ACCT1201

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Chapter 2: Investing and Financing Decisions and the

Balance Sheet
A. Financial Accounting Conceptual Framework
Underlying assumptions of accounting help the decision maker to understand what
accounting information reports as well as the inherent limitations.
1. Qualities that make accounting information useful:
Relevancy
Timeliness
Predictive Value
Able to be used to help predict some future event
Feedback Value
Allows me to evaluate my decisions after they have been made
Reliability Accurate
Representational faithfulness
Truthful
Verifiability
Verifiable, when 2 or more independent look at the same method and come out with the
same outcome
Neutrality
Unbiased
Comparability
Comparable across firms and across time within the firm (usually 2 or more years of
information presented) (within same industry such as Google and Yahoo)
Consistency
2. Basic Assumptions Relate to the Balance Sheet
Separate Entity (Economic Entity)
Business is distinct and separate from its owners
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Unit of Measure (Monetary Measure) The financial statement are represented in the monetary unit of the country in which it is
operating
Time Period (Accounting Period) Indefinite life, allows a business to break that indefinite life down into measurable
periods
Continuity (Going Concern) 3. Principles:
Historical Cost Principle (Measurement Principle)
Assets are reported on the financial statement at the cost of what was paid to acquire that
asset
Revenue Recognition Principle
Report revenue on our income statement when we have earned the revenue
Expense Recognition (Matching Principle)
Recognize or record an expense in the period in which it was used to generate revenue
Full Disclosure Principle
Companys financial statement should report enough information for users to make
knowledgeable decisions about the company
4. Constraints
Cost benefit
The cost of producing information should not outweigh the benefit
Materiality
A company must report information that is important enough to the users that if it was omitted, it
would make a difference in the users decision
Conservatism
A company must report all items on the financial statement and the amount that leaves to
the most cautious, immediate result
Exercise: Indicate the basic principle or principles of accounting that underlie each of the
following independent situations.
1. Dr. Kline is a practicing pediatrician. Over the years, she has accumulated a personal
investment portfolio of securities, virtually all of which have been purchased from her
earnings as a pediatrician. The investment portfolio is not reflected in the accounting
records of her medical practice.
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Separate entity
2. A company purchases a desk tape dispenser for use by the office secretary. The tape
dispenser cost $10 and has an estimated useful life of 15 years. The purchase is
immediately expensed on the companys income statement.
Materiality
3. A company sells a product that has a two-year warranty covering parts and labor. In the
same period that revenues from product sales are recorded, an estimate of future warranty
costs is recorded on the companys income statement.
Expense recognition/matching principle
4. A company is sued for $1 million by a customer claiming that a defective product caused
accident. The company believes that the lawsuit is without merit. Although the case will
not be tried for a year, the company adds a note describing the lawsuit to its current
financial statements.
Full disclosure principle
B. Accounts and Chart of Accounts
1. Account: a standardized format to accumulate the dollar effects of transactions on a
specific 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. (such as 101, 102, 103, 201, 202,
301, 302, etc.)
Balance Sheet Accounts
a. Assets
Cash, accounts receivable, inventory, land, equipment
b. Liabilities
Accounts payable, unearned revenues, bank loans payable
c. Stockholders equity
Common stock, retained earnings
Income Statement Accountsd. Revenues
Sales,
e. Expenses
Rent expense, salaries expense, utilities expense

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C. The Classified Balance Sheet

Company Name
Balance Sheet
Specific date of statement
Unit of measure
Assets
Assets listed in order of liquidity
Current Assets
Cash
Accounts receivable
Short term investments
Inventory
Prepaid expenses
Total current assets
Non-Current Assets:
Long-term investments
Property, plant and equipment
Intangibles
Total non-current assets
TOTAL ASSETS
Liabilities and Stockholders Equity
Liabilities are listed in order of maturity
Current liabilities
Accounts payable
Dividends payable
Salary payable

Total current liabilities

Non-current Liabilities
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Long-term notes payable

Bonds payable
Other long-term liabilities
Total non-current liabilities

Stockholders Equity
Common stock
Preferred stock
Additional paid in capital common stock
when you sell stock for more than par value (arbitrary # that is set) (an equity kept in the
company to protect our creditors)
Additional paid in capital preferred stock
when you sell stock for more than the par value
Retained earnings
Total stockholders equity
TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
Exercise: The following is a list of accounts from American Eagle Outfitters financial
statements. Categorize each of the following as a current asset, non-current asset, current
liability, non-current liability, or stockholders equity account
Cash and cash equivalents CURRENT ASSET
Marketable securities CURRENT ASSET
Property and equipment, net NON-CURRENT ASSET
Accounts payable CURRENT LIABILITY
Accounts and note receivables CURRENT ASSET
Common stock STOCKHOLDERS EQUITY
Deferred rent CURRENT ASSET
Retained earnings SE
Inventories CURRENT ASSETS

D. Transaction Analyses
Transaction Analyses
o Each transaction affects at least two accounts
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o The accounting equation always remains in balance after each transaction (the duality
of effects)
ASSETS = LIABILITES + OWNERS EQUITY (STOCKHOLDERS EQUITY)
Exercise: Steve Gates first established Web Action on January 1, 2014. The companys
transactions for December, the first month of operations, are given below. For each of these
events, indicate the account, amount and direction of the effect on the accounting equation. If an
event does not affect the accounting equation, explain why.
1. On January 1, the company received $30,000 cash from the Steve Gates who organized
Web Action Corporation. Steve Gates received Capital Stock from the company in exchange
Assets = Liabilities + Stockholders Equity
30,000 = 0 + 30,000

2. On January 3, the company borrowed $75,000 cash and signed a note agreeing to pay back
the money in two years.
Assets = Liabilities + Stockholders Equity
75,000 = 75,000
3. On January 4, purchased $15,000 worth of supplies on credit.
Assets = Liabilities + Stockholders Equity
15,000 = 15,000
4. On January 9, purchased land for $25,000 cash
Assets = Liabilities + Stockholders Equity
25,000
-25,000

E. Summarizing the Transactions using the T-account

1. T-Account
Consists of:
The title of the account
Left side (debit, DR)
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Right side (credit, CR)

2. Debit, Credit and the Normal Balance
A=Liabilites + Contributed Capital + Retained Earnings + revenues Expenses Dividends
Debit, put on left side of T chart. Credit, put on right side of T chart

Increase Assets, dividends + expenses with debit; decrease them with

credit
Increase everything else (liabilities, contributed capital, retained
earnings, revenues) with credit; decrease with debit
The results of the accounting processes do not reflect "exact" information.

Exercise: Identify each of the following accounts as Asset, Liability, Revenue, Expense, or
Stockholders Equity and state the normal balance for the account.
Accounts payable LIABILITY, CREDIT
Capital stock SE, CREDIT
Fees earned REVENUE, CREDIT
Accounts receivable ASSET, DEBIT
Retained Earnings SE, CREDIT
Rent expense EXPENSE, CREDIT
Cash ASSET, DEBIT
Equipment Supplies ASSET, DEBIT
F. Recording the transactions in a journal (Journal Entry)
o Provides a chronological record of transactions
o Written in a debits-equal-credits format (the double entry system)
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.

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Assets

Cash

Supplie
s

= Liabilities

Stockhold
ers
+ Equity

Notes
Payabl
e

Common
Stock

Land

Accts
Payabl
e

50,000

Journalize the transactions and post the transactions to T-accounts.

ASSETS
Cash

Supplies

LIABILITIES
Notes Payable

Land

STOCKHOLDERS
EQUITY
Accounts Payable

G. Financial leverage ratio:

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Capital Stock

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Financial leverage ratio

o average total assets average stockholders equity
o measures the relationship between total assets and the stockholders equity that
finances the assets.
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.
Prepare a simple classified Balance Sheet and analyze the company using the financial
leverage ratio.

EXERCISE 2 1
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.
1
.
2
.

Decide if a transaction took place.

Identify the accounts affected.
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3
.
4
.
5
.
(b)
1
.
2
.
3
.
4
.
5
.
(c)
1
.
2
.
3
.
4
.
5
.

FALL 2014

Classify each account affected.

Identify direction and amount.
Ensure the accounting equation is in
balance.
Borrow $15,000, using a note payable to the bank.
Decide if a transaction took place.
Identify the accounts affected.
Classify each account affected.
Identify direction and amount.
Ensure the accounting equation is in
balance.
Acquire a $15,000 truck and $5,000 worth of equipment.
Decide if a transaction took place.
Identify the accounts affected.
Classify each account affected.
Identify direction and amount.
Ensure the accounting equation is in
balance.

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EXERCISE 2 1, continued
(d) Purchase $300 worth of supplies on credit. On credit means that you receive
the supplies now, and pay for them later.
1
.
2
.
3
.
4
.
5
.
(e)
1
.
2
.
3
.
4
.
5
.

Decide if a transaction took place.

Identify the accounts affected.
Classify each account affected.
Identify direction and amount.
Ensure the accounting equation is in
balance.
Sign contract for first website design for $10,000.
Decide if a transaction took place.
Identify the accounts affected.
Classify each account affected.
Identify direction and amount.
Ensure the accounting equation is in
balance.

Chart
Assets
Ref
.

Cash

(a)

10,000

(b)

-15,000

+ Supplies

Property,
Plant &
+
Equipme
nt

Liabilities
Account
s
Payable

Notes
Payable

SE

Contribut
ed
Capital
10,000

15,000

(c)
(d)

20,000
300

20,000
300

(e)

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EXERCISE 2 2
THE DEBIT/CREDIT FRAMEWORK
Analyze each of the following transactions of World Wide Webster and prepare the
journal entry required to record the related transaction.
(a) Stockholder invests $10,000 into the business.
Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets
=
Liabilities
+
Stockholders Equity

(b) Borrow $15,000 signing a note payable to the bank that is due in three months.
Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets
=
Liabilities
+
Stockholders Equity

(c) Acquire a $15,000 truck and $5,000 worth of equipment.

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets
=
Liabilities
+
Stockholders Equity

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EXERCISE 2 3, continued
(d) Purchase $300 worth of supplies on credit.
Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets
=
Liabilities
+
Stockholders Equity

(e) Sign contract for first website design for $10,000.

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets
=
Liabilities
+
Stockholders Equity

(f) Company pays off $300 Accounts Payable.

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets

Liabilities

Stockholders Equity

(g) Company pays for and receives $600 worth of supplies.

Debit and credit the accounts affected
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Ensure the equation still balances and debits = credits

Assets

Liabilities

Stockholders Equity

(h) Company acquires and receives $1,000 worth of equipment.

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets

Liabilities

Stockholders Equity

(i) Order a $900 computer, to be delivered in 90 days.

Debit and credit the accounts affected

Ensure the equation still balances and debits = credits

Assets

Liabilities

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Stockholders Equity

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EXERCISE 2 5
POSTING TO T-ACCOUNTS
Post the transactions from EXERCISEs 2-3 and 2-4 and
determine
the ending balances of each of the following T-accounts.
Assets

Liabilities

Stockholders Equity

+ Cash

- Accounts Payable +

- Contributed Capital +

+ Supplies

- Notes Payable +

- Retained Earnings +

+ Equipment

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EXERCISE 2 6
PREPARING A BALANCE SHEET
Use the ending balances from the T-accounts on EXERCISE 2-5 to
prepare a classified balance sheet for World Wide Webster as of
December 31, 2014.

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EXERCISE 2 7
CURRENT RATIO
Refer to the classified balance sheet from EXERCISE 2-6 and calculate the current ratio of World Wide
Webster as of December 31, 2014. Then, interpret the current ratio.
Calculation:

Interpretation:

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