Chapter 2

Investing and Financing

Decisions and the Statement
of Financial Position

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Learning ObjectivesAfter studying this chapter, you should be able to:

Part I

1. Discuss the overview of the conceptual

framework of accounting and the key

accounting assumptions and principles
2. Identify the sections of the classified
balance sheet
3. Calculate ratios for analyzing profitability
, liquidity and companys solvency

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Principles for Communicating Useful

Information
Primary
PrimaryObjective
Objectiveof
of External
ExternalFinancial
FinancialReporting
Reporting
To
Toprovide
provideeconomic
economicinformation
informationto
toexternal
external users
usersfor
for
decision
decisionmaking.
making.
Primary
PrimaryQualitative
QualitativeCharacteristics
Characteristics
Relevance:
Relevance: Timely,
Timely,Predictive
Predictiveand
andhas
hasFeedback
FeedbackValue
Value
Faithful
FaithfulRepresentation:
Representation: Accurate,
Accurate,Unbiased,
Unbiased,and
and
Verifiable
Verifiable
Secondary
SecondaryQualitative
QualitativeCharacteristics
Characteristics
Comparability:
Comparability: Across
Acrossbusinesses
businesses
Consistency:
Consistency: Over
Overtime
time
Understandability
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Separate
Separate entity:
entity: Transactions
Transactions of
of the
the business
business entity
entity
are
are separate
separate from
from transactions
transactions of
of owners.
owners.
Going
Going concern/Continuity:
concern/Continuity: The
The entity
entity is
is expected
expected
to
to continue
continue its
its operations
operations in
in the
the foreseeable
foreseeable future.
future.
Justifies
Justifies the
the use
use of
of cost
cost principles
principles
Stable
Stable dollar/unit-of-measure:
dollar/unit-of-measure: Only
Only include
include items
items
that
that can
can be
be measured
measured in
in the
the national
national monetary
monetary unit
unit
($).
($). Purchasing
Purchasing power
power of
of the
the unit
unit of
of measure
measure does
does
not
not change
change over
over time.
time.
Time
Time Period:
Period: The
The long
long life
life of
of aa company
company can
can be
be
reported
reported over
over aa series
series of
of short
short time
time periodsperiodsnecessary
necessary to
to prepare
prepare annual
annual f/s.
f/s.
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Historical
Historicalcost:
cost: The
The cash
cashequivalent
equivalent cost
cost given
givenup
up isisthe
the
basis
basisfor
forinitial
initialrecording
recordingof
of financial
financialstatement
statement elements.
elements.
Assets
Assetsand
andliabilities
liabilities are
arerecorded
recordedat
at costcost-how
how much
muchyou
you
paid
paid
Objectivity:
Objectivity: amount
amount used
usedin
inrecording
recording transactions
transactions are
areto
to
be
bebased
basedon
onobjective
objective evidence
evidencerather
ratherthan
thansubjective
subjective
judgments
judgments
Revenue
Revenuerecognition:
recognition: Requires
Requiresthat
that revenue
revenuebe
beassigned
assigned
to
tothe
theaccounting
accountingperiod
period which
whichisisearnedearned- chapter
chapter 33
Matching:
Matching: Requires
Requiresthat
thatrevenue
revenueand
andexpenses
expensesbe
be
matchedmatched- chapter
chapter 33
Full
Fulldisclosure:
disclosure: Events
Eventsthat
that make
makeaa difference
difference to
tousers
users
should
shouldbe
bedisclosed
disclosed
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Classified Balance
Classifying assets and liabilities into significant
Sheet
groups is helpful to users in judging:
The adequacy of different types of assets used in

the business
The availability of assets to meet liabilities
Listed in order of liquidity and maturity

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Definition of Assets
Three Characteristics:
1. Something that has probable future value

that can be measured

2. The company can control the benefit from
future value through ownership or rights
to use the assets
3. The event that gave the company the
ownership or right has already occurredpast transaction
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Assets
Current Assets
Assets expected to be

converted to cash or
used in the business
within the year
Listed in order of
liquidity
Examples include cash,
short-term
investments, accounts
receivable, inventories
and prepaid expenses
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Long Term
Investments
Investments in the debt

or equity securities of
other corporations
These assets are
normally not intended to
be sold within the next
year

Assets
Property, Plant and
Intangible Assets
Equipment
Noncurrent assets that
Tangible assets with
do not have physical
relatively long useful
substance and
lives
represent a privilege or
Assets used in operating
a right
the business
Examples include land, Examples include
goodwill, patents,
building, machinery,
delivery equipment,
copyrights,
furniture and fixtures
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trademarks, trade
names and licenses

Liabilities &
Shareholders
Equity
Definition of Shareholders Equity
Definition of
Liabilities
The value of the shareholders interest
Three characteristics: in the company is measured as:
1. Amounts that the
Share capital
company owes to
Represents shares issued by the
others
company-- $$ amount invested by
2. Probable future
investors for shares
sacrifice of
Retained earnings
resources: cash,
services, or goods
Earnings of the company retained
3. Based on past
by the company, not paid out in the
transaction
form of dividends
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10

Liabilities &
Shareholders
Equity
Current liabilities
Share capital
Obligations that are supposed

to be paid within the coming

year
Examples include accounts
payable, notes payable,
interest payable, etc.
Long-term liabilities
Debts expected to be paid
after one year
Examples include bonds
payable, mortgage payable,
notes payable, lease
liabilities, etc.
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Investment of

cash (or other

assets) in the
business by the
shareholders in
exchange for
preferred or
common shares
Retained
earnings
Earnings kept
for use in the
business
11

Learning ObjectivesAfter studying this chapter, you should be able to:

Part II
1. Understand a typical business operating

cycle- business transactions that affect

the income statement
2. Define debits and credits and explain how
they are used to record the transactions
3. Understand the basic steps in the
recording process
4. Prepare a trial balance
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12

External events:
events complete exchanges of assets
and liabilities between the business and one or
more other parties.

Internal events:
events not an exchange between
the business and other parties, but have a direct
effect on the accounting entity.
Ie: depreciation, prepaid insurance, accruals

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13

Business Papers (Source

Documents)
Provide evidence of transactions this the
basis of recording the transactions
Examples: retail or manufacturing company
sales invoices
cheques
purchase orders
Customer billings
Employee earnings records
Bank statement
Cash register tape
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14

Two tools used:

1. T- Accounts
2. Journal Entries
used to represent an account in
the general ledger
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15

Method #1: TAccounts

A standardized format to accumulate the dollar effects of transactions.

Account title should be descriptive and clear- Rent could be an asset

(Prepaid rent), a liability (unearned rent), a revenue (rent earned) or

expense (rent expense)

Cash

Equipment

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Inventory

NotesPayable

16

Balance Sheet
Equation
Every transaction affects at least two
accounts (double entry accounting).
The accounting equation must remain in
balance after each transaction.

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A = L +
SE

17

Balancing the Accounting

Equation
Accounts and effects
Identify the accounts affected.
Classify each as an asset, liability or equity

account.
Determine the direction of the effect
(increase or decrease) on each account.

Determine that the accounting equation

remains in balance.

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18

Debits
Debitsand
andcredits
creditsaffect
affectthe
theBalance
BalanceSheet
Sheet
DR
DRmeans
meansleft
leftside;
side; CR
CRmeans
meansright
right side
side
Equality
Equalitymust
mustbe
bemaintained
maintainedDR=CR
DR=CR

A = L + SE
ASSETS

LIABILITIES

EQUITIES

Debit
Credit
for
for
Increase Decrease

Debit
Credit
for
for
Decrease Increase

Debit
Credit
for
for
Decrease Increase

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19

Shareholders Equity
Withdrawl
Debit for
Increase

Credit
for
Decrease

Capital

Revenue

Debit
Credit
for
for
Decrease Increase

Debit
Credit
for
for
Decrease Increase

Expenses
Debit for
Increase

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Credit
for
Decrease
20

Entries to T Accounts
Assets
Beginning
balance
Increases
Ending
balance

Liabilities

Decreases

Decreases

Beginning
balance
Increases
Ending
balance

Shareholders Equity
Decreases

Beginning balance
Increases
Ending balance

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21

Normal
Normal balance:
balance: isis aa debit
debit or
or credit
credit

balance
balance depending
depending on
on which
which side
side of
of the
the account
account
is
is used
used to
to record
record the
the INCREASE
INCREASE
Assets=
Assets=Debit
Debit
Liabilities=
Liabilities=Credit
Credit
SE=
SE=Credit
Credit
Capital=
Capital=Credit
Credit
Withdrawal=
Withdrawal=Debit
Debit
Revenue=
Revenue=Credit
Credit
Expenses=
Expenses=Debit
Debit
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22

Method #2: The

Journal Entry
Provide a reference
date for each transaction.

Credits are indented and

written after debits.
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Debits are written first.

Total debits must equal

total credits.

23

Posting Process
After journal entries are prepared, the
accountant posts (transfers) the dollar
amounts to each account that was affected
by the transaction.

Ledger

Post

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24

Van Houtte issues additional shares to new

investors in exchange for $1,300 cash.

Beg. Bal.
(a)

Cash
6,100
1,300

7,400
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Share Capital
300 Beg. Bal.
1,300 (a)

1,600
25

The company borrows $1,000 from the local

bank, signing a note to be paid in one year.

Beg. Bal.
(a)
(b)

Cash
6,100
1,300
1,000

8,400
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Notes Payable
Beg. Bal.
1,000 (b)

1,000
26

Van Houtte purchases $2,200 of new coffee brewers,

counters, etc., and other equipment (fixed assets)
paying $1,500 in cash and signing a note for $700,
payable in 2 years.

Lets see how to post this entry . . .

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27

Van Houtte purchases

$2,200 of new coffee
brewers, counters, etc.,
and other equipment
(fixed assets) paying
$1,500 in cash and
signing a note for $700,
payable in 2 years.
Beg. Bal.
(a)
(b)

Cash
6,100
1,300
1,000

1,500 (c)

6,900
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28

The company sold coffee products to office service

clients for $35,200 in cash. The cost of the sales
was $19,600.
Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1.
2.
2.
3.
3.
4.
4.
Determine
the
Direction
of
the
Effect
Determine
the
Direction
of
the
Effect
Determine
Determinethe
the Direction
Directionof
ofthe
theEffect
Effect
1.
1.
2.
2.
3.
3.
4.
4.
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29

The company sold coffee products to office service

clients for $35,200 in cash. The cost of the sales
was $19,600.

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30

A = L + SE
ASSETS

LIABILITIES

Debit
Credit
for
for
Increase Decrease

Debit
Credit
for
for
Decrease Increase

Next, lets see

how Revenues
and Expenses
affect Retained
Earnings.
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SHARE CAPITAL

RETAINED
EARNINGS

Debit
Credit
for
for
Decrease Increase

Debit
Credit
for
for
Decrease Increase
31

Dividends decrease
Retained Earnings.

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RETAINED
EARNINGS
Debit
Credit
for
for
Decrease Increase

Net Income increases

Retained Earnings.

REVENUES

EXPENSES

Debit
Credit
for
for
Decrease Increase

Debit
Credit
for
for
Increase Decrease
32

Van Houtte signed contract with new office service clients

and receives $500 cash. The company earned $400
immediately. The rest will be earned over several months.
Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
Identify
Identify&&Classify
Classifythe
theAccounts
Accounts
1.
1.
2.
2.
3.
3.

Determine
Determinethe
the Direction
Directionof
ofthe
theEffect
Effect
Determine
the
Direction
of
the
Determine the Direction of theEffect
Effect
1.
1.
2.
2.
3.
3.
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33

Van Houtte signed contract with new office service clients

and receives $500 cash. The company earned $400
immediately. The rest will be earned over several months.

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34

Trial Balance
The equality of DR and CR in the ledger is tested
periodically by preparing a trial balance which lists
the balance in each account
Locating errors:
Check the journalizing, posting and trial balance (in
reverse order)
Check the addition of trial balance
Check copying of account balances from the ledger
Correcting errors:
All errors must be correct do not erase j/e or posting
in accounts. This may indicate an effort to conceal
something
Incorrect account posted- record a correcting journal
entry, which requires full explanation
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35

Some Misconceptions
Bookkeeping does not equal accounting - its

only a small part of accounting

All transactions ARE NOT subject to precise
and objective measurement- its an estimate
Some people believe that financial
statements report the market value of the
company only using historical costs.

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36

11/27/16

International
Perspective

Although financial statements prepared using GAAP and IFRS include

Understanding
Foreign
Statements
the same elements
(assets,Financial
liabilities, revenues,
expenses, etc.), a
single, consistent format has not been mandated. Consequently,
various formats have evolved over time, with those in Canada and the
U.S. differing from those typically used internationally. The formatting
differences include:

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