Lecture Notes: Chapter 2 – Investing and Financing
Decisions and the Accounting System
Based on Financial Accounting, 11th Edition by Libby, Libby, and Hodge
Introduction
Financial accounting provides the foundation for tracking and understanding business activities
through the accounting equation and financial statements, particularly the balance sheet. This
chapter introduces the underlying assumptions and principles, explains how business
transactions affect financial statements, and shows how to record, summarize, and analyze these
effects using tools like journal entries, T-accounts, and the trial balance. We’ll also explore
investing and financing activities, and how they impact cash flows, setting the stage for deeper
analysis in subsequent chapters.
1. Accounting Assumptions, Principles, and Balance Sheet
Elements
1.1 Key Accounting Assumptions
Separate-Entity Assumption: A business’s finances are separate from its owners'
personal finances.
Unit-of-Measure Assumption: All financial data is reported in a single, stable monetary
unit (e.g., Canadian dollars).
Going-Concern Assumption: Assumes the business will continue operating unless
stated otherwise.
1.2 Accounting Principles
Historical Cost Principle: Assets are recorded at their purchase cost, not market value.
Revenue Recognition Principle: Revenue is recorded when earned, regardless of cash
receipt.
Matching Principle: Expenses are recorded in the same period as related revenues.
, 1.3 Elements of the Balance Sheet
The balance sheet reports a company’s financial position at a specific point in time using the
accounting equation:
Assets: Resources controlled by the company (e.g., cash, accounts receivable, inventory,
equipment).
Liabilities: Obligations owed to outsiders (e.g., accounts payable, loans).
Stockholders’ Equity: Owner claims on assets after liabilities (e.g., common stock,
retained earnings).
2. Identifying Business Transactions
A business transaction is any economic event that affects the financial position of a company
and can be measured reliably.
Examples of Business Transactions:
1. Buying equipment for cash
2. Receiving a loan from a bank
3. Selling products on credit
4. Paying employee salaries
Not a transaction: Signing a contract without an exchange of goods or money.
Common Balance Sheet Account Titles
Assets: Cash, Accounts Receivable, Supplies, Equipment, Prepaid Expenses
Liabilities: Accounts Payable, Notes Payable, Salaries Payable, Unearned Revenue
Equity: Common Stock, Retained Earnings, Dividends
3. The Accounting Equation and Transaction Analysis
The accounting equation must remain in balance after each transaction:
Decisions and the Accounting System
Based on Financial Accounting, 11th Edition by Libby, Libby, and Hodge
Introduction
Financial accounting provides the foundation for tracking and understanding business activities
through the accounting equation and financial statements, particularly the balance sheet. This
chapter introduces the underlying assumptions and principles, explains how business
transactions affect financial statements, and shows how to record, summarize, and analyze these
effects using tools like journal entries, T-accounts, and the trial balance. We’ll also explore
investing and financing activities, and how they impact cash flows, setting the stage for deeper
analysis in subsequent chapters.
1. Accounting Assumptions, Principles, and Balance Sheet
Elements
1.1 Key Accounting Assumptions
Separate-Entity Assumption: A business’s finances are separate from its owners'
personal finances.
Unit-of-Measure Assumption: All financial data is reported in a single, stable monetary
unit (e.g., Canadian dollars).
Going-Concern Assumption: Assumes the business will continue operating unless
stated otherwise.
1.2 Accounting Principles
Historical Cost Principle: Assets are recorded at their purchase cost, not market value.
Revenue Recognition Principle: Revenue is recorded when earned, regardless of cash
receipt.
Matching Principle: Expenses are recorded in the same period as related revenues.
, 1.3 Elements of the Balance Sheet
The balance sheet reports a company’s financial position at a specific point in time using the
accounting equation:
Assets: Resources controlled by the company (e.g., cash, accounts receivable, inventory,
equipment).
Liabilities: Obligations owed to outsiders (e.g., accounts payable, loans).
Stockholders’ Equity: Owner claims on assets after liabilities (e.g., common stock,
retained earnings).
2. Identifying Business Transactions
A business transaction is any economic event that affects the financial position of a company
and can be measured reliably.
Examples of Business Transactions:
1. Buying equipment for cash
2. Receiving a loan from a bank
3. Selling products on credit
4. Paying employee salaries
Not a transaction: Signing a contract without an exchange of goods or money.
Common Balance Sheet Account Titles
Assets: Cash, Accounts Receivable, Supplies, Equipment, Prepaid Expenses
Liabilities: Accounts Payable, Notes Payable, Salaries Payable, Unearned Revenue
Equity: Common Stock, Retained Earnings, Dividends
3. The Accounting Equation and Transaction Analysis
The accounting equation must remain in balance after each transaction:
