Financial Accounting Chapter 1

Objective 1 - Explain why accounting is the language of business

 Accounting is an information system that measures and records business activities,

processes data into reports, and reports results to decision makers.

Who Uses Accounting Information?

 Managers- Managers have to make many business decisions. Should they introduce a
new product line?

 INVESTORS AND CREDITORS- Investors and creditors provide the money to finance
a business’s activities.
 GOVERNMENT AND REGULATORY BODIES. Many government and regulatory
bodies use accounting information. For example, the federal government requires
businesses, individuals, and other organizations to pay income and sales taxes. The
Canada Revenue Agency uses accounting information to ensure these organizations pay
the correct amount of taxes.
 NOT-FOR-PROFIT ORGANIZATIONS. Not-for-profit organizations—churches,
hospitals, and charities, such as Habitat for Humanity and the Canadian Red Cross—base
their decisions on accounting information.

Two Kinds of Accounting: Financial Accounting and Management Accounting

 Financial accounting provides information for managers inside the business and for
decision makers outside the organization, such as investors, creditors, govnernment
agencies, and the public.
 Management accounting generates inside information for the managers of the
organization. Examples of management accounting information include budgets,
forecasts, and projections that are used to make strategic business decisions.
Organizing a Business

DESCRIBE THE PURPOSE OF EACH FINANCIAL STATEMENT AND EXPLAIN

THE ELEMENTS OF EACH ON

Generally Accepted Accounting Principles

  GAAP- Specify standards for how accountants must record, measure, and report
financial information. Established by the Chartered Professional Accountants of Canada
 (CPAC), one of the country’s three professional accounting bodies.
 Publicly accountable enterprises (PAEs), are corporations and other organizations that
have issued or plan to issue shares or debt in public markets such as the Toronto Stock
Exchange
 IFRS are set by the International Accounting Standards Board and have been adopted by
over 100 countries in an effort to enhance the comparability of the financial information
reported by public enterprises around the world.
 Private enterprises, which have not issued and do not plan to issue shares or debt on
public markets, have the option of applying IFRS. Because IFRS are relatively complex
and costly to apply, however, very few Canadian private enterprises have adopted them
Accounting Standards for Private Enterprises (ASPE), which have been set by the
CPAC.

Income Statement

 The Income Statement Measures Operating Performance The income statement (or
statement of profit or loss) measures a company’s operating performance for a specified
period of time.
 Period of time covered is typically a month, a quarter (three months), or a year, and will
always be specified in the heading of the income statement
 Fiscal year is known calendar year end.
 INCOME. A company’s income includes both revenue and gains. Revenue consists of
amounts earned by a company in the course of its ordinary, day-to-day business
 EXPENSES. A company’s expenses consist of losses as well as those expenses that are
incurred in the course of its ordinary business activities. Expenses consist mainly of the
costs incurred to purchase the goods and services a company needs to run its business on
a day-to-day basis.
 The income statement also reports the company’s net income, which is calculated as
follows: Net Income = Total Revenues and Gains – Total Expenses and Losses
 In accounting, the word net refers to the amount of something that is left after something
else has been deducted from an initial total.
 When total expenses exceed total income, the result is called a net loss.
 Net income is sometimes known as net earnings or net profit, and is usually
considered the most important amount in a company’s financial statements.
 It is a key component of many financial ratios, including return on equity and earnings
per share.

The Statement of Retained Earnings Reports Changes in Retained Earning

  A company’s retained earnings represent the accumulated net income (or net
earnings) of the company since the day it started business, less any net losses and
dividends declared during this time.
 When the accumulated amount is negative, the term deficit is used to describe it. The
statement of retained earnings reports the changes in a company’s retained earnings
during the same period covered by the income statement.

The Balance Sheet Measures Financial Position

 The balance sheet reports a company’s financial position as at a specific date, which
always falls on the last day of a monthly, quarterly, or annual reporting period.
 Because it is presented as at a specific date, think of the balance as a snapshot of the
company’s financial position at a particular point in time.
 The balance sheet takes its name from the fact that the assets it reports must always equal
or be in balance with the sum of the liabilities and equity it reports. This relationship is
known as the accounting equation.
 ASSETS. An asset is a resource controlled by the company as a result of past events and
from which the company expects to receive future economic benefits.
 Classify assets into two categories on the balance sheet: current assets and non-current
assets.
 Current when we expect to convert it to cash, sell it, or consume it within one year of the
balance sheet date, or within the business’s normal operating Cycle.

 Current assets are listed in order of their liquidity, which is a measure of how quickly
they can be converted to cash, the most liquid asset.
  All assets that do not qualify as current are classified as non-current assets, which are also
known as long-term assets.
 Liability is a present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources embodying
economic benefits.
 current liabilities or non-current liabilities (or long-term liabilities), with the
distinction based on how soon after year-end the company expects to pay off the debt.
 Current liabilities are debts the company expects to pay off within one year of the
balance sheet date or within the company’s normal operating cycle if it is longer than one
year.
 Owners’ equity is the owners’ remaining interest in the assets of the company after
deducting all its liabilities. (could also be known as shareholders equity)
 Owners’ Equity = Assets – Liabilities

The Statement of Cash Flows Measures Cash Receipts and Payments

 The statement of cash flows (or cash flow statement under ASPE) reports a compa-ny’s
cash receipts and cash payments for the same fiscal period covered by the income
statement.
1. OPERATING ACTIVITIES
o the main revenue-producing activities of a company, and generally result from the
transactions and other events that determine net income.
o include cash receipts from a company’s sales of its primary goods and services as
well as cash payments to suppliers and employees for the goods and services they
provide to generate these sales.
2. INVESTING ACTIVITIES.
o These activities include the purchase and sale of long-term assets and other
investments that result in cash inflows or outflows related to resources used for
generating future income and cash flows.
o Cash payments to acquire property, plant, and equipment, and the cash received
upon the sale of these assets, are common investing activities.
3. FINANCING ACTIVITIES
o These activities result in changes in the size and composition of a company’s
contributed equity and borrowings.
o Common financing activities include the issuance and acquisition of shares, the
payment of cash dividends, the cash proceeds from borrowings, and the
repayment of amounts borrowed.

Fundamental Qualitative Characteristic

To be useful, information must have two fundamental qualitative characteristics:

• Relevance and

• Faithful representation

 To be relevant, information must have predictive value, confirmatory value, or both.

Enhancing Qualitative Characteristics

To be useful, accounting information must also possess four enhancing qualitative

characteristics:

• Comparability: For accounting information to be comparable, it must be reported in a

way that makes it possible to compare it to similar information being reported by other
companies. It must also be reported in a way that is consistent with how it was reported
in previous accounting periods.
• Verifiability - Accounting information is verifiable when it can be checked for
accuracy, completeness, and reliability. Verifiability enhances the chance that
accounting information reflects a faithful representation of the economic substance of a
transaction or event.
• Timeliness - Timeliness means reporting accounting information to users in time for it
to influence their decisions. Accounting information tends to become less relevant as it
 gets older, so it should be reported to users as soon after the end of the accounting
period as possible, without sacrificing the other qualitative characteristics in the process
• Understandability- Accounting information is understandable when it is clearly and
concisely classified and presented to reasonably knowledgeable and diligent users of
the information.

Assumptions Underlying the Conceptual Framework

• The conceptual framework has only one explicit underlying assumption: the going-
concern assumption.
• They are the separate-entity, historical-cost, and stable-monetary-unit assumptions.
• GOING-CONCERN ASSUMPTION
o Prepare financial information under the assumption that the reporting entity is a
going concern, means expect it to continue operating normally for the
foreseeable future.
o A company that is not a going concern is at risk of going bankrupt or closing
down, so it may need to significantly scale down its operations or sell some of
its assets at heavily discounted rates.
• SEPARATE ENTITY ASSUMPTION
o We also prepare financial statements under the assumption that the business
activities of the reporting entity are separate from the activities of its owners, so
we do not mix the assets, liabilities, income, or expenses of the entity with those
of its owners when reporting the entity’s operating performance and financial
position.
• HISTORICAL-COST ASSUMPTION
o The historical-cost assumption states that assets should be recorded at their
actual cost, measured on the date of purchase as the amount of cash paid plus
the dollar value of all non-cash consideration (other assets, privileges, or rights)
also given in exchange.
• STABLE-MONETARY-UNIT ASSUMPTION.
o The vast majority of Canadian entities report their financial information in
Canadian dollars (or monetary units), although some choose to report in U.S.
dollars instead. Regardless of the reporting currency used, financial
information is always reported under the assumption that the value of the
currency is stable, despite the fact that its value does change due to economic
factors such as inflation.

MAKE ETHICAL BUSINESS DECISION

• Generally, three factors influence business and accounting decisions: economic, legal,
and ethical factors.
• The economic factor states that the decision being made should maximize the economic
benefits to the decision maker.
• The ethical factor recognizes that while certain actions might be both economically
profitable and legal, they may still not be right.
• Ethical standards are shaped by our cultural, socioeconomic, and religious backgrounds.
An ethical analysis is often needed to guide judgment when making business decisions.
FRAUD
The two most common types of fraud that affect financial statements are:
1. Misappropriation of assets: Examples include stealing inventory, falsifying invoices,
forging or altering cheques, or overstating of expense reimbursement requests
2. Fraudulent financial reporting: This type of fraud is committed by company managers
who make false and misleading entries in the accounting records, usually to present a
more favourable financial picture than would be presented if the actual results were
disclosed.

Chapter 2 Financial Accounting

Describe Common Types of Accounts

• Each asset, liability, and element of shareholders’ equity has its own account.
• CASH- Cash consists of bank account balances, paper currency and coins, and under
posited cheques.
• ACCOUNTS RECEIVABLE. Accounts Receivable represent the amounts owing from
customers who have purchased goods or services but not yet paid for them. In other
words, they have purchased goods or services on account or on credit.
• INVENTORY- Inventory consists of the goods a company sells to its customers.
• PREPAID EXPENSES-Prepaid Expenses are expenses a company has paid for in
advance of actually using the product or service it has purchased.
• BUILDINGS. Any office buildings, factories, and other buildings owned by a company
are included in the Buildings account.
• EQUIPMENT, FURNITURE, AND FIXTURES. These accounts include a variety of
office, computer, and manufacturing equipment, as well as any furniture and fixtures
owned by a company.
Liability Accounts

• ACCOUNTS PAYABLE. Accounts Payable represents the amounts a company owes to

suppliers who have sold the company goods or services on credit.
• ACCRUED LIABILITIES- An accrued liability is a liability for an expense that has not
been billed for or paid.
• LOANS PAYABLE. Loans Payable include funds a company has borrowed from banks
and other creditors to finance its business activities.

Shareholders’ Equity Accounts

• SHARE CAPITAL. The Share Capital account includes the capital (usually in the form
of cash) a company has received from its owners in exchange for shares of the com-pany.
This account is sometimes called Common Shares, which is the most basic element of
equity.
• RETAINED EARNINGS. The Retained Earnings account shows the cumulative net
income earned by the company over its lifetime, minus its cumulative net losses and
dividends.
• DIVIDENDS- The Dividends account includes dividends that have been declared during
the current fiscal period. Dividends are payments to shareholders that represent the
distribution of a portion of the company’s past earnings.
• REVENUES- Are a form of income that increase shareholders’ equity. Companies
typically earn revenue through the sale of their primary goods and services.
• EXPENSES- Decrease shareholders’ equity and consist mainly of the costs incurred to
purchase the goods and services a company needs to run its business. Common types of
expenses include Salary Expense, Rent Expense.
• GAINS AND LOSSES- Also affect shareholders’ equity via their impact on net income
and retained earnings. Gains, which usually occur outside the course of a company’s
ordinary business activities, are another form of income, so they increase shareholders’
equity. Losses, which also typically occur outside of ordinary business activities, are a
type of expense, so they reduce shareholders’ equity.

LO3 ANALYZE BUSINESS TRANSACTIONS USING T-ACCOUNTS

• Double-Entry System- It is called the double-entry system because every transaction has
two sides and affects two (or more) accounts.

CHART OF ACCOUNTS
 • The chart of accounts lists the name of every account and its unique account number,
but it does not provide the account balances.

Increases and Decreases in the Accounts: The Rules of Debit and Credit

• Increases in assets are recorded on the left (debit) side of the T-account, whereas
decreases are recorded on the right (credit) side. When a business receives cash, the Cash
account increases, so we debit the left side of the Cash account to record the increase in
this asset. When a business makes a cash payment, we credit the right side of the Cash
account to record the decrease in this account.
• Conversely, increases in liabilities and shareholders’ equity are recorded on the right
(credit) side of the T-account, whereas decreases are recorded on the left (debit) side.
When a business receives a loan, the Loan Payable account increases, so we credit the
right side of the Loan Payable account to record the increase in this liability. When a
business makes a loan payment, we debit the left side of the Loan Payable account to
record the decrease in this account.
The Expanded Accounting Equation

• To record an increase in assets, use a debit. • To record a decrease in assets, use a credit.
• For liabilities and shareholders’ equity, these rules are reversed:
• To record an increase in liabilities or shareholders’ equity, use a credit
• To record a decrease in liabilities or shareholders’ equity, use a debit.
RECORD BUSINESS TRANSACTIONS IN THE JOURNAL AND POST THEM TO
THE LEDGER

When recording transactions, accountants use a chronological record called a journal. The
recording process follows these three steps:

1. Specify each account affected by the transaction.

2. Use the rules of debit and credit to determine whether each account is increased or decreased
by the transaction.

3. Record the transaction in the journal, including a brief explanation for the entry and the date of
the transaction. The debit side is entered on the left margin, and the credit side is indented
slightly to the right.

Posting from the Journal to the Ledger

The journal is a chronological record containing all of a company’s transactions. The journal
does not, however, indicate the balances in any of the company’s accounts. To obtain these
balances, we must transfer information from the journal to the ledger, which is an accounting
process we call posting. The ledger contains all of a company’s accounts, along with their
balances as of the most recent posting date. Posting is a simple process of directly transferring
information from the journal to the ledger.

The Flow of Accounting Data

PREPARE
AND USE A
TRIAL
BALANCE\
• A trial balance lists all of a business’s ledger accounts and their balances. Asset accounts
are listed first, followed by the liability accounts, and then all the accounts that affect
shareholders’ equity. We add all the debit balances and all the credit bal-ances and place
the totals at the bottom of the trial balance. If the total debits equal the total credits, we
can go on to prepare the financial statements using the account balances from the trial
balance.