Accounting Equation - Part 2

chapter
Accounting Equation
Financial Accounting
9e FAC 102
Libby
Prof.•Shivangi
Libby • Hodge
Gupta
2-1
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
Exhibit 2.2 • Typical Account Titles
Title expense accounts by what was
incurred or used followed by the
Accounts with “payable” in the title are word “expense,” except for
always liabilities and represent amounts inventory sold, which is titled Cost
owed by the company to be paid to of Goods Sold.
Accounts with others in the future.
“receivable” in
the title are
always assets; Stockholder’s
Assets Liabilities Revenues Expenses
they represent Equity
amounts owed
by (receivable Cash Accounts Payable Common Stock Sales Revenue Cost of Goods
from) customers Short-Term Accrued Expenses Additional Paid-in Fee Revenue Sold
and others to the Investments Capital Interest Revenue Wages Expense
business. Accounts Payable Retained Earnings Rent Expense
Rent Revenue
Receivable Notes Payable Interest Expense
Service Revenue
Notes Receivable Taxes Payable Depreciation
Inventory (to be Unearned Expense
sold) Revenue Advertising
Supplies Bonds Payable Expense
Prepaid Expenses Accounts with “unearned” in the
is always an asset; it Prepaid Expenses Insurance
title are always liabilities Expense
represents amounts Long-Term
representing amounts paid in the
paid in advance by Investments Repair Expense
past to the company by others who
the company to Equipment expect future goods or services Income Tax
others for future Buildings from the company. Expense
benefits, such as
Land Title revenue accounts by
future insurance
coverage, rental of Intangibles their source followed by
property, or the word “revenue.”
advertising.
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Principles of Transaction Analysis
Every transaction has at least two effects (dual effects) on the basic
accounting equation. Most transactions with external parties involve an
exchange where the business entity both receives something and gives
up something in return.
Assets (A) = Liabilities (L) + Stockholders’ Equity (SE)
 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.
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Exhibit 2.3 • Analyzing Investing and Financing Transactions
The accounting equation must remain in balance after each transaction.
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Analyzing Chipotle’s Transactions (1 of 9)
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 2020, the first three months following the balance sheet in
Exhibit 2.1. Account titles are from that balance sheet. All amounts are in
millions, except per share data.
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(a) Chipotle issued (sold) 100 additional shares of common stock with a
par value of $0.01 per share at a market value of $0.17 per share,
receiving $17 in cash from investors – a financing activity.
Step 1: What was received? (account name, type of account, amount, and direction of effect)
Step 2: What was given?
Step 3: Verify that the accounting equation balances: A 17 = L 0 + SE 17
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(b) Chipotle borrowed $4 from its local bank, signing a note to be paid in
three years (a noncurrent liability) – a financing activity.
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(c) Chipotle purchased for cash $26 in new equipment and $5 in additional
intangible assets – an investing activity.
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(d) Chipotle acquired $20 in additional land and $40 in new buildings,
signed leases for $86 for right-of-use (ROU) assets, paid $29 in cash, and
signed $6 in current leases and $111 in long-term leases to rent facilities—
an investing activity.
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(e) Chipotle sold $19 in its short-term investments for $19 cash—an investing
activity.
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(f) Within the quarter, assume Chipotle paid $1 on the note payable in (b)
above (ignore any interest on the loan in this chapter)—a financing
activity.
Step 3: Verify that the accounting equation balances: A (1) = L (1) + SE 0
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(g) Chipotle repurchased a portion of its issued common stock from
investors for $103 cash—a financing activity.
Step 3: Verify that the accounting equation balances: A (103) = L 0 + SE (103)
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(h) 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 a total of $2 in cash as
dividends to shareholders next quarter.
Step 3: Verify that the accounting equation balances: A 0 = L 2 + SE (2)
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Transaction Analysis Wrap Up
In summary:
 Transaction analysis involves identifying accounts
affected in a transaction (by title), recognizing that at
least two accounts are affected, classifying the
accounts (asset, liability, or stockholders’ equity), and
determining the direction of the effect on the account
(increase or decrease).
 If all accounts and effects are correct, then the
fundamental accounting equation (A = L + SE) will
remain in balance.
 Practice is the most effective way to develop your
transaction analysis skills.
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Exhibit 2.4 • The Accounting Cycle
To handle the multitude of daily transactions that a business generates,

companies establish accounting systems, usually computerized, that follow a
cycle.
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How Do Companies Keep Track of Account Balances?
General Journal
(chronological list of each
transaction’s effects)
POS
T
General Ledger
or T-accounts
(a record of effects to
and balances of each
account)
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Exhibit 2.5
• Basic Transaction Analysis Model
STOCKHOLDERS’ EQUITY
ASSETS LIABILITIES Contributed Capital Earned Capital
(many accounts) = (many accounts) + (2 accounts) (1 account)
Common Stock and Retained

+ – – +
Debit Credit Debit Credit Additional Paid-in Capital Earnings
+ – +
Credit Debit Credit
Investment Dividends Net income
by owners declared
(expanded
in Ch. 3)
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• In Summary:
Debits and Credits
https://www.youtube.com/watch?v=VhwZ9t2b3Zk
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The Journal Entry (1 of 2)
 In an accounting system, transactions are recorded in chronological order in

a general journal (or, simply, journal).
 After analyzing the business documents (such as purchase invoices,

receipts, and cash register tapes) that describe a transaction, the effects on
the accounts are recorded in the journal using debits and credits.
 The journal entry is an accounting method for expressing the effects of a

transaction on accounts.
 It is written in a debits-equal-credits format.
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The Journal Entry (2 of 2)
(a) Assume Chipotle issued (sold) 100 additional shares of common
stock with a par value of $0.01 per share at a market value of $0.17 per
share, receiving $17 in cash from investors.
Account Titles:
Debited accounts on top. Amounts:
Credited accounts on bottom, usually indented. Debited amounts on left.
Credited amounts on right.
Debit Credit
(a) Cash (+A) 17
Common stock (+SE) 1
Additional paid-in capital (+SE) 16
Dollar signs are not needed!

Reference:
Letter,
While you are learning, use the symbols A, L, and
number, or SE next to each account title in journal entries.
date. For example, if cash is to be increased, write
Cash (+A).
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Exhibit 2.6
• Posting Transaction Effects from the Journal to the Ledger
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Exhibit 2.7
• T-Accounts Illustrated
Start with a Draw a line across the T

beginning when you are ready to
balance. compute the ending balance.
+ Cash (A) – − Common Stock (SE) +

Beg. balance 481 1 Beg. balance
(a) 17 1 (a)
End. balance 498 2 End. balance
Use the same

reference as
in the journal Put the ending balance amount
entry. on the side of the T-account that
it represents (e.g., + side if it is a
positive number).
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Expressing the T-accounts as Equations
To find the account balances, we can express the T-accounts as
equations:
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Inferring Business Activities from T-Accounts
In many cases, we will use T-accounts to determine what transactions a

company engaged in during a period.
If we know the beginning and ending balances of Accounts Payable and the
amount of purchases on account (for credit) during a period, we can
determine the amount of cash paid.
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Transaction Analysis Illustrated (1 of 9)
 We will now use the hypothetical quarterly investing and financing

transactions for Chipotle Mexican Grill that were analyzed earlier to
demonstrate recording journal entries and posting effects to the
relevant T-accounts.
 Note that the accounting equation remains in balance and that debits
equal credits after each entry.
 In the T-accounts, the amounts from Chipotle’s December 31, 2019,
balance sheet (Exhibit 2.1) have been inserted as the beginning balances.
Careful study is essential to an understanding of:

(1) the accounting model,
(2) transaction analysis,
(3) the dual effects of each transaction, and
(4) the system of balancing the debits and credits and the accounting
equation for each transaction.
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Exhibit 2.8 • T-Accounts
After analyzing the transactions from (a)–(h), the T-accounts balances are:
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Trial Balance
• List the names of the
T-accounts in
financial statement
order (assets,
liabilities,
stockholders’ equity,
revenues, and
expenses).
• The purpose of the
trial balance is to
check the equality of
the debits and
credits.
• Errors may still exist
if the wrong
accounts or amounts
were used in the
journal entries!
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Classified Balance Sheet
The balance sheet is prepared from the
trial balance. It has a good heading
(name of company, title of statement,
date, dollars if rounded to thousands or
millions).
Group assets and liabilities into current

and noncurrent (long term).
Include comparative data such as

12/31/2021 and 12/31/2020.
Most companies do not provide a total

liabilities line. To determine that amount
add total current liabilities and each of
the noncurrent liabilities.
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Exhibit 2.9 (1 of 3)
• Chipotle Mexican
Grill’s First
Quarter 2020
Balance Sheet
(based on hypothetical
investing and financing
activities)
2-39
Chipotle Mexican Grill’s First Quarter 2020 Balance
Exhibit 2.9 (2 of 3) Sheet (based on hypothetical investing and financing activities)
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Chipotle Mexican Grill’s First Quarter 2020 Balance
Exhibit 2.9 (3 of 3) Sheet (based on hypothetical investing and financing activities)
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International Perspective
IFRS (International Financial Reporting Standards) uses the same

system of analyzing, recording, and summarizing the results of
business activities as GAAP.
However, the financial statements are formatted differently as

follows:
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Current Ratio
Current Ratio = Current Assets

Current Liabilities
Does a company have the short-term resources to pay its short-term debt?
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Investing and Financing Activities (1 of 2)
Companies report cash inflows and outflows over a period in their

statement of cash flows, which is divided into three categories:
operating, investing, and financing activities.
• Operating activities are covered in a later chapter.
• Investing activities include buying and selling noncurrent
assets and short- and long-term investments.
• Financing activities include borrowing and repaying debt,
including short-term bank loans; issuing and
repurchasing stock; and paying dividends.
Only transactions affecting cash are reported on the statement.
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Investing and Financing Activities (2 of 2)
An important step in constructing and analyzing the statement of cash flows

is identifying the various transactions as operating (O), investing (I), or
financing (F). Let’s analyze the Cash T-account for Chipotle’s transactions
in this chapter.
Only transactions affecting cash are reported on the statement.

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chapter

Assets (A) = Liabilities (L) + Stockholders’ Equity (SE)

 Every transaction affects at least two accounts.

 The accounting equation must remain in balance after each

The accounting equation must remain in balance after each transaction.

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

Step 2: What was given?

Step 3: Verify that the accounting equation balances: A 17 = L 0 + SE 17

Step 2: What was given?

Step 3: Verify that the accounting equation balances: A 4 = L 4 + SE 0

Step 2: What was given?

Step 3: Verify that the accounting equation balances: A 0 = L 0 + SE 0

Step 2: What was given?

Step 3: Verify that the accounting equation balances: A 117 = L 117 + SE 0

Step 2: What was given?

Step 3: Verify that the accounting equation balances: A 0 = L 0 + SE 0

Step 2: What was given?

Step 3: Verify that the accounting equation balances: A (1) = L (1) + SE 0

Step 2: What was given?

Step 3: Verify that the accounting equation balances: A (103) = L 0 + SE (103)

Step 2: What was given?

Step 3: Verify that the accounting equation balances: A 0 = L 2 + SE (2)

To handle the multitude of daily transactions that a business generates,

Common Stock and Retained

 In an accounting system, transactions are recorded in chronological order in

 After analyzing the business documents (such as purchase invoices,

 The journal entry is an accounting method for expressing the effects of a

 It is written in a debits-equal-credits format.

(a) Cash (+A) 17

Common stock (+SE) 1

Additional paid-in capital (+SE) 16

Dollar signs are not needed!

Start with a Draw a line across the T

+ Cash (A) – − Common Stock (SE) +

Use the same

In many cases, we will use T-accounts to determine what transactions a

 We will now use the hypothetical quarterly investing and financing

Careful study is essential to an understanding of:

Group assets and liabilities into current

Include comparative data such as

Most companies do not provide a total

IFRS (International Financial Reporting Standards) uses the same

However, the financial statements are formatted differently as

Current Ratio = Current Assets

Companies report cash inflows and outflows over a period in their

An important step in constructing and analyzing the statement of cash flows

Only transactions affecting cash are reported on the statement.

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