FINANCIAL ACCOUNTING
A USER PERSPECTIVE
Hoskin • Fizzell • Davidson
Second Canadian Edition
Transaction Analysis and
Accounting Entries
Chapter Two
Basic Accounting Equation
Assets =
Liabilities +
Shareholders’ Equity
Transaction Analysis
• Demo Retail Company, Inc. is
formed as a company in
December of 2000.
Transaction Analysis
• Transaction A: Common shares
are issued for $7,500.
• Effects:
– Assets (Cash) increase
– Shareholders’ Equity (Common
Shares) increase
Effects on the Balance Sheet
Exhibit 2-1
= Liabilities + Share-
Assets
Cash
A +7,500
B
C
Inven- Equiptory
ment
Accounts
Payable
Equity
holders’
Common Retained
Shares
Earnings
+7,500
Transaction Analysis
• Transaction B: Purchased
equipment for $4,500.
• Effects:
– Assets (Cash) decrease
– Assets (Equipment) increase
Effects on the Balance Sheet
Exhibit 2-1
= Liabilities + Share-
Assets
Cash
Inven- Equiptory
ment
A +7,500
B -4,500
C
Accounts
Payable
holders’
Common Retained
Shares
Earnings
+7,500
+4,500
Equity
Transaction Analysis
• Transaction C: Purchased $2,500
of inventory on account.
• Effects:
– Assets (Inventory) increase
– Liabilities (Accounts Payable)
increase
Effects on the Balance Sheet
Exhibit 2-1
= Liabilities + Share-
Assets
Cash
Inven- Equiptory
ment
Accounts
Payable
A +7,500
holders’
Common Retained
Shares
Earnings
+7,500
B -4,500
C
Equity
+4,500
+2,500
+2,500
+3,000 +2,500 +4,500 = +2,500
+ +7,500
+0
Demo Retail Company, Ltd.
Balance Sheet
As at December 31, 2000
Assets
Cash
Liabilities
$ 3,000
Inventory
2,500
Equipment
4,500
Accounts payable
$ 2,500
Shareholders’ Equity
Common shares
Retained earnings
7,500
0
Total liabilities and
Total assets
$10,000
shareholders’ equity $10,000
Transaction Analysis Operating Period
• Transaction 1: Sold units of
inventory on account for $2,500.
• Effects:
– Assets (Accounts Receivable)
increase
– Shareholders’ Equity (Retained
Earnings) increases
Revenue Recognition Criteria
• Accrual basis accounting:
measures performance in the
period in which the
performance takes place, rather
than when the cash is collected.
Transaction Analysis
Transaction #1
Assets
Cash Accounts Inventory Prepaid
Land
Insurance
Receivable
+3,000
0
+2,500
0
0
1
Equipment
+4,500
+2,500
Liabilities
Accounts Interest Bank
Payable Payable Loan
+2,500
0
0
1
+ ShareEquity
holders’
Common Retained
Shares
Earnings
+7,500
+2,500 R
Transaction Analysis Operating Period
• Transaction 2: The cost of units
removed from inventory: $1,800.
• Effects:
– Assets (Inventory) decreases
– Shareholders’ Equity (Retained
Earnings) decreases
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.
Transaction Analysis
Transaction #2
Assets
Cash Accounts Inventory Prepaid
Land
Insurance
Receivable
2
Equipment
-1,800
Liabilities
Accounts Interest Bank
Payable Payable Loan
2
+ ShareEquity
holders’
Common Retained
Shares
Earnings
-1,800 E
Transaction Analysis Operating Period
• Transaction 3: Purchase of new
inventory: cost of $2,100.
• Effects:
– Assets (Inventory) increase
– Liabilities (Accounts Payable)
increase
Transaction Analysis
Transaction #3
Assets
Cash Accounts Inventory Prepaid
Land
Insurance
Receivable
3
Equipment
+2,100
Liabilities
Accounts Interest Bank
Payable Payable Loan
3 +2,100
+ ShareEquity
holders’
Common Retained
Shares
Earnings
Transaction Analysis Operating Period
• Transaction 4: Received $2,200
from customers as payments on
their accounts.
• Effects:
– Assets (Cash) increase
– Assets (Accounts Receivable)
decrease
Transaction Analysis
Transaction #4
Assets
Cash Accounts Inventory Prepaid
Land
Insurance
Receivable
Equipment
4 +2,200 -2,200
Liabilities
Accounts Interest Bank
Payable Payable Loan
+ ShareEquity
holders’
Common Retained
Shares
Earnings
Transaction Analysis Operating Period
• Transaction 5: Made payments on
accounts payable: $2,700.
• Effects:
– Assets (Cash) decrease
– Liabilities (Accounts Payable)
decrease
Transaction Analysis
Transaction #5
Assets
Cash Accounts Inventory Prepaid
Land
Insurance
Receivable
Equipment
5 -2,700
Liabilities
Accounts Interest Bank
Payable Payable Loan
5 -2,700
+ ShareEquity
holders’
Common Retained
Shares
Earnings
Transaction Analysis Operating Period
• Transaction 6a: Paid $360 for sixmonth insurance policy.
• Effects:
– Assets (Prepaid Insurance) increase
– Assets (Cash) decrease
Prepaid Expenses
• An amount paid in advance of
the coverage period is recorded
as an Asset (Prepaid Expense).
• When time passes, the coverage
is “consumed,” and is then
recognized as an expense.
Transaction Analysis
Transaction #6a
Assets
Cash Accounts Inventory Prepaid
Land
Insurance
Receivable
6 - 360
a
Liabilities
Accounts Interest Bank
Payable Payable Loan
Equipment
+ 360
+ ShareEquity
holders’
Common Retained
Shares
Earnings
Transaction Analysis Operating Period
• Transaction 6b: One month’s
insurance consumed: $60.
• Effects:
– Assets (Prepaid Insurance)
decrease
– Shareholders’ Equity (Retained
Earnings) decrease
Transaction Analysis
Transaction #6b
Assets
Cash Accounts Inventory Prepaid
Land
Insurance
Receivable
6
b
Equipment
- 60
Liabilities
Accounts Interest Bank
Payable Payable Loan
6
b
+ ShareEquity
holders’
Common Retained
Shares
Earnings
- 60 E
Amortization of Assets
• 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.
Amortization of Assets
• Straight-line Amortization:
Original — Estimated Residual
Cost
Value
Estimated Useful Life
Transaction Analysis Operating Period
• Transaction 7: Amortize
equipment for January: $150.
• Effects:
– Assets (Equipment) decrease
– Shareholders’ Equity (Retained
Earnings) decrease
Transaction Analysis
Transaction #7
Assets
Cash Accounts Inventory Prepaid
Land
Insurance
Receivable
7
Equipment
- 150
Liabilities
Accounts Interest Bank
Payable Payable Loan
7
+ ShareEquity
holders’
Common Retained
Shares
Earnings
- 150 E
Transaction Analysis Operating Period
• Transaction 8a: Issued new shares
for $5,000.
• Effects:
– Assets (Cash) increase
– Shareholders’ Equity (Common
Shares) increase
Transaction Analysis
Transaction #8a
Assets
Cash Accounts Inventory Prepaid
Land
Insurance
Receivable
Equipment
8 +5,000
a
Liabilities
Accounts Interest Bank
Payable Payable Loan
8
a
+ ShareEquity
holders’
Common Retained
Shares
Earnings
+5,000
Transaction Analysis Operating Period
• Transaction 8b: Borrowed from
the bank: $10,000.
• Effects:
– Assets (Cash) increase
– Liabilities (Bank Loan) increase
Transaction Analysis
Transaction #8b
Assets
Cash
Accounts Inventory Prepaid Land
Insurance
Receivable
Equipment
8 +10,000
b
Liabilities
Accounts Interest Bank
Payable Payable Loan
8
b
+10,000
+ ShareEquity
holders’
Common Retained
Shares
Earnings
Transaction Analysis Operating Period
• Transaction 8c: Purchased land
for $15,000.
• Effects:
– Assets (Cash) decrease
– Assets (Land) increase
Transaction Analysis
Transaction #8c
Assets
Cash
Accounts
Receivabl
e
Inventory Prepaid
8 -15,000
c
Liabilities
Accounts Interest Bank
Payable Payable Loan
8
c
Insurance
Land
Equipment
+15,000
+ ShareEquity
holders’
Common Retained
Shares
Earnings
Accrued Expense
• Expenses that are recognized
on the income statement in the
period in which they are
incurred, which is prior to the
period in which they are paid in
cash.
Transaction Analysis Operating Period
• Transaction 9: Recorded one
month’s interest on the loan at 6%:
$10,000 x 6% x 1/12 = $50.
• Effects:
– Shareholders’ Equity (Retained
Earnings) decrease
– Liabilities (Interest Payable) increase
Transaction Analysis
Transaction #9
Assets
Cash Accounts Inventory Prepaid
Land
Insurance
Receivable
Equipment
9
Liabilities
Accounts Interest Bank
Payable Payable Loan
9
+ 50
+ ShareEquity
holders’
Common Retained
Shares
Earnings
- 50 E
Transaction Analysis Operating Period
• Transaction 10: Dividends were
declared and paid: $250.
• Effects:
– Assets (Cash) decrease
– Shareholders’ Equity (Retained
Earnings) decrease
Transaction Analysis
Transaction #10
Assets
Cash
Accounts Inventory Prepaid
Land
Insurance
Receivable
Equipment
10 - 250
Liabilities
Accounts Interest Bank
Payable Payable Loan
10
+ ShareEquity
holders’
Common Retained
Shares
Earnings
- 250 D
Financial Statements
• Balance Sheet
• Income Statement
• Cash Flow Statement
Classified Balance Sheet
• Current assets and liabilities
are distinguished from
noncurrent assets and liabilities
Demo Retail Company, Ltd.
Balance Sheet
As at December 31, 2000
Current Assets
Cash
Current Liabilities
$
Accts receivable
Inventory
Prepaid insurance
1,890
800
2,800
300
Accounts payable
Interest payable
Total current liabilities
Bank loan
$ 1,900
50
1,950
10,000
Total current assets 5,290
Total liabilities
11,950
Land
Common shares
12,500
Equipment
15,000
4,350
Retained earnings
190
Total liabilities and
Total assets
$24,640
shareholders’ equity
$24,640
Income Statement
• Calculates profit (net income)
by subtracting expenses from
revenues for the period.
• Dividends:
– are not expenses
– are payments of earnings to
shareholders.
Demo Retail Company, Ltd.
Income Statement
For the month ended January 31, 2001
Sales revenues
$ 2,500
Less:
Cost of goods sold
(1,800)
Gross profit
700
Amortization expense
(150)
Insurance expense
( 60)
Interest expense
( 50)
Net income
$
440
Profitability Ratios
• Profit Margin Ratio:
Profit
Revenues
Profitability Ratios
• Return on Assets:
Profit
Average total assets invested
Profitability Ratios
• Return on Equity:
Profit
Average total shareholders’
equity
Cash Flow Statement
• Explains the changes in cash flow
during the period
• Details changes in:
– Operating activities
– Investing activities
– Financing activities
Demo Retail Company, Ltd.
Cash Flow Statement
For the month ended January 31, 2001
Cash from operating activities:
Cash receipts from customers
$ 2,200
Cash disbursement to suppliers
(2,700)
Cash disbursement for insurance
( 360)
Cash flow from operating activities
$ (860)
Demo Retail Company, Ltd.
Cash Flow Statement
For the month ended January 31, 2001
Cash from investing activities:
Purchase of land
(15,000)
Cash from financing activities:
Proceeds from issuance of common shares 5,000
Proceeds from bank loan
Dividends paid
Cash flow from financing activities
Decrease in cash
10,000
( 250)
14,750
$ ( 1,110)