FINANCIAL ACCOUNTING Prepared by L. de Grace C.A. a user perspective Sixth Canadian Edition John Wiley & Sons Canada, Ltd. ©2011 CHAPTER 2 ANALYZING TRANSACTIONS AND THEIR EFFECTS ON FINANCIAL STATEMENTS

Basic Accounting Equation John Wiley & Sons Canada, Ltd. ©2011 Assets = Liabilities + Shareholders’ Equity or Shareholders’ Equity = Assets – Liabilities 2

Transaction Analysis – Start-Up Period John Wiley & Sons Canada, Ltd. ©2011  Demo Company, Ltd. is formed as a corporation in December of 2011 o Transaction 1: Common shares are issued for $17,500 o Effects: Assets (Cash) increase Shareholders’ Equity (Common shares) increase 3 INFO LINK

Transaction Analysis John Wiley & Sons Canada, Ltd. ©2011 o Transaction 2: Purchase equipment for $4,500 o Effects: Assets (Cash) decrease Assets (Equipment) increase 4

Transaction Analysis John Wiley & Sons Canada, Ltd. ©2011 o Transaction 3: Paid $360 cash for an insurance policy o Effects: Assets (Inventory) increase Liabilities (Accounts Payable) increase 5

Transaction Analysis John Wiley & Sons Canada, Ltd. ©2011 o Transaction 4: The company borrowed $10,000 from its bank.  Effects: Assets (Cash) increase Liabilities (Loan Payable) increase 6 Demo Co. Worksheet

Transaction Analysis John Wiley & Sons Canada, Ltd. ©2011 o Transaction 6: The company purchased land for $15,000. o Effects: Assets (Land) increase Assets (Cash) decrease 7

Transaction Analysis Operating Period o Transaction 7: Sold units of inventory on account for $13,000  Effects:  Assets (Accounts Receivable) increase  Shareholders’ Equity (Retained Earnings) increases John Wiley & Sons Canada, Ltd. ©2011 8

Transaction Analysis Operating Period o Transaction 8: The cost of the units sold is removed from inventory – $9,000  Effects: Assets (Inventory) decrease Shareholders’ Equity (Retained Earnings) decreases John Wiley & Sons Canada, Ltd. ©2011 9

Revenue Recognition  Revenue Recognition:  Criteria established stipulate when revenues should be recognized in the financial statements  Generally recognition occurs when the earnings process is substantially complete  Most common basis of recognition is related to the delivery of goods or services John Wiley & Sons Canada, Ltd. ©

Matching Concept  Matching Concept:  All costs associated with generating sales revenue must be matched with the revenue earned  Cost of goods sold related to revenue should be recognized in the same period as the sales revenue  Other costs (customer support, warranties) should be recognized in the same period as the sales revenue John Wiley & Sons Canada, Ltd. ©

Cost Classifications  Under accrual-based accounting, costs can be classified as:  Assets  Expenses John Wiley & Sons Canada, Ltd. ©2011  If the cost represents something that still has value to the company, and will be of economic benefit to it in the future, then it is classified as an asset and reported on the balance sheet.  If the cost represents something that has already given up its value to the company, and will not be of further benefit to the company in the future, then it is classified as an expense and reported on the income statement. 12

Cost of Goods Sold Calculation Beginning inventory + Goods purchased during the period = Goods available for sale during the period - Ending inventory =Goods sold during the period John Wiley & Sons Canada, Ltd. ©

Transaction Analysis John Wiley & Sons Canada, Ltd. ©2011 o Transaction 9: Demo Co. received $11,000 from customers as payments on their accounts  Effects: o Assets (Cash) increase o Assets (Accounts Receivable) decrease o Transaction 10: Demo Co. made payments of $13,500 on its accounts payable.  Effects: o Assets (Cash) decrease o Liabilities (Accounts Payable) decrease 14

Transaction Analysis John Wiley & Sons Canada, Ltd. ©2011 o Transaction 11: Demo Co. paid the following operating costs for January: $2,000 for salaries; $500 for rent; $300 for utilities.  Effects: Assets (Cash) decrease Liabilities (Accounts Payable) decrease 15

Transaction Analysis John Wiley & Sons Canada, Ltd. ©2011 o Transaction 12: Demo Co. declared and paid dividends of $250.  Effects: Assets (Cash) decrease Shareholders’ Equity (Retained Earnings) decreases 16 Demo Co. Worksheet

Amortization of Assets John Wiley & Sons Canada, Ltd. ©2011  When an asset is used up over time, some of the cost of the asset should be shown as an expense in each period in which it is used  The amount shown as an expense in any period is called the amortization of the asset 17

Amortization of Assets John Wiley & Sons Canada, Ltd. ©2011  Straight-line amortization Original Cost - Estimated Residual Value Estimated Useful Life 18

Transaction Analysis John Wiley & Sons Canada, Ltd. ©2011 Transaction 13: Amortize equipment for January – $150.  Effects: o Assets (Equipment) decrease o Shareholders’ Equity (Retained Earnings) decrease 19

Prepaid Expenses John Wiley & Sons Canada, Ltd. ©2011  An amount paid in advance of the coverage period is recorded as an asset (Prepaid Expense)  As time passes, the coverage is “consumed” and is then recognized as an expense 20

Transaction Analysis John Wiley & Sons Canada, Ltd. ©2011  Transaction 14: One month’s insurance consumed, $60.  Effects: Assets (Prepaid Insurance) decrease Shareholders’ Equity (Retained Earnings) decrease 21

Accrued Expenses John Wiley & Sons Canada, Ltd. ©2011  Expenses that are recognized on the income statement in the period in which they are incurred, which is usually prior to the period in which they are paid in cash 22

Transaction Analysis John Wiley & Sons Canada, Ltd. ©2011 o Transaction 15:Interest expense on the bank loan is 6% per annum and interest payments are to be made quarterly. $10,000 x 6% x 1 month = $50  Effects: Liabilities (Interest Payable) increase Shareholders’ Equity (Retained Earnings) decreases 23

Transaction Analysis John Wiley & Sons Canada, Ltd. ©2011 Transaction 16: Income tax expense must be recognized each accounting period. Demo Co.’s income tax rate is 25%.  Effects: Liabilities (Income Tax Payable) increase Shareholders’ Equity (Retained Earnings) decreases 24

Financial Statements John Wiley & Sons Canada, Ltd. ©2011  Balance Sheet  Income Statement  Cash Flow Statement 25 Demo Co. Worksheet We can now use the Demo Co. worksheet to prepare the financial statements:

Statement of Earnings John Wiley & Sons Canada, Ltd. ©2011  Calculates profit (net income) by subtracting expenses from revenues for the period  Dividends Are not expenses Are distributions of earnings to shareholders 26

Demo Company, Ltd. Statement of Earnings For the Month Ended January 31, 2011 Sales $ 13,500 Expenses: Cost of goods sold (9,000) Salaries(2,000) Rent(500) Utilities(300) Depreciation (150) Insurance( 60) Interest ( 50) Income tax(235) Net income$ 705 John Wiley & Sons Canada, Ltd. ©

Classified Statement of Financial Position John Wiley & Sons Canada, Ltd. ©2011  Current assets and liabilities are distinguished from noncurrent assets and liabilities 28

Demo Company, Ltd. Classified Statement of Financial Position As at January 31, 2011 John Wiley & Sons Canada, Ltd. ©2011 Current AssetsCurrent Liabilities Cash $ 2,090 Accounts payable $ 1,900 Accounts receivable 2,000 Interest payable 50 Inventory 14,000 Total current liabilities 1,950 Prepaid insurance 300 Bank loan 10,000 Total current assets 18,390 Total liabilities 11,950 Land 15,000 Common shares 12,500 Equipment $ 4,550 Retained earnings 190 (150) 4,350 Total assets $24,640 Total liabilities and $24,640 shareholders’ equity 29

Variations in Presentation  Sections of the balance sheet may be presented in a different sequence.  Typical European practice is the reverse of North American practice. John Wiley & Sons Canada, Ltd. © LINDT & SPRÜGLI Example

Profitability Ratios John Wiley & Sons Canada, Ltd. ©2011 o Profit Margin Ratio Profit Revenues o Return on Assets Profit Average total assets invested o Return on Equity Profit Average total shareholders’ equity 31

Profitability Ratios for Demo Co. John Wiley & Sons Canada, Ltd. ©2011 o Profit Margin Ratio $705 $13,000 o Return on Assets $705 $37,740 o Return on Equity $705 $17, =5.42% =1.87% =3.93%

Cash Flow Statement John Wiley & Sons Canada, Ltd. ©2011  Explains the changes in cash flow during the period  Details changes in:  Operating activities  Investing activities  Financing activities 33

Demo Company, Ltd. Cash Flow Statement For the Month Ended January 31, 2011 John Wiley & Sons Canada, Ltd. ©2011 Operating activities: Cash receipts from customers $ 11,000 Cash paid for insurance(360) Cash paid to suppliers (13,500) Cash paid for salaries(2,000) Cash paid for rent (500) Cash paid for utilities (300) Total cash from operating activities $ (5,660) 34 Investing activities: Cash paid for equipment purchase(4,500) Purchase of land (15,000) Total cash from investing activities$ (19,500)

Demo Company, Ltd. Cash Flow Statement For the Month Ended January 31, 2011 John Wiley & Sons Canada, Ltd. ©2011 Financing activities: Proceeds from issuance of shares17,500 Proceeds from bank loan 10,000 Dividends paid ( 250) Total cash from financing activities 27,250 Net change in cash (2,090) Cash balance on December 31, Cash balance on January 31, 2011 $ 2,090 35

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