9:35 minutes)

The video covers transaction analysis in a lecture replacement format. Platinum Technology is featured during the 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.

IDEAS FOR INCORPORATING THE STUDY GUIDE

Encourage your students to preview the chapter before they begin reading it. They should start by reading the Organization of the Chapter, Learning Objectives, and Chapter Focus Suggest reading and completing the sections that appear at the beginning of each chapter in the Study Guide. Next, they should thumb through the Chapter in the textbook, noting the names of each of the section headings. Finally, they should read the textbook Chapter Summary and key terms list.

The Read and Recall Questions in the Study Guide focus on each learning objective, including the Chapter Features set forth in the chart above. Students are asked to document their understanding of the material presented in the text as they read. Collecting the Read and Recall Questions pages at the start of the coverage of this chapter will help to ensure that students have read the chapter before coming to class.

Encourage your students to practice and apply what they have learned by completing the Self-Test Questions and Exercises in the Study Guide. They will match the key terms with the textbook definitions and answer true-false and multiple-choice questions, which cover all of the learning objectives. The exercises described below provide additional reinforcement opportunities:٠ Exercise 2 (LO 2, 3 and 4) Transaction analysis and preparation of journal entries.٠ Exercise 6 (LO 2, 3, 4, 5, & 6) Transaction analysis, preparation of journal entries, posting to

T-accounts, preparation of balance sheet, computation of financial leverage ratio, and preparation of statement of cash flows.

Your students will be able to check their answers using the Solutions to Self-Test Questions and Exercises section.


END-OF-CHAPTER MATERIALS CHART

LearningObjective

Mini-Exercises Exercises Problems

AlternateProblems

Cases &Projects

1 1, 2 1 1 1 1, 2, 6, 9, 102 2, 3, 4 1, 2, 3, 20 1, 2, 3, 5 1, 2, 3 1, 2, 3, 4,7 113 2, 5 1, 4, 5 2 1, 24 1, 2, 6, 7, 8, 9 1, 3, 6, 7, 8, 9,

10, 11, 12, 13, 15, 16, 17

3, 5 2, 3 7

5 9, 10, 11 9, 10, 13, 14, 15, 20

2, 3, 5 3 1, 2, 3, 4, 5, 7, 8, 9, 11

6 12 18, 19, 20 4, 6 4 1, 2, 3, 4, 11

END-OF-CHAPTER MATERIALS COMPARISON CHART

5th Edition 6th Edition ComparisonDemonstration Case Demonstration Case Modified

M2-1 M2-1 UnchangedM2-2 M2-2 UnchangedM2-3 M2-3 UnchangedM2-4 M2-4 UnchangedM2-5 M2-5 ModifiedM2-6 M2-6 UnchangedM2-7 M2-7 UnchangedM2-8 M2-8 UnchangedM2-9 M2-9 Modified

M2-10 M2-10 ModifiedM2-11 M2-11 ModifiedM2-12 M2-12 UnchangedE2-1 E2-1 ModifiedE2-2 E2-2 UnchangedE2-3 E2-3 UnchangedE2-4 E2-4 ModifiedE2-5 E2-5 UnchangedE2-6 E2-6 UnchangedE2-7 E2-7 UnchangedE2-8 E2-8 ModifiedE2-9 E2-9 ModifiedE2-10 E2-10 ModifiedE2-11 E2-11 ModifiedE2-12 E2-12 Modified


E2-13 E2-13 ModifiedE2-14 E2-14 ModifiedE2-15 E2-15 ModifiedE2-16 E2-16 ModifiedE2-17 E2-17 ModifiedE2-18 E2-18 UnchangedE2-19 E2-19 ModifiedE2-20 E2-20 UnchangedP2-1 P2-1 ModifiedP2-2 P2-2 ModifiedP2-3 P2-3 ModifiedP2-4 P2-4 UnchangedP2-5 P2-5 ModifiedP2-6 P2-6 Modified

KEY WORD SEARCH IDEASAccountAssetContinuity (Going Concern) AssumptionContributed CapitalCreditCurrent AssetsCurrent LiabilitiesDebitHistorical Cost PrincipleJournal EntryLiabilitiesPrimary Objectives of External Financial ReportingRetained EarningsSeparate-Entity AssumptionStockholders’ Equity (Owners’ or Shareholders’ Equity)T-accountTransactionTransaction AnalysisUnit-of-Measure Assumption

POWERPOINT SLIDE SHOW


chapter 2: investing and financing decisions and the...

Documents